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Cashmere Valley Bank v. Department of Revenue

Supreme Court of Washington, En Banc

September 25, 2014

Cashmere Valley Bank, Petitioner ,
The Department of Revenue, Respondent

Argued May 29, 2014

Reconsideration denied November 25, 2014.

Appeal from Thurston County Superior Court. No. 09-2-01756-2. Honorable Paula Casey.

George C. Mastrodonato and Michael B. King (of Carney Badley Spellman PS ), for petitioner.

Robert W. Ferguson, Attorney General, and Heidi A. Irvin and Charles E. Zalesky, Assistants, for respondent.

Dirk J. Giseburt and Michele G. Radosevich on behalf of Washington Bankers Association, amicus curiae.

AUTHOR: Justice Charles K. Wiggins. WE CONCUR: Chief Justice Barbara A. Madsen, Justice Charles W. Johnson, Justice Susan Owens, Justice Mary E. Fairhurst, Justice Debra L. Stephens, Justice Steven C. Gonzá lez, Justice Sheryl Gordon McCloud, Justice Mary I. Yu.


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[181 Wn.2d 624] Wiggins, J.

¶ 1 This case turns on interpretation of a state tax deduction statute. Former RCW 82.04.4292 (1980) provided that in computing their business and occupation (B& O) tax, banks and financial institutions could deduct from their income " amounts derived from interest received on investments or loans primarily secured by first mortgages or trust deeds on nontransient residential properties." [1] Between 2004 and 2007, Cashmere Valley Bank invested in mortgage-backed securities known as real estate mortgage investment conduits (REMICs) and collateralized [181 Wn.2d 625] mortgage obligations (CMOs). Cashmere claims that interest earned on these investments is deductible under RCW 82.04.4292.

¶ 2 We hold that Cashmere cannot claim the deduction because its investments in REMICs and CMOs were not " primarily secured" by first mortgages or trust deeds. Cashmere's investments in REMICs and CMOs gave it the right to receive defined income streams from a pool of mortgages, trust deeds, and mortgage-backed securities, held in trust for investors. The ultimate source of cash flow was mortgage payments. However, Cashmere's investments were not backed by any encumbrance on property nor did Cashmere have any legal recourse to the underlying trust assets in the event of default. Thus, Cashmere's investments were not " primarily secured" by mortgages or trust deeds. We affirm the Court of Appeals and deny Cashmere the deduction.


I. History and Overview of Mortgage-Backed Securities

¶ 3 A mortgage-backed security (MBS) is a type of tradable asset entitling its owner to principal and interest payments from a pool of mortgages. [2] The creation of an MBS begins when a home buyer borrows money from a lender to purchase a home. [3] As security for the loan, the borrower gives the

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lender a mortgage on the home. The lender then may sell the mortgage to a buyer on the secondary market.

¶ 4 The secondary market buyer acquires the right to receive the borrower's principal and interest payments on the home loan and also the right to foreclose on the home if [181 Wn.2d 626] the borrower fails to make timely payments. [4] The buyer often purchases numerous mortgages from various institutions and then " securitizes" the mortgages by pooling (or packaging) the mortgages and issuing interests based on those pools to investors. These interests--that is, these MBSs--vary in how they are structured and what kind of interest the investors receive. See Cashmere Valley Bank v. Dep't of Revenue, 175 Wn.App. 403, 305 P.3d 1123 (2013) (explaining creation of MBSs).

¶ 5 A simple type of mortgage security is known as a pass-through security. Investors who purchase a pass-through security own a portion of each of the underlying mortgage loans in the pool and are entitled to a pro rata share of principal and interest payments. The mortgages underlying the securities remain largely intact; any division of interest between investors is accomplished through warranties or proportionate ownership of those whole loans. The cash flows from these investments " pass through" from borrowers to investors. Thus, cash flows may vary from month to month depending on the actual payments borrowers make on the mortgages in the pool.

¶ 6 Pass-through securities may be pooled again to serve as collateral for a more complex type of mortgage security known as a collateralized mortgage obligation (CMO) or, since 1986, a real estate mortgage investment conduit (REMIC). CMOs and REMICs (terms that are often used interchangeably) are essentially the same type of investment instrument; REMICs are more recent, and they enjoy certain federal tax benefits. [5] The remainder of this opinion [181 Wn.2d 627] will generally refer to these investments collectively as REMICs.

¶ 7 To create a REMIC, a secondary market buyer pools MBSs and/or whole mortgage loans and deposits them into a REMIC trust account. The securities and mortgages in the pool are divided into individual principal and interest payments due under each instrument:

For example, a 30-year fixed-rate mortgage requiring monthly principal and interest payments would consist of 720 individual payments--360 principal payments and 360 interest payments. A pool with 1,000 of these kinds of mortgages would thus have 720,000 separate payments of principal and interest.

Cashmere Valley Bank, 175 Wn.App. at 412 n.9. The REMIC issuer reconfigures these payments into new combinations of principal and interest called " tranches." [6] Each tranche represents a new security and has a unique risk profile. [7]

¶ 8 Investors buy securities in the different tranches, which entitle the investors to a specific payment stream. The issuing trust collects principal and interest from the underlying assets and then pays out distributions to the different tranches based on the terms of the security. Usually, this creates a

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" waterfall" of payments, where the most senior tranches are paid first and subordinated tranches are paid later.

¶ 9 Unlike pass-through investors who purchase slices of each mortgage in the pool, REMIC investors purchase fractional [181 Wn.2d 628] shares in the different tranches. That tranche may have a claim on principal payments, interest payments, or both. Typically, investors are not promised that they will receive 100 percent return on their initial investment. They are merely buying a cash flow ...

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