Cadwalader partner Jason Schwartz examines the tax considerations applicable to two common distressed mortgage securitization structures: the distressed mortgage real estate mortgage investment conduit and the distressed mortgage fund.
Distressed debt investors are waiting for the next downturn.1 By the end of 2018, asset managers reportedly had raised $200 billion in private credit funds that remained uninvested.2 While it is hard to predict when and how this capital will be deployed, it could pay to reexamine the tax considerations applicable to one of the primary ways that hedge funds and other institutional investors historically have financed their positions in distressed mortgage loans: the distressed mortgage securitization.
Distressed mortgage securitizations are special purpose vehicles that issue securities primarily to institutional investors; invest the proceeds mainly in distressed mortgage loans; and apply the interest, principal, and sale proceeds they receive to pay interest and principal on the securities that they issue. Distressed mortgage securitizations allow hedge funds and other institutional investors to make a leveraged, tax-efficient investment in a pool of distressed mortgage loans, and allow banks, real estate investment trusts, and other mortgage loan originators to finance or sell their distressed mortgage loan portfolios, freeing up capital that they can then use to make or acquire additional mortgage loans. Meanwhile, by issuing multiple classes of securities with different seniorities and payment characteristics backed by a pool of mortgage loans, distressed mortgage securitizations appeal to investors that may be unwilling or unable to invest directly in distressed mortgage loans.
This report discusses the tax considerations applicable to two common distressed mortgage securitization structures, which it refers to as (1) the distressed mortgage real estate mortgage investment conduit and (2) the distressed mortgage fund.3
At the outset, it should be noted that managing a portfolio of distressed mortgage loans is a "high-touch" business that regularly involves negotiated workouts and foreclosures. Each securitization structure represents countless hours spent by collateral managers and tax advisers reconciling business imperatives with tax law. Accordingly, each structure has its own complexities, and the choice between structures may depend in part on how comfortable the parties and their tax advisers are with these complexities.
1 See "Distressed Debt Funds Are Waiting for a Downturn," The Economist, Nov. 7, 2019.
2 Julie Segal, "How Dry Powder Could Blow Up Private Credit and Private Equity," Institutional Investor, Mar. 6, 2019.
3 For reasons described in Section II.B, distressed mortgage fund securitizations sometimes are referred to colloquially as debt-for-tax deals.
Originally published in Tax Notes Federal, January 20, 2020
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