Tax Analysts Blog

Do Tax Rules Encourage Risky Mortgage Securitization?

Posted on Oct 5, 2009

The U.S. government encourages corporations to issue as much debt as possible, to pay their executives more for excessive risk taking, and to load up company pension plans with company stock rather than create a diversified portfolio. It encourages banks to set up innumerable subsidiaries in tax havens where they enjoy "light touch" regulation. It encourages banks to meet capital requirements by issuing hybrid debt rather than more resilient common equity. It encourages massive overbuilding of housing and massive consumer leverage. And it provides an uncapped subsidy for state and local governments to issue their own debt. The U.S. government encourages all this risky financial behavior through the tax code.

Recent research by academic types on the role of taxes in promoting the financial crisis include papers by Joel Slemrod of the University of Michigan ("Lessons for Tax Policy in the Great Recession"), Daniel Schaviro at the University of Chicago Law School ("The 2008-09 Financial Crisis: Implications for Income Tax Reform"), Geoff Lloyd of the OECD ("Moving Beyond the Crisis – Strengthening Understanding of How Tax Policies Affect the Soundness of Financial Markets"), the International Monetary Fund ("Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy"), and a 2008 article and a 2009 article by yours truly at Tax Analysts.

The most intriguing new idea on the interplay of tax and risk comes from a paper ("Tax Arbitrage Feedback Theory") by Samuel Eddins, Director of Research (pictured on right) at IronBridge Capital Management. In a nutshell, his argument goes something like this:

(1) Losses on mortgage investments for traditional (non-financial) investors are tax disadvantaged because of the limitation on losses and because of the preferential capital gains rate.

(2) Because losses play a larger role in the expected return of risky assets, this tax disadvantage increases with risk.

(3) By pooling mortgages, the securitization process can transform risky high-yield mortgages into relatively safe low-yield debt. More specifically, securitization went into "overdrive" around the year 2000 when Wall Street developed and used a new legal structure: opaque offshore Collateralized Debt Obligations (CDOs) insured with Credit Default Swaps (CDSs).

(4) Financial firms that are required to mark-to-market do not suffer the same tax penalty on losses as do traditional investors. Their relatively advantageous tax treatment is the basis of their profits from selling insurance in the form of CDSs.

(5) The profitability of this tax arbitrage increases as bankruptcy risk increases.

(6) Therefore, tax arbitrage encourages risky credit mortgage credit and mortgage backed securities.

Eddins concludes: "In essence, this multipart, transactional structure legally transferred government tax receipts to Wall Street bonus pools."



This is a complicated story. And it is hard to gauge the quantitative importance of the effects Eddins describes. Almost certainly it is less than what he implies with statements claiming his theory may be the key to understanding the whole financial crisis.

But his core ideas are original and, more importantly, plausible. With deregulation, financial innovation, and advances in communication, the tax wedges found throughout our clunky tax system are bound to become increasingly important in determining the directions of fund flows. Economists always knew that the unfavorable tax treatment of losses was a penalty on risk taking. Eddins shows how securitization can eliminate that penalty with the largest benefits going to risky mortgages.






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