Farmington Finance SIV: A Look at a Key Contributor to the 2008 Crisis
Farmington Finance was a structured investment vehicle (SIV) sponsored and managed by Lehman Brothers. SIVs, like Farmington, were complex financial entities that played a significant role in the lead-up to the 2008 financial crisis. Understanding Farmington Finance is crucial to grasping the mechanics of the crisis.
The primary purpose of Farmington Finance, like other SIVs, was to generate profit through arbitrage. It did this by issuing short-term debt, primarily in the form of asset-backed commercial paper (ABCP), and using the proceeds to invest in longer-term, higher-yielding assets. This difference in maturity and yield, known as the maturity transformation, was the source of profit. Farmington invested primarily in mortgage-backed securities (MBS), collateralized debt obligations (CDOs), and other asset-backed securities.
The business model of Farmington Finance was predicated on a stable and liquid market for its assets and continuous access to short-term funding. As long as the short-term debt markets remained open and the value of its investments held stable, the SIV could refinance its maturing ABCP and continue to generate profit. Crucially, the value of the assets needed to remain high enough to provide adequate collateral for the short-term debt.
However, this model was inherently fragile. The collapse of the housing market in 2007 triggered a chain reaction. The value of the mortgage-backed securities held by Farmington Finance plummeted. This decline in value made it increasingly difficult for the SIV to refinance its ABCP. Investors became wary of purchasing short-term debt backed by increasingly risky assets. As confidence eroded, the market for ABCP dried up, leaving Farmington Finance unable to roll over its maturing debt.
With no access to short-term funding, Farmington Finance faced a liquidity crisis. It was unable to meet its obligations, and its assets had to be sold at fire-sale prices, further depressing their value. This distressed selling added to the downward pressure on the market for mortgage-backed securities, contributing to the broader financial crisis. Lehman Brothers, as the sponsor, was ultimately forced to absorb Farmington Finance’s losses, further weakening its already precarious financial position.
Farmington Finance exemplifies the risks associated with complex financial instruments like SIVs. Its reliance on short-term funding and its exposure to risky assets made it particularly vulnerable to market disruptions. The failure of Farmington Finance, along with other SIVs, highlighted the systemic risks embedded in the financial system and contributed significantly to the severity of the 2008 financial crisis. It underscored the dangers of excessive leverage, inadequate risk management, and the interconnectedness of financial institutions.
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