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

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Author: Jessie S. Lotay
Date: Spring 2010
From: Houston Journal of International Law(Vol. 32, Issue 2)
Publisher: Houston Journal of International Law
Document Type: Article
Length: 14,270 words

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I. 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...

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Gale Document Number: GALE|A232945506