Notes vs Collateralized Debt Obligations (CDOs)

2022-09-20T07:28:16+0000

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Turning to today’s point.

Ever since Mintos announced they will be transitioning to notes, we have observed an increasing number of comments and discussions across various social media channels comparing notes to something called Collateralized Debt Obligations (CDOs). 

Here are just some examples.

In case you don’t know what the buzz is about, CDOs have been infamous ever since causing quite a financial and economic turmoil back in 2007/2008, so a comparison like this gathers quite some attention, but also requires careful consideration.

Therefore, we decided to address the elephant in the room and explain the fundamental differences and similarities between these two financial instruments.

Let’s get started!

Fundamentals

CDOs

Collateralized Debt Obligations are simply a fancy term for baskets of loans that have been issued to consumers and businesses and that are made available for investments.

How are the baskets built?

It all starts with banks selling baskets of loans (mortgages, bonds, personal loans, etc.) to investment banks. 

The investment bankers then split these baskets (CDOs) into discrete classes (tranches). The tranches are based on the cash inflows and the credit risk that the investors are ready to take with the safest (senior) tranches getting the lowest returns but getting paid first in case of cash inflows.

The final product - various tranches - are then sold out to investors that now own the rights to the proceeds from the underlying loans and become the end-risk takers.

Notes

Very much like CDOs, notes too are, essentially, baskets of loans that have been issued to consumers and businesses and that are made available for investments.

The notes are constructed in the following way. 

First, a lending company makes loans available to a loan marketplace via a special legal entity (a special purpose vehicle if you want to get fancy). 

The marketplace then groups 6-20 loans with similar characteristics into a single note. The note is then made available to investors.

All note investors have equal rights to the cash inflows from the underlying loans.

Different core risks

While at the first glance Notes and CDOs indeed seem to have many fundamental similarities in how they are constructed and the underlying assets they bear, the risks at play are significantly different. 

When investing in notes via platforms like Mintos, where most of the loan originators have a buyback obligation, your only worry should be whether the lending company will honor the buyback guarantee in case the loans making up to the note end up being late and need to be bought back. Essentially, the only risk assessment you need to conduct is the assessment of the loan originator defaulting, rather than individual loan defaulting.

Obviously, it is great when the loans in the note are all paid on time. If some of them, however, get delayed or even default, while the lender’s portfolio is generally doing well, there is nothing to be worried about as delays in microfinance are quite usual and lending companies always plan for them.

With the CDOs, however, we have a slightly different picture.

As neither banks nor investment bankers offer anything similar to buyback obligations, the is no extra line of defense, and the investors become the immediate risk takers.

In addition, as CDOs are segmented into tranches, the senior tranch investors get repaid first in case of defaults and junior tranch inventors bear all the losses. So the risks of a CDO are very different depending on the tranch that you are investing in.

Other differences

Furthermore, there were some problems that were at play in the CDO crisis of 2008 that are not applicable to notes.

One of the biggest problems was that CDOs were often times rated as ‘AAA’ and, hence, believed to be as safe as it gets while, in reality, they were very risky.

This was so because, while the underlying loans were individually risky, it was believed that the correlation among the defaults of underlying loans was very low, so it seemed statistically impossible that many loans can default at the same time.

It turned out that the correlation among individual loan defaults was actually much higher than expected and, hence, the CDOs turned out to be much riskier than the rating agencies have forecasted.

In the case of the introduction of notes, the investors' primary safety mechanism is still the buyback obligations from the lending company that has issued the underlying notes.

Consequently, whether you invest in a single loan or a set of them via a note, you still primarily should worry about the ability of the lending company to cover its obligations to you. 

Hence, with the introduction of notes, the underlying risk does not change at all and still remains to be evaluated on a lending company’s level.

The introduction of notes might actually be a good thing.

While the risks of the investments do not change, in our view, having more regulation and Latvian financial authority supervising the operations of the loan marketplaces helps improve risk management and ensure more safety for investors.

Conclusions

On the final note, we have observed that some of you are worried that the underlying quality of the loans in the notes could deteriorate over time and investors would have no control over that.

If the quality of the loans that are included in notes were indeed to decrease, you should still worry only about the ability of the lending company to cover the buyback obligations. 

As long as the lending company stays healthy and its overall portfolio quality does not reduce, you should not worry about the components of individual notes. 

To avoid a deterioration of the overall portfolio quality of the lending companies, you should monitor their performance closely and always do your due diligence before investing. This was true with claims and this remains true with notes. We at Welfio are here to help you simplify that. 

We hope this post clears any doubts you have about the introduction of notes and will help settle the ongoing discussion once and for all!

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