The Insidious SIV

The latest and greatest carry trade threat to the capital markets is the structured investment vehicle (SIV). A month ago, I'd never heard of an SIV. Now I'm sweating buckets that the estimated $400 billion in SIVs outstanding might derail the capital markets. What happened, and what does it mean for the rest of us?

At the risk of oversimplifying, an SIV is an entity set up when a bank buys long-term assets and finances them by issuing short-term commercial paper (CP). The bank gets a fee for managing the SIV, but can keep the SIV's debt off the balance sheet because it doesn't take on the credit risk. However, many banks agreed to give the SIV a liquidity backstop -- meaning the bank ensures that the SIV will be able to refinance its short-term CP debt.

That liquidity guarantee is coming back to haunt the banks. Until very recently, it would have been almost laughable to predict that the commercial paper markets would come to a screeching halt. The CP markets are extremely deep and liquid.

However, these are not normal times, and the CP markets, especially the asset-backed CP markets, are very, very unaccommodating right now.

What now?
With many banks facing obligations -- based on contracts or their reputations -- to provide liquidity backstops to their SIVs, it's very important that the banks solve this problem. If the banks can't find CP buyers, they will have to fund the SIVs themselves -- no easy task given the amounts of money in play here.

There's an estimated $400 billion in SIVs outstanding, and according to The Wall Street Journal, Barclays (NYSE: BCS  ) recently injected $1.6 billion into one of its SIV affiliates, HSBC (NYSE: HBC  ) had an SIV affiliate with $35 billion in debt, and Citigroup (NYSE: C  ) manages SIVs with a whopping $80 billion in assets.

I recently listened in on Zions Bancorp's (Nasdaq: ZION  ) conference call. Zions has a SIV-like affiliate (called Lockhart) with $3.1 billion in debt. Management noted that the CP markets had been accommodating enough to allow it to reduce the assets it had assumed from the SIV to $160 million now from $500 million at the end of the latest quarter. The company also thought that Lockhart had stabilized and would be able to function on its own.

So it appears that the players with smaller SIV exposures may be able to breathe easier. However, for banks with larger exposures, it might get tricky.

Enter the superSIV
To deal with the billions of SIV debt coming due in the near term, the largest banks like Citigroup, and Income Investor recommendations Bank of America (NYSE: BAC  ) and JPMorgan Chase (NYSE: JPM  ) , are trying to raise a fund of up to $100 billion to help roll over near-term SIV debt.

Will it work?
It had better, because the stakes are high. It's telling that Bank of America and JPMorgan are involved, because they don't have any SIV debt. Rather, according to the Journal, they're in it for the fees.

I'm merely speculating, but I think they feel an obligation to help avert additional problems the SIVs may cause. After all, an SIV-induced panic would harm nearly every major financial player, regardless of whether they hold SIVs.

Keep in mind, the main problem with SIVs isn't that the loans they hold are defaulting, it's that the credit market turmoil has disrupted their ability to find short-term financing in the CP markets.

What Fools should do
Keep an eye on any SIV-related news. If the superSIV goes well, and buys the big banks time to wait for the CP markets to heal, then that's a good sign that we may have a softer landing. If the CP markets close up again and the banks have a hard time rolling over their SIV debt, then we may be in for major turbulence.

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