We’ve written at some length about the failure of the IRS to go after what look like slam-dunk violations of the rules governing the tax treatment of mortgage-backed securities. As we said earlier this year:
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.
Back to the current post. Apparently the noise has been made about the failure to pursue REMIC violations, the latest by two law professors in a journal article, has roused the IRS from its official somnolence (we posted on the piece when it was made public). I happened to be vastly amused by the pointedness of article by Bradley T. Borden and David J. Reiss. Its synopsis:
Investors in mortgage-backed securities, built on the shoulders of the tax-advantaged Real Estate Mortgage Investment Conduit (“REMIC”), may be facing extraordinary tax losses because of how bankers and lawyers structured these securities. This calamity is compounded by the fact that those professional advisors should have known that the REMICs they created were flawed from the start. If these losses are realized, those professionals will face suits for damages so large that they could put them out of business.
The IRS supposedly started a review of REMICs in April of last year, but the comments we got on its views were in 2010, long before the “review.” That suggests this is merely
an official ass-covering exercise a formality. It must be about to come to fruition, since an article in Dealbook by Victor Fleischer (aha, another tax prof to take issue with the Borden/Reiss position!), which looks awfully consistent with the IRS position, was published today (hat tip AKS).
The article makes no bones about its position: “Why a Tax Crackdown Is Not Needed on Mortgage-Backed Securities.” Gee, if necessity is the standard, the IRS doesn’t need my late fee while I miss a filing deadline. Can I get a free pass too? This piece is priceless. It starts with the usual warning about the importance of the MBS market:
These are the tax plumbing that allows the modern mortgage market to function.
That is narrowly true but misleading. The part of the market where the REMIC rules were violated was in the private label mortgage backed securities market. The MBS guaranteed by Fannie and Freddie had different transfer procedures stipulated and they were adhered to. And that private label market happens to be completely dead because the originators so badly abused investors that they want nothing to do with them until the market is reformed, which the sell side has stymied. I was at a conference recently where Pimco’s head of mortgage and asset-backed securities said he saw no reason for a private label securities market, it had only existed in a meaningful fashion from 2003 onward and had comported itself badly. So this thinly veiled “you enforce REMIC rules, you mess with mortgage finance” is simply untrue in our new normal of mortgage finance on government life support and sell side refusal to agree to needed, pro-investor reforms on private deals.
Then we get the next canard:
The legal process of transferring a mortgage is complex.
No, mortgage transfers are NOT complex. Dirt law is well established. What was complex was how these private label deals were structured. And the mortgage transfers, the part that was botched, was CUMBERSOME, rather than complex. Big difference. These deals set up their own transfer procedures, that the notes be endorsed through multiple parties to get to the final owner, a trust, and that had to take place in a stipulated time frame. And the proof that the Fleischer’s position is bunk is that these procedures were adhered to for the most part in the first decade plus of private label securitizations, from the late 1980s through at least the late 1990s.
The position taken in the article is effectively “The intent was there, so who cares if they screwed up on the execution?” And that is precisely the argument the IRS is making privately, which is why I suspect the Fleisher article is official messaging. Um, so can I tell the IRS I intended to get my taxes in on time when I filed them a day late and not pay any penalty?
The truly offensive part is the way the Wall Street boosters like Fleisher blame the failure of the industry to follow the regulations on the IRS:
Modern financial products do not always mix well with the more arcane aspects of legal process.
These aspects were not arcane, or not so arcane as to be a credible scapegoat. This was a back office breakdown at best but looks to have been a deliberate, system wide change in procedures and no one bothered updating the deal documents to reflect the change in transfer procedures. But the reason they didn’t is investors expected the old process and would have negotiated over changes, and likely would have demanded some changes in the fee structures to reflect the fact that bankers were saving themselves a lot of costs by the changes in procedures. The failing, as we’ve stressed again and again, was not in the law, the deal design, or the contracts, but that the sell side systematically refused to live up to the terms of its own agreements. And those agreements, as we’ve discussed, also happened to be unusually rigid and unforgiving; Adam Levitin and Anna Gelpern have called them “Frankenstein contracts“.
It has been clear for over two years that the IRS won’t touch this issue with a ten foot pole. Even though the violations look clear cut from a tax perspective, the liability would fall on the investors, who would then sue the sponsors and originators to kingdom come. It would put on full view what the Administration has been working overtime to hide, that of the massive legal abuses at the heart of the mortgage crisis. So while the outcome is predictable, articles by shills like Fleischer are an insult to the intelligence of the long-victimized public.