What it means
Start with a bank that has made thousands of mortgages and wants to free up its capital. It can place those loans into a REMIC, which then sells securities to investors, using the loan repayments to pay them.
The bank gets cash today and can lend again. The key feature is the division of the pool into tranches (the French word for slices).
Senior tranches are paid first and carry the least risk, while junior tranches are paid later and absorb losses first, in return for a higher potential yield. A residual interest collects whatever is left after the other classes are paid.
REMIC status comes from tax rules, particularly in the United States, where a qualifying entity avoids paying tax on the pool's income at the entity level. To qualify, the structure must meet tests about its assets, its classes of interest and a fixed timetable.
If it fails, it can lose the benefit and face a double layer of tax. Investors choose between tranches depending on their appetite.
An insurer needing safety may hold a senior class, while a hedge fund hunting yield may take a junior class. The cash flows depend on how quickly borrowers repay, so early repayment can shorten a bond's life and change its return.
The structure played a notable part in the 2007 to 2009 financial crisis, when many mortgages supporting such securities defaulted. That history is a useful reminder that slicing risk does not remove it.
The losses simply land on the investors lowest in the order of payment. For a finance team, the main questions about any REMIC investment are who ranks where, what the underlying loans look like and how fast borrowers are likely to repay.
Rating agencies grade each class, but a grade is an opinion, not a guarantee. Reading the documents that describe the order of payment is the safest way to see where an investor really stands.
In practice
Real-world examples.
Example
A regional bank holds $400,000,000 of residential mortgages and wants to reduce its exposure. It transfers a pool to a REMIC and receives cash from investors who buy the securities. The bank uses the proceeds to make new loans while the REMIC pays investors from the borrowers' repayments.
Example
A life insurer buys a senior REMIC class paying a modest yield because it needs predictable cash to meet future claims. The class is paid before any other, so the insurer is exposed to losses only if the pool suffers a severe wave of defaults. Its investment committee records the holding at amortised cost. The committee reviews the credit rating of the class each quarter to make sure it still fits the insurer's policy.
Example
A specialist investment fund takes a junior class of a REMIC backed by office building loans. The fund expects a yield well above the senior classes, but it accepts that it will lose money first if tenants leave. The manager stress tests the pool by assuming vacancy rises sharply.
Formula
Calculation
Remaining balance of a tranche = Original balance - Losses allocated to that tranche
Losses are allocated from the bottom of the structure upwards. Suppose a REMIC holds $10,000,000 of mortgages, split into Class A of $6,000,000, Class B of $3,000,000 and a residual interest of $1,000,000. Borrowers default and the pool suffers $1,500,000 of losses. The residual absorbs the first $1,000,000, leaving it at 1,000,000 - 1,000,000 = $0, and Class B absorbs the remaining $500,000, so Class B falls to 3,000,000 - 500,000 = $2,500,000. Class A is untouched at $6,000,000, and the total remaining is 6,000,000 + 2,500,000 = $8,500,000, which equals 10,000,000 - 1,500,000.Case study
Seen in the real world.
Marlowe Mortgage Capital is an illustrative, fictional lender that assembles $50,000,000 of home loans into a REMIC. It issues senior bonds of $38,000,000, mezzanine bonds of $9,000,000 and a residual of $3,000,000.
During the first year, the economy weakens and loan defaults cause $4,000,000 of losses. The residual is wiped out and the mezzanine bonds lose $1,000,000, while the senior bonds remain intact.
The senior investors keep receiving their payments, but the mezzanine holders are shaken. In this illustrative case, the finance team learns that the ranking in the structure, rather than the quality of the average loan, decides who feels the pain first. The senior bonds now have only $8,000,000 of cushion beneath them instead of the original $12,000,000, which is why their price softens even though they have not lost a cent.
Watch out
Common mistakes.
- Assuming a REMIC is a company that originates loans, when it is a pooling structure that holds loans already made.
- Believing senior classes are free of risk, when a deep enough wave of defaults can reach them.
- Overlooking prepayment risk, where borrowers repay early and shorten the life of the investment.
Questions
People also ask.
Why is REMIC status valuable?
A qualifying REMIC is generally not taxed on its income at the entity level, so the earnings pass through to investors and avoid being taxed twice.
Who can invest in a REMIC?
Mostly institutions such as banks, insurers and funds, although individuals can reach them indirectly through bond funds.
Is a REMIC the same as a mortgage-backed security?
Not exactly, because a REMIC is a tax-qualified structure often used to issue mortgage-backed securities in classes.
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