Refinancing a conduit structure is done through a special purpose vehicle SPV, and these include purchased securities or claims such as loans and receivables. The securities may be short-term (short maturities) be it asset-backed commercial paper (ABCP) or medium term (medium term notes).
In a conduit, different programs from various clients are often combined. This is summarized by each client holding a pool of identical ssets, whose value in the context of the history and structure is checked.
A structured investment vehicle (SIV) can be viewed as a virtual bank. Which apart from accumulating deposits from its clients, alternatively takes up funds through trading short maturity commercial paper on the money market.
The rate of interest billed is normally nearer to the LIBOR (bank to bank lending rate). In turn the bank employs the money to acquire long term bonds with higher interest.
Based on the failure history and the related asset quality, a percentage of the total amount of these assets will be funded through money market instruments. The remaining reduction is called collateralisation.
The arrangement also provides banking facilities under the ABCP program, these include liquidity facilities, letters of credit or subordinated loans. The amount of these facilities is usually determined by the rating agencies in order to achieve the corresponding rating of the issued money market instruments. The facilities are generally considered due to short-term sales problems of commercial paper in the money market or short-term uncollectibility of the claims.
The short-term securities provided by a structured investment vehicle frequently comprise two levels of liabilities, and these include junior and senior, that come with a leverage ratio of between ten to fifteen. As can be expected, the senior debt has ratings ranging from AAA/Aaa/AAA to A-1+/P-1/F1.
Rating may apply to the junior debt, however in cases where rating is applied it generally hovers in the region of BBB. With the exception of a mezzanine tranche rated A. Medium-term notes (MTN) and commercial paper (CP) usually make up the bulk of the senior debt.
As a means of upholding their high ratings, structured investment vehicles (SIVs) can be compelled to secure liquidity facilities (otherwise known as back-stop facilities) from financial institutions to compensate for their senior issuance. In principle, this assists in cutting down investor exposure to any eventualities in market activities such as disruptions, since these have the potential of undermining the refinancing of CP debt.
The subprime crisis in the United States and the sudden illiquidity of the ABCP securities and asset-backed securities in 2007, landed many banks in existential crises, given that their purchased receivables could not refinance in the money market.