Thursday, October 2, 2008
Sigma collapse ends shadow bank project
In the context of the string of bank failures, bail-outs and the political battles in Washington in the past month, the collapse last night of the last vehicle from a once $400bn-plus industry might seem a relatively obscure footnote. But a wind-down of Sigma Finance, the oldest and once the single largest structured investment vehicle, marks the final chapter in an extraordinary project to create a credit industry outside the world of traditional banking. The "shadow banks" came to play a crucial role in the latter stages of the bubble when the acceleration in mortgage-backed bond issuance and the arrival of new entrants with a greater risk appetite helped channel billions of dollars from short-term debt markets into the finance industry. When the credit crunch struck in the summer of 2007, however, the SIV industry was at the heart of the troubles because the sudden withdrawal of liquidity from all funding markets that could possibly be exposed to US subprime mortgages put huge pressure on the business model. The past month, which has included the biggest debt default the financial industry has seen in the shape of Lehman, along with tensions in the money market worse than at any previous point in the crisis, finally pushed Sigma over the edge. The vehicle, which is managed by London-based Gordian Knot, managed to outlive its rivals by months, mainly through its ability to raise funding directly from banks in the form of repo, or repurchase, agreements. It received up to $17bn worth of repo funding, but had to pledge up to $25bn worth of collateral in exchange. Stephen Partridge-Hicks and Nicholas Sossidis, the founders of Gordian who pioneered the first SIVs while at Citigroup in the mid-1980s, also protected Sigma by getting its lenders to agree to knock out the market-value-based triggers on their investments that can restrict such a vehicle's operations. Such triggers have been the downfall of most of the 30-plus other SIVs since last summer. However, Moody's and Standard & Poor's both said late on Monday that one repo counterparty had filed a notice of default on its funding to Sigma, seizing collateral. That bank, JPMorgan, was followed yesterday by at least one other repo lender filing a notice of default. JPMorgan would not comment on the situation. Nor would the agencies or other repo lenders such as HSBC, RBS and Deutsche Bank - the last of which also owns equity in Gordian. Moody's and S&P said one filing of default might lead to others. The standardised master agreements that govern repo contracts generally include a cross-default clause such that if one notice is filed, others are triggered. Neither agency would comment on the specifics of Sigma's contracts. However, the fact that one of the strongest banks filed the first default removed doubts that the notice was more to do with the funding problems at a lending bank than with the SIV itself. Senior management at JPMorgan have been uneasy about SIVs for several years, largely because they became concerned about the risks created by maturity mismatches much earlier than other banks. Earlier this decade, the bank was running credit lines to SIVs worth more than $10bn. However, after 2003, it slashed those lines to well under $1bn. JPMorgan also inherited a SIV as a result of its merger with Bank One in 1994, but subsequently sold this on, much to the surprise of many rivals who saw the vehicles as cash cows. This stance was a dramatic contrast to Citi, which came to dominate the SIV world, running seven vehicles with assets of almost $100bn at their peak. However, JPMorgan managers did not believe that the returns and fees were high enough to justify the inherent liquidity risks of such funds. However, the one SIV that the bank continued to deal with was Sigma, partly because it believed that in removing market value triggers in 2003 it had conquered one of the biggest risks to such vehicles. JPMorgan also had longstanding dealings with Sigma's founders, and it helped to arrange a synthetic SIV that Sigma created a few years ago. This was believed to pose less risk since it required less funding, due to the use of derivatives. Banks provided repo financing to the tune of $17bn, but held $25bn of collateral to protect them from losses. If all the collateral is seized, this would leave only $2bn left to share out between $6bn of senior medium-term noteholders. Analysts at Citigroup estimate that repo providers would not recover all their financing through asset sales and would make up to $2.5bn worth of residual claims against Sigma. These claims would rank alongside the medium-term notes and would recover only 15 to 20 per cent of what they were owed, the analysts said. "We do not believe that repo counterparties will necessarily liquidate their collateral, but they are making sure they can document current [distressed] market levels for their claims against Sigma," Birgit Specht at Citi said. "The outcome for senior creditors looks grim." These losses would be greater than those incurred by investors in SIVs placed in receivership. Some of the latter, including Cheyne Finance, have recently been auctioning assets. Sigma also has $4bn of junior capital-note investors, who are very likely to be wiped out now that the vehicle has collapsed.