System Will Survive Demise of the Great Oz
What happens now that Drexel Burnham Lambert, the firm that made junk bonds a household word, has filed for protection from creditors in Chapter 11 bankruptcy?
Distress for some, opportunity for others--and no big threat to the broad economy.
The filing itself doesn’t change much. The high-interest, high-risk junk bond market has been in disarray for most of the last year, with individual issues selling at 60% or less--often much less--of face value. Drexel, the firm that underwrote half or more of the $204 billion in junk, hasn’t been able to make a market--serve as an ultimate backstop buyer of its bonds--for several months.
Many junk bonds are already toxic waste in the accounts of the institutions that purchased them--insurance companies, pension trusts, mutual funds, savings and loans. Solving the problem won’t be easy. The bonds are flawed, say debt experts. Holders have no rights and companies that issued junk bonds may give all other creditors priority. In time, many junk companies will have to restructure debt and there will be writedowns and losses.
The federal government is moving to limit the damage--but it should not do too much. The Pension Benefits Guaranty Corp., a government agency, will have to see that innocent wage earners do not suffer loss of pension benefits due to failures in high-powered financial markets.
But the federal government should in no sense bail out brokerage houses. Farmers and manufacturers in the Midwest weren’t bailed out in their credit crisis in the early 1980s, nor were oil drillers and lots of other businesses in the Southwest. Now it’s Wall Street’s turn to suffer, and few will shed tears. In fact, said one businessman, “sometimes when it’s darkest on Wall Street, it’s brightest for America.”
Indeed, as Drexel’s board of directors contemplated bankruptcy on Tuesday, the stock market rose, the government reported increased car sales and shrewd business operators were already looking at opportunities in the restructuring of junk bond companies.
The truth is, junk bonds aren’t that big a deal. The junk market totals $204 billion in bonds, of which perhaps $50 billion worth are in default. That’s no real threat to the vast U.S. financial system that includes $700 billion in non-junk corporate bonds, $800 billion in tax-exempt municipal bonds and $2 trillion in U.S. government bonds and notes. There are also more than $3 trillion in mortgages and $3 trillion worth of New York Stock Exchange common stocks, not to mention the hundreds of billions more on other exchanges and traded over the counter.
Compared to those huge markets, where bonds and stocks are freely tradable, junk was a little like Oz--a great and powerful image pumped up by pretentious talk and hot air. Drexel, or, more precisely, its former employee, Michael Milken, created the market, often by persuading client companies to borrow more than they needed, $150 million instead of $100 million, say, and use the excess to buy the bonds of other Drexel customers.
Why did clients play along with Drexel in such business? There was lots of money in it. Some insurance companies based better-paying annuity policies on junk’s high yields and thus gained a competitive edge on firms that avoided junk. Corporate raiders used junk bonds as financing for takeovers and threats of takeovers.
But Drexel’s power, like that of Oz, has been shown up. The distress of the whole junk market refutes Milken’s sales pitch that the high interest would offset the risk of default if a diverse portfolio of bonds were held. And Drexel lately has been unable to stand behind its bonds. The firm is an admitted felon, having agreed in December, 1988, to plead guilty to six counts of securities law violations, and Milken awaits trial on 98 counts.
So, just as Dorothy went back to Kansas, U.S. business goes on. There will be fresh opportunity as junk bond companies default on their heavy debt loads and need to restructure.
“There are a lot of people with broken furniture looking for repairmen,” says Morton Meyerson, a Ft. Worth private investor and longtime business associate of H. Ross Perot. There will be opportunity, says Meyerson, for people with access to capital, “and the ability to operate a company to produce real products and real services.”
“Having access to capital will require skills to run the business,” agrees Los Angeles investor Alfred Checchi, who last year led a team that bought Northwest Airlines. As junk companies default, he explains, creditors won’t sell the assets to get their money back but will try to revive cash flow and profits by installing new management. “There will be a premium on operating people, a return to basics.”
So the system adjusts, as usual--having once again survived the abuse of financial manipulators. Soon junk bonds and the name Drexel Burnham will become mere footnotes to a decade of uncommon greed.
