The Secret World of Mike Milken (page 2)

September 1987

by Edward Jay Epstein

Milken's position proceeded directly from his domination over junk bonds. Once considered something of a joke on Wall Street, they become by the mid-1980s, under Milken's direction, the main means of financing through debt the expansion of medium sized corporations-- which meant 95% of the corporations in America. Although he had no exclusive monopoly on junk bonds, his ability to sell them to financial institutions, through his personal network of money managers, made him one of the most powerful financier in the world.

How Milken created this new universe of money in a few short years, with himself at the center as the "grand sorcerer" of finance, as the Institutional Investor called him, is remarkable testimony to the power of a single idea. The insight came to him gradually in the mid seventies, he explained. He then was working at Drexel in New York as a specialist in so-called "fallen angels"-- which were the bonds of once great corporations that, because they had fallen from grace, had been downgraded by the rating services from investment quality (BB or better) to "junk." His job, figuring out whether the actual risks were of them defaulting was outweighed by the premium interest they paid, led him to question the structure of the entire market for capital in the United States.

When he recounted his thinking on how the corporate economy gets its money, "The World According to Milken," as he put it-- he reminded me of the chess prodigy Bobby Fisher. Just as Fisher could see combinations in a chess board no one else could, Milken seemed to see moves not obvious to others in finance. With a series of assertions, often in incomplete verbal shorthand, he would move from level to level.

Level One. "What is a bank?" he asked rhetorically. "It is nothing more than a bunch of loans."

Level two. " How safe are these loans?" "They are made mainly to three groups that may never repay them in a real economic crisis-- home owners, farmers and consumers of big ticket items."

Level Three. "What guarantees these loans?" "These banks usually have $100 in loans for every dollar of equity-- which means there is very little backing them up."

Level Four. "They are hardly a risk-free investment yet their bonds get triple-A ratings" " What does this tell us about bond ratings?"

This brought him to his main target: the bond rating system. As it had existed for a hundred years, two companies-- Standard & Poor's and Moody's-- assigned corporate bonds a letter grade rating descending from AAA to C. Anything above BB was considered investment-grade, which meant there was virtually no risk of default, and the bond-buyer could count on a fixed rate of interest. Since the rating was awarded on the basis of how large the company was, as well as its historical stability, only "the 600 to 700 largest companies qualified," Milken found. These were companies with assets over $200 million, and which had been in business for decades. Because of the rating system, they were the only companies in which many insurance companies, pension plans, college endowments, banks and other institutions permitted their money-managers to buy bonds. This "half-trillion dollar capital market", as Milken calculated it, was closed to the other "24,000 American corporations." These excluded companies could only borrow from commercial banks, at unpredictable short-term interest rates from banks, or from insurance companies, which attached restrictive covenants to the money.

This "black and white" distinctions made no sense to Milken. As he saw it from his analysis of "fallen angels," the underlying "risk free" premise was wrong: "There is no such thing as a risk free investment." Top rated bonds could fall precipitously in value, not only if the company went bankrupt, but if its credit-rating was lowered because their industry declined-- like steel and ship-building did in the seventies. Ratings measured "the past not the future" risk. "This was crazy," Milken said. "rating services had the wrong computer program."

To correctly weigh the risks, it was necessary to appraise the future. He reasoned: "The value of a company is the sum of two components: its past, as represented by its historic balance sheet, and its future, represented by its prospects." By concentrating on the first component in his equation--the historical balance sheet-- the rating services had seriously neglected the other component--future cash flow.

"And that what bonds are all about-- getting paid off in the future," he added. He cited the case of Metromedia-- which then owned four television stations. "You didn't have to know much about its past record, or the number of years it paid a dividend, or what letter the rating services gave it. All one had to do was be able to add together four numbers-- the value of its stations in New York, L.A., Chicago and Boston-- to find the total value greatly exceeded what it owed." So long as one believed these stations would not decrease in value in the foreseeable future, its bonds would be a safe investment "whatever their ratings."

This brought Milken to the next level of his insight. If bonds were pegged to their future cash flow, rather than past track record, then the old rules would no longer hold. Nor would the investment-grade labels matter. Bonds would then become, like common stock and real estate, just another form of risk management, which is what Milken saw them to be in reality. If the bonds of medium-sized companies were more risky, they could compensate the buyer for the extra gamble by paying extra interest. He assumed that many growth companies could afford to pay this premium interest out of their future earnings (especially since interest, unlike dividends on stocks, is tax deductible).

What he eventually came up with was a cross between a bond and a common stock. It was called a bond, and therefore institutions, restricted to bonds, could buy it for their portfolios, but, in paying out a large slice of its future cash flow to the holder, it acted like stock. Unlike existing junk bonds, which were the debris of fallen companies, Milken custom designed his issues to be unrated bonds. He realized they were "subversive" since they undercut the established rating system, but, as an outsider, this did not disturb him. He had always been, as he described himself, "something of an iconoclast." He, moreover, saw that if he could open up the huge capital market to growth corporations, they would beat a path to his door. Milken conceived of his role as a marriage-broker, "bringing about kind of a marriage between institutions" and aggressive-new corporations.

At Drexel, Milken had already proven himself a money-making phenomena. By 1976, he was earning over 100 per cent on the capital he was given to trade his exotic Fallen Angels -- and got a $5 million bonus (which he immediately re-invested). When Fred Joseph listened to his analyses, he realized that Milken, "understood credit better than anyone else in the country." Joseph then headed Drexel's corporate finance department, which would have to work in close collaboration with Milken in selecting and advising corporations that issued these new bonds. But the profits would be enormous-- if Milken could persuade money-managers of the validity of his concept, and thereby break the strangle-hold the rating services had on the bond market.

The idea required changing the mind set of institutions. Even if it meant earning higher returns, money managers had, as Milken shrewdly recognized, "career reasons" for sticking to buying bonds that carried an investment-grade rating. As long as they bought bonds with this "seal of approval," there careers would not be in jeopardy-- even if the bonds went bankrupt (as, for example, the Washington State Bonds did). On the other hand, if they invested their funds' money in anything else, they would be held personally accountable.

Milken therefore embarked on a determined campaign to bring the more aggressive money managers into an alliance with him. Like any political campaign aimed at changing perceptions, Milken's crusade operated at different levels; public, and hidden.

As if to symbolize his break with the establishment, he moved his headquarters from Wall Street to Los Angeles on July 4th 1978. It was his 32nd birthday-- and his declaration of personal independence from New York. His first order of business was, he recalled teaching his top aides "how to communicate ideas."

His immediate target were the money-managers who invested the portfolio of the highly-competitive thrift banks, pension funds and life insurers. Since the very survival of these institutions, unlike older and more established ones in the East, depended on their being able to attract new clients by paying the highest possible rates of return. They desperately needed some edge over rivals that put their funds only in investment-grade bonds; and Milken offered them the means to save themselves: junk bonds. They still had to be convinced these new instruments were safe.

Milken worked tirelessly to tell them the message what they wanted to hear: ratings were irrational. In his pitch, he compared rating services to movie reviewers that gave theater owners "incorrect reviews" of risks-- with the result that the theaters missed booking the right films. He argued that they ignored the growth potential in their equation. After he laid down the logic of junk bonds, he ran through numbers intended to demonstrate how the higher interest would more than compensate for any losses through defaults in a portfolio of junk bonds. The "bottom line" was that they could earn more money than their competitors in the world of institutional finance. It was a message his audiences evidently wanted to hear.

In a remarkably short period of time, Milken won over a host of money managers with "billion dollar checks in their pocket." As these money managers found junk bonds gave them an edge of over five percent over investment grade bonds-- or $50 million a year for every billion they had in their institution's portfolio-- they were able to attract more institution's to their funds. Other money managers, seeing the results, joined the ranks of the converted.

Many of these fund managers whom I saw, not only accepted his philosophy-- but preached it themselves. Howard Marks, the managing director of Trustco, a Beverly Hills based manager of pension funds, for example, had been convinced by Milken about the bias in the rating system when he was at Citibank in 1977. He recalled Milken talked then not only about making money but, on a more altruistic level, about how the nation would benefit by making capital available to growth companies. He then moved to Trust Company of the West, which invests pension funds; and by investing 1.5 billion in junk bonds, he became one of the top fund managers in America. (He also has been recruited by Milken to help him coach children's basketball team.)

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