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Gordian Knot - Sigma Finance, Ltd. - SIV

2008-10-02

Count of distinct funds: 1
Capital base: $27B
Loss: possibly as much as $5B

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stories: wsj.com

Gordian Knot's $27 billion Sigma Finance SIV is being shut down. The Lehman bankruptcy and surrounding market turmoil was the kicker. According to the WSJ:

Sigma survived in part because it had invested in high-quality securities, and because it had taken precautions to protect itself from being forced to sell its assets if markets turned against it.

The Lehman default, however, proved fatal -- not only because the fund held an estimated $110 million in Lehman debt, but because it had come to depend heavily on the so-called repo market to finance its investments. In a repo transaction, a fund turns over securities as temporary collateral for a loan, then buys them back at a price that includes interest. If the value of the collateral falls below a certain level, the lender can demand added collateral in a move known as a margin call.

Lehman's default on Sept. 15 precipitated a drop in the value of the bank-issued bonds that make up nearly two-thirds of Sigma's investments. That, in turn, led to increased margin calls from lenders and a depletion of Sigma's cash reserves, according to a report from ratings firm Moody's Investors Service.

On Monday, one of Sigma's lenders, J.P. Morgan Chase & Co., terminated its repo agreements, followed by HSBC Holdings PLC and Royal Bank of Scotland Group PLC, people familiar with the matter say. On Tuesday, at least one lender issued a notice of default, according to Moody's. As a result, all of Sigma's lenders are expected to move to seize Sigma's assets if they haven't already, essentially paralyzing the fund.

Regarding the extent of the pain and where it might fall:

The default will likely leave investors in some $6 billion of Sigma's own debt holding paper worth as little as 15 cents on the dollar, and allows banks that lent to Sigma to sell some $25 billion in collateral, consisting largely of bank-issued bonds.

If the banks sell, they could worsen the pain in credit markets, which have suffered in recent weeks on concerns that banks and funds will be unable to honor their obligations. "This doesn't help," said Howard Simons, a bond strategist at Bianco Research in Chicago. "The lending markets that banks rely on were already rattled before this."

Sigma's lenders could choose to keep the fund's souring assets, rather than sell into a weak market. In that case, they could face a total of some $2 billion in write-downs, according to a report from Citigroup Inc. On Tuesday, at least three banks were circulating lists of Sigma assets to potential buyers to get a sense of what they would be worth, people familiar with the matter say.

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Important: This fund is on our list of hedge funds that have "imploded" (see also ailing lenders). However, please note that "imploded" is a somewhat subjective. The "imploded" list contains hedge funds (or other unregulated and autonomous speculative investment funds) which have gone through some sort of permanent adverse change. This is a somewhat subjective call, and does not necessarily mean total shutdown or bankruptcy. It can also mean steep and rapid mark-downs in net asset value; or abnormal "bail-out" by corporate parents or peers in order to avoid write-downs and provide liquidity. The funds are of any type and sector.