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Among the world's great novelists, Ayn Rand stands almost alone in providing stirring portraits of entrepreneurs, industrialists, and bankers. But given the way modern journalists depict those who control and organize capital, her fictional creations appear to have few real-life counterparts. And so it is no wonder that when Objectivists think of a financier, they are more likely to mean Midas Mulligan than Michael Milken. Yet Milken was the greatest financier of his age—the 1970s and 1980s—and nearly comparable to J.P. Morgan at the turn of the last century.
Who is Michael Milken? What did he do? How did he do it? Why did he do it? Why was he destroyed? Anyone seeking to understand America's capitalist economy, and its anti-capitalist culture, must discover the answers to those questions.
Born on the Fourth of July, 1946, Michael Milken grew up in Encino, California, enjoying a pleasant middle-class childhood. He was extremely bright, with a prodigious memory, and a competitive spirit. In high school, Milken threw himself into everything: student council, basketball, track, Boys' League, debate tournaments, Pep club, and other activities. He was voted "most spirited" and "friendliest" class member in the class of 1964. His high school sweetheart, Lori Ann Hackel, later became his wife.
After graduating from high school, Milken attended the University of California at Berkeley as a business major. Despite Berkeley's infamous reputation as the center of the counterculture during the mid- to late sixties, Milken did not take drugs, smoke, or drink. He avoided even soft drinks and carbonated beverages.
Following Berkeley, Milken enrolled in the Wharton School at the University of Pennsylvania, specializing in finance, information systems and operational research. Several professors singled him out as the brightest student they had ever taught, but that level of achievement did not come effortlessly to him. A fellow student has said that Milken, though he had a quick mind, studied very hard and late at night. He wanted to be number one; indeed, Milken wanted to graduate with straight As.
In January 1969, on the recommendation of a Wharton professor, Milken began working as a consultant for the chairman of Drexel Harriman Ripley, a fading investment bank. According to an executive at the bank, Milken's arrival was that of a bull entering a china shop. Nevertheless, he organized the firm's overnight delivery of securities, saving the company half a million dollars annually. In 1970, Milken went to work full time for Drexel, first in Philadelphia and then in New York. Some at the company thought he was not cut out for the business, being out of place socially. For example, Milken had been educated in public schools, while most of the firm's employees had gone to private schools.
Milken's investment policies were likewise shunned by others at the firm. He took an interest in investments that had fallen on hard times, such as convertible bonds, preferred stock, and real estate investment trusts. To Milken, these were buying opportunities, since the underlying assets had remained unchanged. Certain bonds that had fallen into disrepute by losing their investment grade rating were also undervalued, in Milken's eyes, again because the companies behind them possessed assets sufficient to generate earnings. By uncovering such values, Milken made the company a fortune. But his approach appeared speculative to a firm that had historically preferred blue-chip companies. And his elevation of research over sales naturally upset the sales staff. As a result of these tensions, Milken was considering leaving the firm in 1973, to teach at Wharton.
In the end, though, Milken stayed and in 1973 Drexel merged with Burnham and Company. Milken's salary at the firm comprised a base of $52,000 a year and a portion of the company's profits. In 1976, when he was thirty years old, Milken made $5 million by trading in securities no one else would touch, the most famous of which were "junk bonds."
While at Berkeley, Milken had studied the work of many financial scholars, but especially that of W. Braddock Hickman. Hickman's investigations in the late 1940s and 1950s suggested that the danger of companies' failing to meet payments on their obligations had, historically, been overestimated by the market. That is, though the risk of default on low-grade bonds was higher, it was more than offset by the higher interest these bonds paid, a fact the market did not recognize. Thus, the prices of such bonds were too low, and a diversified portfolio comprising such bonds would outperform a portfolio of investment-grade bonds.
Some who have studied the history of junk bonds contend that a proper reading of the data which Milken studied provides no basis for new investment insights. But though one might argue about the historical data on junk bonds, there is no arguing with Milken's success in using them. For even if Milken completely misread the history of bond price data—which is highly unlikely—his use of high-yield securities in promoting new types of investments, such as the leveraged buyout, was still an important innovation.
Milken's first customers for junk bonds were mutual funds. High-performance funds were always looking for ways to increase their returns. Massachusetts Mutual, Keystone, Lord Abbott, and First Investor's Fund for Income all became purchasers of the new high-yield securities, and remained so throughout the Eighties.
Other buyers of the new Drexel product included insurance companies, for these companies depended on investment income, and some of the less well-established companies wanted to increase their yields in order to compete with the dominant players. Among the buyers in this category were Larry Tisch and Meshulam Riklis, both of whom owned insurance companies, as well as Fred Carr, who owned Executive Life (First Executive Corp.). Such investors were outside the Wall Street mainstream, which had its own syndicates of buyers for debt products. Drexel created a new pool of buyers—some of them considered unsavory by Wall Street's traditional lights—to get around that loan-placement hierarchy.
At this time, Milken was not yet underwriting junk bonds, merely trading them. But demand for the bonds picked up as new money sought the potential high returns suggested by Drexel's good record. Another investment bank, Lehman Brothers Kuhn Loeb, was experimenting with their troubled clients, devising ways to allow their client companies to originate debt. Milken, trading in that debt, reasoned that Drexel could also participate in such origination. He suggested to Frederick Joseph, head of the corporate finance department (and later CEO) at Drexel in New York, that the company seek clients and underwrite debt. That is, he was suggesting Drexel find non-investment grade companies that were being shunned by larger firms and let Drexel raise money for them. In April 1977, the first Drexel-underwritten junk bond issue was Texas International. By the end of 1978, with Milken now operating in Beverly Hills, California, Drexel was the number-one issuer and would never be overtaken. Thus, Milken opened wide the bond market to firms that had never had investment-grade ratings. The innovation was not the bond itself but the tight linkage Milken created between the issuers of debt and the buyers. Many companies could not get money at any cost, and high-yield bond buyers placed a vast new network of funds—even international funds—within their reach for the first time. Over the next decade, Milken raised funds for more than one thousand such companies, including MCI, CNN, McCaw Cellular, and many others. And he continued to assist firms that had fallen out of favor, raising money for Lorimar in 1979, Warner Communications in 1984, and Chrysler in 1984, when no one else would touch the auto company.
The result was truly national. Dynamic medium-size and smaller companies created the surge in employment that characterized the long economic expansion of the Eighties. From 1980 to 1986, firms using high-yield debt accounted for 82 percent of the average annual job growth at public companies. While large-company job growth remained at a constant level, firms funded with high-yield venture capital added jobs at six times the average rate in each industry. Junk bonds—because of their record of success from roughly 1978 to 1985, and their association with growth and job creation—had a favorable connotation, akin to that of venture capital or start-up capital.
But junk bond financing was evolving quickly. In 1981, Drexel took a daring new step, issuing bonds for leveraged buyouts (LBOs). In a typical LBO, a public corporation is taken private by top management working with a pool of investors led by a buyout firm. These investors purchase all outstanding shares of the company, putting up 5 to 10 percent of the purchase price from their own money and borrowing the rest—hence the term "leverage." Two new incentives are now in play: first, management has a much higher share of the company's equity than before and thus a greater stake in the company's profitability; secondly, the company has a higher debt burden. About 18 percent of the LBOs from 1983 to 1988 were "going-private" transactions designed to concentrate ownership and avoid the disadvantages of public stock ownership. But over two-thirds of the LBOs in this period were intended for more radical restructuring. The economic motive for the LBO was the need to consolidate business lines, not unlike the need serviced by J.P. Morgan in steel and farm equipment a hundred years ago. The main goal of the raider and his banker was to break apart poorly performing conglomerates, where managers tended to subsidize poorly performing business lines with the profits from solid business lines. Thus, LBOs brought to the surface economic values submerged in large companies.
Then, in 1983, Drexel made a more daring and fateful decision to provide junk bond financing for hostile takeovers, or leveraged buyouts taken against the incumbent directors' desires. Drexel, primarily the East Coast corporate office, aggressively sought out customers, but often the corporate raiders such as T. Boone Pickens came directly to the firm. For his part, Milken always stressed the difference between the use of junk bonds in hostile takeovers and the original junk bond market, which he had created as a means of financing midsize companies. He saw that takeovers launched against the desires of incumbent directors would have negative political repercussion on the market that he had created. Apparently, one of two things happened: Either Fred Joseph, the ambitious and confident head of Drexel, thought he could handle the political reaction to hostile takeovers, thus overruling Milken's objections; or Milken's objections were made too modestly, and he acquiesced in Drexel's decision to participate in a controversial market. Casting reservations aside, Milken began to arrange "war chests" in 1984 for willing and able corporate raiders who were likely to succeed and who could propel Drexel into the top of the mergers and acquisitions field. By March 1985, Drexel completed its first junk bond-financed hostile takeover.
Thus, in the early Eighties, Milken and Drexel's corporate finance department enabled raiders to contest for companies, reinvigorating the market for corporate control. Takeovers, and more importantly, the threat of takeovers, had a sobering effect on management strategy. In the past, only large, well-capitalized firms could initiate hostile acquisitions, supported by top-tier investment banks. But now, small and aggressive raiders—armed with vision and borrowed capital—could take over corporate giants. Milken would arrange some seed money for a raider to provide an initial stake. Then Milken's syndicate of buyers would commit themselves to buying the debt (or that part of the debt not lent by banks). In effect, Drexel could then announce that it had the money to back the raid, though no one had actually put up the money. Drexel issued a form of guarantee or credit: a letter stating that Drexel was "highly confident" that the money borrowed for the purchase of stock could be placed among buyers. That letter was enough to get the banks and other players involved. Milken raised $1.5 billion in 48 hours for Carl Icahn's offer for Phillips Petroleum. From 1985 to 1990, hostile-takeover financial transactions tallied $140 billion.
Public misperception of leveraged hostile takeovers—inevitable given the media's focus on "bust-ups"—largely ignored the rational foundation for eliminating such cross-subsidies as existed in the conglomerates broken up, and for offering managers higher pay for better performance. It should be noted, too, that junk bonds were never the primary source of takeover funding. Bank debt and the internally generated funds of the target company were larger components. However, junk bonds were essential to the purchase, because that part of the funding had always proved difficult.
Unfortunately, as often happens on Wall Street, and elsewhere, the innovation of a genius was misapplied through the ineptitude of his imitators. And so it was with junk-bond financing. In the early Eighties, Wall Street had come to look on junk bonds favorably as an important source of funds for middle-market companies, either new entrepreneurial companies or older firms that needed new funding to change their ways of doing business. In the mid-Eighties, junk bonds began to be used for LBOs in loud and public contests between the famous takeover artists and the companies they targeted for purchase. By the late Eighties, the market had grown tremendously, thinning the potential profits and limiting buyout opportunities. Furthermore, high-yield debt was being used by big companies to structure their balance sheets in the same way outside competitors were promising to do. In this last stage, that is, internal management was leveraging the corporation as a defense against outside managers. But the insiders took on debt without the vision of the outsiders, and, most crucially, without aligning the interests of the managers with the fortunes of the company. Those engaged in misguided buyouts used the form of the LBO but without fully understanding its function, though some simply did not recognize the signs of a higher risk market. In response, the reputation of the market Milken had created suffered. Milken himself was quoted publicly as saying that it was time to de-leverage, time to stop raising money by borrowing and consider other means. As he later recalled,
After 1986 I felt like a skilled surgeon who's been locked out of the operating room and watches through the glass in horror as some first-year medical students go to work on a patient. They're cutting him open while referring to the textbooks, but they're turned to the wrong chapter. I keep pounding on the glass and crying, "No, no, no." ("My Story—Michael Milken," Forbes, March 16, 1992)
True to his form as financial engineer, not merely the "junk bond king," Milken said that the best deal of 1989 was the buyout of United Airlines—because it did not go through.
Such, in essence, is what Michael Milken did and what became of his financial innovation. Why did he do it? We know that Milken had developed a deep understanding of certain new financial theories, and one factor motivating him was undoubtedly the drive to give those theories reality. He believed profoundly that there is no one financial structure—no fixed composition of debt and equity—that is always right for a given company. The world changes and presents opportunities that require dynamic reorganizations of capital. The value of a company can be enhanced by changing its capital composition in response to changes—in taxes, ownership structures, business prospects, even in the possibilities of failure. "Managing the Corporate Financial Structure," a paper he wrote with one of his professors after leaving Wharton, examined ways of optimizing investor returns by modifying a company's capital structure. Companies, it said, "should vary the capital structure as their businesses change and markets prefer debt or equity, or as interest rates fluctuate." Traditional commercial and investment bank financing techniques could not fulfill this need. Most people, including many people on Wall Street, were not interested in such financial engineering. Milken loved it.
More personally, it is clear Milken's enthusiasm for client companies surpassed that of most other investment bankers. In his mind, the plight of smaller companies was a morally righteous cause. The way they were treated by banks and rating agencies, he once remarked, was "discriminatory." Many of his associates—Reginald Lewis of Beatrice, William McGowan of MCI, Ted Turner of CNN—shared this anti-establishment attitude.
Milken also thought of himself, not unreasonably, as a social scientist. "Wealth," he remarked, "is a by-product of solving problems and creating value. If you do those things, you get a high rate of return. If you don't solve problems and create value with your investments, you lose money. . . . The best investor is a good social scientist." What he meant was that he has an understanding of broad social trends and a grasp of the potential impact of scientific and technological breakthroughs. His success in the cable television industry is a good example.
In 1981, 1982, 1983, at the Drexel conferences, I would get up and say NBC, CBS, and ABC are left at the post. The networks were providing broad entertainment. Mass audiences. There was a parallel earlier when we had this explosion of special-interest magazines that put the big, broad mass magazines like Look and the old Life and the Saturday Evening Post nearly out of business. The same thing was inevitable in TV. Cable would eventually be able to provide 50 channels—50 special-interest broadcasts instead of one mass broadcast. People can watch sports when they want to watch sports, news when they want news, movies when they want movies, not when the network wants them to. But from a borrower's point of view, cable was junk and network TV was blue chip. ("My Story")
Lastly, Milken can fairly be described as a futurist, someone with grand visions of mankind's destiny. Reportedly, he has been influenced by the works of author John Naisbitt (Megatrends, 1982; and Re-inventing the Corporation, 1986). Thus, he is loosely associated in style and purpose with Alvin and Heidi Toffler (Future Shock, 1970; and The Third Wave, 1980) and George Gilder (Microcosm, 1989; and Telecosm, 1996). The difference is that Milken brings to his futurism not an author's air of prognostication, but a financial entrepreneur's can-do spirit.
The final question in the story of Michael Milken must be: Why was he virtually destroyed by banishment and imprisonment?
Milken and Drexel constituted the most successful Wall Street firm of the Eighties. They made the most profits in one year of any Wall Street firm—$545.5 million in 1986, a record that stands today. And Drexel's legacy of sponsorship for new and troubled companies remains an industry model. How did they do it? Stylistically, Drexel was more aggressive than any other firm, eschewing some of Wall Street's traditional rules. Organizationally, the firm experimented. They offered a product no one else had conceived and that, after it had been conceived, competitors were slow to adopt. How did they sell their product? Following Milken's personality, they energized their business tactics with nearly religious fervor. How intense was the drive to succeed? In an estimate once offered by Drexel chairman Robert E. Linton, an estimate far more psychological than economic: "Michael wants to win the game. Michael wants to have it all. Michael wants to do every piece of business and every deal and make every dollar."
But though many people want to be the best, Milken was. A money manager who visited Milken in the late seventies remarked, "He had the issuers. He had the buyers. He had the most trading capital of any firm. He had the know-how. 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 trading prices going back to at least 1971. He had boxed the compass." And in a 1986 portrait of Milken, published in Institutional Investor, one investment banker said, "Mike is the only person in the securities business today who can do it all. He is a master trader, salesman, deal structurer, credit analyst, merger tactician, securities venturer. And he does these things at the level of the best guy in each of these categories. You look at the difficulty firms have in putting all these together—and here you have one man embodying all these attributes."
What drove so many to seek the destruction of a creator this great?
Along with his tremendous achievements in the realm of finance, Michael Milken made some errors of judgment and committed some minor infractions of industry regulations. A detailed assessment of those errors and infractions is provided in my forthcoming monograph on the "decade of greed." But Milken's errors and infractions cannot explain the persecution of him, for the disproportion is too gross. What, then, can explain it? Does Milken's story demonstrate that we live in an age blinded to greatness by envy? That subject, too, is discussed in my monograph.
Jeff Scott is a financial analyst and assistant vice-president at Wells Fargo Bank in San Francisco.