The Total Return Swap, or TRS, allows an investor to gain exposure to the economic return of an asset without actually holding the underlying security. The swaps, often used by activist investors, allow funds to gain economic control of a large number of shares in a company without largely disclosing their stake, as they do not technically own the shares, simply an investment tied to them. The flip side of this is that the bank with which they enter into the swap agreement hedges their exposure to the swap by purchasing the underlying shares.
My thoughts, however, are that TRS's tied to leveraged loans are actually artificially depressing loan prices. Because the banks issuing the swaps linked to the loans already have huge inventories of the securities on their own balance sheets, it's simple for the bank to simply set up an entity to purchase the loans on behalf of the swap-issuer from the bank (yes, a bank subsidiary purchasing loans from its parent). By doing this, there is no need for purchases to take place on the open market, therefore preventing large buyers from stepping into the market and providing bids.
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If the bank sells the loans that are underlying the TRS (that is, the loans that the TRS is providing economic exposure to), what difference does it make if the bank holds them or a bank sub holds them? Either way it seems that the bank wouldn't have to buy the underlying loans. If you're talking about the bank hedging against these loans (b/c if it issues a TRS, it agrees to take the short position on the loan and therefore would need to buy up loans to perfectly hedge its exposure), why wouldn't the bank sub have to or want to hedge it's position?
Basically, could you elaborate more on this? I'm unclear as to how you arrived at your conclusion and I think I'm missing something. Thanks!
"If you're talking about the bank hedging against these loans (b/c if it issues a TRS, it agrees to take the short position on the loan and therefore would need to buy up loans to perfectly hedge its exposure), why wouldn't the bank sub have to or want to hedge it's position?"
By creating a sub which buys the loans from the bank, the sub can issue the TRS and therefore no open market transactions take place, preventing anyone from having to purchase the loans on the open market
I think it's arbitrary whether the banks have to establish a separate entity to do this or not.
But, playing devil's advocate, I'd argue that, whether TRS are being created or not, the bank is trying to reduce (or say, maintain, in normal times) its exposure to leveraged loans. If they issue TRS, this reduces their exposure, they don't buy loans, and now market prices are lower. If they don't issue TRS, they still want to reduce their exposure, they'll sell loans, and now market prices are lower. Either way, the price of these assets will decline.
Basically I'm saying that their target exposure levels to leveraged loans are independent of their TRS structuring business. While I do see TRS as a tool for banks to reduce their exposure to leveraged loans, I doubt they're artificially depressing prices.
Evan,
It makes sense that no open market transaction takes place in the transfer of the underlying loans. However, could you explain why the prices of loans are artificially depressed if the sub & not the bank itself is issuing the TRS?
Paul,
That's part of what I was unclear about. It seems to me that TRS issuance is in part independent of a banks exposure to loans unless it is being used to hedge.
"If they issue TRS, this reduces their exposure, they don't buy loans, and now market prices are lower."
However, I still don't understand why prices would fall if a bank simply doesn't buy the loans. Issuing a TRS would reduce their economic exposure, but if anything their counter-party would buy the loans to hedge some risk (or they could also not do that if they want the risk). Wouldn't the price stay unchanged until the settlement of the contracts? (Presumably the contract wouldn't be settled in the present or very near future otherwise that would largely defeat the purpose of a TRS).
Thanks again to both of you!
Simplification: Let's say that the bank wants to keep it's exposure to these loans at 100. Also, the hedge fund (the bank's client) wants to purchase 10 no matter what.
If the bank issues a TRS for 10, its exposure is now 90. It buys 10 on the market. Result = Bid orders increase by 10.
If the bank doesn't issue a TRS, it's content with 100 exposure. The client still wants 10. It buys 10 on the open market. Result = Bid orders increase by 10.
The point I'm trying to make is, assuming each party wants a certain exposure to the asset, it doesn't matter whether there's a TRS involved or not. (If anything, TRS increase market prices, because the leveraged-type structure of the TRS is favorable to the hedge fund.)
Paul,
Point well taken. Thanks for the explanation.
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