Structured Investment Vehicles (SIVs), like Mortgage-Backed Securities (MBSs), are an option banks have to lend more money than deposits alone would allow, and are simple in concept but tricky in detail. Looking at the big picture, with SIVs banks expand their deposit base by selling short-term bonds. In essence, bond investors become depositors. Like deposits, capital is given to banks for which interest is paid in return, and then banks lend it out a higher rate, which is called the "carry trade."
Now, the detail. These bonds are called “commercial paper,” and typically mature in a month. They are regarded as very low risk, about as safe as cash, while paying moderate returns. Their advantage over regular deposits is they pay more. Their disadvantage is they are not FDIC insured (generally, except for CDs which are included in the term), and require more oversight. These are sold month-to-month at auctions. As long as there is an endless stream of buyers, banks have this source of extra capital to work with.
So, say Sally wants $300,000 for a mortgage, and the bank has no capital to lend. But she appears to be a good risk. So, on January 1, they sell $100,000 commercial paper, with a term of one month, to Tom, Dick, and Harry, at 5% (per annum month adjusted). They now have the $300,000 to lend Sally, at a rate of 7%. February 1 rolls around, and Tom, Dick and Harry want their money with interest. So the bank puts more commercial paper up for auction: three $100,000 bonds are sold to Larry, Moe, and Curly, at 5%. With that money, they pay Tom, Dick, and Harry their principle, and with Sally’s first mortgage payment of 7% (per annum month adjusted, plus a little more for the principle) they pay the 5% interest to Tom, Dick, and Harry, who are made whole. The bank profits by 2% (per annum month adjusted); that’s $6000 per year the bank gets for managing the SIV (plus other fees). March 1 rolls around and it’s the same thing, month after month, for the life of the loan.
Pretty smart, no? Yeah, smart until the buyers of commercial paper go elsewhere, which is what happened in Fall of 2007. Maybe all the news about subprime mortgages spooked them a little. Maybe with Federal funds rates rising there are just better investments in other places. Without this monthly turnover at auctions, commercial paper freezes. The system collapses if the bank can’t find new buyers to pay off buyers from the prior month. It would be in a pinch; they have to scramble to get that money from somewhere else.
Maybe they could by answering all the credit card mail they get—or maybe from Papa Luigi’s Sharks-r-Us Emporium. No, banks get helicopter money instead. Even more, Bernanke happily took their garbage high risk securities and gave them treasury bonds in exchange. This is what happened in November 2007-March 2008, and perhaps this is only the beginning.
ADDENDUM (8/8/08): Recent events around banks forced by regulators to pay delinquent auction rate securities reveal that I was a little bit off in how this works. If Tom, Dick, and Harry each buy $100,000 worth of commercial paper, at 3% interest, with a 30-day cycle, the bank does not refund the principle at the end of 30 days. Rather, investors get their interest payment, the bank continues to hold the capital, and then investors can continue to hold the bond for another month or put it up for auction where their principle would be repurchased by a new buyer.