Real Estate Mortgage Investment Conduits (REMICs)

What is it?

A real estate mortgage investment conduit (REMIC) is a complex type of mortgage security that is comprised of other mortgage securities. The most basic type of mortgage security, known as a pass-through," represents a direct ownership interest in mortgage loans made by financial institutions (lenders) to finance or refinance borrowers' purchases of new homes or other property. These loans are pooled by the lenders, and interests in these pools are sold as "pass-through" mortgage securities to investors, who own a direct interest in the underlying mortgage loan pool. As the borrowers pay off the mortgages, the investors receive payments of principal and interest.

Mortgage loan pools also may be sold by lenders to a secondary mortgage market (referred to as issuers, servicers, dealers, or guarantors). The issuers may restructure those loan pools, sometimes combining them with other pools of mortgage loans. to create collateral for a more complex type of mortgage security called a REMIC or more generically, a collateralized mortgage obligation (CMO). Those REMICs are then sold to investors. (Most CMOs created after 1986 are actually structured as REMICs for tax and accounting reasons, though many people still refer to them simply as CMOs.)

Mortgage securities are important because they (1) enable lenders to access a larger reservoir of capital, (2) make financing available to purchasers of real estate at a lower cost, and (3) offer some benefits to investors.

Why the need for real estate mortgage investment conduits (REMICs)?

The first pass-through mortgage security was issued in 1970. The pass-through is equivalent to an outright sale of the underlying mortgages. The lender receives payments from the borrowers and then passes pro rata shares of those payments directly to the investors. The lender cannot reinvest or reallocate the cash flow before passing on the payments. This structure regulates cash flow and fixes final maturity dates. This is undesirable to many investors. Generally, mortgages are fixed for 30 years. This holding period is too long for most investors. However, many mortgages are paid off early. Thus the actual average life of a mortgage is uncertain. This uncertainty can be unattractive to many investors.

REMICs, which were created in 1986 by Congress, address the problems of long maturity and cash flow uncertainty because they restructure interest and principal payments into separately traded securities. This allows the issuers to create a security that has several classes or "tranches" (which means "slices" in French). Each class carries a different coupon rate, average life, prepayment terms, and final maturity. With this flexibility, the securities can be designed to meet the needs of many different types of investors.

Who issues REMICs?

Federal agencies

Most mortgage securities are issued by a U.S. government agency (e.g., Ginnie Mae) or a U.S. government-sponsored enterprise (Fannie Mae and Freddie Mac). Ginnie Mae, the Government National Mortgage Company, is a government-owned corporation within the Department of Housing and Urban Development. Fannie Mae and Freddie Mac are chartered by Congress and owned by stockholders (though both have been in conservatorship and operated by the Federal Housing Finance Agency (FHFA) since 2008). Mortgage securities issued by these organizations are known as agency securities.

Ginnie Mae, Fannie Mae, and Freddie Mac buy mortgage loans from the financial institutions that lend the money to the borrowers. They place them in pools and issue securities that represent interests in the pools. The interests are then distributed to investors. In addition, these agencies provide some type of guarantee to the investors.

Private-label securities

Some private institutions also buy mortgage loans from financial institutions and package them for sale to investors as mortgage securities. These securities are known as private-label securities. In contrast to agency securities, private-label securities are not guaranteed by any governmental entity.

The underlying mortgages that back private-label securities are generally nonconforming loans. Agency securities are backed by mortgage loans that must pass certain criteria. For example, mortgages that are eligible for Ginnie Mae pools must be less than one year old, insured by the FHA, or guaranteed by the VA. The size of the loans backing Fannie Mae and Freddie Mac securities must not exceed a certain amount (so-called jumbo loans do not qualify). Thus, there are a number of loans that are nonconforming, but not necessarily of lesser quality, that cannot be securitized by the agencies and are available to private institutions.

Who invests, and how?

Individual investors, corporations, commercial banks, life insurance companies, pension funds, trust funds, and charitable endowments all invest in mortgage securities. Minimum investment amounts range from $1,000 to $25,000. Some costs may be incurred if a dealer is used. Mortgage securities are traded over the counter, rather than on an exchange.

How are REMICs structured?

Sequential Pay (SEQ), Plain Vanilla, Clean Pay, or Current Pay

The most basic REMIC structure consists of classes referred to as Sequential Pay (SEQ), Plain Vanilla, Clean Pay, or Current Pay. This structure includes several regular interest classes and a single residual interest class. A regular interest entitles the investor to receive a specified principal amount. The single residual interest is an interest that is not a regular interest. The classes are designated by letter (e.g., A class, B class), and each is assigned a coupon and the terms for payments to the investors. The single residual interest class is usually designated as the R class. The Z class is generally an accrual or zero coupon class.

Principal is paid sequentially in alphabetical order. An investor with an A class interest receives principal repayments first. An investor with a B class interest does not receive principal repayments until the A class is totally repaid (retired). This process continues until the last class (the Z class) is retired. Investors in all regular interest classes, except the Z class, receive interest payments calculated on the principal balance of the class. The interest to the Z class accrues until all other classes have been paid in full. Any collateral remaining after the final class has been paid is paid to the investors in the single residual interest class.

The disadvantage to this type of structure is that it is susceptible to prepayment risk. Borrowers prepay their mortgage loans for many reasons. Prepayments are treated the same as repayments (i.e., they go first to investors in the first classes). This may reduce the interest income paid to those investors. For more information on prepayment risk, see below.

Planned Amortization Classes (PACs)

Planned Amortization Classes (PACs) were introduced in late 1986 and are designed to reduce prepayment risk by redirecting prepayments to other classes of securities called Companion or Support Classes. It is the Companion or Support Classes that absorb the cash flow volatility caused by prepayments. Investors in PACs receive a fixed amount of principal, regardless of whether there are prepayments. PACs more or less assure that investors will receive payments over a predetermined time period under various prepayment scenarios.

Targeted Amortization Classes (TACs)

Targeted Amortization Classes (TACs) work similarly to PACs. Investors in TACs receive constant scheduled payments because prepayments are redirected to companion or support classes. However, the TAC also serves to absorb some of the cash flow variability directed away from PACs. Thus, TACs are riskier than PACs, but TAC investors can expect higher yields.

Companion or Support Classes (SUPs)

Prepayment variability cannot be eliminated, only redistributed. The Companion or Support Classes (SUPs) absorb the variability of cash flows to PACs, TACs, and other scheduled classes. Because SUPs have the highest degree of volatility, they also generally pay a higher yield.

Floaters and inverse floaters

A floater or inverse floater pays a variable rate of interest. The coupon rate payable to the investor is adjusted periodically by adding or subtracting a certain amount to or from an index, usually the London Interbank Offered Rate (LIBOR). A superfloater is a variation that floats a certain percentage above LIBOR. These securities are generally used by highly sophisticated investors as a hedge against interest rate risk in their portfolios.

Interest Only and Principal Only Classes (IOs/POs)

Mortgage securities may be divided into two classes: one to which only interest is distributed, the other to which only principal is distributed. In other words, repayments and prepayments made by the borrowers on the underlying mortgages are "stripped apart" into interest and principal cash flow streams. The interest goes to the Interest Only Class (IOs) while the principal goes to the Principal Only Class (POs). IOs and POs are very sensitive to prepayment and interest rates and so are highly volatile. As such, investors in this type of security tend to be institutional.

What are the risks?

Prepayment or option risk

Prepayment risk, also called option risk, refers to the possibility that the borrowers of the mortgage loans underlying the security will make some or all of the payments before they are due. Although some prepayments are assumed when calculating the price and yield of a security, there is the chance that the rate of prepayment will be faster than expected. Borrowers are unrestricted and may prepay mortgage loans for any reason at any time. Often, borrowers prepay mortgages and refinance in order to take advantage of lower interest rates. In these cases, investors receive principal sooner than anticipated. Consequently, the investor is in the position of reinvesting at lower interest rates. This is referred to as call risk. A CMO's yield and average life will fluctuate depending on the actual rate at which mortgage holders prepay the mortgages underlying the CMO, as well as changes in current interest rates.

Extension risk

Extension risk is the flip side of prepayment risk. It refers to the possibility that prepayments will be slower than the anticipated rate. This causes principal to be returned later than the investor expects. This generally occurs when interest rates rise because prepayments slow down. In these cases, the investor may be delayed in taking advantage of the opportunity to reinvest in other higher-yielding securities.

Market risk

Market risk is the risk that the price of a security with fluctuate at any time. Fluctuations in the price of mortgage securities occur when interest rates rise and fall. Market demand for securities whose prices are fluctuating, as well as the prices offered, may decrease.

Credit risk

Credit risk refers to the chance that an investor may or may not receive all or part of the principal because the issuer defaults. Although agency securities come with some sort of guaranty, they are not totally risk free. Private-label securities come with no guaranty. Also, a REMIC may have an entirely different credit rating than the loans in the underlying mortgage loan pools. REMICsplayed a role in the 2008 financial crisis because some REMICs received high ratings despite the fact that the underlying mortgage loans had a much higher risk of default. When borrowers began to default on the underlying loans, the value of the REMICs that included them suffered.

What are the tax consequences?

The tax consequences of investing in mortgage securities vary depending on the prepayment structure, the issue price, and the price actually paid.

Generally, interest paid or accrued to investors is subject to income tax on a current basis. Principal paid to investors to the extent that it is a return of investment is not taxable. If an investor pays for a security at a discount (i.e., less than its issue price), the accrued original discount (OID) will be taxed over the life of the security.

For most taxpayers, interest is shown on Form 1099-INT. OID is shown on Form 1099-OID.

Caution: REMICs are complex investments that require the consideration of various tax issues. Investors should consult a tax advisor for more information.

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

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