When Issuers, Not Investors, Drive Rates Higher

Justin Lahart says that if you buy a high-return investment, you ought to know it's likely to be high-risk as well. He's talking about CDOs, of course:

Anyone buying these debt investments, which had become increasingly popular in the past few years, should have known full well they were riskier than they appeared to be at first blush. All they had to do was look at the price...
[Investors have] long demanded that CDOs offer higher returns than similarly rated bonds. One year ago, for example, investors in CDOs with an investment-grade triple-B credit rating demanded roughly two percentage points more on their investments than did investors in more plain-vanilla mortgage-backed securities with the same rating, according to J.P. Morgan data. Their demands for returns were even great when compared with similarly rated corporate debt.
Lots of investors understood what they were getting into. They demanded more return because they saw there was more risk, regardless of the ratings.

This is true, but I'd add a caveat. Most debt obligations are designed to minimize the cost to the issuer. No company would issue a bond at 200bp over Treasuries if it could issue the same bond at 100bp over Treasuries. The same goes for the issuers of mortgage-backed securities, who buy up a pool of mortgages at one price and then sell it off to the capital markets for a larger price. The tighter the spread they can achieve, the more money they make.

Structured products like CDOs, on the other hand, are different. They're designed to maximize the returns to the investor, rather than to minimize the costs to the issuer. If I issue a CDO, the way I make my money is by charging a management fee. I may also retain some of the equity in the CDO, in which case I would have some incentive to issue the CDO tranches at the highest possible price. But I might not retain some of the equity, or I might take a longer view and try to structure the CDO so that the investors get as high a return as possible – which would increase the chances that they would come back and invest even more of their money with me.

So rather than investors demanding higher returns, this might well have been a case of CDO managers offering higher returns. When CDO managers compete against each other in terms of structuring products which will generate the highest returns, it's the people issuing the paper who are driving returns up – it's not the investors, worried about risk.