real estate mortgage investment conduits (remics) chapter 22 tools & techniques of investment...

Real Estate Mortgage Investment Conduits (REMICs)

Chapter 22Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• A Real Estate Mortgage Investment Conduit (REMIC) is a limited-life, self-liquidating entity that invests exclusively in real estate mortgages or in securities backed by real estate mortgages.



Investment Planning


What is it?

• REMICs may issue two types of securities:– Regular interests

• The REMIC may issue multiple classes of regular interests (REMIC bonds).

• REMIC bonds are treated for tax purposes as debt securities.• Investors receive a specified cash flow from the underlying pool of

interests

– Residual interests• The REMIC may issue only one class of residual interests.• Treated for tax purposes much like interests in a partnership or

grantor trust• Residual interest holders take into account all of the REMIC’s net

income that is not taken into account by the REMIC bondholders.



Investment Planning


What is it?

• A REMIC is typically exempt from federal income tax.– It is a flow-through entity.

• The REMIC terminates when its mortgages are repaid.• Eventually, REMICs are intended to be the exclusive

means for issuing multiple-class real estate mortgage-backed securities.– They will eventually replace all collateralized mortgage

obligations.



Investment Planning


When is the use of this tool indicated?

• When an investor is interested in an income-producing investment with risk and return characteristics similar to conventional bonds, regular interests in REMICs would be indicated.

• When an investor desires a potentially high-yielding investment with risk and return characteristics similar to common stocks or partnership interests, residual interests would be indicated.

• When an investor wants the added safety provided by pooling a number of mortgages into one investment.

• When an investor desires a relatively high rate of return on a debt-type instrument.



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• When an investor wants to diversify beyond holding stocks, traditional corporate bonds, and government bonds.

• When an investor wants liquidity.• When an investor wants a relatively secure type of

investment– Regular interests are treated like debt and will have risk

characteristics similar to comparably rated traditional bonds.• Senior and subordinated classes of interests offered by some

REMICs



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• When an investor wants more predictability regarding prepayments of principal than is available with other mortgage-backed securities– REMICs may issue multiple classes of regular interests.

• Short-term class (matures in 3 to 5 years)

• Mid-term class (matures in 5 to 15 years)

• Long-term class (matures in 15 to 30 years)

– Investors can invest in classes that match their investment horizons and avoid a great deal of the uncertainty regarding when principal will be repaid.



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Advantages

• Taxation of REMIC interests is established by statute without regard to their form, provided such interests qualify as regular or residual REMIC interests.– Although regular interests may be issued as stock, bonds, or

interests in trusts, they will always be treated as debt (bonds) for tax purposes.



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Advantages

• Regular interests in many REMICs are virtually risk-free in terms of return of principal and certainty of income.– Many REMICs invest in mortgages guaranteed by the

Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), or the Federal Home Loan Mortgage Corporation (FHLMC)

– REMICs invested in non-guaranteed mortgages are growing, which will require investors to examine the following to assess risk:

• The reputation of the issuing agency• The quality of the mortgages in the pool• The existence and nature of the private insurance behind

the mortgage



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Advantages

• REMICs offer investors a way to minimize the prepayment risk inherent in a mortgage pool.– Prepayment risk arises because the mortgages in the

underlying pool may be paid off sooner than anticipated.• Forced to reinvest at lower interest rates.

– REMICs can issue different classes of REMIC bonds with different maturity dates and different interest rates.

• Certain investors have claim to predetermined principal repayment cash flows.



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Advantages

• REMICs combine the predictable cash flow of bonds with the relatively high yields of mortgage securities– Interest rates on mortgages are typically higher than short-term

money market rates or even long-term corporate bond rates.– More predictable cash flow.

• By segregating the cash flows to create issues with different maturities, investors who have little desire to hold 3-year mortgages in their portfolios can still participate in the high yields associated with mortgage-secured investments by purchasing one of the shorter-term issues.



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Advantages

• As the number of these issues grows, the secondary market will also grow.– Increased liquidity

• The price volatility of REMIC bonds tends to be less than for bonds of similar quality and maturity.– The prices of REMIC bonds move in the same general manner

as bond prices, but the velocity of the move is dampened by changes in the rate of prepayments.

• The minimum purchase requirement is still less than the $25,000 minimum for Ginnie Maes.– Most REMICs issue regular interests with small denominations

that will attract smaller investors.



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Advantages

• REMICs allow a great deal of flexibility in the forms of the securities issued.– May soon offer coupon-stripping, adjustable and variable rates,

and other innovative forms of securities.

• REMIC bonds with variable interest rates may provide some inflation-hedging protection since interest rates typically move in concert with inflation.



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Advantages

• Advantages to issuers– No need to follow debt format and substance– No need for excess equity capital to build in a minimum

investment risk for the residual holders• More capital for high yielding mortgages

– Risk of being taxed as a corporation eliminated– REMIC regular and residual interests are qualifying assets for

thrift institutions and REITs– Residual interests are freely transferable



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Disadvantages

• The price of regular interests in REMICs will tend to fall when the market interest rates rise.– Investors who must sell their interests before maturity may have to sell

them at a loss.

• The actual yield an investor will realize on a REMIC bond is uncertain.– Due to the unpredictability of prepayments on the underlying mortgage

pool

• Secondary markets are expected to grow, but may never be as well developed as for conventional bonds.– Investors who must sell their securities before maturity may have to sell

at a sizable discount, depending on the size of the issue, the reputation of the issuer, and the quality of the mortgages backing the security.



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Disadvantages

• REMIC Bonds with fixed interest rates are subject to two types of inflation risk:– The risk that the purchasing power of income will be eroded over

time.– The risk that the purchasing power of capital received at maturity will

have diminished.

• Many REMIC bonds are callable at the discretion of the issuer.– Others are issued with a sinking fund feature, which requires that a

specified number of securities be redeemed at specified dates.– May be called before the holder would otherwise choose to redeem

them.



Investment Planning


Tax Implications

• There is a great deal of flexibility in the form of entity that may be used for a REMIC.– A trust, partnership, corporation, association or merely a

segregated pool of mortgages is suitable.– Once the entity elects REMIC status at startup, the entity is

taxed under the special REMIC rules.– They are taxed as pass-through entities.

• REMIC taxable income or loss flows through to the holders of residual interests on a pro rata basis.



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Tax Implications

• Regular Interests– A regular interest is treated as debt, regardless of its form.– REMIC bonds have two unique features for tax purposes:

• Holders of REMIC bonds must use the accrual method to report income on their bonds, even if they are cash-basis taxpayers for other purposes.

• A special rule requires that a part of the gain on sale or exchange of a REMIC bond be taxed as ordinary gain

– The portion of the gain on the sale or exchange of a REMIC bond that is treated as ordinary income under the special rule is an amount equal to the excess of the amount that would have been includable on the bond if its yield were 110% of the Applicable Federal Rate (AFR) over the amount actually included by the holder in gross income during the time the bond was held.



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Tax Implications

• Regular Interests– Original issue discounts, market discounts, and premiums

arise when there is a difference between the acquisition price of a debt instrument and the total principal repaid when it matures

• Purchase price greater that principal repaid = premium

• Purchase price less that principal repaid = market discount



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Tax Implications

• Regular Interests– Market discount

• Arises two ways– Mortgages acquired at a market discount , or– The investor acquires the REMIC bond for a price that is less

than the unpaid principal • Accrues two ways

– At a constant rate, or– In proportion to original issue discount accrual or to stated

interest on regular interests• Investors decide when they will recognize the accrued

market discount for tax purposes• If mortgages in a pool are acquired at a market discount,

residual holders will take the discount



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Tax Implications

• Regular Interests– Original issue discounts, market discounts, and premiums arise

when there is a difference between the acquisition price of a debt instrument and the total principal repaid when it matures

• Original Issue Discount (OID) arises 2 ways– The mortgages in the pool are acquired with OID, or– The class of regular interests is structured so that the issue

price is less than the redemption price» Special rule for calculating OID

• Investor required to report this amount with ordinary income from interest paid / accrued

– If OID arises because the mortgages in the pool are acquired with OID, the residual interest holders must report OID



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Tax Implications

• Regular Interests– Principal payments received are considered nontaxable return

of capital to the extent of the investor’s basis in the security• Except to the extent of any market discount



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Tax Implications

• Residual Interests– Residual interest holders must compute taxable income from

the REMIC on an accrual basis.• Taxed as if they owned a pro-rata partnership interest in the

REMIC’s taxable income, which is gross income including:– Interest– Original issue discount income– Accrued market discount income on the qualified mortgages– Income on reinvestment of cash flows

• Minus deductions, including– Interest and original issue discount expense on the REMIC bonds– Premium amortization– Servicing fees on qualified mortgages– Bond administration expenses



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Tax Implications

• Residual Interests– Taxable losses are limited to the residual holder’s adjusted basis

• Losses may be carried over indefinitely and used to offset future income generated by the same REMIC.

– An individual investor is allowed to deduct certain expenses• Expenses for the production of income

• Only to the extent that his miscellaneous deductions in the aggregate exceed 2% of the investor’s adjusted gross income

– A REMIC’s taxable income may include “phantom income”• Arises as a result of timing differences between the recognition of

accrued income on the underlying mortgages and the corresponding interest deductions for payments on the regular interests.



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Tax Implications

• Residual Interests– Residual holders are also subject to a complicated set of rules

that limit the deductions that may be passed through the REMIC to reduce their taxable income from the REMIC.

• These rules provide that a residual holder’s taxable income shall in no event be less than what is called the “excess inclusion.”

– Residual holders will have taxable income to the extent cash distributions exceed their bases in their residual interests.

– Gains or losses on the sale or exchange of residual interests or liquidation of the REMIC generally will be treated as capital gains or losses.

• Certain losses on dispositions of residual interests will be disallowed or deferred.



Investment Planning


Alternatives

• Large mutual funds– Many offer funds that invest in mortgage-backed securities

such as participation certificates issued by GNMA, FNMA, FHLMC, private issuers, and CMOs

• Minimum required investment– Less yield uncertainly– Less price volatility– Investors are not able to get prepayment protection



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Alternatives

• Ginnie Maes, Fannie Maes, Freddie Macs, and other PCs– No flexibility to match maturity to the desired holding period– No prepayment protection of the longer-maturity REMIC bonds

• REITs– May be organized as REMICs

• REMIC funds may be offered in the future• CMOs



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Where and How do I get it?

• Interests in REMICs can be acquired from a brokerage firm in much the same fashion as stocks or bonds.

• Thrift institutions and banks that offer investment services offer some issues.



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What fees or other costs are involved?

• The fees or acquisition costs depend on how the investor acquires the security– Investors will pay no commission on a new issue.– If the security is acquired in secondary after-issue market, an

investor can expect to pay a fee ranging from $2.50 to $20 per unit

• Depending on the number of units acquired

• In most cases, the fee will not be less than $30



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How do I select the best of its type?

• The Identity of the Issuer of the Underlying Mortgages– Mortgages guaranteed or backed by the U.S. government

provide the highest degree of safety of principal.

• The Types of Guarantees on the Underlying Mortgages• The Risk-Return Tradeoff

– The safest mortgages with the most prompt payoff are those guaranteed by GNMA.

– Mortgages insured by private institutions trade at higher yields because of the slightly higher risk of default or delay in payment of principal.



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• The Quoted Yield and the Assumed Prepayment Rate– Return may differ from the quoted yield

• The Characteristics of the Mortgage Pool that Serves as Collateral– FHA and VA mortgages tend to prepay more slowly than

conventional loans because they are often assumable and are not due on sale.

– Conventional mortgages tend to have higher original principal amounts

• Higher income



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• The Similarity in the Coupon Rates and Maturity Dates of the Mortgages– Different prepayment pattern for varying versus constant

coupon rates and maturity dates

• The Pool Size and Diversification– A larger, more geographically diversified pool is more likely to

experience average prepayment experience

• The Relative Size and Number of Classes of REMIC Bonds in the Issue– A particular class has protection from prepayments as long as

a faster paying class exists



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• The Return on Collection Accounts and Reserve Funds– Difference in payment collection and distribution to

shareholders• Size of the collection and reserve funds• The rate assumed to be earned on these funds• Whether the issuer uses the excess earned to pay off bonds

• The Existence of a Secondary Market in the Securities or the Presence of a Put or Redemption Feature for the REMIC Bondholder– More liquidity

• Lower yield



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Where can I find out more about it?

• Banks and Brokerage Firms• Offering prospectus from brokers• Brokerage firms• “Real Estate Mortgage Investment Conduits: An

Introduction” The Journal of Taxation of Investments• “Tax Reform Brings New Certainty to Mortgage Backed

Securities” The Journal of Taxation



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Where can I find out more about it?

• “Real Estate Mortgage Investment Conduits – A Flexible New Tax Structure for Issuers and Investors” Tax Notes

• “REMICs: Removing Tax Obstacles to More Efficient Trading of Mortgage backed Securities” Real Estate Review

• “Securitization” Economic Perspectives

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