Freytag v. Comm'r of Internal Revenue, Docket Nos. 4934-82

Decision Date21 October 1987
Docket NumberDocket Nos. 4934-82,33016-83,3749-84,204-84,29012-82,7658-84,9307-82,3250-83,11821-84.,1240-83,27146-82,8616-83
Citation89 T.C. No. 60,89 T.C. 849
PartiesTHOMAS L. FREYTAG AND SHARON N. FREYTAG, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
CourtU.S. Tax Court

89 T.C. 849
89 T.C. No. 60

THOMAS L. FREYTAG AND SHARON N. FREYTAG, ET AL., Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 4934-82

9307-82

27146-82

29012-82

1240-83

3250-83

8616-83

33016-83

204-84

3749-84

7658-84

11821-84.

United States Tax Court

Filed October 21, 1987.


HELD: Losses from transactions in forward contracts writte n by First Western Government Securities are not deductible.

[89 T.C. 849]

Robert M. Fink, Richard J. Sideman, Ellen I. Kahn, Charles R. Billings, Barry M. Bloom, John M. Campbell, Robert J. Chicoine, John S. Pennish, Thomas E. Redding and Robert E. Wilbur, for the petitioners.

Stephen M. Miller, Joyce E. Britt, Robert W. Towler and James M. Eastman, for the respondent.

OPINION
STERRETT, CHIEF JUDGE:

This case was assigned to Special Trial Judge Carleton D. Powell pursuant to the provisions of section 7456(d) (redesignated as section 7443A(b) by the Tax Reform Act of 1986, Pub. L. 99-514, section 1556, 100 Stat. 2755) and Rule 180 et seq.1 The Court agrees with and adopts the opinion of the Special Trial Judge that is set forth below.

OPINION OF THE SPECIAL TRIAL JUDGE

POWELL, SPECIAL TRIAL JUDGE:

There are currently over 3,000 cases in this Court that involve the issues presented in these cases. The common denominator of all the cases is that each petitioner entered into alleged financial transactions involving forward contracts for government mortgage-backed securities with First Western Government Securities (First Western). These cases were selected as so-called test cases.2 As we view the cases, the

[89 T.C. 850]

primary issues for decision are: (1) whether these transactions should be recognized for Federal income tax purposes, (2) if so, whether they were entered into for profit under the standard set forth in section 108 of the Tax Reform Act of 1984, as amended, and (3) whether certain petitioners are liable for additions to tax for negligence.

FINDINGS OF FACT
A. FIRST WESTERN, THE SUPPORTING CHARACTERS AND THE PROGRAM

First Western is an Illinois corporation with offices in New York, New York and San Francisco, California. Its president and sole shareholder is Sidney Samuels. Mr. Samuels holds a law degree. He was a Revenue Agent of the Internal Revenue Service and subsequently was in private practice in California until 1977. In 1977 he became a general partner in Price & Company,3 dealer in stock options. In 1978, he formed Samuels & Company (later Samuels, Kramer & Company) and First Western. Samuels & Company was an investment advisory company specializing in the futures markets. First Western is described by Mr. Samuels as a dealer in Government securities. From 1978 to mid-1980, Samuels & Company advised customers with respect to transactions with First Western by recommending ‘portfolio selections‘ of forward contracts based on the customer's interest rate forecast. After that time, First Western took over the functions of Samuels & Company.

In 1978, First Western began marketing portfolios of ‘forward contracts‘ for securities of the Government National Mortgage Association (‘GNMA's‘) and the Federal Home Loan Mortgage Corporation (‘FMAC's‘).

GNMA Securities, also commonly referred to as ‘Ginnie Mae's‘, are registered certificates which represent undivided interests in a specified pool of mortgages guaranteed by GNMA, the Veteran's Administration, the Federal Housing Administration or the Farmers Home Administration. These pools contain approximately $1,000,000 of mortgages. GNMA security holders are protected by the full faith and

[89 T.C. 851]

credit of the United States Government. The stated maturity of a GNMA pool depends on the mortgages that underlie it. During the period with which we are concerned, the coupon or interest rate of the pools in existence varied between 6.5 and 16.5 percent. Most single-family residential mortgages carry a stated maturity of 30 years.

Although Ginnie Mae's are not callable, the underlying mortgages may be prepaid at any time. Due to the prepayment of principal on single family home pools, the average maturity of a pool is considerably less than 30 years. High coupons would pay down faster than low coupons, particularly when interest rates fall. The market practice is to quote Ginnie Mae yields on a pool of such mortgages to a twelve-year half-life (i.e., the point in time when the principal amount of the pool is expected to be repaid.) FMAC securities or ‘Freddie Macs‘ are participation certificates representing an undivided interest in a pool of conventional (non-VA and non-FHA) mortgages, the principal and interest are guaranteed by the Federal Home Loan Mortgage Corporation, a corporation owned by the Federal Government. They also are subject to prepayments. While there are differences in these securities, for our purpose, those differences are not relevant.

THE PORTFOLIOS

A forward contract is a transaction in which two parties agree to the purchase and sale at a future time, known as the settlement date, of a commodity, financial instrument or security under the terms negotiated by the parties. Forward contracts are similar in concept to futures contracts; the latter, however, are for short periods of time, contain standardized terms and are traded on a regulated board or exchange. GNMA and FMAC forward contracts are exempt from registration under the Securities Act of 1933. Forward contracts in these securities were developed because, while the mortgagee was committed to loan the funds, the actual mortgage would not come into existence for 60 or 90 days. During this time the mortgagee was at risk. Thus the concept originated as a device to ‘hedge‘ that risk. There is an active market for forward contracts; however, that market was not designed for individual

[89 T.C. 852]

investors.4 In the market forward contracts for 5 or 6 months or longer are rare because of the extreme financial risks involved.

A forward contract to purchase a security, or a ‘long position,‘ represents an obligation to accept delivery of the underlying security on a specified day. A forward contract to sell a security, or a ‘short position,‘ represents an obligation to make delivery of the underlying contract on a specified day. An outright or ‘naked‘ long or short position involves great risk. The risk in an outright position is that the price of the underlying security will rise or fall.

The simultaneous holding of a long position for one settlement date and a short position for another settlement date constitutes a ‘straddle.‘ The long and short positions are commonly referred to as the ‘legs of the straddle.‘ A straddle theoretically enables an investor to close out the loss leg and offset the loss recognized against ordinary income or capital gain from another source, while holding the gain leg open until a later year with an offsetting position to protect the unrealized gain. This technique theoretically results in both tax deferral and conversion of ordinary income into long term capital gain. In a straddle position, the risk is that the spread or the difference between the prices of the two legs will widen or narrow. With respect to the petitioners, First Western dealt only in complete portfolios of straddles in GNMA and FMAC forward contracts.

First Western structured the portfolios such that the short and long legs of the straddle consisted of forward contracts calling for the delivery of underlying securities with different interest rate coupons and different settlement dates. The settlement dates of these contracts were often 18 months and longer. These strategies are called ‘coupon spreading‘ and ‘time spreading‘ respectively, and they implement several market assumptions. First, the price of fixed income securities is inversely related to the market interest rate. Second, the price of a higher coupon security changes more, for a given change in interest rate, than that of a lower coupon security. This assumption is critical to the First Western theory of coupon spreading. Third, the

[89 T.C. 853]

longer the maturity of a fixed income security, the greater will be its price change for a given change in interest rate. Fourth, the larger the portfolio, the larger will be its dollar change in value for any change in the interest rate. These assumptions require that all other market variables remain constant.

PRICES

The prices for the GNMA forward contracts in issue were not quoted on an exchange. Rather than consult the primary dealers for a market price,5 First Western used computerized pricing algorithms to set prices for the forward contracts involved here. First Western did not quote its prices to market dealers.

Prior to January 14, 1980, First Western used the Telerate6 quote for the cash price of a GNMA 9.5 coupon to generate cash prices for other GNMA and FMAC coupons. From the Telerate composite quote for the cash price of the GNMA 9.5, First Western calculated the GNMA yield for this security. This step is called a price to yield conversion. First Western then calculated various coupon yields by assuming a constant yield spread between any two GNMA or FMAC coupons — always equal to 20% of the difference between two GNMA's or two FMAC's and always equal to .03% as between a FMAC and a GNMA with the same coupon rate.7 This step is called a yield to price conversion.

From these assumed GNMA and FMAC yield numbers, First Western calculated cash prices on which it traded forward contracts. Specifically First Western calculated the cash price for each GNMA and FMAC coupon that would

[89 T.C. 854]

result in a GNMA yield or FMAC yield already calculated for that coupon.

First Western used these assumed cash prices as a starting point from which to calculate forward prices. In so doing, First Western assumed a linear relationship between the forward price for each maturity and the cash price. In other words, forward prices for all coupons and maturities precisely tracked the movement in the cash price, which itself depended on the...

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