As the dust from the financial crisis begins to settle, we learn that the lack of IRS enforcement of the mortgage-backed securities industry bears blame for the financial crisis. The financial crisis began when lenders started making bad loans on a large-scale basis in the late '90s and early '00s. Big banks purchased these bad loans, bundled them into trusts, and sold interests in the trusts to investors worldwide. The interests in the trusts are mortgage-backed securities. The investors (financial institutions, pension and retirement plans, insurance companies, state and local governments and individuals) did not know the loans were bad, and paid inflated prices for the mortgage-backed securities. Now that the practices of lenders and banks are coming to light, borrowers and investors are seeking to recover losses through lawsuits. And it is obvious that better practices, as required by tax law and enforced through IRS audit, would have prevented or mitigated those losses.
Mortgage-backed securities are a vital part of our economy. A person who borrows to buy a house gives the lender a mortgage note. The lender often sells that note to another bank for cash. That cash allows the lender to make another loan. This process makes more money available for lending, helps keep mortgage interest rates low and makes homeownership available to more people. Banks that purchase mortgage notes bundle them, place them in trusts and sell mortgage-backed securities to investors. Banks use the cash they get from investors to purchase more mortgage notes. Thus, mortgage-backed securities support the real estate market, and doing away with them is not an alternative. Instead, we must ensure that they are properly formed and include quality mortgages -- IRS oversight would have helped make this happen.
Many of the trusts that hold mortgage notes are called real estate mortgage investment conduits or, more affectionately, "REMICs." REMICs receive preferential tax treatment, which encourages investors to purchase interests in the trusts and helps support the real estate market and general economy. The special tax treatment REMICs receive is conditioned upon the mortgage notes meeting three fundamental requirements. First, the trusts must actually own mortgage notes. Second, the mortgage notes must be properly secured by real property (generally the borrower's home). Third, the property value must be at least 80 percent of the amount of the loan.
Regular and competent IRS audits of purported REMICs would ensure that they satisfy the three requirements. Satisfaction of those requirements would help ensure that only quality mortgage notes flow into REMICs, and the demand for good notes would trickle down to lenders and encourage robust lending practices. Through audit, the IRS could have ensured that REMICs held mortgage notes, that the mortgages were properly recorded, and that the value of property securing the mortgage was worth at least 80 percent of the amount of the notes. IRS audits would thus have helped ensure that REMICs held quality mortgage notes and would have prevented or lessened the effect of the financial crisis.
Things we are learning about lending and bundling practices reveal that the IRS was noticeably absent from this industry or grossly incompetent in its audit procedures. The IRS's apparent failure to audit the industry during the years preceding the financial crisis opened the door for banks and lenders to skirt the law. We know now that the financial crisis that imploded in 2008 could have been prevented if the IRS had been more active policing REMICs and their organizers.
The IRS's failure in this area is puzzling. Perhaps it relied too much on special interests within the industry. Maybe others did not play a big enough role in studying and commenting on this area of the law that had seemed so esoteric up to the collapse of the mortgage-backed securities market. Perhaps Congress and Treasury relaxed their oversight of the IRS and neglected this important part of our economy. Whatever caused the IRS's failure, we are witnessing the fallout now and beginning to appreciate the enormity of the situation.
Several lawsuits reveal how lenders and banks violated the REMIC rules by failing to transfer mortgage notes to trusts or by transferring bad mortgage notes to the trusts. For example, a lawsuit against Barclays Bank includes a report of three purported REMICs that Barclays Bank formed. That report shows that the purported REMICs did not hold the notes (in violation of the REMIC rules) that they told investors they held. The report also shows that the value of property securing mortgage notes was often well below what the lenders and Barclays claimed it was. Simple calculations suggest that -- in reality -- many of the mortgage notes would not be secured by property worth at least 80 percent of the amount of the loans.
Other cases further illustrate that purported REMICs may not be able to foreclose on property because purported REMICs either do not hold mortgage notes or mortgage notes they hold are not properly recorded. In a lawsuit against JPMorgan Chase, the New York Attorney General claims that JPMorgan relaxed its due diligence, disregarded defective mortgage notes of which it became aware, and manipulated defective note claims. As a result, mortgage notes that it claimed to transfer to purported REMIC trusts probably would not satisfy the requirements in the REMIC rules. High-profile cases filed by the federal government against major financial institutions claim that the mortgage notes transferred to purported REMICs were bad loans. These and other lawsuits allege that banks knowingly misled investors about the quality of the loans that purported REMICs claimed to hold.
The IRS possesses a fearsome audit power that gives it access to records and information that the public and litigants are yet to obtain. It should have used that power more effectively before the financial crisis. With hundreds of billions of dollars of potential tax revenue at stake and an unprecedented federal deficit, the IRS can use its audit power now with respect to purported REMICs to collect tax revenue and penalties. Action it takes now should enhance the current federal budget, help stabilize the real estate market and uncover bad actions and bad actors in the mortgage-backed securities industry. Congress and Treasury have an obligation to help the IRS realize its grave responsibility and act with respect to this serious matter.
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