$160-Billion Behemoth : Junk Bonds: Will Glitter Wear Thin?

The market for “junk bonds”--the high-yield, high-risk debt that has been so controversial lately--functioned just fine Thursday, and the lack of news says a lot about what one very troubled firm has done to change American business.

The seeming stability of junk bonds is yet another indication that Drexel Burnham Lambert, the maverick securities firm that agreed Wednesday to plead guilty in Wall Street’s biggest criminal case, has built an awesome financial institution--one that may well endure longer than the firm itself.

Drexel built up the junk bond market from virtual obscurity in 1977 into a $160-billion behemoth that has transformed America’s economic landscape, with the bonds financing the growth of hundreds of small companies and fueling dozens of corporate takeovers.

Sung Its Praises

Drexel has sung the praises of its own creation, claiming that junk bonds kept executives on their toes and forced companies to be more efficient. Declared one Drexel button: “Junk bonds keep America fit.”

But Drexel’s agreement to plead guilty to six felony counts of securities violations and pay a record $650 million in fines raises questions about whether the junk bond business--or at least the element of it that involves hostile takeovers--has been partly erected on a foundation of fraud, double-dealing and manipulation.

The apparent criminal charges to which Drexel pleaded guilty signal that it engaged in a series of illegal activities to facilitate takeovers--corporate raids that at times resulted in massive layoffs and gave the nation’s work force a severe case of insecurity.

“We now know that the single most financially successful Wall Street firm of the 1980s in large measure built its fortune on a foundation of criminality,” Rep. Edward J. Markey (D-Mass.), chairman of the House Commerce subcommittee on telecommunications and finance, told reporters after a hearing Thursday.

Such concerns about criminal behavior abetting corporate takeovers were raised in civil charges against Drexel in September, involving 18 separate transactions.

In one instance, for example, Miami Beach financier and Drexel client Victor Posner was threatening several years ago to take over Fischbach Corp., a New York electrical and mechanical contracting firm. But he was prevented by a previous agreement from owning more than 24.9% of the shares unless another individual or firm acquired 10% or more of Fischbach’s stock.

To put pressure on Fischbach and force a takeover, the Securities and Exchange Commission has alleged, Drexel arranged for another client, stock speculator Ivan F. Boesky, to buy 10% of Fischbach’s shares.

The SEC charges that Boesky was secretly buying on behalf of both Drexel and Posner, enabling Posner to eventually seize control of Fischbach and become its chairman. Drexel, critics say, needed these deals to go through to enhance its junk bond operation, earn enormous fees, and buttress its reputation as a Wall Street powerhouse.

The controversy over such alleged tactics comes as the junk bond market faces other strains unrelated to the Drexel matter.

The market, analysts say, could be devastated by possible congressional actions to limit takeovers. Congress, for example, is considering eliminating or reducing the tax deductibility to corporations of interest on debt used to finance takeovers. Such a measure would make junk bonds a far more expensive way to finance corporate takeovers, which are responsible for nearly one-third of all junk bonds issued each year.

The junk bond business also faces growing concerns about its ability to weather a recession. Many companies that have financed operations through junk bonds, with their typically high interest rates, may be unable to make payments if sales and profits decline in an economic downturn. The resulting junk-bond defaults could hurt thousands of small individual investors, who have put billions of dollars into junk-bond mutual funds.

Some market players also worry about whether investors can absorb new junk bonds to be issued to finance such recent corporate takeovers as the record $25-billion buyout of RJR Nabisco. A collapse of one or more of these deals could have a chilling effect on investors’ willingness to buy other junk bonds, causing prices to plummet and investors to take heavy losses.

For the time being, however, the junk bond market has taken the news of Drexel’s agreement to plead guilty in stride. Prices of bonds hardly budged in trading Thursday. Although activity was bound to be slow due to the upcoming Christmas holiday, traders said the market already had anticipated Drexel’s settlement.

Some said, in fact, that Drexel’s settlement helped the market somewhat. “The settlement has a positive implication for high-yield bonds because it removes the uncertainty hanging over the market,” said Robert D. Long, a managing director at First Boston, a main competitor of Drexel’s.

The absence of any market trauma also reflected the fact that the junk bond market has become an institution with a life of its own, no longer as dependent on Drexel--despite the firm’s role as the pioneer and chief cheerleader.

Drexel, which handled about 65% of the junk bonds issued to the public in 1981, lately has seen its share fall to as low as 23%, according to IDD Information Services, a New York research firm.

But the junk bond market continues to grow explosively, from less than $25 billion in bonds outstanding in 1977 to around $160 billion last year. That represented a full 25% of the $650 billion corporate debt market.

These junk bonds are dear to small and large investors alike, attracted to their high yields, typically 3 to 5 percentage points higher than conventional corporate bonds and U.S. Treasury securities. According to Drexel, 30% of all junk bonds issued are owned by mutual funds and money managers, many of them catering to individual investors. Another 30% is owned by insurance companies, and 15% by pension funds.

Junk bonds today are vital for financing the growth of hundreds of small and medium-sized companies, fueling the creation of thousands of jobs and hundreds of factories and offices. Accordingly, Drexel has dubbed the bonds “America’s working capital.”

These companies--including many that are now household names--often were considered too young or risky to obtain bank loans and could not issue the traditional “investment-grade” bonds given top safety ratings by bond-rating firms. So, instead, they issued junk bonds, which carried a higher interest rate because they were deemed less credit-worthy--and investors wanted more money to compensate for the greater risk.

About 1,500 companies have used junk bonds to finance their growth or to launch takeovers. A list of junk bond users reads like a who’s who of corporate America, including such names as Gillette, Safeway Stores, Turner Broadcasting, Western Union, Wickes Cos., MCI Communications, Occidental Petroleum, Trans World Airlines and Holiday Inns, as well as hundreds of smaller, lesser known entities.

Some executives, such as Triangle Industries Chairman Nelson Peltz and MCI Communications Chairman William McGowan, attribute much of their firms’ growth to junk bonds. Triangle, for example, was transformed from a struggling vending machine company into one of the country’s largest packaging firms, thanks to Drexel’s guidance and junk bonds.

Hovnanian Enterprises Inc., a Red Bank, N.J., real estate developer, says its $100 million in junk bonds enabled it to grow more than sixfold over the last six years.

“We feel indebted to Drexel,” Hovnanian President Ara Hovnanian told the Associated Press Thursday. “They helped us a great deal with our financing and that’s why we’ll be standing with them in their difficult times.”

Research by Drexel and others shows that about two-thirds of junk bonds issued are used for internal growth and development. Only about 27%, Drexel says, are used for friendly takeovers where both parties consent to a merger. Fewer still, about 4%, are used to finance hostile takeovers--ones where the target company fights a bid.

“The junk bond market is a legitimate and important market, not just for hostile takeovers,” said David Aylward, executive director of the Alliance for Capital Access, an organization based in Washington that lobbies for companies that issue junk bonds.

But it is those takeovers, because they tend to be bigger and more dramatic, that receive the most media publicity. And Drexel, more than any other Wall Street firm, spawned the 1980s corporate raiders by giving them the financing they needed to make bids for other companies with little of their own money at stake.

Raiders such as Ronald Perelman, Carl C. Icahn, T. Boone Pickens Jr. and Irwin Jacobs--previously scarcely known--became feared in corporate board rooms. And their takeover deals became synonymous with junk bond financing.

Defenders of these raiders claim that their hostile takeovers and the resulting layoffs are rooted in a fundamental restructuring of the American economy and the need for companies to get leaner and meaner to keep pace with foreign rivals.

But the takeovers also lie at the center of allegations of fraud and manipulation.

Although neither Drexel nor federal prosecutors have yet disclosed which six specific charges to which Drexel will plead guilty, it is believed that the charges could include some of the same allegations contained in the civil complaint filed against the company in September by the Securities and Exchange Commission.

In that complaint, Drexel is accused of manipulating stock prices and with informing former stock speculator Boesky of at least one deal before it was announced publicly, a violation of insider trading laws. It is also alleged that it helped Boesky conceal his true ownership of stocks.

Phony Tax Losses

Sources said Thursday that the criminal counts to which Drexel has pleaded guilty might involve charges that it created allegedly phony tax losses for Princeton/Newport Partners, a securities firm indicted on racketeering charges in July. One or more charges also are expected to relate to Drexel’s role in the Posner attempt to destabilize and gain control of Fischbach.

Congressional investigators and some Drexel clients also allege that the firm routinely sold new junk bonds to employees, driving up the price of the bonds and allowing employees to profit when the bonds were sold to other clients, some of whom lost money when the bonds fell in price.

Staff writers William J. Eaton and Art Pine in Washington and Scot J. Paltrow in New York contributed to this story.