Reader Deontos highlighted a post on Reuters by two Brooklyn Law School professors, Bradley Borden and David Reiss, on a subject near and dear to our hearts, the abject failure of the IRS to take interest in widespread, probably pervasive, violations of REMIC, the part of the Federal tax code that governs mortgage securitizations.
The reason this matters is that this situation belies on of the Administration’s pet claims, that its hands were tied as far as addressing the foreclosure mess was concerned because it had no leverage over servicers. As we’ll discuss, in fact the Administration has a nuclear weapon in its hands that it is simply refusing to use.
The reason the Borden and Reiss piece is noteworthy is it’s the first time I’m aware of that experts have chosen to comment at length on the REMIC issue, suggest that there is likely a BIG problem here, and politely point out that the REMICs may have committed fraud, which would allow the statute of limitations to remain open indefinitely, giving the IRS plenty of time to investigate and litigate.
However, I suspect the professors have heard that the IRS is choosing to do nothing, as their quote of Lee Sheppard at the top of their piece suggests:
They take aggressive positions, and they figure that if enough of them take an aggressive position, and there’s billions of dollars at stake, then the IRS is kind of estopped from arguing with them because so much would blow up. And that is called the Wall Street Rule. That is literally the nickname for it.
We suspect they know full well the Wall Street Rule is being applied here.
For those of you who are new to this issue, the 1986 Tax Reform Act created Real Estate Mortgage Conduits, aka REMICs, to allow mortgage securitizations to be pass-through entities, which means their income would not be subject to double taxation. But to get pass through treatment, the REMIC needed to adhere to strict requirements. One of them was it would acquire all its assets within 90 days of its start-up date. If you are at all familiar with chain of title issues in securitizations, you know that appears not to have occurred in 2004 and later securitizations close to universally, and probably happened in a significant number of securitizations between 2002 and 2004. Basically, the securitization industry appears to have decided it couldn’t be bothered to staff up back offices to meet rising origination volumes. And one of the corners they cut was adhering to the carefully designed steps to get the mortgage notes from the originator into the business trust that was supposed to comply with REMIC. That meant everything needed to be done, meaning multiple endorsements on each and every one of a typically 4,000 to 5,000 mortgage notes, by startup date + 90 days. But as the robosigining scandal and the continuing mess in local courts has revealed, in the overwhelming majority of cases, these endorsements (which were to effect transfers through several legal entities to the trust) not only often weren’t done by the cutoff date, and attempt to pretty up the record for the purpose of foreclosure (which is not kosher but is nevertheless common) were often botched.
As far as we can tell, this issue was first raised with the IRS in the summer of 2010, with a senior individual in enforcement who was up on REMIC by virtue of having revised the rules to allow for HAMP mods. She was initially very excited about it. When the attorney who had contacted her had not heard back as promised, he called her and she took the call and said she had been told not to speak to him. She said the question had gone to senior levels in the Treasury and had been referred over to the White House, which said that it did not want to use tax as a tool of policy. Another attorney told me later of securing a meeting at the IRS on the same issue. The staffer (apparently not as senior as the one in the first story) said that the parties intended to do things correctly and that was good enough. The attorney asked if he could call the IRS staffer and have him tell the IRS examiner that intending to do things was good enough the next time the attorney was audited. I’ve since been told by other lawyers that they have also brought up the issue of REMIC violations with the IRS and have been told that the IRS has no intention of pursuing it.
So the IRS refusal to touch this issue seems to be common knowledge in legal circles. I can’t imagine Borden and Reiss aren’t appraised, which means their post (which summarizes a short paper) is meant to make trouble for the miscreant IRS.
But there is a wee problem with the premise of their article:
The issue of REMIC failure for tax purposes is important in at least three contexts:
(1) in any potential effort by the IRS to clean up this industry;
(2) in civil lawsuits brought by REMIC investors against promoters, underwriters, and other parties who pooled mortgages and sold mortgage-backed securities; and
(3) state and federal prosecutors and regulators who consider bringing criminal or civil claims against promoters, underwriters, and other parties who pooled mortgages and sold MBSs.
As for (1), the IRS has no interest in doing anything.
As for (2), I’ve spoken to some of the few litigation-minded investors, and they don’t want to touch this issue (if the IRS were to find the securitizations to have violated REMIC rules, the draconian taxes would fall on investors. so they would sue the various parties that failed to do their duties). To argue that they face tax liability, they’d have to argue that mortgage notes did not get to the trusts. That would mean they were taking the position that the MBS were partly or entirely not mortgage backed. That would lead to serious doubts about their value, lowering their prices. While investors might in the end recover more from the originators and structures than they lost via the intervening fall in prices, litigation is costly, uncertain, and takes time, and in the meantime, they’d be sitting on large, self inflicted losses.
As for (3), even though the mortgage settlement did not release IRS claims, the intent was to make securitization issues a thing of the past. Put it another way: if the near moribund Mortgage Task Force is unable to see any avenues for criminal prosecutions, it will make certain to steer clear of this issue.
Despite this overview, I suggest you read the post. It’s well written and clear, which is a rare accomplishment in articles on tax matters. And in closing, the authors finger the law firms which almost certainly knew the originators and sponsors were ignoring the provisions of their contracts, yet issued opinions (of an “if-then” form: “if you did this, then it’s a REMIC,” which got them off the hook too). This is one of the ugly parts of the mortgage debacle which has not gotten the attention it deserves, the way in which lawyers, rather than acting in their traditional role of drawing bright lines and advising their clients to stay within them, became part of the problem. As Borden and Reiss tell us:
Law firms issued opinions that MBS transactions would qualify as REMICs. They did so even though they knew or should have known that an insufficient percent of trust assets would satisfy the definition of qualified mortgage under the REMIC rules. Nonetheless, the IRS does not appear to be engaged in auditing REMICs. Its reasons for not challenging REMIC status at this time may be justified as they study the issue and observe the outcome of the numerous actions against REMICs and originators.
Because REMICs did not file the correct returns and may have committed fraud, the statute of limitations for earlier years will remain open indefinitely, giving the IRS adequate time to pursue REMIC litigation after it obtains the information it needs. If the IRS does not take action at the appropriate time, however, it will be a serious failure and will result in the loss of billions of dollars of tax revenue for the federal government.
More troubling still is the IRS’s failure to address the wide-scale abuse and problems that existed during the years leading up to the financial meltdown. The IRS’s failure to adequately police REMICs is one more reason that the mortgage industry was able to overly inflate the housing market. And that, inexorably, led to the crash and our tepid recovery from it.
More generally, by overlooking the serious defects in the transactions, courts and governmental agencies encourage the type of behavior that led to the financial crisis. Lawmakers, law enforcement agencies and the judiciary cede their governing functions to private industry if they allow players to disregard the law and stride to create law through their own practices.
If we allow the Wall Street Rule to apply, then Wall Street rules. If the rule of law is respected, then Main Street can look forward to the equal protection of the law and returned prosperity without fear of bubbles inflating because powerful special interests can flout the law that applies to the rest of us.
The last paragraph no doubt sounds quixotic to readers of this blog. But if we give up on demanding better of professionals and officials, we are guaranteed never to get it.