Junk Campaign Against Junk Bonds : The Fed Should Stay Out of It--Takeovers Aren’t All Bad

You’d think that the Federal Reserve has enough to do without getting involved in corporate takeovers.

There’s no shortage of other problems: avoiding a recession; keeping the international debt crisis under control, presiding over the decline in the dollar’s exchange rate. But apparently these jobs aren’t enough. Now the Fed wants to regulate “junk bonds,” which are used to finance hostile takeovers. It’s a big mistake.

Mergers are one of the economy’s most important and least understood phenomena. They’re in the news almost daily. Last week General Electric announced that it would acquire RCA for $6.28 billion. Earlier, Philip Morris bought General Foods for $5.67 billion. Both of these are friendly, management-negotiated mergers. But hostile takeovers--attempts to dislodge existing management--are also flourishing. In November Revlon was taken over against its will by Pantry Pride for $1.8 billion.

By regulating junk bonds, the Fed would side with embattled managements against hostile takeovers. But providing job security for these executives isn’t the Fed’s job. On balance, mergers may create few benefits for the economy. Many of them, inspired by corporate expansions, breed inefficiency. In contrast, hostile takeovers by so-called corporate raiders may result in real economic gains. These takeovers can replace poor managements or break up excessively large or diversified companies.

The merger movement, and the surge of hostile takeovers, reflects an often-futile quest for corporate growth. Many large companies are economically mature; their markets have stopped growing rapidly. These companies often generate more profits than can be usefully reinvested in their traditional businesses. But many executives won’t abandon corporate growth by paying out unneeded profits in higher dividends. Since World War II, dividends have typically accounted for half, or even less, of after-tax profits.

A dilemma results: Companies can either overinvest in mature markets or diversify into new businesses. Both are risky. Overinvestment in mature markets creates excess capacity, while moving into unfamiliar industries often invites disaster. Mergers are the easiest way to diversify. Since 1963, estimates the consulting firm of W. T. Grimm & Co., there have been more than 63,000 mergers and acquisitions--worth more than $600 billion. In part, hostile takeovers aim at firms that cope poorly with their growth dilemma, creating inefficiencies and profit opportunities.

The use of junk bonds for mergers in the last two years has made large companies more vulnerable to takeovers. An outsider can borrow the money to bid for the company’s stock by selling junk bonds--typically to pension funds, insurance companies and wealthy individuals. The bonds are attractive because they usually offer interest rates that are 3.5 to 4.5 percentage points higher than the best corporation bonds. This doesn’t mean that the bonds are, literally, junk. In fact, their default rate remains low, and the higher interest rates have compensated for the extra risk.

If the takeover succeeds, the bonds are repaid by selling off parts of the acquired company or managing its cash flow to cover the bonds’ interest and principal. The idea is to profit by eliminating corporate inefficiencies. Before this type of financing, large firms were protected by their size. Only other large companies could raise the cash for a takeover. Junk bonds enable individual investor groups--a T. Boone Pickens of Mesa Petroleum--to bid. But now the Federal Reserve is proposing that in certain situations junk bonds could be used only to raise half the money to buy a company’s stock. The other half could not be borrowed.

What good could this accomplish? Federal Reserve Chairman Paul Volcker fears that American business is becoming overburdened with debt. If it is, junk bonds are a microscopic part of the problem. In 1984 junk bonds used for mergers amounted to about 4% of the $262-billion increase in total business debt. And they’re an even smaller part of the roughly $2.1 trillion in outstanding business debt.

The Fed’s junk-bond proposal reflects a tortured interpretation of its stock “margin” requirement, which forbids individuals to buy stock on more than 50% credit. But this rule was never intended for corporate takeovers. Extending it to junk bonds also violates the Fed’s traditional--and valid--opposition to determining which kinds of loans are worthy and which aren’t. The Fed has correctly argued that playing that role would result in bad economic decisions subject to too much politics.

But that’s precisely what the Fed is doing now. It has bowed to the pressure of corporate executives, and their congressional allies, who don’t want their jobs or their self-esteem threatened by takeovers. Instead of allowing the proposed junk-bond rule to be put into effect early next year, the Fed should gracefully reverse itself. This rule is junk.