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What on Earth is a Total Return Swap? The mere mention of the term "total return swap" has caused brows to furrow and heads to be scratched. The reality is that comprehending these financial arrangements is not that formidable. And because they are gaining in popularity, total return swaps are a concept worth understanding. In this article, we will address the following three questions: -What is a total return swap? -Why do companies use total return swaps? -What are the potential implications of using total return swaps? What is a Total Return Swap? The terms "total return swap" and "credit derivative" are somewhat synonymous. Specifically, a total return swap is a type of credit derivative. Generally speaking, total return swaps represent an arrangement whereby credit risk is transferred from one party to another. Credit risk is simply the risk that amounts due from a debtor will not be collected because of the inability of the debtor to make payment on its obligations. Said another way, credit risk is the risk that a customer will go bankrupt and default on contractual payments due to a vendor. Total return swaps generally work as follows: 1. One party (referred to as the "seller") has a portfolio of receivables. • These receivables may consist of trade receivables, loans, lease payments due to the seller, etc. • These receivables may bear interest at fixed or variable rates, or not even bear interest at all.

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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

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

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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 3 (773) 732-0654 www.mindthegaap.com

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