Industry officials see no losers and perhaps a few new winners in mortgage banking as a result of a U.S. Tax Court opinion in a Fannie Mae vs. IRS case that provides favorable tax treatment for hedge transactions on interest-rate sensitive instruments.
The ruling in effect gives favorable tax treatment for hedges that don't cover all interest rate risk of a particular transaction and which use either a short or long position to reduce interest rate risk, the official said.
For the mortgage backed securities market, it confirms that the use of interest-only or principal-only tranches of MBS in either a long or short position qualifies for favorable treatment.
The decision comes at a fortuitous time for savings associations, because a regulation seeking to reduce interest rate risk at S&Ls is expected shortly from the Office of Thrift Supervision. Confirmation that hedging of MBS risk for S&Ls will win favorable tax treatment is likely to provide an incentive for even greater use of hedging instruments, such as IO and PO MBS tranches, in the future.
The ruling was made in a case involving the Federal National Mortgage Association, Fannie Mae, petitioner, vs. Commission of the Internal Revenue Service, Docket No. 21557-86, filed June 17. Tax lawyers say the ruling appears to generally allow financial institutions to treat hedging losses as ordinary expense.
The IRS had argued that Fannie Mae's transactions were not true hedges and as a result could only be deducted from capital gains, because the hedges did not reduce Fannie Mae's entire interest rate risk. The IRS also argued - equally unsuccessfully - that even if ordinary expense treatment was available for losses on long hedging positions of Fannie Mae, it wasn't available for losses from short positions because a short position cannot be a "substitute" for an ordinary income asset.
The industry's position is that in a hedging transaction, overall gains equal overall losses, so the transaction results in no economic income and therefore shouldn't be taxed.
"This is positive for us," said Albert Elder, a regulatory affairs specialist with the Savings and Community Bankers of America. "The IRS position would have inhibited to some extent the use of hedges by savings associations because it provided unfavorable tax treatment."
Elder said that as of Dec. 31, 1992, thrifts had about $29 billion in swaps transactions outstanding. These were generally certain tranches of mortgage backed securities, as well as futures and options.
The International Swaps Dealers Association, which represents banks and brokerages engaged in swaps activities, hailed the decision, saying it "sends a positive message to the derivatives industry as well as business interests that use financial instruments to hedge risk.
The IRS' position was unfair to taxpayers because it would have taxed ~phantom' income," ISDA said. "While the position of the IRS would have generally undermined the use of futures, forwards and options, the IRS's position would have had a more limited impact on swaps and other notional principal contracts."
A legal opinion provided for the ISDA by Cravath, Swain & Moore noted that the Tax Court issued its ruling on a relatively narrow basis.
The opinion reasoned that Fannie Mae's losses were deductible from ordinary income because the agency is in the business of providing a service to the mortgage market by buying mortgages to provide liquidity. The mortgages are therefore service receivables in FNMA's hands and therefore excluded from the definition of "capital asset" under a provision of the tax code and instead were ordinary expenses because they were "integrally related" to Fannie Mae's mortgages and debenture issues.
The legal paper cautioned that the Tax Court declined to consider broader arguments raised by Fannie Mae, but "clearly rejected" the IRS' arguments that a transaction is not a hedge if it only partly reduces risk.