SWAPS: The Devil in the Details

Paul Volcker, former Fed Chairman said these derivative instruments would destroy us. We persist in allowing them to exist, to be created, traded, sold and misrepresented as deriving their value from a loan, debt, note or mortgage.

And now, after more than 20 years of development of this scheme, the government is too afraid to “tinker” with the “securitization infrastructure” for fear it will freeze the credit markets when investors stop buying “mortgage bonds” (certificates) that derive NO VALUE OR INCOME from borrower payments or proceeds from foreclosure sales.

Homeowners don’t know how to fight the prosecution of false claims for a nonexistent debt account because, quite understandably, they don’t understand securitization, what it means and how it has been applied.

So here is the simple bottom line. Securitization requires sale of your obligation. For the past 20+ years Wall Street has been securitizing data about your debt and NOT your debt. Your debt is retired from the books and records of all companies as an asset receivable. The debt account reflecting ownership of your obligation does not exist. The example referred to below that I used and which is still the truth of the matter is that all securities sold in connection with what appear to be residential mortgage loans are the same as wagers on a horse race that never happened.

When you lose a foreclosure proceeding you are being forced to gift the entire house, any equity you had or should have had, and a whole lifestyle (possibly including your marriage and your health). That’s what happens when you don’t pay a debt. BUT WHAT IF THERE IS NO DEBT TO PAY?

“Summer Chic” just wrote me an email describing swaps that is exactly on point. I would just add that in many cases the swaps are disguised sales. But as you point out it is not easy to determine what they are selling. It most certainly is not any loans, debts, notes or mortgages.

Here is what “Summer Chic” wrote:


Neil had great example re horse race which never happened as a source of revenue on investment.

So, based on June 26th OCC report, the main derivative where Pension Funds invest money are Return Swaps.

$110.6 Billions in 2020, comparing to $152.4 billion in 2013….

All invested in thin-air junk. And the Government knows about it and promotes it as a “reliable investment”


A Total Return Swap is a contract between two parties who exchange the return from a financial asset between them. In this agreement, one party makes payments based on a set rate while the other party makes payments based on the total return of an underlying asset. The underlying asset may be a bond, equity interest, or loan. Banks and other financial institutions use TRS agreements to manage risk exposure with minimal cash outlay. However, in recent years, total return swaps have become more popular due to the increased regulatory scrutiny after the alleged manipulation of credit default swaps (CDS).

In a TRS contract, the party receiving the total return gets any income generated by the financial asset without actually owning it. The receiving party benefits from any price increases in the value of the assets during the lifetime of the contract. The receiver must then pay the asset owner the base interest rate during the life of the TRS. The asset owner forfeits the risk associated with the asset but absorbs the credit exposure risk that the asset is subjected to. For example, if the asset price falls during the lifetime of the TRS, the receiver will pay the asset owner a sum equal to the amount of the asset price decline.

Structure of a Total Return Swap Transaction

A TRS contract is made up of two parties, i.e., the payer and the receiver. The payer may be a bank, hedge fund, insurance company, or other cash-rich, fixed income portfolio manager. The total return payer agrees to pay the TRS receiver the total return on an underlying asset while being paid LIBOR-based interest returns from the other party–the total return receiver. The underlying asset may be a corporate bond, bank loan, or sovereign bond.

The total return to the receiver includes interest payments on the underlying asset, plus any appreciation in the market value of the asset. The total return receiver pays the payer (asset owner) a LIBOR-based payment and the amount equal to any depreciation in the value of the asset (in the event that the value of the asset declines during the life of the TRS – no such payment occurs if the asset increases in value, as any appreciation in the asset’s value goes to the TRS receiver). The TRS payer (asset owner) buys protection against a possible decline in the value of the asset by agreeing to pay all the future positive returns of the asset to the TRS receiver, in exchange for floating streams of payments.

Total Return Swap

Who Invests in Total Return Swaps

The major participants in the total return swap market include large institutional investors such as investment banks, mutual funds, commercial banks, pension funds, funds of funds, private equity funds, insurance companies, NGOs, and governments. Special Purpose Vehicles (SPVs) such as REITs and CDOs also participate in the market. Traditionally, TRS transactions were mostly between commercial banks, where bank A had already surpassed its balance sheet limits, while the other bank B still had available balance sheet capacity. Bank A could shift assets off its balance sheet and earn an extra income on these assets, while Bank B would lease the assets and make regular payments to Bank A, as well as compensate for depreciation or loss of value.

Hedge funds and SPVs are considered major players in the total return swap market, using TRS for leveraged balance sheet arbitrage.  Usually, a hedge fund seeking exposure to particular assets pays for the exposure by leasing the assets from large institutional investors like investment banks and mutual funds.  The hedge funds hope to earn high returns from leasing the asset, without having to pay the full price to own it, thus leveraging their investment. On the other hand, the asset owner expects to generate additional income in the form of LIBOR-based payments and getting a guarantee against capital losses. CDO issuers enter into a TRS agreement as protection sellers in order to gain exposure to the underlying asset without having to purchase it. The issuers receive interest on the underlying asset while the asset owner mitigates against credit risk.

Benefits of Total Return Swaps

One of the benefits of total return swaps is its operational efficiency. In a TRS agreement, the total return receiver does not have to deal with interest collection, settlements, payment calculations, and reports that are required in a transfer of ownership transaction. The asset owner retains ownership of the asset, and the receiver does not have to deal with the asset transfer process. The maturity date of the TRS agreement and the payment dates are agreed upon by both parties. The TRS contract maturity date does not have to correspond to the expiry date of the underlying asset.

The other major benefit of a total return swap is that it enables the TRS receiver to make a leveraged investment, thus making maximum use of its investment capital. Unlike in a repurchase agreement where there is a transfer of asset ownership, there is no ownership transfer in a TRS contract. This means that the total return receiver does not have to lay out substantial capital to purchase the asset. Instead, a TRS allows the receiver to benefit from the underlying asset without actually owning it, making it the most preferred form of financing for hedge funds and Special Purpose Vehicles (SPV).

Risks Associated with a Total Return Swap

There are several types of risk that parties in a TRS contract are subjected to. One of these is counterparty risk. When a hedge fund enters into multiple TRS contracts on similar underlying assets, any decline in the value of these assets will result in reduced returns as the fund continues to make regular payments to the TRS payer/owner. If the decline in the value of assets continues over an extended period and the hedge fund is not adequately capitalized, the payer will be at risk of the fund’s default. The risk may be heightened by the high secrecy of hedge funds and the treatment of such assets as off-balance sheet items.

Both parties in a TRS contract are affected by interest rate risk. The payments made by the total return receiver are equal to LIBOR +/- an agreed-upon spread. An increase in LIBOR during the agreement increases payments due to the payer, while a decrease in LIBOR decreases the payments to the payer. Interest rate risk is higher on the receiver’s side, and they may hedge the risk through interest rate derivatives such as futures.

*Neil F Garfield, MBA, JD, 73, is a Florida licensed trial attorney since 1977. He has received multiple academic and achievement awards in business and law. He is a former investment banker, securities broker, securities analyst, and financial analyst.*

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2 Responses

  1. You don’t get it legisman — the issue is that the “wizard” must come from behind the scene. A borrower does not owe “the world.” And, further, derivatives are NOT securities – they are “derived” CONTRACTS outside any claimed “trust.” So the “Trust” is OUT. Also, borrowers have a RIGHT to negotiate directly with the true creditor – if there is one at all. And, to know the purchase dollar amount of any claimed “collection rights” via invalid securitization, and, therefore, invalid derivative CONTRACTS. The borrowers did not invent the scheme. They are the victims.

  2. Another case of people not knowing what they’re talking about:

    FLORES V.DEUTSCHE BANK NAT’L TRUST CO., 2010 WL 2719848, at *4 (D. Md. July 7, 2010), the borrower argued that his lender “already recovered for [the borrower’s] default on her mortgage payments, because various ‘credit enhancement policies,'” such as “a credit default swap or default insurance,” “compensated the injured parties in full.” The court rejected the argument, explaining that the fact that a “mortgage may have been combined with many others into a securitized pool on which a credit default swap, or some other insuring-financial product, was purchased, does not absolve [the borrower] of responsibility for the Note.” Id. at *5; see also FOURNESS V. MORTG. ELEC. REGISTRATION SYS., 2010 WL 5071049, at *2 (D. Nev. Dec. 6, 2010) (dismissing claim that borrowers’ obligations were discharged where “the investors of the mortgage backed securities were paid as a result of . . . credit default swaps and/or federal bailout funds); WARREN V. SIERRA PAC. MORTG. SERVS., 2010 WL 4716760, at *3 (D. Ariz. Nov. 15, 2010) (“Plaintiffs’ claims regarding the impact of any possible credit default swap on their obligations under the loan . . . do not provide a basis for a claim for relief”).; ROSAS V. CARNEGIE MORTGAGE, LLC, No. CV 11-7692 CAS CWX, 2012 WL 1865480, at *8 (C.D. Cal. May 21, 2012) (“[P]laintiffs’ theory that lenders that received funds through loan securitizations or credit default swaps must waive their borrowers’ obligations fails as a matter of law.”);

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