ft.com/alphaville

It is a truth almost universally acknowledged that a hedge fund in possession of a vast pile of finance will eventually start pursuing risky strategies when markets look too boring for too long, asserts the FT’s Gillian Tett.

So it should be no surprise that the era of ultra-low volatility that existed until last week has produced endless rumours about hedge funds using high-octane gambits to create returns.

But could this gamble with risk have seeped into some corners of the corporate world as well? Hitherto, it has been presumed that the answer was “no”. After all, outside the private equity sector, there has been precious little evidence that the corporate world has been loading itself up with excess leverage.

But recently, talk of high-risk funding antics involving mid-sized companies in places such as Gemany and Italy has emerged. While the scale of this activity is unclear, the rumours are worth noting, Tett argues, not least because if these strategies are proliferating, they have the potential to produce unexpected losses if market volatility turns nastier in the months ahead.

The issue at stake revolves around structures that bankers sometime dub “snowball notes”. These structures apparently work like this: a company will cut a derivatives deal with a bank that in effect provides virtually free funding for a year or two, thus allowing corporate executives to flatter their accounts or stave off a cash crisis.

But if the finance is not quickly repaid and certain trigger points are breached, often linked to market interest rates, funding costs spiral dramatically. In one such allegedly typical structure shown to Tett, interest rates surge to almost 50 per cent after three years if the markets do not move as the company expects. This should make even a loan shark blush.

None of this, of course, is entirely new: as long ago as 1994, P&G was buying risky derivatives structures, which initially offered ultra-cheap financing (but then later caused unexpected losses).

But local European banks have started selling variations on these structures to mid-cap companies again over the last year, before later hedging their own exposure via bulge-bracket banks, in London markets. And the associated leverage can be very high, making them highly sensitive to market swings. In a typical deal, a structure with a notional value of €75m can have more than €8m vega on it, meaning that any rise in volatility can create large losses. Vega measures sensitivity to a key market parameter such as interest rate volatility.

Tett estimates the actual number of snowball deals in the markets is still relatively small, although it is impossible to tell: such deals are apparently being placed, in great secrecy, in private markets and often involve privately held companies, such as the German Mittelstand. Indeed, the bulge-bracket banks often only learn about them as a result of associated hedging.

Nevertheless, whatever the scale, the tale is striking for at least two reasons:

• First, some bankers suspect that the asymmetric hedging activity generated by the snowballs has helped to suppress market volatility in the past year. That is essentially because these deals are so sensitive to volatility that banks involved engage in hefty hedging, but end users — ie companies — are not following suit.
• But the second, most important point is that structures such as snowballs could potentially give a new tenor to any future debate about how the financial world has conducted itself this decade. After all, if a serious market shock does hit in the future, politicians are unlikely to shed too many tears if some hedge funds blow up. But companies are a different matter. Just take a look at the scandal that erupted in the US in the 1990s once the losses from the P&G trade emerged.

That is just one more reason to hope that last week’s market volatility has served to inject a new, badly needed dose of caution among financiers and investors, Tett concludes. And perhaps even any company that has ever been tempted to use this “snowball trade.”