mindthegaap LLC

What on Earth is a Total Return Swap?

Important Note:

The purpose of this

The mere mention of the term "total return swap" has caused
publication is to brows to furrow and heads to be scratched. The reality is that
briefly describe key comprehending these financial arrangements is not that formidable.
developments that
have recently And because they are gaining in popularity, total return swaps are
occurred in the a concept worth understanding.
fields of accounting
or SEC regulation.
Readers seeking In this article, we will address the following three questions:
additional
information about a
topic should review -What is a total return swap?
the underlying
rules, themselves, -Why do companies use total return swaps?
and not rely solely -What are the potential implications of using total return swaps?
on the descriptions
included in this
communication. What is a Total Return Swap?
Mind the GAAP, LLC
is not, by means of The terms "total return swap" and "credit derivative" are somewhat
this publication, synonymous. Specifically, a total return swap is a type of credit
rendering
accounting, derivative.
business, financial,
investment, legal,
tax, or other Generally speaking, total return swaps represent an arrangement
professional advice whereby credit risk is transferred from one party to another. Credit
or services. This
publication is not a risk is simply the risk that amounts due from a debtor will not be
substitute for such collected because of the inability of the debtor to make payment on
professional advice
or services, nor its obligations. Said another way, credit risk is the risk that a
should it be used as customer will go bankrupt and default on contractual payments due
a basis for any
decision or action to a vendor.
that may affect your
business.
Total return swaps generally work as follows:
Before making any
decision or taking
any action that may 1. One party (referred to as the "seller") has a portfolio of
affect your receivables.
business, you
should consult a • These receivables may consist of trade receivables, loans,
qualified lease payments due to the seller, etc.
professional
advisor. Mind the • These receivables may bear interest at fixed or variable
GAAP, LLC shall not rates, or not even bear interest at all.
be responsible for
any loss sustained
by any person who
relies on this
publication.

Making the complex understandable

Mind the GAAP, LLC 6 Ridge Road Danbury, CT 06810 (773) 732-0654 www.mindthegaap.com
-1-
mindthegaap LLC

2. Another party (the "buyer") desires to receive the expected economic returns from
this portfolio of receivables.
• In other words, the buyer wants the expected interest, fees and appreciation
from this portfolio of receivables.
• The buyer could simply purchase the portfolio of receivables from the seller, but
this would require an upfront cash payment.

3. In lieu of the buyer purchasing the portfolio, the two parties enter into a total return
swap.
• The seller agrees to "pay" the buyer the expected returns on the portfolio (this is
actually a bit tricky, as explained below).
• In exchange, the buyer agrees to pay the seller interest on a notional amount,
usually at LIBOR minus a spread for risk.
• To the extent that the actual returns exceed the expected returns, the seller
must pay the buyer those additional returns.
• However, if actual returns are less than expected returns, the buyer must fund
this difference to the seller.

Why Do Companies Use Total Return Swaps?

With respect to the "seller", total return swaps offer a way to maintain a portfolio of
assets, but mitigate economic exposure to those assets. In other words, through a total
return swap, sellers can protect themselves against their assets losing value, as the
buyer is responsible for paying the differential on assets that don't perform according to
expectations.

As noted in the example above, "buyers" enter into these arrangements because they
think they can generate good returns from a pool of assets, but cannot afford (or do
not otherwise wish) to buy these assets outright for cash.

Banks are among the most significant users ("sellers") of total return swaps. Total
return swaps can help banks mitigate exposure, which, ironically, allows the bank to
extend more credit. For instance, assume that a bank has loaned $1 million to a valued
customer. The bank would like to loan additional funds to this customer, but may not
do so because the customer has reached its credit limit. To avoid losing potential future
business with this customer, the bank will enter into a total return swap to mitigate the
credit risk on the customer's existing loans. This will permit the bank to potentially loan
more funds to the customer without running afoul of the customer credit limitations.

Another common user of total return swaps is a securitized pool of assets, such as
asset-backed commercial paper conduits. Simply, investors in these conduits want
security that the assets backing their investments are going to generate a sufficient
return to pay scheduled principal and interest payments. Accordingly, the administrators

Making the complex understandable

Mind the GAAP, LLC 6 Ridge Road Danbury, CT 06810 (773) 732-0654 www.mindthegaap.com
2
mindthegaap LLC

of conduits will sometimes use credit derivatives such as total return swaps to mitigate
the risk of default on the assets backing a conduit.

Hedge funds are one of the largest "buyers" of total return swaps. These funds believe
that these derivatives provide the potential to generate strong returns, while permitting
existing cash on hand to be used for other investing activities.

What are the Potential Implications of Using Total Return Swaps?

Like any derivatives transactions, there is the potential for a tremendous amount of
exposure if the assets perform unfavorably.

On the surface, it would appear that the buyer is the party with the greatest risk. Recall
that buyers sometimes enter into total return swaps because they do not have the
resources necessary to buy the assets outright, and/or such resources are committed to
other investments. Accordingly, buyers may not have available liquid funds to cover
substantial or unexpected losses on the underlying portfolio of assets.

Moreover, under total return swaps, servicing of the underlying portfolio of assets - that
is, processing collections, issuing dunning notices to delinquent accounts, etc. - still
remains with the seller. Thus, there is the implication that if banks and other sellers
continue to transfer their credit risk to investors, they will not be motivated to monitor
the assets' performance or take actions if the performance is poor.

What's interesting, however, is that the seller may ultimately have the highest exposure
in a total return swap. Note that under a total return swap, the seller has not eliminated
credit risk, but has simply transferred it to a third party investor. Thus, there is a risk
that the buyer in a total return swap may experience a decline in creditworthiness. In
extreme cases, the buyer may be forced to declare bankruptcy, effectively shifting the
credit burden back to the seller.

As a result of these risks, some prominent individuals have begun to question the
increasing use of total return swaps. For instance, in the 2003 Berkshire Hathaway
annual report, Warren Buffett notes "the macro picture is dangerous and getting more
so. Large amounts of risk, particularly credit risk, have become concentrated in the
hands of relatively few derivatives dealers, who in addition trade extensively with one
another. The troubles of one could quickly infect the others." For more of Buffett's
comments, click on the following link:
http://www.fortune.com/fortune/investing/articles/0,15114,427751-2,00.html

For more information on total return swaps, click on the link below.

http://my.dreamwiz.com/stoneq/products/total.htm

Making the complex understandable

Mind the GAAP, LLC 6 Ridge Road Danbury, CT 06810 (773) 732-0654 www.mindthegaap.com
3