Snowball traders playing loose in high-risk leverage game
By Gillian Tett
Financial Times: March 9 2007
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.
Thus 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?
Until now, 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 in recent weeks, a tale has reached me about the emergence of some
high-risk funding antics involving mid-sized companies in places such as
Gemany and Italy.
And while the scale of this activity is unclear, the rumours are worth
noting - 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,
with a dose of black humour, "snowball notes". (This is not a joke: if
you don't believe me, try tapping this phrase into Google or Yahoo).
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 that was shown to
me, 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, Procter
and Gamble was buying risky derivatives structures, which initially
offered ultra-cheap financing (but then later caused unexpected losses).
But apparently 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 apparently 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.)
"When I read of central bankers sitting around scratching their heads
worried about foreign exchange carry trades I start thinking that they
really don't understand where the really horrific leverage is out
there," observers one banker who has seen such trades.
I would hazard a guess that the actual number of snowball deals in the
markets is still relatively small though 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 Procter and Gamble 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. And perhaps even any company that has ever
been tempted to use this snowball trade.
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