Subprime carbon: fashioning an appropriate regulatory and legislative response to the emerging U.S. carbon market to avoid a repeat of history in carbon structured finance and derivative instruments.

• Author: Lotay, Jessie S.

1. INTRODUCTION II. STRUCTURED FINANCE: A CONVENIENT FRAMEWORK A. Mortgage-Backed Securities III. WILL HISTORY REPEAT ITSELF? AVOIDING A REPEAT OF HISTORY IN CARBON SECURITIZED AND DERIVATIVE INSTRUMENTS A. Risk Reallocation and Diversification B. Predictive Models and Irrelevant Data C. The Collateral Behind the Security D. Layers: Increasing Complexity & Risk/Value Determinations E. Credit Rating Agencies F. Insurance Companies IV. CONCLUSION I. INTRODUCTION

   Wall Street's most storied financial institutions have collapsed. And along with them, U.S. and global economies. Once lauded for their innovative financial alchemy to engineer high-return, low-risk mortgage-backed securities, Wall Street's finest were permeated by frenzied greed and diminished lending standards. In the years leading up to the lending fallout of 2007, U.S. financial institutions worked around the clock to flood financial markets with securitized and derivative instruments collateralized by mortgage-backed securities whose illusory quality crippled global portfolios. Yet even amidst the most dramatic economic downturn since the Great Depression, U.S. financial institutions continue to seek new ways to bring securitized and derivative instruments to market.

   As the international community embraces the greenhouse gas reduction commitments of the Kyoto Protocol, the ears of U.S. financial institutions and investors are perked. A regulatory framework forcing emissions compliance on U.S. corporations and regulated entities, and the establishment of a market-based cap-and-trade scheme to buy, sell, trade, and exchange carbon credits, means participants in a carbon-constrained market will seek low-cost solutions to meet compliance targets. Outside the primary market, secondary market participants, such as banks, financial institutions, hedge funds, and energy speculators, are poised to play a game of store-and-sell--bringing carbon to market when it can fetch the best price. Just as with mortgage-backed securities, U.S. financial institutions seek inventive ways to cross-pollinate markets by securitizing carbon credits and bringing low-cost carbon credits to the marketplace.

   The dawn of carbon structured finance is near. But before U.S. financial institutions and investors embark on this endeavor, understanding the mistakes and pitfalls of securitizing mortgage-backed securities provides U.S. policy makers guidance as to where similar mistakes may be made in carbon finance. By understanding the historical miscalculations of the recent financial collapse, policy makers are better equipped to fashion appropriate legislative and regulatory responses so that mistakes may be avoided.

   Such issues are becoming increasingly important. Efforts to curtail greenhouse gas emissions spark wide-felt international support. (1) Regulated companies and countries, however, are less enthusiastic, (2) as operating within a greenhouse gas-constrained environment necessarily involves the high cost of compliance. (3) In an effort to provide the most cost-effective means for regulated companies and countries to operate within this greenhouse gas-constrained environment, financial mechanics are being employed to make emission-reduction economically feasible. (4) The most noteworthy, cost-benefiting results will be achieved within the developing carbon market.

   Financial institutions and investors are simultaneously recognizing the profit potential within the developing carbon market. (5) Frenzied in their response, such institutions seek new ways to bring securitized and derivative instruments, collateralized by carbon credits, to the market. (6) Yet with the effects of the recent financial collapse and historical miscalculations made in connection with mortgage-backed securities still reverberating within the U.S. economy, concern should surface as to whether the application of traditional structured finance techniques to carbon credits will cause a relapse of the current financial crisis. (7) With these concerns in mind, before implementing a U.S. carbon market, policy makers should endeavor to temper market forces to avoid similar mistakes in the future.

   The aim of this Article is to provide policy makers, who are concerned about tempering market forces and avoiding a repeat of history in an emerging U.S. carbon market, guidance as to the contributing market failures leading to the recent financial collapse. By comparing the recent financial collapse and carbon offset credits under the common framework of mortgage-backed securities, this Article identifies and highlights mistakes and lessons learned, so that policy makers are better equipped to fashion appropriate legislative and regulatory responses to avoid a repeat of history within a U.S. carbon market.

2. STRUCTURED FINANCE: A CONVENIENT FRAMEWORK

   The convenient framework of structured finance opens the door to allow Wall Street institutions and investors easy access to the complex and rapidly evolving world of carbon credits. (8) By commoditizing assets, institutions and investors are connected to international efforts to reduce greenhouse gas emissions and are able to fuel the cost-effective growth of carbon initiatives through financial means. (9) How this process takes shape is discussed in the following Section. And how this process may cause a relapse of the recent financial crisis is addressed through the lens of mortgage-backed securities.

   1. Mortgage-Backed Securities

   1. Introduction

      U.S. financial institutions possess the wizardry to transmute an assortment of assets into monetized commodities through complex securitization and structured finance techniques. (10) The terms securitization and structured finance are used to describe the financial processes in which the payment streams of groups of similar assets ultimately provide returns to investors holding securities backed by such assets. (11)

      Varieties of assets yielding a payment stream can be securitized and used to collateralize an underlying financial instrument. (12) The most common types of securitized assets include mortgage loans, automobile loans, credit card receivables, student loans, and lease payments. (13) The focus of this Article examines one specific type of asset-backed security, the mortgage-backed security. A mortgage-backed security is a security collateralized by residential or commercial mortgage loans. (14) In light of the recent financial collapse, policy makers can use the mistakes within the U.S. financial marketplace (largely attributable to mortgage-backed securities (15)) to devise appropriate regulatory and legislative responses to a U.S. carbon market.

   2. Early Beginnings

      The concept of securitization dates back to the 1970s when the Government National Mortgage Association ("Ginnie Mae") responded to the need for a more affordable residential housing market. (16) Acting to address this need, Ginnie Mae produced the first financial instrument backed by a mortgage, known as the mortgage-backed security. (17) This financial engineering sparked a subsequent and immediate interest in the capital markets. (18) Investors quickly recognized the incidental and unprecedented financial benefit gained via such a security, i.e., it provided a vehicle for shifting the default risks associated with mortgages to the capital markets of Wall Street, where investors were willing to commoditize, and in turn, be compensated for taking on, such risks. (19)

      Before undertaking a discussion of these risks and the role securitization

      and structured finance played in the recent financial collapse, a discussion regarding the mechanics of the securitization process itself is necessary.

   3. The Process

      Mortgage-backed securities involve two distinct markets: the primary market and the secondary market. (20) The primary market describes the initial relationship between the mortgage borrower and the mortgage lender. (21) A borrower's relationship with the bank, or the direct relationship between a buyer and a seller, are each representative of a primary market relationship.

      The secondary market--the focal point of the analysis of this Article--is defined as the relationship between the mortgage lender and third-parties--namely, investors, banks, financial institutions, and brokerage houses that enter the process subsequent to the mortgage borrower's involvement. (22) The door to the secondary market is opened when a mortgage lender transfers its mortgage loans to these third-party entities, which in turn trade, exchange, and hedge mortgage loans on stock exchanges and over-the-counter markets. (23)

      In the pre-securitization era, lenders made mortgage loans to borrowers, commonly for terms of ten to thirty years, and waited the course of the term of the mortgage loan to be made whole again. (24) As compensation to the mortgage lender for parting with its financial resources and the risk associated with lending to the mortgage borrower, the lender is paid interest on the loan. However, over the course of a mortgage loan's term, the mortgage lender has fewer funds by which it can redeploy to make other loans to prospective borrowers. Thus, it is deprived of the profit it could have made from additional mortgage borrowers. At its worst, mortgage lenders incur risk that a mortgage borrower will default on its payment obligation and be unable to repay the mortgage altogether, thereby leaving the lender shorthanded. (25) Thus, protecting against a lender's exposure to these risks is of paramount concern. Securitization takes shape amidst these fears.

      Securitization transfers the burden of having to wait to receive a mortgage borrower's periodic loan payments and the risk that the borrower may default to investors who are rewarded returns on investment for undertaking such risk. (26) The mortgage lender accomplishes this by selling the mortgage loan to a special purpose entity, or SPE. (27) By doing so, the lender removes the mortgage loan debt...