Junk Bonds and Watered Stock
BROCKWAY, GEORGE P.
The Dismal Science JUNK BONDS AND WATERED STOCK BY GEORGE P BROCKWAY In the 1920s, bond salesmen were admired and envied. Later, when Wall Street laid its egg, they became butts of bitter jests...
...asked a book by Fred Schwed Jr...
...Whatever happens, the financing of the American economy will still be largely an incidental function of speculation, or as Keynes said, of running a casino...
...Second, J.P...
...Therefore a prudent company got its money from stock, rather than bonds...
...Steel was floated, there was no corporation tax...
...This result of undercapitalization is, you may be astonished to learn, not substantially different from the result of overcapitalization...
...The tubes plainly held a lot of water, as did the other trusts that went into United States Steel...
...In addition, the term admits risk and so suggests sport...
...After the deduction, the new load on the company is only about 6-8 per cent, and before it becomes oppressive, the raiders will be long gone...
...The corporation's cash flow will be soaked up by the high interest...
...The case for technological efficiency is, if anything, worse...
...otherwise not...
...I did not imagine that the Rea-ganauts' inten tion was to make paupers and millionaires...
...Although Brandeis doesn't give all the gory details, I would wager that at least half of the original 228 companies were enticed to sell out at greatly inflated (or pumped up) prices...
...Dividends, on the other hand, were not fixed (except for some on preferred stock...
...Steel, Engineering News reported: "We are today something like five years behind Germany in iron and steel metallurgy, and such innovations as are being introduced by our iron and steel manufacturers are most of them following the lead set by foreigners years ago...
...leveraged...
...I dare you to run the risks that may lead to a big killing...
...Today's bond salesmen seem to be following in their grandfathers' footsteps...
...they are also undeniably bad for the morale of our society (see "The Faith of Fiduciaries," NL, December 24, 1984) and for the tax collections that support our society...
...At the same time, these negative connotations are modified by some that are at least ambiguous...
...And some say the present run-up of the stock market will put an end to takeovers by increasing the amount of money needed...
...and their associates for promotion services...
...Interest was a fixed expense...
...For this reason, the bond market has been rising, too...
...Finally, these and other companies were formed into the United States Steel Corporation, combining 228 companies in all...
...They may not necessarily be bad for the new owners of the corporations that issue them or for the purchasers or for the underwriters, but they are almost invariably bad for the corporations themselves...
...The Federal Reserve Board's new rule limiting the use of junk bonds to 50 per cent of the price of a takeover may put a momentary hitch in a few raiders' plans...
...That might have been written yesterday...
...Stock was issued instead of bonds, and the stock was said to be watered— like cheap whiskey...
...But if those shut down were inefficient, why were they bought in the first place...
...The chosen instrument was different, and the metaphor was different, but the results were similar...
...will stay after class and be given a quick review of the effects of mass immigration, Taylor System management, and courts that issued injunctions against labor unions as conspiracies in restraint of trade...
...the sheet steel trust 26...
...For another example, junk food is eaten by an awful lot of people, who apparently have a tolerance, if not taste, for it...
...The wire trust combined 19 mills...
...the interest that investment-grade bonds must pay is falling—and so are the requirements for junk bonds...
...The tube trust, when it was put together a few years earlier, had been capitalized at $80 million...
...The device and the game are j oined in the term "junk bonds...
...The question remains: Who paid for the water...
...How was the water in Big Steel paid for...
...In the end, they were obj ects of opprobrium and scorn...
...Later, when Wall Street laid its egg, they became butts of bitter jests ("Where are thecus-tomers' yachts...
...Without a research assistant, I can only suggest the outline: First, the owners of the original 228 companies were well paid...
...Speculation continues to have the effects I discussed...
...The junk bonds metaphor boldly accepts both connotations and thus disarms criticism...
...The run-up, however, has been caused by the drop in interest rates, which increases the capitalized value of every income-earning asset...
...Once you add it together you have United States Steel, the first corporation capitalized at a billion dollars, and pretty close to half of it was water...
...The rest of Steel Common was watered in its turn, with nearly one-seventh issued directly or indirecdy to the promoters...
...The title displays an innocence on my part...
...No one, it winks, is trying to fool anyone...
...Evidence for this is the fact that most of the 228 were shut down, while the surviving units were expanded...
...and the plate trust 36...
...and the $20 million stock so taken later became exchangeable for $25 million of Steel Common...
...Half of that was common stock, and half of the common "was taken by J.P...
...Guess who's left with the short end of the stick...
...Some of the others may have been squeezed a bit, but the total paid for the 228 was almost certainly far greater than their entire net worth...
...You say that the capitalist system depends on risk taking: Do you dare put your money where your mouth is...
...Currently they are undercapitalized, a.k.a...
...Steel was more efficient than its 228 components had been...
...That the debt will eventually become oppressive, there is usually little doubt...
...openly admitting a superficial weakness or two could get them good marks for sincerity...
...A secondary connotation is of junk mail, which almost everyone hates...
...Third, those who bought the watered stock received "normal" dividends...
...Morgan & Co...
...In Other People's Money, Louis D. Brandeis, later a Supreme Court justice, told how the United States Steel Corporation was formed in 1901: "The steel trust combines in one huge holding company the trusts previously formed in the different branches of the steel business...
...Either way, it is the working man and woman—the people who put that capital to work—who do the ultimate paying...
...My first "Dismal Science" column (NL, September 7, 1981) was entitled "Speculation Will Undo Reaganomics...
...The shift is a function of the tax laws, though you may read many an analysis of takeovers without coming across a mention of the part played by taxes...
...In Morgan's time, high-flying corporations were overcapitalized...
...When U.S...
...Should President Reagan be successful in cutting corporation tax rates (as seems likely), the deductibility of interest payments will become less important and watered stock will tend to displace junk bonds in takeover schemes...
...Are you big enough to afford such risks...
...As the man might say, there's no such thing as a free drink...
...Today, with the corporation tax at 46 per cent (assuming a corporation pays any taxes at all), and with interest payments deductible, a clever company will issue bonds instead of stock, and a clever raider will happily issue junk bonds paying 14-15 per cent in order to buy up stock earning 5-6 per cent...
...Those who didn't immediately answer "Labor...
...directed to obtain a return on more capital than would be required to duplicate their respective properties...
...As profits fall or disappear, so will the benefit from deductibility...
...If the capitalization was half water, Steel's earnings on its real assets would have had to be twice "normal...
...Morgan and his fellow underwriters were very well paid...
...Thus the tube trust combined 17 tube mills, located in 16 different cities, scattered over 5 states, and owned by 13 different companies...
...Here someone is sure to cut in with the claim that U.S...
...and purveyors of junk food make an awful lot of money, something the purveyors and buyers of junk bonds hope to do, too...
...The immediate connotation is of shoddy goods or a tangle of broken machinery, old plumbing fixtures and wrecked automobiles, partly hidden by a tumbled-down board fence as unsightly as what it pretends to hide...
...Palmer tells us in A History of the Modem World of an 18th-century promoter who issued shares in "a company 'for an undertaking which in due time shall be revealed.'" Does anyone doubt that if Carl Icahn made such an offering today it would be oversubscribed tomorrow...
...Yet just as a paranoiac may have real enemies, junk bonds may be really bad...
...Nor was this all...
...I still find it hard to believe that decent people think it's grand...
...Fourth, the price of steel was not grossly exploitative (steel rails stayed at $28 per long ton for more than 10 years...
...And since long before the sophists, children have known how to tempt their peers with the challenge, "I dare you...
...Neither are junk bonds the first securities of "less than investment grade" to be widely marketed in the United States...
...The competitive system is supposed to let inefficient companies die...
...Most of our giant corporations—including many of those now being raided—were originally papered together with such securities...
...In other words, look for an upsurge in new blue-sky issues...
...An asset that earns $ 10 is worth $ 100 when the interest rate is lOpercent, and jumps in value to $200 if the rate falls to 5 per cent...
...In spite of all the present hype, junk bonds are not new...
...Paraphrasing Abraham Lincoln, one might conclude that God must love churches and charities that raise money by mail, since He made so many of them...
...Andrew Carnegie observed in The Empire of Business (1902) that "railway managers today are...
...Those who send out junk mail presumably think well of it...
...the bridge and structural trust 27...
...Since the Civil War days of "Betcha Million" Gates and Jay Gould, speculation has resulted in American enterprises paying too much for capital...
...Practically every railroad issued bonds at usurious rates —and ultimately paid the penalty...
...Even a sluggish cash flow can quickly lead to bankruptcy...
...It matters little whether the capital is paid for with dividends on watered stock or with interest on junk bonds...
...Since earnings were not taxed, interest paid on bonds was obviously not deductible...
...Long before Aristotle wrote his Rhetoric, Greek sophists found that an appearance of frankness could help them win a bad case...
...The interest payments will have to continue in bad times as well as in good...
...Salesmanship is now marvelously subtle, combining an ancient rhetorical device with an even more ancient childhood game...
...In 1911,10 years after the emergence of U.S...
...For reasons why no interest should be deductible, see "The Bottom Line of Tax Reform," NL, November 26,1984...
...Of course, bankruptcy may now be sought to break a labor contract, whereupon the company may become solvent again...
...You paid dividends when you were flush...
Vol. 69 • March 1986 • No. 6
