Junk Bonds, Market Malnutrition

Nothing new in the idea that those who are ready to take big economic risks should be compensated, if they’re lucky, with big economic rewards: It’s as old as commerce itself. For centuries, the prospect of huge profits was precisely what encouraged investors to finance dangerous years-long sea voyages or land caravans. If the ships or the camels eventually came home, laden with eagerly sought cargoes, the daring investor had a good chance to become rich.

In the late 1970s this ancient idea was put in the service of a new concept. Companies that had trouble raising capital in traditional markets began to issue “high risk, high yield” securities, more commonly known as junk bonds. They proved attractive to venturesome investors and also highly lucrative to some big plungers in the financial community, notably Drexel Burnham Lambert Inc., the Wall Street investment house that pioneered their sales. Now Drexel Burnham has discovered anew that great rewards invite great risks. Its parent company, Drexel Burnham Lambert Group, says it is suffering from a severe cash shortage. It has defaulted on $100 million in loans and is looking to protect itself with a Chapter 11 bankruptcy filing.

Does any of this matter to the ordinary person who has never invested in junk bonds? Unhappily it does. Junk bonds are now held by many mutual funds, insurance companies, pension funds, savings and loan institutions and even the federal government, thanks to its ownership of failed S&Ls.; Drexel Burnham’s woes have shaken the $200-billion junk bond market. Regulators have moved quickly to contain the problem, but it’s too early to tell how far the ripples will spread. As with the collapse of many S&Ls;, innocent people could find themselves harmed by the greed of others.

This is obviously an important matter for Congress to look into. Care will have to be taken, however, not to produce a legislative remedy that could lead to over-regulation of the market.