According to this Bloomberg article, Michael Burry (a hedge fund manager and the main character of the novel and movie The Big Short) draws a parallel between Collateralized Debt Obligations (CDOs), whose disastrous flaws were partly responsible for the 2008 financial crisis, and exchange-traded funds (ETFs), and concludes that there is potential for a similar outcome in this market as well. In order to make a judgement, we first need to understand CDOs and ETFs.


What’s a CDO?

A CDO is a bond that’s created by pooling interest-paying investments and redistributing their cash flow. Its underlying assets can be publicly traded corporate bonds or private loans, such as residential mortgages. The assets are pooled into a special-purpose vehicle (SPV), a legal entity created exclusively to hold the assets and redistribute cash flows to CDO holders. Here’s an example of how the cash flows are redistributed: the CDO creates classes of a bond: we’ll call them class A, B and C. When the underlying assets mature, the principal repayments will be funnelled to the CDO holders. Class A holders will receive the first 30% of the principal repayments, class B holders will receive the next 30% and, then, class C holders (the residual claim holders) will receive whatever is left at the end (the full 40% of face value if there are no defaults in the pool of assets). Since the overall pool of assets is typically risky (meaning that defaults have a reasonable chance of occurring), Class A is far less risky and thus pays a lower interest rate because it is reimbursed first. Class B is riskier than class A, and class C is ultimately the riskiest because it is paid last.


What’s an ETF?

Mainstream ETFs, such as the Vanguard Total Market (VTI) in the U.S., or the BMO S&P/TSX Capped Composite (ZCN) in Canada, are pools of publicly traded stocks or bonds that mimic a stock index. ETFs are very similar to mutual funds, but have two notable differences: 1. ETF shares trade on a stock exchange. 2. New ETF shares are created or redeemed by an authorized participant (a market maker), while mutual fund shares are created or redeemed by a mutual fund company.


Differences between ETFs and CDO

Like CDOs, ETFs funnel the current cash flows (interest and dividend) of the underlying assets to the shareholders. But unlike CDOs, ETFs reinvests the principal repayments into the portfolio: ETFs are meant to be a going concern, whereas CDOs are meant to have a finite lifespan. Another key difference is that ETFs do not restructure the cash flow of the underlying assets: all holders of an ETF are treated the same. And lastly, mainstream ETFs invest only in publicly traded stocks and bonds. These underlying assets are subject to severe public disclosure standards and are relatively liquid, whereas the underlying assets of CDOs can be relatively opaque.


What went wrong with CDOs in 2008?

There was one key area that became problematic during the financial crisis: CDOs backed by residential mortgages. Non-insured mortgages started being pooled into CDO structures and, over time, the quality of the mortgages included into these structures became poorer and poorer. Eventually, mortgages of very poor quality, such as NINJA loans (the borrower had “No Income and No Job”) were included in CDO pools. Investors took reassurance from the fact that credit-rating agencies were attributing an investment-grade rating to most CDO tranches sold on the market. But credit-rating agencies wildly overestimated the quality of many of these CDOs. Some financial institutions had to repatriate unsold CDO tranches onto their balance sheet. These toxic assets did so much damage to some large U.S. financial institutions that they went into quasi-bankruptcy and had to be bailed out by the U.S. government. Without the government money, these institutions would probably not be in business now.


Why comparing the two is wrong

The problematic CDOs of 2008 were pooling poor-quality assets and were being presented to investors as relatively safe, a statement backed by misguided credit-rating agencies. The presumption of their high quality was based on the notion that risk can be reduced by diversifying the assets (having a lot of loans in the SPV) and by creating higher-ranking (“A” and “B” in our example) classes. By comparison, ETFs are transparent (their holdings are published frequently). Investors know what they are buying when they purchase a mainstream ETF. They may underestimate the risk of stocks or bonds at a certain point in time, but that’s not a flaw in the ETF itself, but rather, an error in judgement about an asset class. The structure of ETFs is not opaque like that of CDOs. This is why it’s wrong to compare ETFs to CDOs.