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
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 unsecured subordinated debt—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
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
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
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,
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
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
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
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
debt obligations (CDOs).
The financial crimes of the 1980s motivated Oliver Stone's
Wall Street. Its high-powered arbitrager, Gordon Gekko, announces
"greed is good"—mirroring an actual comment made by Ivan Boesky.