A conduit is an organization, with or without a government mandate, that brings together loans.
It then issues a pass through security to investors in its name. A pass through security is simply a collection of fixed-income securities which is supported by assets. Mortgage-backed certificates are examples of such securities. Conduits help banks, particularly large ones, to sell loans investors.
Conduit finance refers to a strategy used by banks to promote short-term financing. To do this, a bank has to make use of special purpose vehicles. Under this, individuals or groups who intend to take out loans for real estate have to pay huge prepayment penalty. This penalty offsets the amount of money that would have otherwise served as interest, which would in turn be paid out to investors. There is a risk that this potential interest would be lost, should the loan be paid early. As such, the penalty needs to be set in place to guard against possible problems in the securitization process.
Special purpose vehicles, otherwise known as special purpose entities, have very specific functions. The main purpose is to help the company avoid risks. They can also be created by companies in order to securitize debt.
By selling SPVs, companies can sustain their financial operations while at the same time ensuring that there is enough money for lending.
Special purpose vehicles can also be created for the purpose of setting up smaller companies in which more innovations can take place, without exposing the parent company to the same risks.
However, since such activities can be used for fraud, the setting up of SPVs should be monitored by legal practitioners.