Joseph shook hands with the intense, slender young man with dark, deep-set eyes. Joseph wondered briefly how someone like Milken had ever ended up at Drexel Firestone, but otherwise Milken didn’t make much of an impression. They didn’t work directly together. Joseph headed the more upscale investment banking area, and Milken was the head of convertibles and noninvestment-grade securities, later dubbed the high-yield department. He reported to a longtime Burnham trader, Edwin Kantor, and, as far as compensation was concerned, directly to Burnham.
To encourage Milken, who complained that he’d always been treated as a second-class citizen by the starched-shirt Drexel WASPs, Burnham let Milken set up his own semi-autonomous bond trading unit. In 1975, he gave Milken a compensation arrangement crafted to provide strong performance incentives. Like all Wall Street firms, Drexel paid relatively low salaries, and most employee compensation came in the form of bonuses. But Milken’s bonus arrangement was unusually generous. Milken and his group of employees were awarded 35% of all the firm’s profits attributed to their activities. Milken was given the discretion to allocate the money among his people, keeping whatever remained for himself. Burnham also gave Milken additional “finder’s fees” of 15% to 30% of the profits attributable to any business brought into the firm by Milken or his people. Burnham paid out 35% of profits to the people actually doing the work and up to 30% of the profits to whomever landed the client. The firm kept as little as 35% to cover overhead and the partners’ share of profits. The system for compensating Milken was a closely guarded secret at the firm.
Over the year or so after they first met, Joseph and Milken came to know each other reasonably well, mostly because Milken was eager to generate finder’s fees by calling Joseph with tips for potential new corporate finance business.
Joseph wasn’t a snob, but at first he tended to associate Milken with the Burnham trading crowd, many of whom knew little about the world beyond the hustle of their native Brooklyn or Queens. Joseph himself came from a modest background, growing up in Roxbury, a blue-collar neighborhood in Boston. His father drove a cab for a living, and his parents were Orthodox Jews. But Joseph had acquired a veneer of sophistication as a scholarship student at Harvard College and then Harvard Business School. He had joined E. F. Hutton & Co., hired by John Shad (future chairman of the Securities and Exchange Commission), and made partner in only four years. He had moved to Shearson, helped negotiate its merger with Hayden Stone, and been named chief operating officer, the firm’s second-ranking position.
Drexel was a big step down from Shearson, but Joseph had wanted to get back into hands-on investment banking, and he had a dream of building a powerhouse firm from scratch and being identified with it for posterity. Joseph had seen enough of the changes sweeping Wall Street to believe that practically everything about the old order was vulnerable. At Drexel, however, he was certainly starting low. Drexel’s corporate finance department consisted of 19 people; Joseph promptly dismissed seven of them. His first year, the department’s entire bonus pool was a measly $15,000.
Joseph felt he had to overhaul the whole culture of the firm. Soon after arriving, he hosted the first of what became annual dinners for new recruits at Windows on the World atop New York’s World Trade Center. He felt he had to build integrity as he instilled the drive to succeed in these new investment bankers. “You will be tempted,” he warned his audience. He mentioned their access to confidential information about clients’ business plans, stock and debt offerings, merger plans. “If you act on that temptation, you will be caught. I guarantee it. They will take your shoelaces. And here at Drexel, we won’t give you the time of day.”
It didn’t take long after their initial meeting for Joseph to realize why Burnham was so eager for him to meet Milken. Milken wasn’t just another trader at the firm. He was, in fact, one of the highest-paid employees. Starting with $2 million in capital in 1973, he was generating astounding 100% rates of return, earning bonus pools for himself and his people that were approaching $1 million a year. And he was doing it in an area that Joseph knew little about and considered distasteful: high-yield, unrated bonds.
The American bond market is dominated by two giant bond-rating agencies, Moody’s and Standard & Poor’s, who for generations have guided investors seeking to gauge the risk in fixed-income investments. The value of these investments depends on an issuer’s ability to make promised interest payments until the bond matures, and then repay the principal. Top blue-chip corporate debt for companies like AT&T or IBM is rated Triple A by S&P. Companies with weaker balance sheets or other problems have correspondingly lower ratings. Some companies are deemed so risky that they receive no rating at all. Interest rates on corporate debt fluctuate with market rates for U.S. Treasuries and the perceived risk of the issuer, so the lower the debt rating, the higher the rate a company must pay in order to attract investors.
In the midseventies there wasn’t all that much low-rated and unrated debt around, and investors, by and large, wouldn’t touch it. The big investment banks weren’t interested; it was too hard to sell, too risky for the firms’ reputations, and tended to alienate the mainstream, top-rated issuers. Much of the high-yielding debt around was once-rated paper of companies that had fallen on hard times (so-called “fallen angels” in the parlance of Wall Street). Milken had been drawn to this obscure backwater of Wall Street.
Unlike Joseph, Milken had grown up in a comfortable, upper-middle-class home. Encino, California, a town in the San Fernando Valley north of Los Angeles, had a sizable Jewish population—the synagogue was near the Milken home—but was about as homogeneous as the rest of rapidly growing Southern California. Milken’s father was an accountant. Starting at age 10, Milken helped his father, sorting checks, reconciling checkbooks, later helping with tax returns. From the first grade, Milken had dazzled his classmates by doing complicated multiplications in his head.
Milken thrived at Birmingham High School in nearby Van Nuys, where he graduated in 1964. Birmingham students were almost all middle-class whites. Many of their parents, like the Milkens, had migrated from the industrial Midwest and East. They loved sports, embraced the surfing craze and bouffant hairdos, were crazy about the Beach Boys, and drove their cars endlessly around town. Milken was full of energy, more academically oriented than most, eager to be accepted by his classmates. He was elected a cheerleader, the next best thing to being a sports star. He was active in student government and was voted most popular. He dated a pretty, vivacious classmate, Lori Anne Hackel, whom he’d met in his seventh-grade social studies class. Other classmates included future movie star Sally Field and Hollywood super agent Michael Ovitz.
The University of California at Berkeley was an abrupt change for Milken. By the time he graduated in 1968, it was the epicenter of the student antiwar and counterculture movements. Milken, comfortably in the mainstream in high school, was suddenly a misfit. He was a member of a mostly Jewish fraternity, Sigma Alpha Mu, when fraternities were out of favor. He didn’t drink, smoke marijuana, or use LSD. He majored in business administration rather than the more-fashionable sociology or psychology, and he studied hard. He was named to Phi Beta Kappa. His social life, for the most part, focused on Lori, who was also studying at Berkeley. They married right after graduation.
Soon after, Milken and Lori moved to Philadelphia where Michael enrolled in the University of Pennsylvania’s prestigious Wharton business school. Milken worked summers and part-time during the school year at Drexel Firestone’s Philadelphia office (a predecessor firm had been headquartered in Philadelphia). After graduating with all A’s, Milken stayed at Drexel, commuting from a Philadelphia suburb, Cherry Hill, N.J., to Drexel’s Manhattan headquarters. He seemed remarkably unsophisticated about Wall Street’s pecking order, largely oblivious to considerations of prestige. He didn’t have any real familiarity with the Morgan Stanleys or Goldman, Sachses of the world.
Milken was unfazed by the tradition that held that promising business graduates we
nt into investment banking—corporate finance, not sales and trading. At Drexel, Milken started in research and then asked to moved to sales and trading, where he gradually focused almost exclusively on the low-rated and unrated securities that would become his hallmark.
Years later, the myth grew up and was cultivated by Drexel that Milken was a “genius” who discovered the profit potential of what became universally known by the pejorative name “junk” bonds. But Milken never made any secret of the fact that the intellectual underpinnings of his interest in low-grade bonds were provided by others. W. Braddock Hickman had done a landmark analysis of low-grade and unrated bonds that Milken read while still at Berkeley. In a thorough analysis of corporate bond performance from 1900 to 1943, Hickman had demonstrated that a diversified long-term portfolio of low-grade bonds yielded a higher rate of return, without any greater risk, than a comparable portfolio of blue-chip, top-rated bonds. A later study of bonds from 1945 to 1965 reached the same conclusion.
Later, in his early conversations with Joseph, Milken, a genius salesman, constantly preached his gospel of high-yield securities. Joseph was intrigued; he asked for a copy of Hickman’s study. Milken kept talking. The only problem with low-grade debt was its lack of liquidity, he argued. Most of Drexel’s customers were still unwilling to invest their assets at higher yields, but Milken began to make some headway. He countered investor reluctance and risk aversion with meticulous research into the underlying business prospects of as many low-grade issuers as he could handle. He amazed Joseph with his grasp of arcane aspects of various businesses, all aimed at predicting a company’s ability to make its interest and principal payments when due.
It was an enormous task; virtually no research on these companies was being done on Wall Street, where research departments focused almost exclusively on stocks of widely traded companies. Milken was handling all his own research, carrying bulging briefcases of research reports and other data on his long commutes to and from Cherry Hill. He used his findings to persuade investors to gamble on high-yielding securities that Milken believed would make their payments and were, as a result, undervalued.
Some of Milken’s prospects were also potential corporate clients for Drexel. Insurance companies with large pools of assets were especially eager to invest profitably. Joseph went along with Milken on countless visits to spread the gospel of high-yield. At each stop, Milken ran through his arguments: The bond market was too risk-averse; a well-diversified portfolio would provide a better return; liquidity was growing as more companies heeded Milken’s message; and returns would comfortably exceed the risk premium. It was a simple, effective message. Increasingly, it worked.
Among Milken’s early big successes was a group of wealthy, mostly Jewish financiers who had acquired insurance companies. None was a member of the Wall Street establishment. They didn’t worry about the stigma associated with low-grade paper, and they liked Milken’s new ideas. Saul Steinberg, Meshulam Riklis, and Carl Lindner became early converts, and Lindner, a non-Jew from Cincinnati, even became something of a father figure. As their annual returns met or exceeded Milken’s predictions, they became increasingly heavy backers of Milken and clients of Drexel. For his part, Milken showed no concern that Lindner was a target of an SEC investigation, had never graduated from high school, was shunned by Cincinnati society, and was viewed as a pariah by many on Wall Street. Or that Steinberg had wrested control of Reliance Insurance Co. and waged an unsuccessful hostile attack on giant Chemical Bank that had enraged the establishment banking world and its investment banking allies. Or that Riklis started as a poor Israeli immigrant who had made his money in movie theaters and liquor. They had all been rebuffed on Wall Street at various times. They would never forget that Milken sought them out as clients.
By early 1977, Milken’s operation controlled a remarkable 25% of the market in high-yield securities. It was really the only firm maintaining an active market-making operation with an eye toward enhancing the liquidity of the market. (A market-maker is a key to liquidity, assuring a holder of a security that it will buy it whenever the holder wants to convert it into cash. The market-maker, in turn, resells the security, keeping as its profit any difference between the “buy” and “sell” price it obtains. The New York Stock Exchange and the NASDAQ over-the-counter market are simply institutionalized market-making organizations, which provide the additional service of published trading prices.) Other banks, such as Lehman Brothers, the market leader in high-yield bonds, would underwrite some new issues and husband those it had previously underwritten, but this was mostly a service to existing clients; other firms weren’t interested in being active market-makers.
So Milken became, in effect, the market for high-yield bonds. He had an incredible memory, and he knew who owned what issues, what they had paid, their yield to maturity, and who else wanted them. Increasingly, his clients developed such confidence in his research and market acumen that when he urged them to invest in a particular issue, they did. They didn’t care about the absence of published prices, or what Milken’s spread was—as long as they made money. And no one except Milken and a handful of his colleagues knew the pricing structure of this market—including the increasingly high spreads between the buy and sell prices.
Milken could thrive to the extent he did, in part, because his market was almost entirely unregulated. His operation dealt almost entirely in what is known as “secondary offerings.” In such transactions, a large insurance company may decide to unload a large bond position it acquired from the original issuer; it might have Drexel buy the block of bonds, then reoffer them to its network of bond buyers. Such offerings don’t have to be registered with the SEC, and there is no published listing of the price at which such offerings are made. The world of junk bonds was the financial equivalent of the early days of the American frontier; a rough justice was extracted from the weak by the strong.
One day a salesman in Drexel’s midtown Manhattan office, Gary Winnick, bought some of Milken’s bond inventory for one of his clients. Winnick earned one-eighth of a point on the spread, or the difference between the price the customer paid and what Milken charged him. (A “point” is $10 for each $1,000 face amount in the price of a bond, or 1%. Thus, one-eighth of a point on a $1 million spread would be $1,250.) Winnick was furious to learn that Milken’s spread had actually been 30 points, and that Milken had kept 29⅞ for himself. Winnick was astounded that Milken would be so greedy. They were, after all, colleagues. Winnick went to Milken’s boss, Kantor, and complained. But Kantor did nothing. Already, by 1976, Winnick concluded, Milken was making too much money for anyone to discipline him.
For Milken, the transaction was just another trade, and the more one could squeeze out of the person on the other side of the trade, the better. For years to come, his colleagues on the trading desk would watch in amazement at the pleasure, even glee, that Milken displayed when he squeezed an extra fraction of a point out of an unwitting trader. Only in trading could superior knowledge be wielded to extract profits with such immediate satisfaction. Few ever got the better of Milken, because he gambled only with superior knowledge; when someone did, Milken went out and tried to hire him. Warren Trepp, for example, was the head fixed-income trader at Dean Witter when he sold short some real estate investment trust securities. One of Milken’s people was on the other side of the trades. The REIT values dropped severely, causing serious losses for Milken and generating a big profit for Trepp. Milken ordered his people to get the name of the Dean Witter trader, then went out and lured him to Drexel. Trepp became Milken’s own head trader.
As Milken’s business grew, so did Joseph’s, if not at so spectacular a rate. Joseph moved quickly to improve the quality of investment bankers at Drexel, hiring several people he had earlier recruited to Shearson, among them John Kissick, Herbert Bachelor, Fred McCarthy, John Sorte and David Kay, whom he put in charge of an infant mergers-and-acquisitions department. And he hired an arrogant, chubby, headstrong young business sc
hool graduate, Leon Black. Black’s father, the head of United Brands, had been caught in a scandal while Leon was at Harvard Business School and had committed suicide by jumping from his office window.
In an effort to give Drexel an “edge” at attracting investment banking business, Joseph had decided to target certain growing industries and smaller companies neglected by the major investment banks. Drexel started building up its research coverage for over-the-counter stocks, even though research brought no immediate profits to the firm. The group managed to do enough deals that, by 1977, the corporate finance bonus pool reached $1 million.
That same year, Joseph called Milken, explaining that a client, Texas International, needed to raise capital but was already so highly leveraged with debt that it would never get an investment rating. Could Drexel do a public high-yield issue, underwritten by Drexel and marketed directly to the public—an original new issue, in other words, rather than the secondary offerings that were the mainstays of Drexel’s practice?
Milken said he’d try. He proceeded to sell the $30 million issue easily, with a whopping underwriting fee of 3%. Milken went on that year to do six more issues for companies that couldn’t otherwise get capital. At about the same time, he sold the idea of the first high-yield mutual funds, allowing small investors to invest in a diversified portfolio of junk bonds. Milken’s dream of liquidity was close to fruition. The mechanism for a revolution in finance was in place, right under the noses of the Wall Street establishment that had disdained low-grade debt.
Winnick, meanwhile, had moved at Kantor’s behest to the high-grade bond desk in Drexel’s downtown offices. He also traded some of Milken’s high-yield products and he quickly became Drexel’s top-producing salesman outside the high-yield area. He worked long hours. One Friday night he mentioned to Milken that he and his wife were looking at houses in Westchester County that weekend, and Milken said somewhat cryptically, “Don’t buy anything.” Shortly after, he asked Winnick to work for him—in Century City, adjacent to Beverly Hills, in distant California.
Den of Thieves Page 5
