Securitization

To understand the role of the SPV, think of a commercial bank in the business of originating residential mortgages. The bank lends its reserves to homeowners and holds these mortgages on its balance sheet as assets earning monthly cash flows in the form of mortgage payments. Without securitization, the bank's ability to originate mortgages is limited by the amount of its reserves. With securitization, the bank can pool these assets together and issue bonds against them—that is, the bank borrows more reserves by issuing bonds and the mortgage payments act as coupons on these bonds. These bonds become liabilities to the SPV, which inherits the credit risk on these bonds (bonds may default if the underlying mortgages default). The SPV therefore takes title to the loans and thereby removes the credit risk exposure from the bank's balance sheet.

In this manner, the bank can expand its mortgage origination function; hence, the rationale behind government sponsored entities (GSEs) such as GNMA, FNMA, FHLMC. The Federal National Mortgage Association (Fannie Mae) was established in 1938, the Federal Home Loan Mortgage Corporation (Freddie Mac) was established in 1970, and the Government National Mortgage Association (Ginnie Mae) was established in 1968. These government sponsored enterprises (GSEs) had different missions—Ginnie Mae to promote home ownership (it is a wholly owned subsidiary of HUD) which offers full government backing, Fannie Mae to promote mortgage lending, and Freddie Mac to expand the secondary market for mortgages. Fannie and Freddie mortgage securities enjoy the implicit guarantee of the federal government. Investment banks securitize these assets by buying mortgages from originators, pooling them and issuing bonds; mortgage originators such as commercial banks and savings and loan institutions retain the fees from servicing these mortgages through their amortization periods.

The credit risk is then shifted from the originator of the mortgages to the bondholders. Thus the structure of the SPV insulates the originator from credit risk. That way, the business of loan origination and securitization are separate. In sum, the bank originates a pool of loans, securitizes these as an SPV, issues bonds against the expected cash flows on the pool, and repeats this process as new pools originate. The credit risk is therefore isolated to the SPV structure and not the bank.

If the SPV issued claims that were not prioritized but were simply fractional claims to the payoff on the pool, then the structure would be known as a pass-through securitization, which is the operational model for the GSEs. Investors simply get a pro rata share of the pool's capital. Thus, if the pool consists of $100 million in mortgage loans and an investor buys 25 percent of the pass-through securities, he received one-quarter of the principal and interest cash flows until the mortgages in the pool are paid off. Since the expected loss is the mean expected loss on the underlying securities, the portfolio's credit rating would be given the average credit rating of the pool. In this case, there is no credit enhancement.

Pass-through securities are originated from pools of conforming loans and guaranteed by GNMA, an agency of the federal government, or implicitly by one of two government sponsored enterprises, Fannie Mae or Freddie Mac. The guarantee requires that the loan pool conform to certain standards regarding loan to value and mortgage size; hence, the conforming nature of the underlying loan pool. GNMA is explicitly backed by the federal government, while the GSEs have implicit guarantees (this implicit guarantee comes at a cost—the bonds issued by the GSEs carry a higher yield).