The Public Policy/Putting Junk to Rest
Mysak, Joe
THE PUBLIC POLICY PUTTING JUNK TO REST J unk bonds seemed like such a great J idea. The young were helped: striving entrepreneurs received financing for bold new projects. The old were made...
...In essence, he created a new use for junk: leveraged buyouts—the newsmagazines' "restructuring of America...
...Such prosperity as it did bring was based on unsound financial principles...
...Banks, which provide much of the cash in financing LBOs, were no longer willing to step up to the plate...
...In 1989, junk bonds totaled a still hefty $25.3 billion of the total $308 billion in corporate bonds sold...
...High-yield bond defaults of $15 billion in a single year, or an annual default rate of 10 percent, are possible in the future...
...What we are getting instead is the martyrdom of Michael Milken, Junk Bond King...
...The new management team then sells off most of the firm's assets, on the theory that the sum of the parts will bring more than the whole, and retains the core business, which it then works "smarter," i.e., with more efficiency...
...He left Drexel, which earlier pleaded guilty to six criminal charges and was fined $650 million only last June...
...Without that, without the Too Big To Fail doctrine and the evolution of deposit insurance, and the partial deregulation of the thrifts, without all of this, there would have been nothing like the junk bond industry...
...W hat final lesson can be learned from the fall of Drexel and Milken...
...The fact is that the American credit system has evolved away from liquidity and individual responsibility toward illiquidity and collective responsibility," what he refers to as the"socialization of credit risk, a state-sponsored phenomenon...
...34 THE AMERICAN SPECTATOR MAY 1990 the 163 basis points from the 437 spread, and this means that investors were actually overcompensated for the risk of default by 274 basis points, a pretty large cushion against risk...
...done shortly after Drexel went down in February, Stein wrote, "Drexel/Milkenism was largely a vast scam based upon myths about bond valuing skills and bond value, kept going by a vast Ponzi controlling markets, prices, reputation and data about defaults...
...But those yields...
...Grant told the House Subcommittee on Telecommunications and Finance last February: "The great financial story of the 1980s was the rise in borrowing by individuals, governments, THE AMERICAN SPECTATOR MAY 1990 35 and corporations alike...
...What happened after that, and with startling speed, was that market discipline reasserted itself as it usually does—with a vengeance...
...In March 1989 Milken was served with a 98-count indictment on charges including insider trading, securities fraud, and racketeering, to which he has pleaded not guilty...
...But the boom in the junk market, and its collapse, was symptomatic of something far more fiscally and ideologically suspect: what one observer has called the socialization of credit risk...
...Thrift institutions aside, Milken convinced usually cautious investors that it was all right to reach for yield by showing that default, what happens when a bond issuer misses a principal or interest payment, was a rare thing...
...The lack of it will deepen and prolong the downturn...
...Drexel's fate was decided five months later, when the banks refused the brokerage house additional financing to cover its own borrowing...
...And like all edifices built on the financial equivalent of sand, it did not take long to crumble...
...A look at the volume figures shows junk's popularity in LBOs...
...Milken and his ilk were able to sell junk bonds during the 1980s because they claimed the default rate was on the order of two percent...
...Thus, the junk bond market is no isolated speculative fluke...
...Those inhibitions usually included outright prohibitions on buying non-investment grade paper...
...In a leveraged buyout, smart entrepreneurs, either an outside "raider" or the firm's own management, take over a company, often an investment grade conglomerate, by buying up all of its stock...
...Finally, tighter credit will push the economy into recession...
...Treasury securities yield...
...By 1984, that figure reached $12.9 billion, and in 1988, the high-water mark, $30 billion—about one-quarter of all corporate debt sold...
...In fact, studies of historical performance have found 10-year cumulative default rates ranging from about 20 percent to 35 percent...
...Instead, it's now clear that the collapse of Drexel was decided in the prosecutorial hothouse atmosphere of the late 1980s...
...This also means fewer leveraged buyouts...
...And on seasoned junk, it was...
...With tighter money abounding, and the value of assets falling, companies tottering along under a staggering load of high-yield debt won't be able to pay, and very likely won't be able to renegotiate their debts...
...But even this can be misleading, as we will see...
...One First Boston analyst last April found that "investor losses due to default, figured as a percentage of par value," amounted to 163 basis points...
...Along the way in the 1980s, as the deals became larger and their credit quality deteriorated, all sorts of junkier permutations on the basic junk bond were concocted—namely, paid in kind (or PIK) debt, and zero-coupon bonds...
...One of his colleagues noted, after the fall of Drexel, "Michael Milken, whether he was guilty or not, was very important to making the junk bond market work...
...Big mistake...
...As Henry R. Kravis, a general partner at Kohlberg Kravis Roberts & Co., said recently, any leveraged buyout that involves selling assets, practically all of them, "is going to be viewed with great skepticism" now because there are "many companies that have had a difficult time selling their assets for what they once believed they were worth...
...Grant refers to such romanticism as "the infatuation with Milken, the Noble Entrepreneur...
...dustry jargon, above what comparable U.S...
...Not since the days when Populists cried for free silver have so many pieties been uttered, this time from conservatives, who should have known better...
...Junk bonds have always been with us, sold by corporations that are either very new, or very feeble, and so not judged to be investment grade by Moody's Investors Service or Standard & Poor's Corporation...
...Meanwhile, the most pious comments came from the Wall Street Journal, which claimed in an editorial that "no serious person is arguing that the government's charges amount to a claim that Mr...
...Now that the speculative bubble has burst, we can also expect default rates to rise...
...The companies, the current wisdom went, had to "wait for cash flow to grow" in order to begin repaying their debt...
...Even taking into account a higher-than-average default rate, an idea that he also disputed, the yield on a diversified portfolio of junk bonds more than compensated the man who bought it, he said...
...They needed "an interest rate holiday for a few years," as a banker at Morgan Stanley told me last year...
...They crippled the venture capital industry with high capital gains taxes and the high-yield securities industry with a massive and ruthless legislative and judicial attack...
...Realists will say that the explosion of easy credit financed businesses that should never have been financed in the first place...
...The collapse of Drexel symbolizes a dire problem in American capital markets as the 1990s begin...
...While the entitled children ache at the burden of laboring nine to five, the entrepreneurs rise before dawn and work happily from five to nine . . ." The striving entrepreneur was once like the Duke of Earl: nothing could stop him...
...The first was by recommending that investors buy junk bonds, because, he said, they were undervalued...
...Subtract 'For a fuller description of PIKs and zeros, see my article "'Turning America Into Junk," TAS, April 1989...
...One need go back only to the 1913 congressional Pujo hearings, when J. P. Morgan answered that the most important thing behind credit was "character...
...So have consumer bankruptcies, 'thrift' insolvencies, and the number of problem banks...
...When in 1983 the supply of junk ran low, Milken took his second step toward a payday that in 1987 totaled $550 million...
...It is no coincidence that now, as the federal government takes over much of the thrift industry, it stands to become the largest holder of junk bonds...
...Grant criticized the buildup of debt, junk and otherwise, throughout the 1980s...
...The credit contraction will deepen the recession that might have been in the cards anyway...
...The decline of the market can be traced to October 13 of last year, when UAL Corporation, the parent of United Air Lines, failed to obtain $7.2 billion in financing for its own management-led buyout...
...Takeover mania peaked in February, with the leveraged buyout of RJR Nabisco for $25 billion, $4 billion of which was done with junk bonds...
...Theodore V. Forstmann, senior partner at Forstmann Little & Co., a leading LBO specialty firm that uses its own cash in buyouts, railed against PIKs and zeros two years ago as being responsible for "the excess which has taken over the market...
...With PIK by Joe Mysak debt, the issuer pays out not cash, but more securities, to his bondholders...
...Period," summed up James Grant, editor of Grant's Interest Rate Observer and a man not given to gloating, although he might...
...And then it was over...
...Money cannot buy it...
...This says a lot about the junk bond market...
...We're in for a time of peace and quiet on Wall Street," said Grant...
...All those without access to the credit markets, who for years had been locked out by white-shoe investment bankers —and they included minorities, women, union members, immigrants, farmers, at least according to Drexel Burnham Lambert, Inc., the top junk bond underwriter—could get their financing with junk...
...Such firms present higher risks to their creditors, and of course must pay more in the market, typically around four points, or 400 basis points in inJoe Mysak, The American Spectator 's chief saloon correspondent, is the managing editor of the daily Bond Buyer...
...Drexel was the top underwriter of junk in 1989, helping to sell $9.7 billion of it, a market share of 38.6 percent, or one out of every three deals...
...He calls the Journal's editorial an exercise in "innocence, ignorance, and arrogance...
...But this is not the lesson that conservatives and libertarians are learning...
...The effect of PIKs and zeros was to delay the day of reckoning for the issuers involved...
...The oldest one: that speculative bubbles burst, and that credit is based upon responsibility...
...The end came in 1989...
...In 1979, only $1.3 billion of junk bonds were sold...
...In sum, the spigot was turned, and the flow of cash stopped...
...By February of last year, $3.35 billion in new issues were sold...
...when it matures, the holder collects the principal amount.' The explosion in LBOs provided Milken with lots of junk to sell to pension and mutual funds, insurance companies, and savings and loan institutions, which had billions of dollars to invest and which, reaching for what has been called "the honey pot of yield," quickly lost whatever inhibitions they might have had about buying such stuff...
...But first things first...
...Grant says that for the 1990s, "our working hypothesis is that creditworthiness will regain its economic franchise—that a bull market in financial safety will begin...
...Just appalling," and continues, "Libertarians are children in financial matters...
...So they will default, and all those who have reached for yield, predictably enough, will be stung...
...They don't know a good bondfrom a bad bond, or a promoter from a reasonably self-respecting investment banker...
...This, then, is what conservatives will learn from the episode...
...But junk progressively got junkier, and credit standards more lax...
...Because there were undoubtedly prosecutorial abuses, free-market minded people have leapt to the conclusion that it was the government that did Drexel in, whereas in truth, Drexel did itself in...
...Milken has been hounded since 1986 by the same insider trading investigation which caught Ivan Boesky, the newsmagazine "genius" and coverboy whose profits came less from genius than from cheating...
...In a story entitled "The Biggest Scam Ever...
...Drexel borrowed long, lent short, and lent to people who couldn't pay...
...What this means for the economy, drunk on easy credit for almost a decade, is fairly easy to project...
...Easy access to borrowed money led to expansion...
...Standard & Poor's reported late last year that "an investor who buys and holds a portfolio of high-yield bonds can expect at least 20 percent of the bonds to default...
...Milken, the eighties Junk Bond King, made his name in two steps...
...Zero-coupon debt does not pay any interest at all, but is sold at a discount...
...The takeover target's balance sheet is raped...
...This was the same George Gilder, however, who once wrote, "While the entitled children speak of an absence of worthwhile work, the entrepreneurs hold three jobs at one time...
...And during the 1980s, investors in junk were very well compensated for the risk they took...
...It does not take much—four points of yield or so—to convince a board of directors that their fund, or company, or S&L is missing out on a really good thing, and to ignore an old Wall Street axiom: that when you reach for yield, you usually get stung...
...There are lessons to be learned from the collapse of the junk bond market, and conservatives are likely to learn the wrong ones...
...Junk, or high-yield, high-risk securities, was indeed a boon to many, once...
...The editorial was bunkum...
...Junk bonds meant the "democratization of capital...
...The old were made virile: bloated American corporations stripped down to global fighting trim...
...The result was a hard hit to the panicky junk bond market, which had seen a pickup in defaults, and a drop in the Dow Jones industrial average of 197.34 points...
...Investment bankers, lawyers, and junk bond dealers walk away with some pretty fancy fees...
...In order to buy up the firm's stock, the entrepreneurs concerned put upsome cash, and raise the rest through bank loans and issuance of junk bonds: often, billions in junk bonds...
...Without Milken there to keep the game going, everything fell apart remarkably quickly...
...Milken built the junk bond on some crooked scheme...
...The junk bond market is unlikely to revive any time soon, no matter how high the yields offered: according to the newsletter Junk Bond Reporter, the volume of new junk bonds sold through February was $350 million...
...This is pretty misty-eyed stuff...
...And Grant sees the problem as extending far beyond the junk bond market, only a symptom of a larger problem...
...His voice, in the main, was that of Jeremiah in the wilderness...
...D rexel borrowed short, lent long, and lent to people who couldn't pay...
...As corporate bond defaults have risen, so have consumer-loan delinquencies...
...In short order, this is what happens: stockholders' shares rocket in value as the takeover begins...
...Benjamin Stein in Barron's thinks along the same lines...
...Michael Milken and his team at Drexel Burnham Lambert did not create the junk bond, although they recast it...
...An important source of capital for small- and medium-sized businesses is now in danger...
...When someone says, 'The government did it,' they have Michael Milken to tea...
...Pessimists will say that this means less financing for new businesses...
...When markets react, they don't do so according to the Golden Mean...
...George Gilder, of all people, reinforced this lesson on the Journal's editorial page: "The forces of reaction have struck back...
...Milken may have been the wizard behind the market, and he did have an incredible capacity for keeping it orderly, but even his magic could not stave off what was, without doubt, inevitable...
...Robert Long, director of high-yield research at the firm, calculated that the average yield spread between junk and Treasury issues of comparable maturities was 437 basis points—about four and a half points...
...The collapse of the junk bond market was caused by tighter credit, and there will be tighter credit still...
...Even widows and orphans benefited from junk tucked away in pension funds and the like...
...Now it turns out that the collapse of the junk bond market might...
...If the takeover target had bondholders, they rage, as their own bonds turn from investment grade to real junk —!'fallen angels" is the term the professionals use...
...There won't be a return to moderation and sweet reason, but unreasonable timidness and caution," said Grant...
...It is mainstream Americana...
...And as far as the S&Ls were concerned—they were insured by the federal government in a big way due to the doubling of deposit insurance...
...And this was down from one out of every two deals in 1988...
...His trial is, in fact, almost beside the point...
...What the bondholder receives is the cachet of the name, without the high-yield coupon...
Vol. 23 • May 1990 • No. 5
