Question

Explain how liquidity risk led to the downfall of Structured Investment Vehicles (SIVs)

Answer 1

Structured investment vehicles are investment vehicles that have been designed in such a way that it will attempt to profit from the credit spread of short term debt and long term debt financial products like mortgage and asset backed securities.

These are generally related to funding of the long term assets with the short-term securities like commercial papers and when there is a liquid freeze in the entire economy then the credibility of organisation to fund their long-term asset will be in questions so, the firm is not able to fulfill their short term debt repayment schedule because they are not able to raise the short term money and they do not have the liquidity, so these structured investment vehicles are highly prone to the change in the economic cycle due to freeze in the liquidity.

When there is an adverse economic cycle and there is a a lack of credit and freeze in the liquidity of the company then the company is not able to find the long-term asset using the short term fund and the short term funds will be having repayment obligation and the company will be defaulting on them, so it will be leading to liquidity risk on structured investment and it led to its downfall.