Liar's Poker

by Michael Lewis

  Meanwhile, the new market was exploding. One indication of Milken’s success was the number of new junk bonds issued. From virtually zero in the 1970s, new junk bond issuance grew to $839 million in 1981, to $8.5 billion in 1985, and to $12 billion in 1987. By then junk bonds were 25 percent of the corporate bond market. Between 1980 and 1987, according to IDD information services, $53 billion worth of junk bonds came to market. That is only a fraction of the market, however, because it neglects the billions of dollars worth of new, man-made fallen angels. Milken devised a way to transform the bonds of the most stable companies to junk: leveraged corporate take-overs.

  Having attracted tens of billions of dollars to his new speculative market, Michael Milken, by 1985, was faced with more money than places to put it. It must have been awkward for him. He simply could not find enough worthy small-growth companies and old fallen angels to absorb the cash. He needed to create junk bonds to satisfy the demand for them. His original premise—that junk bonds are cheap because lenders are too chicken to buy them—was shot to hell. Demand now exceeded natural supply. Huge pools of funds across America were dedicated to the unbridled pursuit of risk. Milken and his Drexel colleagues fell upon the solution: They’d use junk bonds to finance raids on undervalued corporations, by simply pledging the assets of the corporations as collateral to the junk bond buyers. (The mechanics are identical to the purchase of a house, when the property is pledged against a mortgage.) A take-over of a large corporation could generate billions of dollars’ worth of junk bonds, for not only would new junk be issued, but the increased leverage transformed the outstanding bonds of a former blue-chip corporation to junk. To raid corporations, however, Milken needed a few hit men.

  The new and exciting job of invading corporate boardrooms appealed mainly to men of modest experience in business and a great deal of interest in becoming rich. Milken funded the dreams of every corporate raider of note: Ronald Perelman, Boone Pickens, Carl Icahn, Marvin Davis, Irwin Jacobs, Sir James Goldsmith, Nelson Peltz, Samuel Heyman, Saul Steinberg, and Asher Edelman. “If you don’t inherit it, you have to borrow it,” says one. Most sold junk bonds through Drexel to raise money to storm such hitherto unassailable fortresses as Revlon, Phillips Petroleum, Unocal, TWA, Disney, AFC, Crown Zellerbach, National Can, and Union Carbide. It was an unexpected opportunity, not just for them but for Milken, for he certainly did not have the overhaul of corporate America in mind when he envisioned his junk bond market in 1970. He couldn’t have. When he stumbled upon the idea, no one imagined that corporations could be undervalued.

  As a graduate student at the London School of Economics I was taught that stock markets were efficient. Broadly this means that all outstanding information about companies is built into their share prices—i.e., they are always fairly valued. This sad fact was hammered home to students with a series of studies demonstrating that stock market brokers and analysts, people with the very best information, fared no better in their stock market picks than a monkey drawing a name from a hat or a man throwing darts at the pages of the Wall Street Journal. The first implication of the so-called efficient markets theory is that there is no sure way to make money in the stock market other than trading on inside information. Milken, and others on Wall Street, saw that this simply was not true. The market, which may have been quick to digest earnings data, was grossly inefficient in valuing everything from the land a company owns to the pension fund it creates.

  There is no easy explanation why this should be so, not that anyone on Wall Street wasted any time trying to explain it. To the men in Wall Street’s small mergers and acquisitions departments, Michael Milken was a godsend, a vindication of their choice of careers. Joe Perella at First Boston, having started the M&A department in 1973 and hired Bruce Wasserstein in 1978, had devoted resources to take-overs merely “on a hunch,” he says. “There was this huge opportunity,” says Perella, “and it was lying under the dirt. You had a steady supply of companies whose assets were undervalued. But there was a paucity of buyers. People who wanted to buy these companies couldn’t monetize their desire. Someone-Milken-came along and kicked away the dirt. Now anyone with a twenty-two-cent stamp can make a bid for a company.”

  Perella, Wasserstein, and countless others apart from Drexel relished the turn of events. Each take-over required a minimum of two advisers: one for the raider and another for his prey. So Drexel couldn’t keep all the business it created for itself. Most deals involved four or more investment bankers, as several buyers competed for the prize. The raiders were the stone dropped into the still pond, and they sent ripples shooting across the surface of corporate America. The process they began took on a life of its own. Managers running public companies with cheap assets began to consider buying the companies from their shareholders for themselves (what is known in Europe as management buyout, or MBO, and in America as a leveraged buyout, or LBO). They put themselves in play. Then, finally, Wall Street investment bankers became involved in what Milken had been quietly doing all along: taking big stakes in the companies for themselves. The assets were cheap. Why let other people make the money? So the take-over advisory business was all of a sudden shot through with the same conflict of interest I faced every day selling bonds: If it was a good deal, the bankers kept it for themselves; if it was a bad deal, they’d try to sell it to their customers.

  There was, in other words, plenty of work to go around. Mergers and acquisitions departments mushroomed across Wall Street in the mid-1980s, just as bond trading departments had mushroomed a few years before. There was a deep financial connection between the two: Both drew heavily on the willingness of investors to speculate in bonds. Both also drew on the willingness of people to borrow more than they could easily repay. Both, in short, depended on a whole new attitude toward debt. “Every company has got people sitting around who do nothing for what they get paid,” says Joe Perella. “If they take on a lot of debt, it forces them to cut fat.” The take-over specialists did for debt what Ivan Boesky did for greed. Debt is good, they said. Debt works.

  There was a deep behavioral connection between bond trading and take-overs as well: Both were driven by a new pushy financial entrepreneurship that smelled fishy to many who had made their living on Wall Street in the past. There are those who would have you think that a great deal of thought and wisdom is invested in each take-over. Not so. Wall Street’s take-over salesmen are not so different from Wall Street’s bond salesmen. They spend far more time plotting strategy than they do wondering whether they should do the deals. They basically assume that anything that enables them to get rich must also be good for the world. The embodiment of the take-over market is a high-strung, hyperambitious twenty-six-year-old, employed by a large American investment bank, smiling and dialing for companies.

  And the process by which a take-over occurs is frighteningly simple—in view of its effects on community, workers, shareholders, and management. A paper manufacturer in Oregon appears cheap to the twenty-six-year-old playing with his computer late one night in New York or London. He writes his calculations on a telex, which he send to any party remotely interested in paper, in Oregon, or in buying cheap companies. Like the organizer of a debutante party, the twenty-six-year-old keeps a file on his desk of who is keen on whom. But he isn’t particularly discriminating in issuing invitations. Anyone can buy because anyone can borrow using junk bonds. The papermaker in Oregon is now a target.

  The next day the papermaker reads about himself in the “Heard on the Street” column of the Wall Street Journal. His stock price is convulsing like a hanged man because arbitrageurs like Ivan Boesky have begun to buy his company’s shares in hopes of making a quick buck by selling out to the raider. The papermaker panics and hires an investment banker to defend him, perhaps even the same twenty-six-year-old responsible for his misery. Five other twenty-six-year-olds at five hitherto unoccupied investment banks read the rumors and begin to scourge the landscape for a buyer of the paper company. Once a buyer is found, the
company is officially “in play.” At the same time the army of young overachievers check their computers to see if other paper companies in America might not also be cheap. Before long the entire paper industry is up for grabs.

  The money to be made from defending and attacking large companies makes bond trading look like a pauper’s game. Drexel has netted fees in excess of $100 million for single take-overs. Wasserstein and Perella, in 1987, generated $385 million in fees for their employer, First Boston. Goldman Sachs, Morgan Stanley, Shearson Lehman, and others wasted no time in establishing themselves as advisers, and though none had the fund-raising power of Salomon, all made great sums of money. Salomon Brothers, slow to learn about take-overs and largely absent from the junk bond market, missed the bonanza. There was no reason for this other than a certain unwillingness to emerge from our bond trading shell. We were well positioned to enter the business; what with our access to the nation’s lenders we should have been a leader in the financing of take-overs. Of course, we had an excuse; we had to have an excuse for missing such a huge opportunity. Our excuse was that junk bonds were evil. Henry Kaufman made speech after speech arguing that corporate America was overborrowing and that junk bond mania would end in ruin. He may have been right, but that’s not why we didn’t leap into junk bonds. We didn’t underwrite junk bonds because our senior management didn’t understand them, and in the midst of the civil war on the forty-first floor, no one had the time or the energy to learn.

  John Gutfreund could pretend that he had avoided the business because he disapproved of its consequences, highly leveraged companies. But that excuse wore thin when he later plunged like a kamikaze pilot into the business of leveraging companies and brought ruin upon us and a few of our clients. (It also didn’t help that both he and Henry Kaufman purchased junk bonds for their personal accounts at the same time they were preaching corporate austerity.) In any case, whether Salomon Brothers participated or Salomon Brothers abstained, every company was by now a potential target for Milken’s raiders, including Salomon Brothers Inc. That was the final irony of Ronald Perelman’s bid. We were being raided by a man financing himself with junk bonds because we had neglected to enter the business of raiding companies and financing the raids with junk bonds.

  Soon after the news broke of Perelman’s ambitions, Gutfreund made a speech to the firm saying that he didn’t approve of hostile raiders and that he intended to shun Perelman, but apart from that, which we could have guessed on our own, we were left, as usual, uninformed. We relied on the investigative reporting of James Sterngold of The New York Times and the staff of the Wall Street Journal to learn the blow-by-blow of the event.

  The story was this: The tears had first flowed on Saturday morning, September 19, a few days before the news broke. On that morning John Gutfreund received a telephone call at his apartment from his friend and lawyer Martin Lipton, the man whose office he had used two months before to sack Lewie Ranieri. Lipton knew that Salomon’s largest shareholder, Minorco, had found a buyer for its 14 percent stake in the company. The identity of the buyer, however, was still a mystery. Gutfreund must have been badly embarrassed. He had known for months that Minorco wanted to sell its holdings but had been slow to accommodate it. This was bad judgment; as a result, he lost control of the process. Fed up with Gutfreund, Minorco advertised its Salomon shares through other Wall Street bankers.

  On Wednesday, September 23, Gutfreund learned from the president of Minorco the bad news that the buyer was Revlon Inc. It was clearly the beginning of a take-over attempt. Revlon’s Perelman said that in addition to Minorco’s shares, he wanted to buy a further 11 percent stake in Salomon, which would bring his stake to 25 percent. If Perelman succeeded, Gutfreund, for the first time, would lose his grip on the firm.

  Gutfreund scrambled to find an alternative to Revlon for Minorco.

  He called his friend Warren Buffett, the shrewd money manager. Buffett, of course, expected to be paid to rescue Gutfreund, and Gutfreund offered him a surprisingly sweet deal. Instead of Buffett’s purchasing our shares outright, Gutfreund proposed only that Buffett lend us money. We, Salomon, would buy in our own shares. We needed $809 million. Buffett said he’d lend us $700 million of that, by purchasing what was in effect a Salomon Brothers bond. That was just enough. Gutfreund could tap $109 million of our capital to make up the difference.

  Investors around the world envied Warren Buffett, for he had it both ways. His security, known as a convertible preferred, bore an interest rate of 9 percent which was in itself a good return on his investment. But in addition, he could trade it in at any time before 1996 for Salomon common stock at thirty-eight dollars a share. In other words, Buffett got a free play, over the next nine years, in the shares of Salomon. If Salomon Brothers continued to falter, Buffett would take his 9 percent interest and be content. If somehow Salomon Brothers recovered, Buffett could convert his bond into shares and make as much money as if he had stuck his neck out and bought our stock in the first place. Unlike Ronald Perelman, who was willing to commit himself to the future of Salomon Brothers by buying a large chunk of equity, Buffett was making only the safe bet that Salomon would not go bankrupt.

  The arrangement had two consequences: It preserved Gutfreund’s job, and it cost us, or, rather, our shareholders, a great deal of money. Our shareholders, after all, would pay for Buffett’s gift. The simplest way to determine its cost to them was to value Buffett’s bond. Buffett paid Salomon Brothers 100, or par. I punched a few numbers into my Hewlett-Packard calculator. I reckoned (very conservatively) that Buffett could sell it immediately for 118. The difference between 100 and 118, or 18 percent of Buffett’s total investment, was pure windfall. That comes to $126 million. Why should Salomon Brothers shareholders (and employees, if we assume some of it at least might well come out of our bonuses) foot the bill to save a group of men who had taken their eyes off the ball? That was the first question that crossed my mind and the minds of many of our managing directors.

  For the good of Salomon Brothers, explained Gutfreund. “I was shocked,” Gutfreund said of Perelman’s bid. “Perelman was just a name to me, but I felt that the structure of Salomon Brothers, in terms of our relationships with clients, their trust and confidence, would not do well with someone deemed to be a corporate raider.”

  Except for the first sentence, this statement rings false from the beginning to end. Let’s take the last part first. Our relationship with clients hadn’t suffered from having a South African as a shareholder; why should it suffer from an association with a hostile raider? I don’t care to dwell on the morality of either apartheid or hostile take-overs. But at the very minimum, it must be agreed, the former is at least as dangerous to be associated with as the latter. Our business may even have benefited from an association with a hostile raider. Corporations fearing raids, when they saw our backers, might well have kept us on retainer, just as they kept Drexel Burnham on retainer, as a sort of protection fee. Once Perelman was a major shareholder, we could credibly promise to keep him (and his friends) off the backs of others. Perelman, I am sure, was perfectly aware of this synergy when he contemplated buying into an investment bank.

  Second, for a man on Wall Street to refer to Ronald Perelman in September 1987 as “just a name to me” is absurd. Everyone knew who Ronald Perelman was. Christ, I knew who Ronald Perelman was before I started work at Salomon Brothers. From virtually nothing he had amassed a fortune of five hundred million dollars. And he had done it by raiding companies with borrowed money and firing bad management. Gutfreund no doubt knew that his days were numbered if Perelman gained control of Salomon Brothers. And if by some miracle of oversight he did not, he learned quickly when he met with Perelman at the Plaza Athenee Hotel in New York on September 26. The amazing rumor circulated in the managing directors’ dining room on the forty-second floor that Gutfreund’s replacement would be Bruce Wasserstein.

  In view of the circumstances, the way John Gutfreund persuaded the Salomon Brothers board t
o pay Warren Buffett a large sum of money to serve as our white knight appears marvelously shrewd. The board, by law, had to consider the interests of shareholders. On September 28, Gutfreund told the board that if it rejected the Buffett plan in favor of Ronald Perelman, he (together with Tom Strauss and a few others) would resign. “I never stated it as a threat,” Gutfreund later told Sterngold. “I was stating a fact.”

  An aspect of the genius of Gutfreund was his ability to cloak his own self-interest in the guise of high principle. The two could be, on rare occasions, indistinguishable. (If there is one thing I learned on Wall Street, it’s that when an investment banker starts talking about principles, he is usually also defending his interests and that he rarely stakes out the moral high ground unless he believes there is gold under his campsite.) It is possible, even probable, that John Gutfreund felt genuinely appalled by the financial tactics of Ronald Perelman—he is a feeling man—and no doubt he delivered his statement with the conviction of a preacher. He was magnificently persuasive. But he was risking nothing by laying his job on the line; he had nothing to lose and everything to gain; once Perelman acquired his stake, Gutfreund would have been fired before he had a chance to resign.