Selected Issues In The Taxation Of Swaps, Structured Finance and Other Financial Products

Abstract

This article is based on a paper presented by the author to the Tax Review of New York City on November 16, 1992.

The last decade has seen an explosive growth in the use of swaps and other derivative products as part of the asset and liability management strategies of corporations and other institutional investors. Beginning with interest rate and currency swaps, the menu of swap products has expanded to include commodity swaps, equity index swaps, equity swaps, total return swaps, basis swaps, and interest rate caps, floors and collars. According to industry sources, the market for interest rate swaps has grown in notional principal amount from an estimated $3 billion in 1982 to over $3.065 trillion by the end of 1991 (the most recent figures available). Similarly, the outstanding aggregate notional principal amount of currency swaps has grown from $182 billion in 1987 to $807 billion by the end of 1991.
At the same time as the swap market has been expanding, the structured finance market, including mortgage and asset securitization, has seen similar growth. Beginning in the 1970s, U.S. government-backed enterprises such as the Government National Mortgage Association ("Ginnie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac") sponsored transactions in which pools of residential first mortgages were bundled into pass-through certificates that were then sold to thrifts, banks and other institutional investors. In 1983, Freddie Mac introduced collateralized mortgage obligations ("CMOs"). CMOs, which divided up the cashflows from an underlying pool of mortgages into separate debt securities having different maturity, interest rate and credit characteristics, dramatically broadened the market for mortgage-backed securities. With the enactment of the "Real Estate Mortgage Investment Conduit" ("REMIC") provisions as part of the 1986 Tax Reform Act, the taxation of mortgage pass-through and pay-through securities became subject to a new, self-contained set of rules. Moreover, since the mid-1980s, structured finance techniques originally employed in securitizing mortgages have been applied to a broad range of other financial assets, including stocks, credit card receivables, auto loans, lease receivables, home equity loans, commercial and industrial loans and trade receivables.