Back in the 1980s — when Lewis Ranieri was still fighting for the legal status of MBS — something seminal happened for the mortgage securitisation market.
The Tax Reform Act was passed by the US in 1986, creating the tax-free Real Estate Mortgage Investment Conduit (Remic). Before then mortgage securitisation had largely taken the form of Real Estate Investment Trusts (Reits), themselves created under the Real Estate Investment Trust Act of 1960.
We bring up this bit of securitisation history because (surprise) of the foreclosure scandal. There’s a question mark hovering over the chain of title in mortgage securitisation deals, which is feeding in to the Remic structure itself.
Citigroup have a note out quoting Georgetown University associate professor of law, Adam Levitin, on the subject. The whole thing is worth a read for a quick catch-up on the foreclosure scandal and its ramifications, but here’s the Remic-related bit:
Most mortgage trusts were set up as REMICs (Real Estate Mortgage Investment Conduits) which are special purpose vehicles used to pool mortgages. Under the IRS code, REMIC confers a special tax status in which the cash flows to the trust are not taxed. Investors in the trust pay taxes. The tax exempt nature is important. If the trusts were in fact to be taxed, the taxes would distort the yields required by investors.
To qualify as a REMIC under the IRS code and enjoy the beneficial tax treatment, the trust (1) must be passive and (2) cannot acquire any new assets 90 days following the trust’s creation.
If … mortgage documents were never correctly passed through to the trust when it was established, then the trust may not actually own the underlying mortgages it purports to own. Although it is possible that this issue could be remedied by some legal maneuvering, doing so could violate the REMIC status since the trust would be acquiring assets long after the aforementioned 90 day period has expired. Such a violation in turn could trigger a sizeable tax burden for investors. Our speaker indicated that there are a handful of open questions on this front and that this is a legal gray area.
Quite simply, if a break in the chain of title leading up to a mortgage securisation is found to be broken — and subsequently repaired — investors could still come up against a wall. They can’t fix the chain of title (i.e. legally acquire the relevant assets) without possibly giving up their tax-exempt status. Investors could end up being double-taxed, which of course the 1986 Act was meant to abolish in the first place.
On a related issue — the passive nature of securitisation trusts is in itself, worth a mention. And there’s a reason why we brought up Lewis Ranieri, the godfather of securitisation immortalised in Liar’s Poker. Speaking at the 2007 Milken conference, when subprime problems were just beginning to rear their ugly heads, he noted:
The real dilemma for me … will be, we’ve never had to do substantial restructurings in housing in mortgage securities … we’ve never had to do substantial restructurings in housing in mortgage securities… In a very long meeting, last Monday, where we tried to collect virtually everybody in a room, it became evident that there are a whole host of unforeseen technical problems if you try to restructure or do large amounts of restructuring within the security, some of which, we had never even heard of or thought about.
Mortgage servicers are the ones who fill the void left by the trust’s passive status, and they often prove reluctant to restructure loans. We’re thinking if the foreclosure scandal ends up widespread, the passive nature of the trust — and the distribution bit in the originate-to-distribute model — might no longer look so innovative.