The Economist : Michael Milken, Drexel Burnham Lambert, & The Democratization Of Credit
Saturday, October 30, 2010
IN JANUARY 2007 Creative Artists Agency (CAA), which manages George Clooney, Julia Roberts, Brad Pitt and other film-industry luminaries, opened its new offices on Avenue of the Stars in Century City, Los Angeles. As famous actors and directors file into the marble-lined entrance to strike lucrative film contracts, even more serious money is being made upstairs. The 12th floor is occupied by Ares, which has $37 billion of funds invested in private equity, high-yield bonds and other corporate debt. One floor down is Canyon Partners, an alternative-investment firm that manages $18 billion. The CAA building is also home to Imperial Capital, a boutique investment bank. All three firms can trace their origins to Drexel Burnham Lambert, an investment bank that collapsed into bankruptcy in 1990, fatally wounded by an insider-trading scandal.
Twenty years ago next month Michael Milken, Drexel’s most talented and best-paid financier, who was based in Los Angeles, was sentenced to ten years in prison after pleading guilty to six counts of securities fraud. His sentence was later commuted and he was released in 1992 after serving 22 months. He was also forced to pay much of the huge bonuses he earned at Drexel in fines and settlements. It is rare even in Hollywood to find a star that rose and fell so quickly. For much of the 1980s Drexel was the hottest firm in investment banking, thanks to its dominance of the market for high-yield corporate bonds, of which Mr Milken was king. These bonds were known as “junk” because they were ranked below investment grade by ratings agencies. Drexel used its muscle in high-yield bond trading, which Mr Milken had built up in the 1970s, to push into other areas of investment banking such as mergers and acquisitions and underwriting. By 1986 Drexel, which in its long history had not previously threatened to join the financial elite, was Wall Street’s most profitable firm. But Drexel slumped under the weight of legal battles and the $650m fine it agreed on with the American government to settle an investigation of alleged securities fraud. When Mr Milken was forced out at the end of 1988, the firm lost its biggest source of revenue. His acumen was missed all the more as the junk-bond market started to implode at the end of that decade. Rising interest rates, defaults on bonds that had been issued too readily in the go-go years and new regulations that forced troubled savings-and-loans to unload their high-yield holdings all conspired to drive junk-bond prices down. This seemed only to validate claims that the junk-bond market was a Ponzi scheme perpetuated by Mr Milken’s tight control of it. Those claims turned out to be false. Drexel has left three enduring legacies: a junk-bond market that has grown at least sevenfold since the firm’s demise; the firms and industries, from gambling to cable television, that owed their rapid expansion to the investment bank’s junk bonds; and the influence of the “Drexel diaspora”, the young MBA graduates who worked in the 1980s under Mr Milken, on the finance industry in Los Angeles and elsewhere.
In 1990 the outstanding stock of junk bonds (estimated by subtracting redemptions from new registered issues since 1970) was about $150 billion. Now the total is over $1 trillion. Around two-fifths of all outstanding corporate bonds in America are rated as “speculative”, or below investment grade (BB+ or lower), according to Dealogic, a financial-data firm. Even better-class bonds are not as pukka as they once were: much of the non-junk issued since 1992 has been rated BBB-, the lowest investment grade. Like all other credit, the junk-bond market was badly damaged during the recession. But it has bounced back, just as it did in the early 1990s and early 2000s. This year new issuance has surged: with around $200 billion raised in America already, the total for 2010 is sure to be a record (see chart 1). The revival is in part driven by a renewed search for yield by investors disappointed with the poor returns on cash or Treasuries: the interest premium they demand for holding junk has tumbled (see chart 2).
The reopening of the junk-bond market has also afforded medium-sized firms access to credit again. The businesses that have tapped the market are a cross-section of corporate America: airlines, clothing manufacturers and retailers, health-care providers, drug firms, restaurant chains, oil-exploration firms and semiconductor manufacturers. Some of the new issuance is by firms looking to lock in long-term financing on good terms. The market’s revival has been helped by fewer defaults on high-yield bonds. The default rate on junk bonds stayed above 8% for 14 months in 2009-10, according to CreditSights, a research firm. That compares with 20 months in the previous two recessions. Junk bonds, once despised, are now mainstream. “Milken and Drexel took high-yield bonds from a cottage industry to one of the cornerstones of the financial industry,” says Howard Marks, one of Mr Milken’s early customers and now chairman of Oaktree, a Los Angeles firm that manages around $75 billion in funds, much of it in high-yield bonds and related investments.
In the 1970s the market for such bonds was tiny. It comprised “fallen angels”, the securities of former investment-grade companies that had fallen on hard times, which changed hands infrequently and at big discounts to face value. While a student at Berkeley in the late 1960s, Mr Milken came across empirical support for his hunch that a portfolio of these high-yield bonds would outperform an investment-grade portfolio, even taking into account the higher likelihood of default. He found it in a study by Braddock Hickman, a central banker and student of corporate finance, which showed that even during the Depression there was a high rate of return on non-investment-grade bonds. The interest-rate spread over supposedly safer bonds was more than enough compensation for the higher expected losses. When Mr Milken began to trade junk bonds at Drexel from the early 1970s, his pitch to his growing band of clients and followers was always the same: junk was a better bet than investment-grade bonds, which had only one way to go: down. High-yield bonds proved to be resilient in the mid-1970s recession. Such was the meltdown in financial markets that in 1974, when the value of equities fell by half, some bonds could be purchased for the price of their coupon. Yet remarkably few junk bonds went bad and investors achieved high rates of return.
This set the stage for the opening of a sizeable market for new junk issues in 1977. From then on fallen angels would be traded alongside “ascending angels”: the bonds of firms whose prospects were better than their lowly status suggested. Interest rates were volatile and firms wanted to fix their cost of capital. They were wary of relying on banks, which had cut lines of credit to firms at the nadir of the recession to preserve their capital. In April that year Drexel underwrote its first junk-bond issue when it raised $30m for Texas International, a small oil-exploration company. Other issues followed that year but other investment banks initially took a larger share of this new market. That lead did not last (see chart 3). Mr Milken’s preaching of the high-yield gospel secured him a loyal and growing customer base, mostly among insurers and thrifts, with an insatiable demand for low-grade securities. He helped his customers make money. If they did well, they came back for more and in time they built their businesses on the supply of securities from Drexel.
The key to their loyalty was Mr Milken’s commitment to buy or sell on demand the bonds that Drexel had underwritten: he thus offered them a liquid market and a way out of investments they no longer wanted. That liquidity attracted mutual funds into the junk arena. Mr Milken’s skill as a marketmaker was rooted in his knowledge of the bonds issued (which allowed him to price them accurately) and his extraordinary recollection of his clients’ holdings (which helped him find new buyers for junk that others wanted to unload). And he stuck around when other banks retreated from the junk market during the early 1980s recession. This fresh junk became an important weapon for the corporate raiders and leveraged-buy-out (LBO) firms that came to prominence in the 1980s. Drexel’s ability quickly to raise hundreds of millions of dollars in “mezzanine” debt (so called because it ranks between secure bank loans and at-risk equity in the capital structure) made the threat of buy-outs credible and forced many big companies to slim costs and increase returns to shareholders to stave off the threat of takeover. Drexel found much of the mezzanine financing in 1989 for the $25 billion purchase by Kohlberg Kravis Roberts, a buy-out firm, of RJR Nabisco, a cigarette-and-biscuit conglomerate. It was an example of both Drexel’s daring and the muscle the firm had at its peak. “We sat around and said if every one of our existing customers buys the maximum amount they have ever bought of one issue, we could get $3 billion,” says Dana Messina, once a high-yield salesman at Drexel, now the chief executive of Steinway Musical Instruments. Drexel comfortably raised $6 billion to finance the deal.
Junk-bond issues also offered a new way for many small but growing firms, which had been starved of capital by stodgy commercial banks and sniffy investment banks, to finance themselves. “The bread-and-butter business was catering to guys like Craig McCaw or Steve Wynn or John Malone or Ted Turner,” says Mr Messina. These entrepreneurs saw the growth potential in their respective industries. Mr McCaw was head of McCaw Cellular Communications, an early entrant to the mobile-phone business, which had 2m subscribers by the time AT&T bought it in 1994 for $11.5 billion. Drexel also funded Bill McGowan’s MCI, the firm which successfully challenged AT&T’s fixed-line telephone monopoly. Drexel financed Mr Wynn’s Golden Nugget casino in Atlantic City and the Mirage in Las Vegas, replete with a fake volcano. His firm now owns several luxury hotels in Las Vegas, a city whose rapid growth owed much to high-yield finance. Mr Malone’s Tele-Communications Inc became the biggest cable-TV firm in the world. Its growth was financed by Drexel-issued junk. Mr Turner pioneered 24-hour news television at CNN, a channel powered by junk. Rupert Murdoch was another media client.
“None of the firms we financed were pure start-ups,” says Ken Moelis, who worked in Drexel’s corporate-finance team in Los Angeles and who started Moelis & Co, an investment bank, in 2007. Rather Drexel found money for small firms which had enough cashflow to meet interest payments to grow bigger. Some industries were not well-suited for debt finance: the mobile-phone business did not generate much upfront cash and cable-TV firms had big start-up costs before subscription revenue flowed. One solution was to “over-fund” firms, to raise more capital than they needed so that they could make their initial interest payments. Another trick was to use zero-coupon bonds, on which interest payments are deferred until the principal comes due. Not all Drexel’s corporate customers were thrilled with the price extracted for this service. Some felt that Drexel cut too good a deal for itself and for Mr Milken’s loyal junk-bond investors. Drexel’s fees on junk issues were 3-4%; less than 1% was typical for investment-grade bonds. Drexel’s bankers often demanded equity warrants for themselves and their buyers to sweeten the deal. Yet lopsided pricing is a feature of “two-sided markets”, in which one side benefits if there are lots of customers on the other side. For instance, clubs that act as matchmakers for lonely hearts often levy higher charges on men than on women, judging that single men will be keener to join clubs with lots of female members. In a similar way, Drexel was able to charge an enviable fee for access to a scarce investor base. Most firms were willing to pay. “For a lot of issuers, it wasn’t the cost of money. It was the cost of not having it,” says Kyle Kirkland, who was one of the last MBA graduates hired by Drexel’s Beverly Hills office in the 1980s.
The desire to maintain Mr Milken’s hold on high-yield marketmaking may explain why Drexel’s bankers were loth to share deals with other investment banks. If competitors issued lots of junk bonds, that would undermine Mr Milken’s sense of who held what bonds and make control of the market harder. The firm gloried in thwarting rivals and in stealing business from under the noses of a Wall Street “elite” it viewed as snooty and indolent. The firm had plenty of enemies who welcomed its downfall. The firm’s ability swiftly to raise vast sums for LBOs struck fear into the heart of corporate America. The job losses that often followed a junk-financed buy-out, as hitherto inefficient firms were sweated for cash, created a lot of political fury. (That far more jobs were created by the small firms that Drexel financed than were lost in LBOs is often overlooked.) “Junk bonds, junk people” was the sneer from Wall Streeters who loathed the upstart bank. Drexel’s retort, that its rivals would prefer to sell investment-grade bonds on their ratings, rather than put in the hours of analysis needed to hawk junk, was hardly endearing. Drexel also provided a useful scapegoat for the savings-and-loan crisis, because some thrifts were keen buyers of junk bonds.
Yet unloved as it was, Drexel changed the face of corporate finance and of Wall Street. “These days with firms, such as Google and Apple, everyone takes dynamism for granted,” says Mr Moelis. “But Mike Milken started out in the 1970s when capitalism was struggling. In those days, there was very little innovation. Along comes Drexel, a firm with a visionary purpose, and suddenly you could get capital.” Before 1977, when new junk-bond issues took off, says Mr Marks, non-investment-grade bonds were thought of as “bad” investments, at any price. Nowadays a bad credit can be considered a prudent investment if it is available at the right price. Drexel’s third legacy is in the mark it left on the finance industry, particularly in Los Angeles. That Drexel’s most profitable division was based so far from its headquarters in New York is largely down to the accident of Mr Milken’s birth. Born and raised in the San Fernando Valley, Mr Milken returned to Los Angeles in 1978 (taking 20 or so traders with him) to be closer to his family. Since he was the main source of the firm’s profits at the time, his masters could scarcely refuse him.
With Mr Milken at its centre, Drexel’s Beverly Hills operation became a magnet for the best business-school graduates in the late 1980s. That cohort of financiers is still active. Many of them stayed in Los Angeles after Drexel folded. Almost all have now moved to the asset-management side of the business, although the sell-side skills they developed at Drexel are useful in bringing in money to manage or in arranging outside co-financing for private-equity deals. Los Angeles no longer has a big “money centre” bank or a big broker. What stayed was an innovative strain of Drexel-style “next-stage” finance. Local financiers say they are free of the herd mentality that can take hold in New York. The weather and the quality of life help too: firms say they find it harder to recruit, but easier to retain, good staff. Some Drexel alumni are found today in New York. Rich Handler, a junk-bond trader in Drexel’s Los Angeles office, moved with 35 or so colleagues to Jefferies, a local investment bank; they took their knowledge of high-yield bonds and investors with them. Mr Handler is now Jefferies’s chief executive but the bank has long outgrown its Los Angeles and high-yield roots. In 1990 it had 400 employees. It now has around 3,000, of whom 200 are based in Los Angeles: the headquarters these days are in New York. Another alumnus is Leon Black, founder of Apollo, a corporate-credit firm with $55 billion under management. Apollo is based in New York, where Mr Black also spent his Drexel years.
Drexel’s financiers were not altruists; they were dealmakers. But in their search for profit they also brought about a democratisation of credit. Firms that previously had to rely on conservative banks or expensive equity were given access to fixed-interest funds in capital markets by the investors that Mr Milken and his junk-bond traders had cultivated. This was a boon to the American economy: limiting capital to investment-grade firms limits economic progress. If a firm can pay the rate for its risk, it should get the money it needs. Los Angeles is perhaps a curious home for a group of financiers with such a focus on high-yield credit. The Hollywood business model is a search for a blockbuster that will pay for all the turkeys. High-yield bond investment is a different art: the trick is to avoid the losers; then the winners will take care of themselves.
Reference : http://www.economist.com/node/17306419/print