The Trillion-Dollar Hole in America's Stocking Part 2
December 24, 1990

by Curtis Lang		print version
		print version (graphics)

While James Baker was re-establishing a leaner and meaner Trilateral world economic order in preparation for his friend George Bush's ascendancy in 1988, Michael Milken was preparing his own elite team of allies. Milken was gearing up for a campaign of unbridled corporate warfare that would create a new class of jet-set robber barons and saddle most of corporate America with a Brobdingnagian debt burden. All in the name of -- supposedly -- making managers more "efficient."
Milken had pioneered the sale of "junk" bonds at the Wall Street firm of Drexel Burnham Lambert. Junk represented the IOUs of companies with little or no standing among bankers and lenders. To attract lenders, Milken's bonds paid five or six percentage points more intrest than the bonds of blue-chip companies. The bonds also promised the lender a big, fat fee if the company borrowing the money managed to repay the loan ahead of schedule.
"So, when the company makes money, its junk soars, in anticipation of the windfall," explains Michael Lewis in Liar's Poker . "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."
You may say, so what? Well, the reason that many companies issued junk bonds instead of stock was they could deduct the interest payments on the bonds from their federal taxes. Dividend payments to stockholders are not tax-deductible. Obviously, it became much more attractive for companies to raise new money with junk than stock. So, one may ask, why didn't the Securities and Exchange Commission reclassify junk as stock, and disallow these deductions?
That is a question that can only be answered by John Shad and Roderick Hills, two of the last three SEC chairmen, both of whom served on the board of directors of Drexel Burnham Lambert starting in 1989.
These two were directors "when Drexel engaged in some of its most ethically questionable acts of apparent fraudulent conveyance and were fabulously well-paid for their services even after Drexel entered bankruptcy, leaving the pension funds of teachers and janitors owed millioins," charges Benjamin J. Stein, a Los Angeles-based economist, in a recent article in Barron's .
Furthermore, junk bond underwriters like Drexel have access to inside info about corporations. "Drexel's research department, because of its close relationship with companies, was privy to raw, inside corporate data," says Michael Lewis. There is no law against insider trading of stocks and bonds, only stock; but in the case of junk bonds, which act so much like stock, maybe there should be.
The mountain of junk bonds grew from almost zero in the 1970s to $839 million in 1981, to $8.5 billion in 1985. By that time, Milken had a problem. As Michael Lewis explains it, Milken could not find enough small, aggressive companies or old "fallen angels" who needed money to keep up with the demand for junk bonds. Milken had more money than companies wanted to borrow. What to do?
Milken decided he would recruit some would-be robber barons who wanted to take over large corporations with junk bonds. This would create a new market for the bonds, and simultaneously transform the mammoth debt holdings of the target corporations into instant junk, because they would be saddled with so much new, low-grade debt. Fabulous!
Milken funded the dreams of many corporate buccaneers who made the front pages of the newspapers in the Crazy Eighties. Ronald Perelman, Boone Pickens, Carl Icahn, Sir James Goldsmith, Nelson Peltz, Saul Steinberg, Asher Edelman and others. Milken's handkpicked team of corporate predators attacked major U.S. corporations such as Disney, Revlon, TWA, Union Carbide, National Can and Phillips Petroleum.
Many forced management to pay them tens of millions of dollars to go away after only a month or two of laying siege to the corporate fortress. Often the companies would go deeply into debt to discourage the raiders, sell off some of their prize possessions, or otherwise harm themselves, like reluctant virgins disfiguring their faces to repel invaders intent unpon rape. When raiders succeeded in taking over companies, they often had to fire large numbers of workers or sell off whole divisions in order to increase cash flow to service their extremely high-cost junk bond debt. But no matter. They made their money up front, either in greenmail or from the run-up in stock prices that preceded each transaction. Arbitrageurs anticipated the paper profits to be generated by selling off the company's assets, which exceeded the value of the company as a whole.
This created an entire new industry. Those raiding companies and those defending themselves needed special advisers, such as Felix Rohatyn or Bruce Wasserstein or Joe Perella, to help them maneuver through the labyrinth of accounting and legal chicanery each corporate feud entailed. These advisers could make a million or two for a 60 to 90 day gig.
Investment bankers began to fight with one another for this business. They began to want to lend companies money to initiate takeovers, as did commercial banks. Prestigious law firms like New York's Skadden, Arps, Meagher & Flom, the leaders in merger and acquisition work, made fortunes. Skadden became the highest grossing law firm in the U.S. from this type of business, and Joe Flom, a senior Skadden partner, became one of the highest-paid attorneys in the country.
Eventually, the management of such blue-chip companies as RJR Nabisco and Time, Inc. would maneuver to engage in junk-bond financed mergers and acquisitions, and find ways to position themselves for possible cash windfalls in the tens of millions of dollars. Sometimes the deals worked, and sometimes they didn't. Either way, a host of Milken associates, investment bankers, and others attained superstar status in the world of finance.
Milken and his apologists in the press and in Washington claimed that the cannibalization of U.S. industrial companies was healthy and productive. In truth, the companies had become the equivalent of real estate -- one more commodity to be traded, flipped, subdivided and otherwise brokered. Companies were valued for their break-up prices, not their long-term prospects -- or the way they provided jobs. And in one way at least, the market in brokered companies was more exciting than real estate. If you wanted to buy someone's real estate, they could dicker and bargain with you to get the best price -- or even refuse to sell at all. But if you wanted to buy a publicly held company in America, you could just hoist the Jolly Roger, call Michael Milken and fire a broadside across their bow!
Favorable tax treatment for junk bonds underpinned the $1 trillion spent in restructuring American industry in the 1980s through mergers and acquisitions. This restructuring took the form of replacing equity capital with high-cost debt. About $285 billion more in equity was liquidated through mergers and acquisitions and other games perfected by paper entrepreneurs than was created by Wall Street's new stock issues. This was the first time since robber barons had constructed their trust and monopoly empires in the late 19th and early 20th centuries that total equity in American corporations had declined.
Milken critic Benajmin Stein argues that the Junk Bond King actually was the perpetrator of a vast Ponzi scheme, a classic fraud in which early investors in a scam are paid back with money from later investors, and nothing of value is ever produced by the schemer. Stein says Milken used his friends Carl Lindner, Stephen Wynn, Meshulam Riklis and Victor Posner as a "captive network of buyers" of junk bonds. Stein claims that Milken would get these "insiders" to buy and trade the bonds among themselves to create an illusion of value where none existed. This is how Stein says Milken initiated the junk bond marketplace.
Later, Stein says Milken induced unscrupulous S&L operators like Charles Keating, who owned Lincoln Savings in California, to purchase mountains of "brokered deposits" or "hot money" from money brokers like Don Regan's former firm, Merrill Lynch (which led the country in sales of such deposits). The S&L operators used these government-guaranteed deposits to purchase junk bonds that Milken needed to unload. Then Milken would get the companies who were borrowing money through junk bonds to buy still more junk bonds issued by other borrowers, to fund still more S&Ls and sell more junk.
Now that Drexel has collapsed, Milken's S&L buddies have gone bankrupt, and Milken himself has been sentenced to 10 years in prison for fraud, there is a great controversy about whether or not the sentence is appropriate.
Meanwhile, the U.S. government has filed suit alleging that Milken and Drexel looted up to 40 S&Ls of over $6 billion, and one S&L in California is suing for another $4 billion. Taxpayers have made up these losses.
Benjamin Stein calculates that Drexel issued a total of $150 billion in junk during the Crazy Eighties. Stein also calculates that Drexel junk bonds have defaulted or traded in for devalued securities at the rate of four to five percent per year. Forty-three precent of Drexel junk issued in 1977 had defaulted by 1988. Fifty-four percent of Drexel junk issued in 1981 had defaulted or been in distressed exchanges by 1989. Stein calculates that eventually one-half of all Drexel junk bonds will default, resulting in a loss of $75 billion, an amount equal to $1,000 for every family in America. "This sum represents a theft far larger than any other known in history," Stein contends. "This is a gargantuan robbery."