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The Golden Age of Junk

Highly Confident: The True Story of the Crime and Punishment of Michael Milken

by Jesse Kornbluth
Morrow, 384 pp., $23.00

A License to Steal: The Untold Story of Michael Milken and the Conspiracy to Bilk the Nation

by Benjamin J. Stein
Simon and Schuster, 219 pp., $23.00

The First Junk Bond: A Story of Corporate Boom and Bust

by Harlan Platt
M.E. Sharpe, 236 pp., $21.95 (paper)

King Icahn: The Biography of a Renegade Capitalist

by Mark Stevens
Dutton, 326 pp., $23.00

Den of Thieves

by James B. Stewart
Touchstone, 587 pp., $12.00 (paper)

Nightmare on Wall Street: Salomon Brothers and the Corruption of the Marketplace

by Martin Mayer
Simon and Schuster, 272 pp., $23.00

High Yield Bonds: Issues Concerning Thrift Investments in High Yield Bonds, 3/2/89, GGD-89-48

General Accounting Office
51 pp., free, $2.00 each additional document

The Predators’ Ball: The Inside Story of Drexel Burnham and the Rise of the Junk-Bond Raiders

by Connie Bruck
Penguin, 399 pp., $8.95 (paper)

1.

Michael Milken was released from prison to a halfway house on January 4, 1993, after serving twenty-two months in jail for securities fraud and other crimes. His original ten-year sentence was reduced in 1992, because he cooperated, although only in a small way, with the government investigation. A month later, he was released from the halfway house to his home in Encino, California, where he remained under a “home confinement program” until his final release on March 2. He is required to perform community service for three years while on probation and has been working in a drug prevention program in Los Angeles public schools and has lectured at UCLA. He is now exploring the possibility of forming an educational cable-television network. At a dinner this April to raise funds for his foundation to cure prostate cancer, from which he suffers, Milken received a message from President Clinton who said how “impressed” he was by Milken’s “energy.”

The story of Milken’s early life is by now well known and differs little in the many accounts that have appeared. He was raised in a middleclass Jewish family in the San Fernando Valley. He was a good student, active in student government, a cheerleader who was elected prom king. While still in his teens, he resolved to become a millionaire by the time he was thirty, and he spent the mid-Sixties as a business major at Berkeley, aloof from the political and social currents of the time. An active member of his fraternity, he invested money for friends and fraternity brothers, absorbing all losses and keeping 50 percent of the profits. By 1970, two years after graduating from Berkeley, Milken had already decided what he wanted to do. In an op-ed piece, submitted to (and rejected by) The New York Times, he wrote: “Unlike other crusaders from Berkeley, I have chosen Wall Street as my battleground for improving society. It is here that the government’s institutions and industries are financed.”

He became fascinated with lowgrade or “junk” bonds while still an undergraduate, after reading W. Braddock Hickman’s 1958 study Corporate Bond Quality and Investor Experience. Junk bonds are securities that receive a low (below “investment-grade”) rating from Moody’s or Standard & Poor’s, the two major investment rating agencies.1 They are not backed by company assets comparable to those of investment-grade bonds or by comparable cash flow. They also are traded in less liquid markets. If the company that issues them is successful, their yields are much higher than for investment-grade corporate bonds or government bonds, but the risk of default or non-payment is also considered to be high by the rating agencies. Still, Hickman and his National Bureau of Economic Research colleagues’ study of corporate bonds sold in the United States from 1900 to 1943 had found that a portfolio of these high-risk bonds usually outperformed the higher-rated, “safer” securities, “if the list is large and held over a long period.” They also cautioned that these returns were “subject to extreme aberrations over time.”

After Berkeley, Milken attended the Wharton School of Finance while working part time at Drexel Firestone, a declining Philadelphia investment banking firm descended from J.P. Morgan’s Drexel Morgan and Co. By the time the company merged with Burnham & Co., a New York brokerage firm, in 1971, Milken was working full time and commuting from outside Philadelphia to New York every day by bus. According to Connie Bruck, he spent his time on the bus reading bond prospectuses by the light of a miner’s helmet.2

Shortly after the merger, I.W. “Tubby” Burnham, the firm’s founder, established for Milken a semi-autonomous sales and trading unit with about $2 million in capital; Burnham agreed that Milken’s department would keep 35 percent of its profits from high-risk, high-yield bonds as well as up to 30 percent of profits earned in any other business that Milken brought to the firm. Milken also was in charge of allocating and distributing the bonuses paid to his department, which reputedly reached the seven-figure range by the mid-Seventies. This arrangement was still in effect in 1986 when Milken earned a record $550 million. “The only figure comparable to Milken who comes to mind,” Samuel L. Hayes III, a professor of investment banking at Harvard Business School, said to Business Week in July 1986, “is J.P. Morgan, Sr.”

2.

Milken’s rise was linked to several major economic trends of the Eighties: the growth of debt generally; the expansion of junk bonds in particular, and the rise of corporate mergers and acquisitions. During the decade, there was a huge growth of all kinds of debt. Credit, or “Money of the Mind” as James Grant calls it in his book of the same title, was critical to the economy’s recovery from recession in 1982 and its subsequent growth. Beginning in 1984, corporations began to borrow money and buy stock on a large scale (see Chart 1), often to make acquisitions or prevent an unwanted takeover by buying their own stock.

Chart 1

The share-holders who were bought out made large profits which further contributed to the US economy’s increasingly uneven distribution of income and wealth.

Growth in the junk-bond market accounted for much of the explosion of corporate debt as a whole. New issues of junk bonds increased in total value from less than $2 billion a year between 1980 and 1982 to about $13 billion a year in the next three years, and about $31 billion annually between 1986 and 1989. From 1983 to 1989 newly issued junk bonds accounted for 21 percent of all newly issued corporate debt compared to between 3 and 7 percent during the previous six years. About 17 percent of all corporate bonds outstanding between 1986 and 1990 were junk bonds. While many junk bonds were issued so that enterprising companies such as MCI or Turner Broadcasting could finance growth, by 1985 more than one third of all newly issued junk bonds were used to finance mergers and acquisitions. During the peak years of the decade, from 1986 to 1989, almost two thirds were used for these purposes (see Chart 2).

Chart 2

Drexel Burnham’s share of this highly profitable business averaged almost 50 percent between 1980 and 1989.

The early-to-mid-Eighties were a particularly inviting time for acquisitions. The economy was beginning to emerge from the most severe recession of the postwar period, yet valuations of public companies in the stock market were historically low relative to the value of their assets. In this setting, acquisitions mainly financed by debt—“highly leveraged”—were potentially very profitable, whether they were made with the cooperation of existing management (leveraged buyouts or LBOs) or against their will (hostile takeovers). In either case, borrowing large parts of the purchase price significantly increase the rate of return on investment.3 When investors reached a point where financing was hard to find, they typically resorted to junk bonds, whose market was largely controlled by Milken.

In the financial structure of “leveraged” corporations—i.e., corporations whose capital is largely borrowed—junk bonds generally fall somewhere between the most “senior” debt (which is often provided by banks and secured by the best of the company’s assets) and equity. Senior creditors have a higher claim on assets than the more junior bond holders, who in turn outrank equity shareholders. For much of the Eighties, corporations that were formed to make acquisitions or leveraged buyouts raised about half of their capital from bank loans, often secured by the assets of the companies being acquired, and 10 percent from equity investments, leaving a critical gap of about 40 percent which was raised by selling publicly traded junk bonds or borrowed from insurance companies and other lenders who specialized in junior debt.4

3.

Junk bonds were not very significant between World War II and the early 1980s, although they had been much used in the 1920s and 1930s, when they accounted for approximately 17 percent of newly issued corporate debt. A great many investment-grade bonds were downgraded during the Depression and by 1940 over 40 percent of all corporate bonds outstanding had junk-bond ratings. By the early 1970s, however, junk bonds accounted for less than 5 percent of all corporate bonds. While some were newly issued for companies such as Braniff Airways, most junk bonds were “fallen angels,” downgraded bonds like those of the Penn Central Corporation which was forced to declare bankruptcy in 1970 when it could not refinance its commercial paper. The large investment banks were not particularly interested in these securities and markets for them did not exist. It was in this “obscure backwater of Wall Street,” as James Stewart characterized it, that Michael Milken pursued his obsessions.

The keys to Milken’s success appear to have been his indefatigable research and considerable skills as a salesman. The research departments of the big Wall Street firms did not keep track of the companies that had issued high-yield securities. Milken used his growing and almost unique knowledge of such bonds both in his own trading and in cultivating clients who traded through Drexel. Milken’s network expanded quickly. He showed he could make profitable investments in undervalued securities such as the Penn Central bonds (the company’s assets would eventually benefit those who bought its depressed bonds at 20 cents or less on the dollar). And as he attracted loyal clients, he increased trading volume, which gave the market more “liquidity,” making it easier to trade.

Milken, as Stewart aptly put it, essentially “became the market for high-yield bonds.” As with any near monopoly, this was a market that Milken controlled and could manipulate. There were no published prices and Milken’s “spreads”—the difference between what he paid for securities and what he sold them for—were 3 or 4 percentage points, compared to the eighths and quarters of a point spreads typical for Treasury and investment-grade corporate bonds. Milken’s clients did not seem to care, however, as long as they also made money.

Milken’s early clients were not part of the Wall Street establishment. They included Saul Steinberg, Laurence Tisch, Carl Lindner, and Meshulam Riklis, an Israeli immigrant, husband of Pia Zadora, and the force behind a variety of acquisitions which included the liquor distributor Schenley Distributors and department stores like S. Klein and Best & Co. Some of them, like Riklis, had issued junk bonds themselves and clearly stood to benefit from greater interest on the part of investors in high-yield securities. Many, having recognized the tremendous potential of capital-rich insurance companies for providing them with funds to invest, acquired or ran insurance companies and made them the center of their operations. (This was also true of the legendary investor Warren Buffett, an outspoken opponent of junk bonds.) All had previously sought to circumvent the established ways of doing business and several had run-ins with the Securities and Exchange Commission (SEC).5

  1. 1

    The use of the term “junk” for high-yield securities reportedly originated in a conversation between Milken and one of his early clients, Meshulam Riklis, when Milken, after studying Riklis’s portfolio, remarked, “Rik, this is ‘junk’.”

  2. 2

    Apocryphal or not, the story illustrates how Wall Street storytellers like to create myths about the obsessive drive of people like Milken. According to Kornbluth, the helmet story is a gross exaggeration that “annoys Milken no end.”

  3. 3

    Suppose a company is purchased for $100 million and sold a year later for $200 million. The profit is $100 million but the rate of return on investment depends on the amount of the purchase price that was borrowed. If nothing was borrowed, the rate of return is 100 percent (“rate of return” is the profit divided by the amount invested). But if $90 million or 90 percent of the purchase price was borrowed at an interest rate of 10 percent (and interest cost of $9 million), then the rate of return on investment ($10 million) is 910 percent.

  4. 4

    Since the turmoil in the junk bond market in the late Eighties, two to three times as much equity has been required.

  5. 5

    Steinberg is well known for his audacious attempt to take over Chemical Bank in the late 1960s. The stock of Steinberg’s company, Leasco Data Processing, mysteriously dropped by more than 25 percent, causing him to give up the acquisition which was to be paid for in stock. His principal investment banking firm also withdrew, others were pressured not to help him, and regulators in Albany and Washington introduced measures to shield banks from hostile takeovers. “I always knew there was an establishment,” Steinberg said, “I just used to think I was part of it.” Milken recalled this incident almost twenty years later as an example of what the banks might try to do to him for cutting into their corporate lending. (The quotation is from “Why Leasco Failed to Net Chemical,” Business Week, April 26, 1969.)

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