But they are not, it should be emphasized, new. Companies, like people, have always borrowed money to buy things they haven’t had the cash to afford. They also borrow money because, in America at least, it is the most efficient way to finance an enterprise; interest payments on debt are tax-deductible. And shaky enterprises have always wanted to borrow money. At times, as when the turn of the century robber barons built their empires on mountains of paper, lenders have been surprisingly indulgent. But never as indulgent as today. What is new, therefore, is the size of the junk bond market, the array of rickety companies deeply in hock, and the number of investors willing to risk their principal (and perhaps also their principles) by lending to these companies.
Michael Milken at Drexel created that market, by persuading investors that junk bonds were a smart bet, in much the same fashion that Lewie Ranieri persuaded investors mortgage bonds were a smart bet. Throughout the late 1970s and early 1980s Milken crisscrossed the nation and pounded on dinner tables until people began to listen to him. Mortgages and junk made it easier to borrow money for people and companies previously thought unworthy of the funds. Or, to put it the other way around, the new bonds made it possible for the first time for investors to lend money directly to homeowners and shaky companies. And the more investors lent, the more others owed. The consequent leverage is the most distinctive feature of our financial era.
In her book The Predators’ Ball, Connie Bruck traced the rise of Drexel’s junk bond department (Milken reportedly tried to pay the author not to publish). The story she tells begins in 1970, when Michael Milken studied bonds at the University of Pennsylvania’s Wharton School of Finance. He was blessed with an unconventional mind, which overcame his conventional middle-class upbringing (his father had been an accountant). At Wharton he examined fallen angels, the bonds of one-time blue-chip corporations now in trouble. At the time fallen angels were the only junk bonds around. Milken noticed that they were cheap compared with the bonds of blue-chip corporations even considering the additional risk they carried. The owner of a portfolio of fallen angels, by Milken’s analysis, almost always outperformed the owner of a portfolio of blue-chip bonds. There was a reason: Investors shunned fallen angels out of a fear of seeming imprudent. It is a remarkably simple observation. Like Alexander, Milken noticed that investors were constrained by appearances and, as a result, had left a window of opportunity open for a trader who was not. Thus the herd instinct, the basis for so much human behavior, laid the foundation for a revolution in the world of money.
Milken began his career that same year, 1970, in Drexel’s back office. He pushed his way onto the trading floor and became a bond trader. He wore a toupee. Even his friends said it didn’t fit him properly; his enemies said it looked as if a small mammal had died on his head. The parallels between Milken and Ranieri are striking. Like Ranieri, Milken lacked both tact and couth, but not confidence. He was perfectly happy to stand apart from his colleagues. Milken sat in a corner of the trading floor while he created his market, ostracized until he made too much money to be anything but the boss. Also like Ranieri, he built a team of devoted employees.
Milken shared Ranieri’s zeal. “Mike’s difficulty was that he simply didn’t have the patience to listen to another point of view,” a former Drexel executive told Bruck. “He was terribly arrogant. He would assume he had conquered a problem and go forward. He was useless in a committee, in any situation that called for a group decision. He only cared about bringing the truth. If Mike hadn’t gone into the securities business, he could have led a religious revival movement.”
Milken is Jewish, and Drexel, when he joined, was an old-line WASP investment bank with, he felt, an anti-Semitic streak. Milken considered himself an outsider. That was a point in his favor. In 1979 a good guess at who would revolutionize finance in the coming decade would have been made as follows: Search the unfashionable corner of Wall Street; eliminate everyone who appears to have just emerged from a Brooks Brothers catalog, everyone who belongs or claims to belong to exclusive clubs, and everyone who comes from a good WASP family. (Among the leftovers would have been not only Milken and Ranieri but Joseph Perella and Bruce Wasserstein of First Boston, the leaders in corporate take-overs and, coincidentally, the other two men who helped Ronald Perelman chase Salomon Brothers.)
Here the similarity ends. For unlike Ranieri, Michael Milken took complete control of his firm. He moved his junk bond operation from New York to Beverly Hills and eventually paid himself $550 million a year, 180 times what Ranieri made at his peak. When Milken opened his Wilshire Boulevard office (which he owns), he let it be known who was in charge by putting his name on the door instead of Drexel’s. And he created a working environment that was different from Salomon Brothers in one crucial respect: Success was measured strictly by how many deals you brought in, rather than by how many people worked for you, whether you had a seat on the board of directors, and how many gossip columns you appeared in.
It is always hard to say what it is about a man that makes him suited to overturn the conventions by which the rest of the world has been living for ages. In Milken’s case, it is especially difficult because he’s almost neurotically private and offers no helpful insights into his character to would-be biographers, other than the business he does. My view is that he combined two qualities that were, at the time of his ascendancy, regarded as mutually exclusive. They certainly did not coexist within Salomon Brothers in the early 1980s. Milken possessed both raw bond-trading skills and patience with ideas. He had an attention span.
Here Milken overcame great odds. Loss of concentration, a complete lack of ability to focus, was the chief occupational hazard of the trading floor. Dash Riprock was an excellent and typical case in point. Watching Dash was as disconcerting as watching a music video. There were brief moments, for example, when Dash was glum. On occasion, usually when his business had momentarily waned, he dropped his telephone with a thud and explained to me how one day he planned to quit investment banking and go back to school. He was going to bury himself in a library for a few years, then become a history professor. Or maybe a writer. The idea of Dash locked in quiet contemplation, even for five minutes, struck me as uniquely improbable, and these conversations of ours would end with my trying to say so and his not listening because he was bored and wanted to change the topic. “I don’t mean I want to study now,” he’d say “I mean when I’m thirty-five and have a few million dollars in the bank,” as if, after years of jamming bonds, a few million dollars in the bank would make him more likely to pay attention.
After three years of bond sales Dash couldn’t concentrate sufficiently to enjoy a decent period of moodiness. Almost as soon as it had occurred to him to sulk (“Don’t fuck with me, I’m in a bad mad mood,” he’d warn traders) he would have forgotten about it, for somehow, in the throes of his gloom, he’d sell a few hundred million dollars’ worth of government bonds and grow bright again. “Yeah, Mikey!” he’d shout, as he scribbled a sales ticket. “The nippers, they love me. And I’m whipping and driving them. OOOOhhhhhhh yeaahhhh.” Most of his thoughts were entirely devoted to finding the next trade. His was a never-ending search for a fix.
Michael Milken, who began in a job not dissimilar to Dash’s, was building a business, rather than making an endless series of trades. He was willing to look up from the blips on his trading screen and think clear and complete thoughts years into the future. Would a certain microchip company survive for twenty years to meet its semiannual interest payments? Would the U.S. steel industry survive in any form? Fred Joseph, who became CEO of Drexel, listened to Milken on the subject of corporations and thought he “understood credit better than anyone in the country.” As a by-product, Milken came to understand companies.
Companies had long been the domain of commercial bankers and the corporate finance and equity departments of investment banks. They hadn’t been subjected to the mental processes of a bond trader. We at Salomon, as I have said, relegated the equity
department to a corner in our basement. Many of our bond traders thought of our corporate financiers as administrative assistants; their pet name for the corporate finance department was Team Xerox. Anyone who might have seen what Milken saw never reached a position to do anything about it. That was a great shame, because it left us blind to a prize within our reach.
Thinking like a bond trader, Milken completely reassessed corporate America. He made two observations. First, many large and seemingly reliable companies borrowed money from banks at low rates of interest. Their creditworthiness had but one way to go: down. Why be in the business of lending money to them? It didn’t make sense. It was a stupid trade: tiny upside, huge downside. Many companies that had once been models of corporate vitality subsequently went bust. There was no such thing as a riskless loan. Even corporate giants are felled when their industries collapse under them. Witness the entire U.S. steel industry.
Second, two sorts of companies could not persuade risk-averse commercial bankers and money managers to lend them so much as the time of day: small new companies and large old companies with problems. Money managers relied on the debt-rating agencies to tell them what was safe (or, rather, to sanction their investments so they did not appear imprudent). But the rating services, like the commercial banks, relied almost exclusively on the past-corporate balance sheets and track records in rendering their opinions. The outcome of the analysis was determined by the procedure rather than by the analyst. This was a poor way to evaluate any enterprise, be it new and small, or old, large and shaky. A better method was to make subjective judgments about the character of management and the fate of their industry. Lending money to a company such as MCI, which funded most of its growth with junk bonds, could be a brilliant risk if one could foresee the future of competitive long-distance phone services and the quality of MCI’s management. Lending money to Chrysler at extortionate rates of interest could also be a smart bet, as long as the company had enough cash flow to pay that interest.
Milken often spoke to students at business schools. On these occasions he liked, for dramatic effect, to demonstrate how hard it actually is to put a large company into bankruptcy. The forces interested in keeping a large company afloat, he argued, are far greater than those that wish to see it perish. He’d present the students with the following hypothetical situation. First, he’d say, let’s locate our major factory in an earthquake zone. Then let’s infuriate our unions by paying the executives large sums of money while cutting wages. Third, let’s select a company on the brink of bankruptcy to supply us with an essential irreplaceable component in our production line. And fourth, just in case our government is tempted to bail us out when we get into trouble, let’s bribe a few indiscreet foreign officials. That, Milken would conclude, is precisely what Lockheed had done in the late 1970s. Milken had purchased Lockheed bonds when the company looked to be heading for liquidation and had made a small fortune when it was saved in spite of itself, just as Alexander had bought Farm Credit bonds when all seemed lost but wasn’t.
What Milken was saying was that the entire American credit-rating system was flawed. It focused on the past when it should have focused on the future, and it was burdened by a phony sense of prudence. Milken plugged the hole in the system. He ignored large Fortune 100 companies in favor of ones with no credit standing. To compensate the lender for the higher risk, their junk bonds bear a higher rate of interest, sometimes 4 or 5 or 6 percent higher, than the bonds of blue-chip companies. They also tend to pay the lender a big fat fee if the borrower makes enough money to repay his loans prematurely. So when the company makes money, its junk soars, in anticipation of the windfall. And when the company loses money, its junk sinks, in anticipation of default. In short, junk bonds behave much more like equity, or shares, than old-fashioned corporate bonds.
Therein lies one of the surprisingly well-kept secrets of Milken’s market. Drexel’s research department, because of its close relationship with companies, was privy to raw inside corporate data that somehow never found its way to Salomon Brothers. When Milken trades junk bonds, he has inside information. Now it is quite illegal to trade in stocks on inside information, as former Drexel client Ivan Boesky has ably demonstrated. But there is no such law regarding bonds (who, when the law was written, ever imagined that one day there would be so many bonds that behaved like stock?).
Not surprisingly, the line between debt and equity, so sharply drawn in the mind of a Salomon bond trader (Equities in Dallas!), becomes blurred in the mind of a Drexel bond trader. Debt ownership in a shaky enterprise means control, for when a company fails to meet its interest payments, a bondholder can foreclose and liquidate the company. Michael Milken explained this more succinctly to Meshulam Riklis, the de facto owner of Rapid-American Corporation, at a breakfast meeting in the late 1970s. Milken claimed that Drexel and its clients, not Riklis, controlled Rapid-American. “How can that be when I own forty percent of the stock?” asked Riklis.
“We own a hundred million dollars of your bonds,” said Milken, “and if you miss one payment, we’ll take the company away.”
Those words are balm for the conscience of any bond salesman, like me, weary of screwing investors on behalf of corporate borrowers. If you miss one payment, we’ll take the company away. “Michael Milken,” Dash Riprock said, “has turned the business inside out. He screws the corporate borrower on behalf of investors.” Borrowers were squeezed because they had nowhere else to go but to Milken for money. What Milken offered was access to lenders. The lenders, along with Milken, made money. The gist of Milken’s pitch to them was this: Build a huge portfolio of junk bonds, and it does not matter if a few turn out to be lemons, the higher payoff on the winners should more than offset the losses on the losers. Drexel was prepared to gamble on companies, said Milken to institutional investors. Join us. Invest in the future of America, the small-growth companies that make us great. It was a populist message. The early junk bond investors, like mortgage investors, could make money and feel good about themselves. “You should have heard Mike’s speech each year at the junk bond seminar in Beverly Hills” (known as the Predators’ Ball, for the carnivores, like Ronald Perelman, in attendance), says a Drexel executive in New York. “It would have brought tears to your eyes.”
It’s impossible to say exactly how much money Milken converted to his cause. Many investors simply gave over their portfolios to him. Tom Spiegel of Columbia Savings & Loan, for example, responded to Milken’s message by inflating his balance sheet from $370 million in assets to $10.4 billion, much of it junk. A company that in sweet theory made loans to homeowners was simply taking billions of dollars in savings deposits and buying junk bonds with it. Before 1981 savings and loans did, almost exclusively, lend money to homeowners. Since the deposits were insured by the federal government—giving thrift managers cheap funds—the investments were restricted by the federal authorities. In 1981, when they began to flounder, the U.S. Congress decided to let the savings and loans try to speculate their way out of trouble. And though it meant, effectively, gambling with the government’s money, they were allowed to buy junk bonds. Spiegel has spent some of the profits from his junk bond portfolio on television advertisements that say what a prudent place the Columbia Savings & Loan really is, in spite of what you might hear. A little man in a blue suit climbs a bar graph to demonstrate how quickly Columbia’s assets are growing.
By 1986 Columbia Savings & Loan was one of Drexel’s biggest customers. Tom Spiegel’s salary was ten million dollars, making him the highest paid of America’s 3,264 thrift managers. Other S&L managers thought Spiegel a genius and followed his lead. “Zillions of little S and Ls all over the country now own junk bonds,” one of my former training program classmates told me as he rubbed his hands together in glee. He had left Salomon in the middle of 1987 and, like many other Salomon bond experts, had gone to work with Michael Milken in Beverly Hills.
Herein, funnily enough, lies one of the chief reasons why Salomon Brothers did
not rush into the junk bond market when the opening presented itself in the early 1980s or succeed in it later on. As it stood, the entire savings and loan industry was, within Salomon, Lewie Ranieri’s captive customer. Had Salomon become big dealers in junk bonds, Bill Voute, the head of corporate bonds, would have demanded equal access to savings and loans. Lewie Ranieri feared losing his grip on Salomon Brothers’ savings and loan customers and found a couple of ways to foil the small, fledgling junk bond department created by Voute in 1981.
In 1984 our two-man junk bond department spoke at a Salomon Brothers seminar for several hundred savings and loan managers. They had been invited to address the thrifts by the mortgage department. But after their three-hour presentation, Ranieri rose to deliver the closing address. The customers, of course, hung on his every word; as I’ve said, they viewed Lewie as their savior. “There are two things you absolutely should never do,” said Ranieri. “And the first is buy junk bonds. Junk bonds are dangerous.” Of course, he might have believed it. In the end, however, the thrifts did not, and Ranieri’s objection served only to discredit Salomon’s junk bond department and drive the thrifts into the arms of Drexel. And Bill Voute’s people were livid about being humiliated before such an important audience. “It was sort of like being invited to dinner and finding out you’re the dinner,” says one former Salomon junk bond man.
The same two-man team of junk bond specialists spent six months crossing America making presentations to individual S&L managers. “It was a crackerjack presentation, and we were getting a great response, but no one was calling up to buy bonds,” says one of the Salomon former junk bond specialists. They expected that the orders to buy junk bonds would soon follow their road show. But not one savings and loan manager ever called. “We found out why later, when a member of the team quit Salomon and went to Drexel to work for Milken,” says this man. “The customers told him that one of Lewie’s salesmen had been right behind us telling the thrifts not to believe us.” It says a great deal about the lack of leadership on the forty-first floor that the mortgage department got away with this little stunt. But such was the state of our corporation.
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