SEC No-Action Letter Regarding Investments in Credit Risk Transfer Securities

Financial Industry Alert | October.20.2017

On October 16, the SEC Division of Investment Management granted no-action relief in response to a request by Orrick on behalf of Redwood Trust. The Redwood request and the SEC staff response impact the way in which investments in certain credit risk transfer securities are treated under the Investment Company Act of 1940. The action by the SEC does not directly impact the REIT tax eligibility of credit risk transfer securities.

The Request

On behalf of Redwood Trust, Inc. ("Redwood"), this is a request to the staff of the Division of Investment Management (the "Staff") regarding the Section 3(c)(5)(C) exclusion from the registration requirements of the Investment Company Act of 1940 (the "1940 Act"). Specifically, we request that the Staff advise that it will not recommend that the Securities and Exchange Commission take any enforcement action if subsidiaries of Redwood treat their investments in the notes or other instruments by which Fannie Mae and Freddie Mac (the "Enterprises") transfer credit risk to the private sector, as described more fully below, as "real-estate-type interests" for purposes of determining the applicability to such entities of the Section 3(c)(5)(C) exclusion.

SEC Division of Investment Management Response

Based on the facts and representations in your letter, we would not recommend enforcement action to the Commission under Section 7 of the 1940 Act if the Redwood Subsidiaries treat their investments in the credit risk transfer securities, as described in your letter, as real estate-type interests for purposes of the Asset Composition Test in utilizing the exclusion from the definition of investment company set forth in Section 3(c)(5)(C) of the 1940 Act.

Please click here to see the SEC response as well as our request.

The action by the SEC staff will facilitate the ability of Redwood, and other mortgage REITs as well, to support the FHFA’s efforts to have the GSEs transfer most of their mortgage credit risk to the private sector, and thereby to diminish risk to taxpayers. While we were confident that there was support for our request, there were compelling public policy arguments as well.

In contemplation of changes in the Fannie and Freddie credit risk transfer programs, the relief covers Fannie and Freddie’s existing credit risk transfer securities as well as similar securities that have the following commonalities: (1) payment of the stated principal and interest on such securities is not guaranteed; (2) the performance of the securities is designed to simulate the delinquency and principal payment experience of a designated reference pool of mortgages that are owned by Fannie Mae or Freddie Mac or that back specified Fannie Mae- or Freddie Mac-guaranteed MBS; (3) their payments are not derived directly from mortgage cash flows; (4) the securities are not secured by and do not represent a direct ownership interest in mortgages; and (5) ownership does not empower investors to control the servicing of, or foreclose on, any of the pooled mortgages.