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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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