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Secondary market.

SECONDARY MARKET

On Friday, August 9, 1991, the mortgage banking industry received a major ruling from the IRS regarding the taxability of retained excess servicing. The good news is that the ruling brings much-needed certainty to mortgage securitizers/servicers creating and owning excess servicing. The not-so-good news is that the ruling raises new questions relative to the functioning of the primary and secondary mortgage markets. Will lenders continue to create excess servicing? If lenders decide not to create excess servicing, how will loan pricing and mortgage sales/securitization decisions be affected?

Rev. Rul. 91-46 holds that where mortgage servicing is retained at an amount that is deemed to be in excess of reasonable compensation for the services to be performed (i.e., excess servicing), the mortgages are "stripped bonds" within the meaning of Code Section 1286(e) (2), the bond coupon stripping rule. It defines reasonable compensation for providing services to be the sum of: (1) the amounts that the taxpayer is entitled to receive from mortgage interest collections up to the applicable safe harbor; and (2) the other income (late charges, interest on escrows, etc.) that the taxpayer is entitled to receive in the course of servicing the mortgages. For taxpayers who want to avoid the uncertainties of the "reasonable compensation test," a companion Revenue Procedure, Rev. Proc. 91-50, provides a safe harbor that taxpayers may elect to use in applying Section 1286. The safe harbors are as follows (1) .25 percent for conventional, fixed-rate mortgages; (2) .44 percent for government-insured mortgages less than one year old; (3) .375 percent for any other one-to four-unit residential mortgage; and (4) .44 percent for mortgages with original principal balances of less than $50,000.

The excess servicing fee (ESF) is that percentage of interest income in excess of that needed to cover the MBS coupon rate, agency guaranty fee and the contract servicing fee. ESFs are properly viewed as byproducts of the securitization process. ESFs result from the lender's desire to obtain an optimal return on the sale of mortgages subject to MBS/capital market pricing inefficiencies, origination competition pressures, agency pooling guidelines and mortgage sales commitment terms.

The MBS/capital market pricing inefficiencies are such that investors have a preference for agency securities set in whole and half-point increments. Thus, investors, working through their dealers will typically discount (or not "pay up" for) securities with coupons set in quarter points or eighths. The primary reason for the discounting is the psychological aversion investors have for coupons set in quarter or eighth points. Another reason for investor aversion is the lack of liquidity for eighths and quarter point securities. Swap and repo transactions are more straightforward with whole/half point coupons.

An informal survey of mortgage companies reveals that 12 1/2 to 20 basis points of excess servicing is regularly created as a byproduct of the loan pricing/securitization process. This is a natural consequence of agency pooling parameters. For example, the Fannie Mae MBS program at lows a variety of note coupons in an MBS pool, (i.e., note coupons up to a 200 basis points range between the highest and lowest note coupons in a single pool.) Frequently, prices quoted to prospective borrowers will be set in eighths and quarter points. If one assumes the IRS safe harbor servicing fee of 25 basis points and guaranty fee of 25 basis points, the result would be an MBS coupon set in eights or quarter points, other things being equal. This would be undesirable because of the market's unwillingness to pay full value for securities set in eighth or quarter point coupons above the next lowest whole/half point coupon. In the past, lenders would prefer to take the capitalized value of this excess coupon as a tangible asset on their balance sheet. Alternatively, Fannie Mae and Freddie Mac sellers could eliminate their excess to "buying up" the guaranty fee in exchange for cash payment and a more liquid security coupon.

After the IRS ruling, lenders who keep the excess portion of retained servicing or sell it to the agencies pursuant to a guaranty fee buyup are likely to have excess servicing taxed as ordinary income. Those lenders who choose to continue to create excess servicing will also have to maintain tax reporting and record keeping that goes along with the tax liability. For example, if the actual economic life of the excess servicing is less than that assumed for tax purposes, we assume the IRS would allow some rebate of taxes that were based on the longer life assumption. Keeping track of such transactions is likely to be a tax accountant's dream and a mortgage company's nightmare. In light of the financial and administrative problems associated with the excess servicing asset, lenders are likely to stop creating it.

Lenders can avoid creating excess servicing by offering to borrowers only those note coupons that do not produce an ESF. This may mean fewer rate/point combinations for borrowers. The desire to avoid excess servicing creation is likely to discourage lenders from offering high coupon, low point mortgages to borrowers with qualifying incomes but who are short on cash for closing costs. Alternatively, lenders may continue to offer the same menu of coupon options to borrowers and sell these loans to the agencies' cash windows and take back a quarter point servicing. The fact that agencies are offering premium pricing for delivering note rates above the required net yield may make selling through the cash window attractive in light of the IRS's ruling. The ruling may diminish the relative price advantage of MBS versus cash thus undermining the securitization process.

Notwithstanding the problems for the secondary market, we are pleased that the IRS saw fit not to pursue mortgage companies for past transgressions. Fortunately, the ruling has a prospectively effect only, thus allowing mortgage companies to structure their operations accordingly. Lenders will be able to avoid the tax liability. More than anything else, the IRS's decision hurts the homebuying public.

Michael S. Taliefero Staff Vice President
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Title Annotation:taxability of retained excess mortgage servicing
Author:Taliefero, Michael S.
Publication:Mortgage Banking
Date:Sep 1, 1991
Words:1005
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