Days of "benign neglect" over in fixed income

The Internal Revenue Service is now planning a number of new regulations that, if enacted, could seriously shake up and possibly damage the derivatives and securitization markets.

Some likely regulations, which are still in the planning stages and have yet to be formalized by Department of Treasury officials, could have a major impact on asset-backed securities, in particular those collateralized by credit derivatives. Such deals are the next evolutionary step in the ABS market, which has gone from issuers pooling actual assets (student loans, credit card accounts) and selling future revenue streams to investors, to issuers designing complex, wholly synthetic deals that transfer risk off balance sheets via issuing derivatives.

Lawyers and analysts familiar with the IRS' strategy said they believe the agency on the whole has noble ideas - it wants to bring order to such esoteric markets as contingent swaps and synthetic collateralized debt obligations. Yet because the IRS has been essentially absent throughout these markets' early stages, the agency is betraying its unfamiliarity with the nuances of some extremely complex capital markets.

"They're not going out and intentionally harming [the market] but by being so far out of the market, even when they try hard they're too far behind to get it fully right," said David Nirenberg, an attorney specializing in securitization at Orrick, Herrington & Sutcliffe LLP.

The IRS has made it clear that it will be investigating a variety of capital markets sectors over the next year, and the agency has begun serious work on two sectors, for which new regulations could emerge as early as this summer. These sectors are the swaps markets and the credit derivatives markets, and the IRS's ultimate decision could have a serious impact on investors and issuers. Already, market players noted that trading of such securities as tax-exempt derivatives has lessened since it became apparent new regulations were coming through.

The IRS' treatment of these sectors for most of the last decade has been essentially "benign neglect," securitization lawyers said, and the market has set up its own rules and regulated itself. Now, faced with Congressional outcries about the Enron Corp.'s abuse of synthetics and special-purpose entities, the IRS has felt pressure to issue some form of regulations over the still-fledgling market sectors.

"There's a lot of places where the proposed rules I've seen don't work, but the [IRS] feels they've got to do something," said one securitization official, adding that he was concerned that the IRS did not have a complete grasp of the market's current issues. "The IRS often regulates yesterday's market."

Derivative question

A key issue confronting the IRS is whether credit derivatives should be considered as financial instruments, as they generally are treated now, or whether they qualify as a type of insurance.

This question is crucial to many players in the derivatives markets, including the growing number of CDO managers that are backing their ABS deals with credit derivatives. If the IRS does rule that credit derivative issuers should be treated as insurers, such issuers would be hit with a corporate tax on their income. In most cases, the costs of this tax would nullify the benefits of offering any derivative securities transactions.

This question has come up primarily because there is currently no statutory or regulatory definition of insurance for tax purposes, said attorney David Miller at Cadwalader, Wickersham & Taft. Instead, the U.S. Supreme Court established in 1941 a very broad definition of insurance for tax purposes, which credit derivatives arguably could satisfy. Changing that precedent could close off the derivatives markets for a good number of current issuers. "Treatment of credit derivatives as insurance for U.S. federal tax purposes could have significant adverse tax consequences for both credit protectors and protected parties," Miller said.

Miller and two colleagues met with Treasury officials in March to discuss the issues, and made several recommendations. The attorneys requested that the IRS confirm in regulations that derivatives are to be treated as financial instruments and not as insurance, and The New York State Bar Association will soon offer a similar opinion in an upcoming report on securitization. So far, the IRS has not indicated what decision it will make.

A lack of nuance

In other sectors, the IRS' early hints at upcoming regulations have some players fearing that the agency has not fully comprehended market complexity.

One example of how the agency could unwittingly cause chaos in the fixed-income sector is credit swaps, in particular those that feature contingent payments. What has the IRS sniffing around the sector is the belief that such swaps can be used by issuers to defer income - which in the post-Enron environment, seems to regulators like a tax dodge at best, and a way to disguise fraud at worst.

What is worrying fixed-income players is that so far, the IRS has not shown any indication that it is separating equity-related swaps from those based in the credit derivatives or fixed-income markets, and that any new regulations that come out will be applied as a broad-brush to all market sectors. That could be a disaster for fixed-income swaps in particular.

"I'm afraid whatever rules the IRS designs for equity swaps will apply across board, even though fixed-income swaps are a wholly different market," said Nirenberg, who along with James Peaslee authored the book Federal Income Taxation of Securitization Transactions. He added that the IRS has shown willingness to negotiate with capital markets officials and attorneys about the issue, and that it is currently accepting comments so as to better hone its regulations.

Another controversy lies in the IRS's recent decision to go against market common law in the area of tax-exempt bonds. For much of the last 10 years, the market has essentially made its own precedents with little IRS guidance, and so investment partnerships that invest in tax-exempt bonds have been able to elect not to be subject to partnership tax accounting, which some investors consider onerous. However, the IRS recently has told some investors it does not agree with the Street's position and is making recommendations on how to change strategies.

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