Based on their credit ratings, corporate bonds are arbitrarily divided into investment grade bonds and junk bonds. The dividing line is the BBB rating, which is the lowest credit rating considered to be investment grade. Below BBB–, bonds are considered junk. Less common, but less disparaging names for junk bonds are below investment grade, speculative grade and high-yield bonds. Junk bonds combine features of debt and equity. Legally, they are debt. In the event of bankruptcy, the bond holders essentially become equity investors. Accordingly, the prices of junk bonds tend to be very sensitive to the fortunes of the issuer. At lower credit ratings, prices for a firm's debt and equity can be highly correlated. Junk bonds will forever be associated with the defunct investment bank Drexel Burnham Lambert and that firm's star trader Michael Milken. Drexel Burnham was formed in 1973 with the merger of Drexel Firestone and Burnham and Company. Drexel Firestone was a white shoe investment bank whose better days were behind it. Burnham and Company was a Jewish bucket shop. The Belgian firm Bruxelles Lambert acquired an interest in 1976. Ignored by former Fortune 500 clients and the prestigious investment banks of Wall Street, Drexel Burnham Lambert struggled to reclaim the reputation Drexel Firestone once had—or at least carve out some niche for itself. In the early 1970s, it appeared that Drexel's niche might be serving mid-sized firms—those with limited access to bank or capital markets financing. Michael Milken traded high-yield bonds for the firm. He was an unassuming, occasionally obsessive genius who sported a toupee. In 1973, there was hardly a market for his bonds. Firms rarely issued below investment grade bonds. Most of what Milken traded were fallen angels—bonds issued by firms that had since become troubled. He believed that, precisely because such bonds were shunned, they offered exceptional value. Academics had proposed this thesis before, but it was Milken who proselytized it. He went out and found buyers for his bonds. He shared his vision with portfolio mangers at savings & loans, insurance companies, pension funds and mutual funds. His arguments made perfect sense. Investors who could get beyond the stigma of junk, made handsome returns. Milken's network of buyers grew. In 1977, Lehman Brothers underwrote a number of below investment grade issues—USD 75MM for steel maker LTV, USD 75MM for Zapata Corporation, USD 60MM for Fuqua Corporation, and USD 53MM for Pan Am. Actually issuing below investment grade debt was a novel idea. Milken reasoned that he could do the same thing. He already had the distribution network, and underwriting the debt would dovetail with management's vision of serving a clientele of mid-sized corporations that had limited access to financing. Junk bonds—structured as subordinated debentures—combined appealing qualities of both debt and equity. All that was needed was buyers—and Milken had buyers. In April 1977, Drexel did its first deal, a USD 30MM syndicated loan for Texas International. Drexel did six more deals that year for a total of USD 124MM. The firm was finding its niche, and Milken was making it happen. In 1978, Milken asked that he be allowed to move the firm's junk bond operations from Manhattan to Los Angeles. With Milken single-handedly accounting for most of the firm's profits, management could hardly say no. Milken pulled up stakes and moved his staff of 30 to new offices on the West Coast. There, he was shielded from day-to-day oversight, which Milken detested. His business continued to blossom. Over the next decade, Milken raised funds for more than a thousand firms, including MCI, CNN, McCaw Cellular, Warner Communications, and Chrysler. Soon, Milken was issuing junk bonds to finance hostile takeovers, helping to fuel a takeover boom. Greenmailers and takeover artists—including T. Boone Pickens, Saul Steinberg, Carl Icahn, and Ronald Perelman—flocked to his Beverly Hills offices. Milken routinely provided these raiders with more financing than they needed, so they could turn around and participate as investors in his other junk bond offerings.
Drexel was the master of the mushrooming market for junk bonds. Other investment banks tried to emulate Milken, but they were small players. Milken was the "junk bond king." He knew the issuers. He knew the buyers. He knew who owned what bonds. If a client had to get out of a position, Milken would find him buyers. If an issue was close to default, Milken would organize a restructuring—replacing existing debt with higher-yielding debt that pushed payments further into the future. Milken had the clout to convince investors to accept such terms. He insisted on absolute loyalty. If a client worked with another bank, Milken would hear about it—and the transgressor could expect to pay. Access to Milken's steady stream of deals was the life blood of junk bond mutual fund managers. They couldn't afford to alienate him. Corporate raiders knew no one could raise capital on short notice the way Milken could. Today, the 1980s are remembered as the "decade of greed". Investment bankers, takeover artists and arbitragers made fantastic profits from junk financed takeovers. Not all those profits were made ethically or even legally. Insiders swapped privileged information and other favors freely, assuming they could never be caught. Regulators and law enforcement officials knew that abuses were widespread. Routinely, company's stock prices would move dramatically just before a major announcement. The challenge was identifying and somehow bringing to justice the perpetrators.
Dennis Levine was an investment banker with Lehman Brothers who eventually moved to Drexel. He had formed an insider trading ring of professionals working at a number of Wall Street firms. Participants exchanged and traded on inside information they obtained through their work. Levine placed his trades through an account maintained under an assumed name at Bank Leu in the Bahamas. Bank Leu executed those transactions through several brokers, including Merrill Lynch. One of Merrill Lynch's brokers suspected that trades from Bank Leu were based on inside information and started piggy backing personal trades on the Bank Leu trades. In May 1985, Merrill Lynch detected suspicious activity in that and two other brokers' personal trading accounts. Following an internal investigation, they passed the information to the Securities and Exchange Commission (SEC). The ensuing investigation lead to Bank Leu and eventually to Dennis Levine. The SEC and the US Attorney's office for Southern Manhattan conducted parallel investigations that soon extended beyond the immediate participants in Levine's ring. Abuses were widespread. There seemed to be an entire web of relationships among professionals exchanging information and other favors, including the parking of stock, the accumulation of stock to pressure firms' management, and stock price manipulation. Levine's ring provided investigators a point of entry to this web. Famous market participants were soon embroiled in the investigations, including investment banker Martin Siegel of Kidder Peabody, arbitrager Robert Freeman of Goldman Sachs, and arbitrager Ivan Boesky, who ran his own trading firm. Inexorably, the investigations led to Milken. At the center of his junk bond universe, Milken was engaged is numerous abuses. He traded on and exchanged inside information gleaned from his junk bond underwriting. He was engaged in stock parking and colluded with Boesky and others to manipulate the stocks of takeover targets. He actively misled regulators. Milken set up a number of limited partnerships for himself and his family. These posed blatant conflicts of interest, but management at Drexel was largely in the dark about them. The limited partnerships made extraordinary profits, benefiting from Milken's insider information. One trick Milken employed frequently was to insist that clients for whom Drexel underwrote junk bonds bundle stock options on their own stock with the junk bonds. Milken claimed that the options were a necessary inducement to get investors to buy the junk bonds. In actuality, Milken would keep the options and place them in the limited partnerships. To promote loyalty, Milken invited select Drexel employees and investors to invest in limited partnerships. For anyone unperturbed by the blatant conflicts of interest, receiving an invitation to invest was like winning the lottery. One famous investor was Patsy Ostrander, who managed a junk bond fund for Fidelity Investments. In 1991, she would be charged with accepting illegal compensation and failing to inform her employer of her personal investment. Convicted in July 1992, she served a two month prison term.
Despite its enormous influence, Drexel had few allies outside Milken's network of clients. Drexel was largely a one-product upstart that alienated other investment banks. Corporate consolidations and layoffs resulting from the takeover boom attracted resentment on main street. Drexel had little influence in the halls of government. If things started to unravel, the firm had few friends to turn to. On November 14, 1986, things started to unravel. That was the day Federal prosecutors revealed that Ivan Boesky had pled guilty to charges of insider trading and agreed to pay a USD 100MM fine. He had also agreed to cooperate in the ongoing government investigations. November 14 came to be known on Wall Street as Boesky Day. Ivan Boesky was the son of a Russian immigrant who ran a number of seedy bars around Detroit. A lawyer by training, Boesky found work on Wall Street during the mid-1960s. His wife Seema was the daughter of Ben Silberstein, whose real estate fortune helped Boesky launch his trading firm in 1975. Through that firm, Boesky speculated on the stocks of takeover targets. He became a close associate of Milken, who ultimatly recapitalized Boesky following a significant loss. Milken and Boesky developed a close relationship, exchanging information and favors. They spoke on the phone almost daily. When government investigators secured Boesky's cooperation, Milken's days were numbered.
It took almost two years for investigators to develop their case against Milken and Drexel. During that time, Drexel conducted a spirited public relations campaign, sullying the investigators' actions and promoting Milken as a "national treasure" whose junk financing had rescued companies and created jobs. Milken, who had always shunned publicity, was soon making public appearances and immersing himself in charitable works. In September 1988, the SEC filed a complaint against Drexel, Milken and five other individuals. That December, under the threat of indictment, Drexel settled with the Attorney's office, agreeing to plead guilty to six felony counts of mail, wire and securities fraud and to pay USD 650MM in fines and restitution. Drexel also agreed to settle with the SEC and to assist the Attorney's office in its case against Milken. Two months later, Milken was indicted on 98 counts including stock manipulation, insider trading and racketeering. In a plea-bargain, he agreed to plead guilty to six charges and to pay USD 600MM in fines and restitution. He was sentenced to ten years in prison. Without Milken, Drexel's business soon floundered. The firm continued to underwrite junk bond offerings, including a massive 1989 LBO deal for RJR Nabisco. However, without Milken, the firm had a hard time placing the debt. Increasingly, Drexel had to buy the bonds itself, tying up capital in illiquid, high-risk investments. When junk bond issuers couldn't make payments on their debt, Milken was no longer there to force investors to accept restructurings. Instead, the issuers—starting with Integrated Resources in 1990—defaulted. Drexel's capital was rapidly being depleted. The cost of the legal settlement, attorneys fees, bonuses paid to keep key employees and now losses on its own junk bond positions pushed Drexel over the edge. In February 1990, Drexel filed for bankruptcy protection. The following year, Milken was incarcerated at a minimum-security facility in Pleasanton, California. Two years later, he was diagnosed with prostate cancer. His sentence was reduced to time served, and he was released. As Drexel failed, the US economy stumbled towards recession. In 1990, default rates on junk bonds skyrocketed, rising from 4% to 10%. The market has since recovered, but not with the vigor of the mid 1980s. Because of their stigma, junk bonds still tend to trade at depressed prices. It was this realization that attracted Milken's interest in the 1970s. The same phenomena today helps fuel the market for collateralized debt obligations (CDOs). The financial crimes of the 1980s motivated Oliver Stone's famous movie Wall Street. Its high-powered arbitrager, Gordon Gekko, announces "greed is good"—mirroring an actual comment made by Ivan Boesky.
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