Wednesday, October 24, 2007

Tranche Warfare

Jeff Kahn and I have been discussing the financial and tax consequences of mortgage debt forgiveness and restructuring as a response to the emerging crisis of default in the subprime mortgage market. This is too good not to share. The Congressional Research Service (CRC) has just issued a report to Congress that concludes that a private solution to the problem is more complicated than it would first appear.

Home mortgages are commonly pooled and sold by originators to Real Estate Mortgage Investment Conduits (REMIC's) who in turn issue securities backed by the mortgage payment obligation to investors. An REMIC can qualify as a pass through entity and escape corporate tax provided it refrains from "active management" of the financial assets it holds. Moreover, under Financial Accounting Standard (FAS) 140, when a mortgage originator transfers loans to a REMIC and agrees to service the loans, the servicer must refrain from "active management" of the loans or risk invalidating the "true sale" of the pool of loans to the REMIC for purposes of the originator's balance sheet. Both tax and accounting rules cause problems for a servicer who modifies mortgage debt.

The SEC as part of its oversight of the Financial Accounting Standards Board (FASB) stated in a letter to the House Financial Services Committee last summer that accounting principles regarding servicer passivity would not create an obstacle for loan servicers to modify home mortgages in favor of borrowers at risk for default. The SEC stated that modification of mortgage payement obligations by a loan servicer would not constitute "active management" of the loans.

The remaining problem, according to the CFC report, is not concern about corporate taxation or accounting treatment. In 1986, to accommodate the nascent securitization industry, Congress modified the tax code to permit REMIC's to divide the flow of mortgage payments among investors in tranches without triggering corporate taxation as "active management." For example, one tranche receives a priority right to payment over another, or a different intererest to principal allocation. Because most REMIC's have issued securities in tranches, when a loan servicer renegotiates mortgage obligations, one tranche may benefit while others lose. The disproportinate effect of renegotiation on tranches creates a confict of interest that loan servicers worry runs afoul of REMICs' obligations to investors. Putting out the fire caused by rising default and flat or declining home values in the consumer mortgage market may spawn another problem: "tranche warfare."

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