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A renewable energy derivative is based on a new method of securitization, which is a structured finance process that pools and repackages cash-flow-producing financial assets into securities which are then sold to investors. The term "securitization" is derived from the fact that securities are used to obtain funds from investors. [1]
Cash-flow-producing financial assets were traditionally mortgages, credit cards, and then student loans. More recently the assets have become more exotic, like annual airline flight tax, intellectual property such as Bowie Bonds, and life insurance premiums for captive orcas. In essence any asset's cash flow can be securitized if the historical, realized cash flow demonstrates a statistical predictability. This process was first applied to renewable energy by Joseph Brant Arseneau and his team at IBM.
A renewable energy derivative is just that: a cash flow that has been proven historically and demonstrates a statistical predictability. The predictability of the cash flow is achieved by consulting with professionals to ensure that the primary asset, in this case a private home, is equipped with the optimal types of renewable energy sources for its immediate environment. These energy sources are chosen with respect to the location of the home, the weather, and supporting data, including historical wind patterns, heat changes, and earth core temperatures.
If the assets produce more power than is required by the home, the excess power is sold to a Special Purpose Vehicle (SPV), which pools all of the surrounding assets, conducts credit enhancements, and may buy weather derivatives to offset some local weather risk. The accumulation of these cash forms are considered to be the earnings of the SPV. The SPV is a company that owns the cash flow and is capitalized in a structure that provides several different types (tranches) of debt and a few layers of equity. These capital structures are then sold to the capital markets as securities.
The originator is the initial owner of the assets engaged in the deal. This is typically a company looking to raise capital, restructure debt, or otherwise adjust its finances. Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, a bond issue, or the issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the company's credit rating and the associated rise in interest rates.
To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering targeting institutional investors or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities to provide an external perspective on the liabilities being created and help investors make better-informed decisions.
Unlike conventional unsecured corporate bonds, securities generated in a securitization deal are credit enhanced , meaning their credit quality is increased above that of the originators' unsecured debts or underlying asset pools. This increases the likelihood that the investors will receive cash flows to which they are entitled, causing the securities to have higher credit ratings than the originators. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees, although this may introduce a conflict of interest.
A servicer collects payments and monitors the assets at the crux of the structured financial deal. The servicer can often be the originator because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to the Special Purpose Vehicle.
The servicer can significantly affect the cash flows to investors because it controls the collection policy, which influences the proceeds collected, the charge-offs, and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements, and the probability of default. [2]
Unlike corporate bonds, most securitizations are amortized, meaning that the principal amount borrowed is paid back gradually over the specified term of the loan rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralized by fully amortizing assets such as home equity loans, auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed in an attempt to define common prepayment activity. The PSA prepayment model is a well-known example.
Originators have less incentive toward credit quality and greater incentive toward loan volume since they do not bear the long-term risk of the assets they have created and may simply profit by the fees associated with origination and securitization.
Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. In financial accounting, debt is a type of financial transaction, as distinct from equity.
In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.
Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the principal amount on maturity. Fixed-income securities — more commonly known as bonds — can be contrasted with equity securities – often referred to as stocks and shares – that create no obligation to pay dividends or any other form of income. Bonds carry a level of legal protections for investors that equity securities do not — in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.
A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor needs.
A mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. Bonds securitizing mortgages are usually treated as a separate class, termed residential; another class is commercial, depending on whether the underlying asset is mortgages owned by borrowers or assets for commercial purposes ranging from office space to multi-dwelling buildings.
Structured finance is a sector of finance - specifically financial law - that manages leverage and risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of financial instruments.
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.
An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized by a specified pool of underlying assets.
Sukuk is the Arabic name for financial certificates, also commonly referred to as "sharia compliant" bonds. Sukuk are defined by the AAOIFI as "securities of equal denomination representing individual ownership interests in a portfolio of eligible existing or future assets." The Fiqh academy of the OIC legitimized the use of sukuk in February 1988.
A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and to a lesser extent, derivatives. Structured products are not homogeneous — there are numerous varieties of derivatives and underlying assets — but they can be classified under the aside categories. Typically, a desk will employ a specialized "structurer" to design and manage its structured-product offering.
Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial and multifamily mortgages rather than residential real estate. CMBS tend to be more complex and volatile than residential mortgage-backed securities due to the unique nature of the underlying property assets.
A commercial mortgage is a mortgage loan secured by commercial property, such as an office building, shopping center, industrial warehouse, or apartment complex. The proceeds from a commercial mortgage are typically used to acquire, refinance, or redevelop commercial property.
A real estate mortgage investment conduit (REMIC) is "an entity that holds a fixed pool of mortgages and issues multiple classes of interests in itself to investors" under U.S. Federal income tax law and is "treated like a partnership for Federal income tax purposes with its income passed through to its interest holders". REMICs are used for the pooling of mortgage loans and issuance of mortgage-backed securities and have been a key contributor to the success of the mortgage-backed securities market over the past several decades.
A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, frequently "lending" by investing in securitizations, but also by investing in corporate bonds and funding by issuing commercial paper and medium term notes, which were usually rated AAA until the onset of the financial crisis. They did not expose themselves to either interest rate or currency risk and typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt obligations (CDOs) in that they are permanently capitalized and have an active management team.
Credit enhancement is the improvement of the credit profile of a structured financial transaction or the methods used to improve the credit profiles of such products or transactions. It is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization.
Bonds securitizing mortgages are usually treated as a separate class, termed residential mortgage-backed security (RMBS). In that sense, making reference to the general package of financial agreements that typically represents cash yields that are paid to investors and that are supported by cash payments received from homeowners who pay interest and principal according to terms agreed to with their lenders; it is a funding instrument created by the "originator" or "sponsor" of the mortgage loan; without cross-collateralizing individual loans and mortgages, it is a funding instrument that pools the cash flow received from individuals and pays these cash receipts out with waterfall priorities that enable investors to become comfortable with the certainty of receipt of cash at any point in time.
A collateralized fund obligation (CFO) is a form of securitization involving private equity fund or hedge fund assets, similar to collateralized debt obligations. CFOs are a structured form of financing for diversified private equity portfolios, layering several tranches of debt ahead of the equity holders.
A synthetic CDO is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage products, rather than a real mortgage security. The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments – as in the case of a regular or "cash" CDO—but from premiums paying for credit default swap "insurance" on the possibility of default of some defined set of "reference" securities—based on cash assets. The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation usually defines the tranches as different "classes" of notes, each identified by letter with different bond credit ratings.
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).