Structured investment vehicle investors, as well as Standard & Poor's and Moody's Investors Service, have been increasingly perplexed over the timing of Fitch Rating's recent decision to place the long- and short-term ratings of Gordian Knot Ltd.'s SIV, Sigma Finance Corp., on Rating Watch Negative.

In what some market participants have characterized as a "playground spat" between the rating agency and the U.K.-based investment manager, Fitch announced its Rating Watch action on Gordian Knot's SIV, which has a balance sheet of $32.5 billion, on Feb. 14, threatening to lower the ratings to A' long-term and F1' short-term, from the SIV's current status of AAA/F1+'. Citing the need for "greater transparency to investors" and the spectre of "operational risk issues" associated with the SIV, Fitch expressed serious concerns over several proposed structural changes to Sigma which Gordian plans to implement within the next year.

The funding cost for Sigma's paper widened between two and five basis points on the news of Fitch's action, sources say, while medium-term notes with a maturity of one year and out widened five to six basis points.

Gordian Knot's proposed changes to Sigma, which involve the removal of certain market-value, liquidity and defeasance triggers in favor of a book-value capital approach, are intended to alter the SIV's structure so that the program can grow to a higher level without the threat of a sudden, precipitous and irreversible unwind should the vehicle need to delever during a period of credit and liquidity stress. The way Sigma's operational/capital structure is set up now, any such period of stress will activate defeasance triggers, which, once breached, would cause Sigma to shut down its doors forever - there would be no way back, sources say.

With the proposed structural changes, however, many of these triggers would be removed, and the "instant liquidation" scenario would be prevented.

According to market sources, not only is this the first time that the senior debt of an SIV has been placed on Watch, but investors say that Gordian Knot's SIV - which is ironically one of the lowest-levered and fastest-growing in the market - absolutely must get the approval of all three rating agencies before any overhaul is made to Sigma's structure. Moreover, Gordian has been discussing this with the rating agencies for well over a year in private negotiations, and the actual proposed changes have not even been fully developed yet. Therefore, market sources say, Fitch's action is both premature and moot.

"I applaud Fitch in their continued effort to improve transparency in the ratings process; however, its recent watchlisting of Sigma may have erred too much on the liberal side," said one SIV investor. "It appears overzealous to watchlist a $30 billion program based on changes that may occur six months from now, or may not even occur at all. Moreover, since Sigma is required to obtain approval by each of the three rating agencies prior to any structural implementation, why did Fitch take action, since it can effectively prevent those proposed changes from occurring?"

Nobody seems to have a clear-cut answer yet. And to intensify the spotlight on Fitch's decision, S&P affirmed the SIV's triple-A ratings (AAA/A1+') right after Fitch's announcement, while Moody's affirmed them the very next day (Aaa/P-1'). Both agencies stressed that in addition to the fact that these changes have not been implemented yet, any changes whatsoever to Sigma's structural features would have to be pre-approved by all three rating agencies. In fact, the other agencies see the changes as broadly positive for the SIV.



Therefore, investors ask, why is Fitch Ratings putting the SIV on Rating Watch now, especially when it has full power to revoke any material changes to Sigma Finance anyway? Market participants contend that the decision, and its timing, doesn't make sense.

Some sources speculate that Fitch's action was prompted by the agency's assumption that Gordian Knot would go ahead and make these fairly monumental changes to Sigma without involving them.

However, executives at Gordian Knot have made it clear that this is absolutely not so, as the investment manager always intended to make each rating agency comfortable with any proposed restructuring of Sigma's capital methodology. "We have every intention to have a resolution with Fitch," said Nicholas Sossidis, who co-founded Gordian Knot in 1993 along with fellow ex-Citibank partner Stephen Partridge-Hicks. "As to the question of why they chose to Watch List now, I don't have an answer. Not only does [Fitch] have veto power over changes, but we had every intention and still have every intention to have them involved and we are not going to move ahead without them."

The whole ordeal, therefore, may just be a misunderstanding. However, Fitch defends its position by maintaining that its action is consistent with the role that the agency plays in informing investors of events that could have a possible negative effect on senior note-holders. "When the management of an entity that we rate wants and needs to make material changes to their program - and even highlights some of their own concerns with existing structures, concerns that dovetail with Fitch's concerns - then that is information which is material to existing investors, and potential investors," said Roger Merritt of Fitch Ratings. "Sigma's management has been very determined to move forward on these structural changes, and in fact are under pressure to make these changes. We believe that this is material information that should be publicly disclosed to investors."

Interestingly, however, in a previous special report regarding Sigma Finance Corp. issued on Dec. 20, 1999, Fitch affirmed its AAA/F1+' ratings after a thorough analysis of several risks that can affect the full and timely payment of Sigma and Sigma Inc. senior debt: "Fitch IBCA believes that these risks are addressed through the company's stringent operating guidelines and are consistent with the AAA/F1+' ratings," the report said.

This judgment, Fitch claims, is contingent on the "termination" or "defeasance" structure which would follow any of various trigger events. Without those trigger events woven into the fabric of Sigma's capital structure, "downside protection is weaker, the period of risk is extended and credit protection for senior debt-holders may be reduced," Fitch now says.

However, the other rating agencies construe the proposed changes as potentially positive developments for Sigma. "Our philosophy has been to provide this vehicle with the options and flexibilities to right itself [should it hit stress levels], while still maintaining its triple-A rating," said Perry Inglis, a director from S&P's London office. "We were actually surprised as well by the timing of Fitch's action, and our surprise was that these discussions have been ongoing for some time. We are aware that Gordian is successful in growing to a significant size now, and we are aware that the vehicle has a fairly short period of correction, if there is a downgrade."

Investors often refer to this short period of correction as a "cliff," meaning that if some of the triggers are hit, the whole portfolio would wind down, or go off the cliff. This is more a function of the time period during which Sigma was formed; more recent SIVs could correct themselves if a trigger is hit, and come back into normal-operations mode. They would not have to delever 100% of their securities. However, if one of Sigma's triggers is hit, the entire portfolio would have to be sold as maturing liabilities come due.

"These changes [to Sigma] may be beneficial as long as you don't remove other protections," added Richard Hewitt, a senior vice president in Moody's London office.

The issue of disclosure

Therefore, the ongoing discussions between Gordian Knot and the rating agencies revolved around the "easing" of this cliff, so that the termination structure would be partially eliminated. With all the new SIVs currently coming out, sources say Gordian hoped that adjusting the defeasance structure would give them a competitive advantage in attracting capital note-holders, and therefore a larger avenue for the growth of Sigma.

Even though these discussions are not over yet, Fitch seems to have taken a preemptive move to protect noteholders. One central issue that the rating agency brings up is the poor disclosure of the portfolio securities within SIVs. While Fitch reviews a "summary analysis" of the securities in the vehicles, the exact securities are never seen by the rating agency, or by investors for that matter.

S&P and Moody's, on the other hand, have a record of each and every asset within an SIV, in addition to the bonds' CUSIP numbers. "We see this as an important part of our surveillance analysis," Inglis said, since some of the assets are marked to market and appear in several different SIVs.

"SIVs must disclose a large amount of information to rating agencies on a regular basis," added Moody's Hewitt.

But the overarching question that market participants are asking is why this year-long private negotiation between Gordian Knot and the rating agencies has been brought into the public eye. "Gordian immediately had a conference call with investors the night that the Fitch announcement came out, which is both appropriate and good," said one source close to the situation. "But given that an SIV can't boot any rating agency off it, what is this doing in the public arena, especially for the short-term market?"

Despite differences in levels of disclosure to the rating agencies, it is clear that Gordian Knot is not going to proceed with structural changes to Sigma without Fitch's approval. Both sides say that they are talking with each other actively and working towards an expedient resolution that addresses concerns that are of interest to CP and MTN holders.

Still investors want answers as to Fitch's motivations. "In the end, I think Fitch caused unnecessary confusion and a level of panic in the market for a program that has been historically conservative and fundamentally sound," the SIV investor said.

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