Conduit Financing - Explained
What is Conduit Financing?
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What is Conduit Financing?
This is a financing mechanism for a non-profit organization. It occurs when the government or other agency acquires fixed income securities for a non-profit organization to finance large projects. Here, the government or other agencies involved do not pay returns to investors but the returns due investors are paid from the profit accrued from the project.
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How Does Conduit Financing Work?
Conduits are specially created by banks to serve as a means of sourcing finance for financial institutions etc. This is regarded as a special purpose vehicle. Banks deployed this medium to purchase loans and in turn offer these loans as collateral for investors, this is not included in the balance sheet of the financial institution. In order to service this conduit, banks offer new debts and money gained through these debts are used to repay other financial obligations arising as a result of the maturing debt. On the other hand, Conduit financing is said to have occurred when the government or related bodies offer tax-exempt municipal bonds to finance a larger project of a non-governmental organization or other related companies. The sales of these conduits provide funding for capital projects such as airports, hospitals, private schools, housing, and public works. The non-governmental organizations here are referred to as the conduit issuer. They pay investors and lenders the interest and principal repayment on the loan offered through the profits accrued from their larger projects. Commonly, private activity bonds (PAB), multi-family housing revenue bonds, and industrial development bonds are the types of municipal security used for conduit financing. One of the risks the lenders in conduit finance incurred is prepayment risk. This occurs when borrowers in a conduit are being paid earlier than the stipulated time and this affects the interest gained by the lender. In order to minimize this risk, the borrowers pay a fee termed as the yield maintenance. This puts the lender in a safe position if an early repayment occurs and serves as the interest due to the loan. Conduit bonds in terms of advantages exclude investors from being taxed on the income received as a result of this loan, where an investor lives in the state where this loan is offered, the investor is granted state and local taxation on interest payments. It is quite important to note that these bonds issued for conduit financing are subject to Alternate minimum tax. This tax feature of municipal bonds accounts for the lower interest rates of conduit financing. However, where capital gains are achieved, higher taxing is allowed, which is handled by the Internal Revenue Service (IRS).