Investment Theory and Risk Management, + Website

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, ...