In a few words SIVs are "investment tools" - approved by the Financial Accounting Standards Board (FASB) - that give our largest financial institutions the legal means to transfer billions of dollars worth of toxic crap off their books. As a result of this neat "deregulation" gift companies like Merrill Lynch, Citigroup, etc. looked much better right before the market crash.
If you're having trouble understanding the concept think of this: It would be the same as if you were able to legally take your credit card debts, your car payments, and other annoying debts off of your financial statements. You could then get additional lines of credit, and continue doing business as usual ... like buying more toxic crap.
I'm oversimplifying, but this is how it worked for Merrill Lynch ...
1. BAD BETS: Because they're greedy and stupid they made terrible investments in soon to be toxic mortgage-backed securities (also called collaterlitized debt obligations, or CDOs). They now had toxic crap they needed to get off their books.
2. FRAUD FRONTS: Merrill Lynch created a special company, Pyxis, which helped them borrow money. Pyxis issued I.O.U.s saying they would pay the borrowed money back (referred to as issuing short-term debt).
3. SIV DEBT BOMBS: With borrowed money Pyxis purchased portions (tranches) of toxic crap from Merrill's CDOs. These purchases by Pyxis created our SIVs and made it look like someone else (Pyxis) was on the hook for the toxic crap Merrill Lynch had in their CDOs.
4. SMOKE & MIRRORS: To make the people at Pyxis look legit Merrill entered into a "derivatives" contract (known as a "total return swap"), which obliged Merrill to cover any losses at Pyxis. Because derivative markets are NOT controlled or regulated like the NYSE billions of dollars of these toxic contracts flew under the regulatory radar.
This is how Merrill Lynch was able to claim that it was exposed to only about $15.2 billion in toxic crap. In reality it was actually exposed to $46 billion worth of securities that would eventually collapse. As I pointed out in December, these neat little financial toilets allowed our nation's largest financial institutions to flush billions of dollars in future losses off their books, legally.
This encouraged Merrill Lynch - and other firms on Wall Street - to go out and create more CDO and derivative contracts (for which they paid themselves handsome fees and bonuses).
I ask you, is this financial innovation or financial fraud? The geniuses on Wall Street think it's financial innovation.
However you look at it (it's "control fraud" in William K. Black's book) there's little doubt that even the experts who have a reputation for understanding the nitty gritty behind these transactions find the details hard to follow, or understand. Take a look at this and this to see what I mean.
This is important because the rules were changed after the 2008 market collapse so that banks had to bring certain derivative assets back on to their balance sheets.
But - and this is a very big "but" - companies like Wells Fargo found that they would NOT have to add certain derivatives back on their books after all. Why? Because, while they believed they would have to add $46 billion back on to the books, government guarantees from the bailout programs (and other agency guarantees) allows Wells Fargo to claim that they're only exposed to $10 billion in losses from the derivatives market ... when they're actually into the derivatives market for $2 trillion (see page 31).
Throw in the trillions Bank of America, JPMorgan Chase, etc. have in derivative markets and you can imagine how much value in toxic derivatives we still have out there (to get an idea you can start here, here, and here ...)