These two SIVs, and a number of others, were not able to roll over their commercial paper, nor were they able to repay maturing debt by selling off their double-A and triple-A bond investments, which were supposed to be highly marketable. Today, the rating agencies and the SIV sponsors now throw up their hands and say, "Who could have foreseen this meltdown?"
Just about anyone who understands the commercial paper markets. A buyer of commercial expects a clear and cogent answer to a simple and direct question: How can I be sure that I'll get repaid on time? The answer, except for SIVs, is always the same. In 2007, the same answer applied to Exxon, Lehman Brothers, to AMBAC and to AIG.
Exxon and every other major corporate issuer of commercial paper had a 100% liquidity backup, whereas SIVs did not. If Exxon were faced with bad news, or if the commercial paper market suddenly froze up, it could repay all of its maturing commercial paper, by drawing down on an unused committed bank facility. These bank facilities were set up precisely to deal with that type of market risk, the seemingly remote possibility that the commercial paper market could suddenly become frozen.
Exxon may have been financially stronger than most banks, but in times of market havoc, the banks, not Exxon, had direct access to the discount window of the Fed. That is, during times of market turmoil, a bank that is stretched for cash can always borrow short-term funds from the Federal Reserve, by pledging the notes of its bank loans as collateral.
Commercial paper rates were comparable to the fed funds rate because of this indirect access to the Fed's discount window.
Stronger Than Exxon? Stronger than a Bank?
SIVs
were part of the shadow banking system--which included Lehman, AMBAC and
AIG--because they financed long-term assets with short-term debt, commercial
paper that must be continually rolled over. But SIVs were different because they
lacked a 100% liquidity backstop; it was more like 8% to 16%. This was why SIV paper was much riskier
than all other forms of commercial paper. When Golden Key was launched in 2005,
the commercial paper had a 9% liquidity backup provided by pre-funded notes.
Consider the level of confidence S&P had in the safety of those triple-A notes ranked in the bottom 10% of the capital structure. Only the strongest banks, which all had the implicit support of the Fed, had triple-A ratings assigned to their most senior obligations. (In 2007 these included JPMorgan, Citi and BofA.) By contrast, the bottom 10% of a banks' capital structure was deemed to be equity, and generally unrated.
Why did Golden Key's subordinated notes deserve such high credit ratings? Because of the investment portfolio's grade point average, or in Moody's nomenclature, a Weighted Average Rating Factor. The SIV was required to maintain a bond portfolio with minimum ratings of triple-A for 30% of the portfolio, and double-A-minus for the remaining 70%.
The rating agencies had extraordinary confidence in an SIV's ability to withstand a proverbial run on the bank. If a deposit taking institution suffers a run on the bank, it can access the discount window of the fed to maintain sufficient liquidity. If an SIV suffers a run on the bank, i.e. when the CP cannot be rolled over, it should be able to promptly pay off its debt obligations by liquidating its triple-A and double-A bonds at prices close to par.
How could S&P, or anyone, establish such confidence?
Rating Agencies As Bank Regulators
"SIVs were quite frankly banks, just narrowly focused banks," says Henry Tabe, formerly the SIV guru at Moody's. The difference was that SIVs were aggressively regulated by the rating agencies. " Unlike banks, structured investment vehicles had restrictions placed on the type of assets they could buy," Tabe continues. "They had restrictions placed on concentrations of assets; they had restrictions placed on their bankruptcy remote status. So all of these structured finance type features enabled SIVs to be rated triple-A."
SIVs were not like other rated entities. They were required to demonstrate, each and every business day, that they deserved to retain their triple-A ratings, based on a battery of financial tests. Most of the tests, which were designed and sanctioned by the rating agencies, were calculated daily. And all test results were forwarded to the rating agencies on a weekly basis
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