THE CREATORS AND CORRUPTORS

OF AMERICAN FINANCE

E D WA R D M O R R I S

© Byron Purvis/AdMedia/AdMedia/Corbis

Michael R. Milken: 1946–Junk Bond King

11

In the spring of 1970, I graduated from Wharton, the business school at the University of Pennsylvania. At a dean’s reception for soon-to-be MBAs a few months earlier, I had bumped into a particularly driven and single-minded classmate—when I asked him about his plans after school, he answered without hesitation that he would first become independently wealthy by working a few years at the Drexel Harriman Ripley investment banking firm and then would return to a university to teach. I might have been skep-tical of this goal had it been voiced by another peer, but this was Michael Milken; already well known among faculty and students alike, it was clear he had an unusual talent for finance and business. Renowned among our cohort, he would soon be famous—and then infamous—throughout the entire financial world.

But in 1970, Milken was still just a prospective MBA graduate—albeit one with an unheard of three majors (information systems, operations research, and finance) who landed his job after one of Wharton’s finance professors told Drexel’s managing director that Milken was “the most astounding young man I have ever taught.”1 Milken achieved straight As during his MBA studies, getting grades so high that they skewed professors’ grading curves and led some A-seeking students to avoid classes in which he was enrolled. (Milken finished all of his course work and left Wharton

Mike Milken believes in 100 percent market share.

— JOHN KISSICK, DREXEL BURNHAM LAMBERT CHIEF

OF WEST COAST CORPORATE FINANCE

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in 1970 but didn’t receive his degree until 1973, when he finally completed the required thesis.)

My impression of Milken was as an intensely serious young man with few social or intellectual interests beyond business—but in those areas, his interest seemed boundless. Inspired not by assigned classwork but by his own desire to better understand the business world, he compiled binders full of articles and reports arranged by industry groups to more thoroughly analyze companies within the markets they served. He even asked to read classmates’ term papers if the subject piqued his enormous curiosity. I shared one of my papers with him, on how investment bankers raise money for their clients through privately placed securities offerings. He returned it with insightful comments in the margins. Who could have guessed that fifteen years later (with certainly no credit due to my elemen-tary term paper) Milken would became famous on Wall Street for raising $1.1 billion for MCI Communications through the largest private place-ment of securities in history.

The topic that most consumed his interest, however, was low-rated corporate bonds. In his soft, monotonic voice, Milken could talk for hours about the investment merits of what would later be called junk bonds. While an undergraduate at the University of California, Berkeley (where he graduated Phi Beta Kappa), he had come across a little known book by W. Braddock Hickman titled Corporate Bond Quality and Investor Experi-ence. This text set the foundation for Milken’s later career and fortune.2 Hickman’s book was not exactly a how-to manual on making money in the bond market, but it provided much of the impetus and statistical raw mate-rial on lower-quality bonds that would drive Milken’s research at Whar-ton. And that research convinced the twenty-three-year-old Milken that he could quickly become a millionaire by trading in a selective portfolio of bonds that were outside the investment-worthy ranges established by the Standard & Poor’s and Moody’s credit-rating agencies. At Drexel, he set out to do just that.

Making a Market

Drexel Harriman Ripley had a storied past, but—when Milken joined in 1970—an uncertain future. A century earlier, in 1871, prominent Phila-delphia banker Anthony J. Drexel joined forces with the young J. Pierpont Morgan to form Drexel, Morgan & Company. The firm grew into a powerful

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American banking house, financing many of the era’s leading railroads and engineering a bailout of the U.S. government during the panic of 1893. Not long after, the firm split into a dual-partnership arrangement, with shared directors but separate names: New York–based J. P. Morgan & Company and Philadelphia-based Drexel & Company. The Drexel firm’s business was mainly in commercial banking, and shortly after the passage of the Glass-Steagall Act in 1933 its partners elected to merge into the J. P. Morgan oper-ation. But in 1940, following the lead of former J. P. Morgan partners who established Morgan Stanley & Company as an investment banking offshoot of the House of Morgan, several Philadelphia partners bought the Drexel name and launched their own wholesaler investment firm. For the next few decades, they enjoyed success by trading on the long-honored Drexel reputation for investment banking excellence and conducted a gentlemanly and upscale underwriting business for companies with whom they had pre-served longtime personal and business connections.

By the time Milken arrived in 1970, Drexel had combined with another old-line investment house, Harriman Ripley & Company. And though the resulting Drexel Harriman Ripley had a rich combined history of financing railroads and early twentieth-century industrial companies, their roster of blue-chip corporate clients was shrinking below the level necessary to con-duct a viable investment banking business. The only reliable client the firm could count on for ongoing stock and bond offerings was the Philadelphia Electric Company.

Over the next twenty years, Milken would transform Drexel into a high-flying investment banking firm far beyond the imagination of the current or prior Drexel partners. But when he first joined he was assigned to less glamorous projects, many of them in the firm’s “back office.” One of the back office projects involved revamping the way Drexel delivered its securities, with Milken’s recommended improvements purportedly saving the firm about a half-million dollars per year.3 The back office assignments were productive, but Milken wanted to pursue work in the firm’s research and trading departments, where he could apply his academic studies on low-grade bonds to the real world. The firm acceded to his wishes, but there was one catch: he would have to transfer from Philadelphia to the New York office.

The prospect of living in New York held little appeal for Milken. His wife Lori was enrolled in graduate school and working as a research assis-tant on a history of the University of Pennsylvania. Uprooting themselves from their Philadelphia home for what could be a short-lived assignment

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seemed unwise. What’s more, they both missed California and their fami-lies and planned a return to the West Coast as soon as an opportunity arose.

The solution Milken settled on was commuting by bus to and from New York, leaving before sunrise and not returning until midevening. But he made those long commutes—two hours each way—highly productive. He boarded the bus with tote bags full of research reports and securities fil-ings on the issuers of low-grade bonds, and spent the trips in nondistracted study. He eschewed the faster and more comfortable commuter train, pre-ferring the bus’s assured anonymity and the near certainty of an adjacent empty seat for his bags of paperwork. (His routine was well known to col-leagues, and one gave Milken a gag gift of a miner’s hat with an attached light to better illuminate reading material during the dark hours of his bus trips.)

The prodigious amount of research he dedicated to his bond endeav-ors, both on the bus and off, is important in explaining his ultimate success. Making money on low-rated bonds was not just a matter of reading Hick-man’s book on the historic yields available on such bonds and then dedi-cating money to that market segment. By their nature, bonds with a weak credit standing, namely those carrying BB, B, CCC, and lower ratings, have greater inherent risks, and their purchase demands more scrutiny and a thorough knowledge of the underlying business. Bond salesmen and trad-ers had an easier time of it when dealing in bonds rated AAA, AA, A, and BBB, relying on the credit agencies’ assessment of investment quality and the risk of default. A pleasant personality and a decent golf swing was often enough to forge a lucrative career in selling low-risk bonds.

Milken, meanwhile, did not play golf and could hardly be described as congenial. He would ultimately wear the (not-so-cherished) mantle of “Junk Bond King,” but the first leg of his road to success required convinc-ing the innately conservative bond buyers of the day on the merits of junk bonds—or, as he preferred to call them, high-yield bonds. It was a hard sell. When he began on Drexel’s bond research desk in the 1970s, the sup-ply of junk bonds was composed entirely of “fallen angels”: bonds that had once been investment grade but were subsequently downgraded to “below investment grade” status. A bond analyst or trader at an insurance com-pany or an investment advisor in a staid trust department of a bank could hardly be faulted for a lack of interest in such maligned bonds. And it did not help Milken’s cause that he was just in his midtwenties when he set out to change the world of bond investing. Or that he covered his prema-ture baldness with an ill-fitting toupee and wore clothes that looked to be

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straight off the rack. Or, for a sizable percentage of institutional investors who occupied the buy-side desks on Wall Street, that he was Jewish.

But if he could get an audience, Milken was often able to make a com-pelling case for one or more of his fallen angels. If the prospective bond buyer had been trained through a strict Graham and Dodd approach to securities analysis—one, that is, that relied on demonstrating that the issu-ing company had ample cash flow to make principal and interest payments and had sufficiently valuable assets to back up the bonds—Milken was at the ready. Many of the junk bonds of the day had been issued by conglom-erates formed in the 1960s that were struggling with their unwieldy col-lections of diverse businesses. Once-prominent companies such as AVCO, Ling-Temco-Vought, Rapid-American, General Host, and City Investing had suffered downgrades from credit agencies as their fortunes waned. But through endless hours poring over complex financial statements and indus-try statistics, Milken (like Benjamin Graham before him) was able to ferret out investment value and safety that had escaped the notice of less consci-entious analysts. He could answer every question about the bond issuer’s business prospects and balance sheet, and more importantly, he could paint a convincing picture as to why many of the fallen angels, with their high yields, could provide a very enticing return on investment—and could do so with a much lower level of risk than their bond ratings suggested.

If the bond buyer was attuned to the academically based “modern port-folio theory” coming out of the business schools, so much the better. This approach called for investment managers to control risk by balancing their portfolios with a mix of two very different securities: investment-grade bonds and common stocks. If the manager wanted to lower the portfolio’s risk, he would weight the investment mix toward the bonds; if he was feel-ing less risk averse and was more interested in higher returns, he would move toward a higher proportion of stocks. But now Milken was advocat-ing a third component: non-investment-grade bonds that were more risky than their investment-grade counterparts but less so than common stocks. With Hickman’s study of the corporate bond markets between 1900 and 1943, and the update by T. R. Atkinson for the years 1944 through 1965, Milken had the statistics to back up his pitch.4 Some small percentage of the lower-rated bonds went into default, leaving their holders with a substantial loss of principal value, but on average the return realized on those bonds more than made up for a few losses. Over time, Milken argued, a portfolio of riskier but higher-yielding bonds was much more profitable than a port-folio of investment-grade bonds. And history showed that, when compared

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with common stocks, the returns to high-yield bondholders were smaller, but the risks were lower, because with any bond there was a contractual obligation from the issuer to make the payment of the bond’s principal amount upon maturity. As Milken explained it:

No matter how much research you have done regarding a particular stock, you don’t have a contract as to what the future price will be. But with a high-yield bond there is a date certain in the future when it matures, and if you hold it to maturity and your analysis is correct, you will be correct in your calculation of your yield—and you do have a contract as to future price. One is certain if you’re right. The other is not.5

While the investment logic for junk bonds may have been compelling, their lack of liquidity in the marketplace often remained a final stumbling block for the potential buyer. With few buyers and sellers in the high-yield bond market, investors faced an unwelcome prospect of holding a bond to its maturity date as the only sure way to be paid. Milken solved that liquid-ity issue by assuring those investors that Drexel would always be ready to buy or sell the bonds it was promoting. He was able to make this promise because, in addition to his encyclopedic knowledge of the bond issuer’s business and financial position, he knew one other crucial set of facts: which financial institutions owned the bonds and what their inclination might be for buying or selling them. With this information, and a capital allocation of $500,000 from Drexel, Milken developed the first secondary trading market for junk bonds on Wall Street.

A 35 Percent Arrangement

On its face, a junk bond trading operation lodged within a white-shoe firm like Drexel Harriman Ripley was a puzzle. With its elitist, wholesaler pre-tensions, the firm had limited most of its trading in bonds to the shrinking list of investment grade–rated corporations it could still count as clients. Bond trading was merely an accommodation to its investment banking cli-entele, not a profit generator. As Milken began his junk bond operation, one of the high-grade bond traders confronted a Drexel top executive with a demand that Milken be fired lest he tarnish the firm’s reputation among the Fortune 500 firms it was pursuing. The executive responded by asking,

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“Milken on a modest capital base is making money, while your high-grade department on a large capital base is losing it. Now, whom should I fire?”6 Milken stayed, and the advocate for his firing was soon gone. It was an early indication of Milken’s growing influence at Drexel.

In 1971, Milken’s nascent power base expanded further when the ail-ing and capital-poor Drexel was acquired by the much stronger Burnham & Company, to become Drexel Burnham & Company. While the name Burnham Drexel & Company (or even just Burnham & Company) would have been more in keeping with the reality of the arrangement, pedigrees were important in the investment banking hierarchy of Wall Street at the time, and Drexel’s name retained a cachet that Burnham’s, associated with the second tier of investment bankers, lacked. Before the merger took place, Burnham’s founder and majority partner, I. W. Burnham II—nicknamed “Tubby” throughout his life following a brief period of plumpness as a child—consulted with other firms on the new name. Morgan Stanley (then the arbiter of such things in the caste-like rankings of underwriters) advised Burnham that the combined firm should be called Drexel Burnham if it wanted to participate in Wall Street’s securities offerings as one of the top bracketed firms.

The new Drexel Burnham would prove to be a more hospitable home for Milken for reasons far removed from underwriting brackets. Burnham & Company’s principals were predominantly Jewish, and when Tubby Burn-ham was doing his due diligence prior to the acquisition, he inquired about the number of Jews who were part of the Drexel organization. Drexel’s president at the time, Archibald Albright, said that just a few of their two hundred fifty employees were Jewish. He elaborated: “They’re all bright, and one of them is brilliant. But I think he’s fed up with Drexel, and may go back to Wharton to teach. If you want to keep him, talk to him.”7

Burnham did talk to Milken, and discovered that the source of his unhappiness was that Drexel was allocating only $500,000 of the firm’s capi-tal for junk bond trading—even though he was earning a 100 percent return per year on that capital. He also discovered, after Milken provided him with a lengthy tutorial on junk bonds, that “brilliant” was an apt description, and committed on the spot to increase his capital allocation to $2 million. Much more crucial for its long-term ramifications, however, was the deal that Burnham cut with Milken providing that employees of the high-yield trad-ing operation would receive 35 percent of the profit they generated, to be divided among the traders however Milken saw fit. That incentive no doubt helps explain why the Drexel high-yield group lost money in only three

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months during their seventeen-year run—and also explains how Milken, who shared in those profits, eventually became a billionaire.

With a larger capital base, “the Department” (as Milken’s junk bond operation came to be known within Drexel) expanded with respect to both the number of traders and its book of clients. Milken’s approach to attract-ing those institutional clients was short on charm but long on substance. He had never developed any sense of style, and with his shabby suits he could still be confused with a clerk from the firm’s back office. But with an inex-haustible knowledge about junk bonds, he could speak at whatever level of detail the prospective institutional investor required. And by the time he met with investors, he had done enough investigation into each institution’s investment portfolio to tailor a junk bond pitch precisely to its apparent needs, be it an insurance company, pension fund, bank, or mutual fund.

It wasn’t long before Milken evolved from the role of salesman, explain-ing the merits of high-yield bonds, to the much broader and more influ-ential role of trusted investment advisor. In 1973, his guidance was behind the conversion of the First Investors Fund for Income from an investment-grade bond mutual fund to a high-yield bond fund—and as a result, First Investors was the country’s best-performing bond fund in both 1975 and 1976.8 And while mutual funds represented a fertile new market to which he could spread the junk bond gospel, the insurance industry held even more appeal. Insurance companies were major purchasers of corporate bonds, and Milken enticed several of them, including old-line carriers such as Massachusetts Mutual, to diversify from investment-grade bond portfolios by giving them a sampling of his offerings from the junk bond arena. Much of his new business, however, came from institutions that had recently come under the control of mavericks who acquired insurance-based financial conglomerates through hostile takeovers—familiar names from the 1970s, they included Laurence Tisch (CNA Financial), Carl Lind-ner Jr. (American Financial Group), and Saul Steinberg (Reliance Insurance Group). For each of these companies, Milken designed as well as imple-mented much of their high-yield investment strategies.

One bedazzled institutional investor, after a visit to Drexel’s bond operation, summed up Milken’s accomplishments by stating: “He had the issuers. He had the buyers. He had the most trading capital of any firm. He had the knowhow. He had the best incentive system for his people. He had the history of data—he knew the companies, he knew their trading prices, probably their daily trading prices going back at least to 1971. He had boxed the compass.”9

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Yet Milken had a major and fundamental problem in the early 1970s: he was faced with a limited supply of product. His promotion of high-yield investing had led to many recent converts and fresh entrants to his mar-kets, thereby fostering a growing demand for junk bonds. But the prob-lem was on the supply side. New fallen angels continued to drop into his orbit, but the number of junk bonds was also being depleted as issuers were acquired by larger, more creditworthy companies. Compounding the shortage were rising stars, the once junk-rated companies that moved back into the investment-grade sphere. And, of course, some of the fallen angels fell even further, disappearing into bankruptcy. With the rise and fall of new and old fallen angels, Milken had only about twenty-five separate junk bond names to trade. That stasis, however, ended shortly after the 1974 arrival of Frederick Joseph at Drexel Burnham.

“Let’s Do Some Deals”

The combination of the blue-blooded investment bankers of the old Drexel with the hard-driving traders and salespeople from the Burnham side was bound to create problems, and it did so without much delay—especially on the investment banking side. The conflicting missions of the old and new versions of Drexel investment banking were colorfully described by a for-mer Drexel & Company banker who said, “The Drexel people were sitting at one end of the hall, waiting for Ford Motor Company to realize it had made a mistake and call us up and tell us that they’d really appreciate it if we would take them back. And you had the guys from Burnham and Com-pany running around Seventh Avenue trying to underwrite every schmate factory they could find.”10

Recognizing the incompatibility of the two approaches, the combined Drexel Burnham fell back on the often-used but rarely successful solution of naming coheads to direct its investment banking operation. But in real-ity, there was little business to direct. Drexel’s stable of clients included a few remaining Fortune 500 companies, mixed in with many decidedly smaller and lower-quality companies. So when Fred Joseph was recruited to repre-sent the “Burnham side” to complement John Friday on the “Drexel side,” the investment banking business was essentially a turnaround project.

The son of a Boston cabdriver, Joseph had gone on to become a col-legiate boxing champion at Harvard College and later earned an MBA from Harvard’s graduate business school. From there, he had gone on to work for