Sunday, August 2, 2009

TRS is now the tool of choice to provide leverage

Leverage is back. Banks are once again pitching total return swaps (TRS) to clients. A typical structure involves a bank providing total return on a portfolio of HY corporate loans. An investor can synthetically control a $200 - $300MM portfolio of loans by posting 25%-30% in margin. The investor receives (or pays) total profit/loss on the portfolio and pays LIBOR + spread (spreads are linked to the bank's financing cost and these days vary from 1.25% to 2.5%.) Here is a diagram that illustrates the structure.

Note that a TRS investor doesn't actually own the portfolio, but receives the performance (the economics) of the reference assets. What's powerful about this product is that a TRS investor can change the composition of their portfolio at any time. The bank usually has strict criteria for it's composition and can restrict certain assets from being included.

From the accounting perspective, a TRS and the underlying asset form a precise hedge, receiving "hedge accounting" treatment. That allows an offsetting and consistent mark to market on both the asset and the TRS. The transaction is generally done out of the bank's trading book with the "value at risk" of zero. Thus the only regulatory capital required is based on credit risk - which is mitigated by the margin posted. Therefore the spread charged on the TRS delivers a decent return on capital for a bank.

Banks love this product because they can provide financing without the capital charges associated with loans. A TRS provider is hedged precisely and (unlike a loan) can call for additional margin and liquidate quickly. A bank would guarantee performance on a portfolio, then buy that same portfolio to hedge themselves. To mitigate credit risk they require margin and mark the portfolio daily. If the value of the portfolio drops, the bank calls for additional margin, thus always maintaining sufficient cushion.

From the investor's perspective it's a useful product, but can become a problem if the portfolio is illiquid. As the portfolio drops in value, the investor is forced to post margin. If the price goes up, the extra money the investor put up is returned. At some point in a falling market however, the investor may not have enough capital to post, forcing liquidation into a volatile, illiquid market. Imagine you bought a house with 20% down. Your house gets revalued daily by your mortgage provider, and if it drops in value, you are forced to put more money down. When you run out of money your house is put up for sale. That's precisely the condition that existed for many TRS at the end of 08 with forced liquidations and unwinds. The liquidations exacerbated market deterioration, forcing more liquidations.

For those who think this is an obscure product, think again. Most leveraged ETFs create and adjust their leverage daily using TRS. The ETF doesn't own any stocks - just a TRS. So if you ever traded a leveraged or an inverse ETF, you've been trading TRS.

In fact many equity prime brokerage accounts are set up as one big TRS. The investor has a portfolio of equities (long and short) which she trades actively. But legally the TRS provider owns the portfolio. The investor has one position on - a portfolio TRS, and receives the performance on the leveraged portfolio synthetically. This way the bank doesn't have to take possession of securities in case of prime brokerage client's failure to post margin - the bank can just start liquidating.

One key feature of these transactions is that each TRS transaction is unique. That makes this product nearly impossible to move to an exchange or even a clearing platform. Given the total obliteration of structured product, TRS has become the tool of choice to create customized leverage.

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