REMICs: Real Estate Mortgage Conduits and CMBS Loans
A Real Estate Mortgage Investment Conduit, or REMIC, is a legal entity, typically a special purpose vehicle (SPV) or a special purpose entity (SPE) used to pool loans and issue mortgage-backed securities (MBS), or commercial mortgage-backed securities (CMBS). After being organized REMICs are split into bonds, which are issued and sold to investors on the secondary market.
REMICs can be organized as corporations, trusts, partnerships, and are generally pass-through entities. This means that, unlike traditional corporations, they do not have to pay taxes.
However, individual investors in REMIC-issued securities, whether CMBS or MBS, will have to pay capital gains taxes on any profit they derive. Investors generally do this by filing a 1066 form with the IRS.
REMICs are also used by the GSEs, Fannie Mae and Freddie Mac, in order to issue their government-backed single-family and multifamily MBS.
MBS or CMBS issued by REMICs are split into various classes, or tranches, generally based on risk, each of which may have different coupon rates, maturities, and prepayment rules. For example, Class AAA mortgage-backed securities pay investors first but generally offer a lower interest rate, or coupon, to investors.
On the other end of the spectrum, the investors in an MBS or CMBS B-piece are paid last, yet generally enjoy the highest interest rates of all tranches in the CMBS. However, unfortunately for B-piece investors, if a large amount of the loans collateralized by the MBS or CMBS go into default, they may not be paid back at all.
REMICs and MBS and CMBS Pooling and Servicing Agreements (PSAs)
REMICs and mortgage-backed securities they issue are governed by pooling and servicing agreements (PSAs). PSAs define the various roles and limitations of each party involved in the transaction process. For instance, a PSA will define the exact situations in which the servicing of a CMBS loan is switched from a master or primary servicer to a special servicer. PSAs also define which assets can be held inside the REMIC, pursuant to U.S. federal regulations, which we’ll detail in the paragraphs below.
What Assets Be Held Inside a REMIC?
According to federal regulations, only certain types of assets can be held within a REMIC. These include “qualified mortgages” and “permitted investments,” which generally consist of any properties a special servicer has foreclosed on, as well as “qualified reserve assets,” which could potentially consist of cash or U.S. Treasury bonds. Mortgage loans held inside REMICs must be secured by real property If a REMIC begins to hold other, non-qualified assets, it can lose its tax-exempt status and will be subject to regular taxation.
REMICS and Disqualified Mortgage Assets
Potential issues can arise with REMIC-issued CMBS or MBS in situations where loans are subject to significant modifications, such as in the case of a loan workout. REMICs generally have specific exemptions for defaults and other special situations where loans may require modification. As we mentioned earlier, in some situations, a modification could result in the mortgage becoming a disqualified asset, and therefore, the REMIC losing its tax-exempt status.
For instance, if a non-defaulted loan is modified by a servicer, it could result in serious tax consequences for the REMIC, and therefore, the CMBS or MBS investors. The potential tax implications of modifications are one of the reasons why it can be so difficult for CMBS borrowers to obtain loan modifications from special servicers.
General REMIC loan modification exemptions, which will be listed in a loan’s pooling and servicing agreement, often include:
Modifications resulting from reasonable or reasonably foreseeable defaults
Loan assumption by qualified borrowers
Payment deferrals, with some limitations
Interest-rate conversions
Modifications that change a loan from non-recourse to recourse, or vice-versa
CMBS, MBS, Property Improvements, and Credit Enhancements
Due to the types of restrictions mentioned above, many CMBS borrowers are actually not allowed to improve their property, even if it would increase their cash flow and prevent them from defaulting on their loans. Since property improvements typically reduce the investment risk of commercial mortgage-backed securities, they are referred to as “credit enhancements”.
Legislation has been introduced by Congress in order to allow MBS and CMBS borrowers to enact value-add improvements to their properties. The REMIC Improvement Act of 2009 would have eased REMIC rules to allow these improvements, but, as of 2022, the bill has not been passed.
In 2020, members of Congress proposed the HOPE Act, which would require the Treasury to establish a temporary liquidity facility that CMBS borrowers could tap into in order to stay current on their mortgages. The bill was intended to help boost up retail businesses, many of which would be disrupted if the shopping centers they rent from went into foreclosure. Like the REMIC Improvement Act, as of 2022, the bill has not been passed.
REMICs and the Dodd-Frank Act of 2010
After massive CMBS delinquencies following the financial crisis of 2008, Congress wanted to ensure that MBS and CMBS lenders followed stricter guidelines regarding the loans they issued. In 2010, the Dodd-Frank Act, which was passed by both houses of Congress, introduced risk-retention rules that required the originating lender of an MBS or CMBS loan to hold on to 5% of the loan on their balance sheets.
The law, which was enacted in 2016, ensured that lenders had “skin in the game” and would not originate loans that they believed would eventually go into default. Prior to this, lenders could pass on 100% of the risk to bondholders, which leads to far less stringent underwriting procedures, and, as a result, the issuance of bonds with a significantly higher risk profile for investors.
This law did not directly impact REMICs but is still important to understand the environment in which REMIC-issued MBS and CMBS are issued.
REMICS vs. Real Estate Investment Trusts (REITs)
REMICs are sometimes compared to real estate investment trusts (REITs), but they are actually quite different in nature. REITs, unlike REMICs, are trusts which, instead of mortgages, typically hold income-producing commercial or residential real estate. However, some REITs referred to as mortgage REITs, actually do own pools of commercial mortgages. This makes mortgage REITs, in practice, somewhat similar to REMICs.
Unlike REMICs and the mortgage-backed securities they issue, REITs are required to pay out 90% of their taxable income to shareholders in the form of dividends. Some pay monthly, while others pay quarterly.
Like REMICs, REITs are generally pass-through entities and do not pay income taxes, though they do pay property taxes on the individual properties they hold.
REMICs vs. Collateralized Morgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs)
REMICs are also often compared to collateralized mortgage obligations (CMOs), as they are both financial instruments that pool mortgages together into bonds that are sold to investors on the secondary market. Technically, they are the same thing, as REMICs issue CMOs in the form of CMBS or MBS.
However, in practice, many securities referred to as CMOs are slightly different. For example, some non-REMIC issued CMOs are generally taxed directly, unlike REMICs, which are generally pass-through entities.
In contrast to REMICs and CMOs, collateralized debt obligations (CDOs) are securities that can be collateralized by a wide variety of debt obligations, not just residential or commercial real estate loans.
For example, CDOs can be backed by student loans, credit card debt, automobile debt, and other types of consumer debt, or even a combination of different types of debts. Like REMICs and CMOs, CDOs are divided into tranches based on risk and return and are typically structured as special purpose vehicles (SPVs) or special purpose entities (SPEs).
In Conclusion
REMICs are simply the vehicle through which mortgage-backed securities and commercial mortgage-backed securities are issued. They are typically pass-through entities for tax purposes and can be organized in a variety of ways. REMICs and their pooling and servicing agreements enact strict requirements and borrowers and servicers, some of which may not be beneficial to either. Various legislation introduced by Congress has attempted to reform REMICs, but none has passed.