Drexel: The Fall of the House That Junk Built

The rapid demise of Drexel Burnham Lambert has shocked Wall Street and roiled world markets, but some people connected to the investment firm’s fabled Beverly Hills office say they have seen it all coming for a long time.

“The group that worked here was like the San Francisco Forty-Niners,” one longtime employee said. Then, “one day they took away the quarterback; then the receivers, the old linemen left . . . . It wasn’t too hard to see what was next.”

History hasn’t passed its final judgment on Drexel or Michael Milken, the indicted Drexel junk bond chief who ran the firm’s Beverly Hills office until the government forced his resignation last year. But few would disagree that the firm he built was a worldbeater and that its wrenching demise has been under way for a long time now.

In the last few weeks, the firm’s unraveling has accelerated as the problems of the junk bond market have worsened, the firm’s capital has been stretched ever further and Wall Street’s faith in the one-time powerhouse has ebbed.

For most of the last decade, Drexel’s influence was immense. The firm was arguably the most powerful concern on Wall Street in the 1980s, revolutionizing the business of raising money with the high-yield, high-risk junk bonds that it popularized.

Milken, an intense super-salesman, raised capital for the small and growing firms that could not have raised it before. He strung together a network of bond buyers--insurance companies, savings and loans, pension funds and others--that loved junk’s rich returns and trusted Milken to shelter them from its risks by keeping the markets growing and going.

With Milken, the smallest company could threaten the biggest and most established in a hostile takeover. Drexel and Milken helped give prominence to a whole new generation of financial entrepreneurs, such as Texas oilman T. Boone Pickens Jr. and speculator-turned-TWA Chairman Carl C. Icahn.

Drexel and Milken fostered the growth of Southern California as a financial center by aiding the growth of local businesses and drawing others from the East. Among the firms that grew with Drexel were First Executive Corp., a big Los Angeles insurance company headed by former star investment manager Fred Carr, and Columbia Savings & Loan Assn., a fast-growing Beverly Hills thrift headed by the aggressive Thomas Spiegel.

‘Predators’ Ball’

Milken and his admiring circle celebrated their accomplishment yearly at Drexel’s high-yield bond conference in Beverly Hills, a lavish event that his detractors soon tagged “the Predators’ Ball.” The conferences drew limousines full of some of the nation’s most important businessmen, all talking about corporate expansion, takeovers, moneymaking. To Wall Street and the world, this was the spirit of the ‘80s.

In its peak moneymaking year of 1986, the 11,000-employee Drexel turned $1 billion in profits. In 1987, Milken made an eye-popping $550 million in salary and compensation--a fact that thrust him into the consciousness of Americans who knew nothing and cared less about Wall Street.

But the firm’s undoing began during its moment of greatest glory as federal prosecutors stepped up their pursuit of insider traders, people who profited from inside information about takeovers and other stock-related events.

They jailed a former Drexel investment banker named Dennis B. Levine. In November, 1986, the notorious speculator Ivan F. Boesky pleaded guilty to one felony count, paid a fine of $100 million and agreed to lead prosecutors to other guilty parties.

Boesky’s accusing finger pointed at Milken, other Drexel employees and their bond market allies, who were accused of working as a network to manipulate a variety of securities.

The investigation began taking an immediate toll on the firm. It took two years for prosecutors to prepare their case, but, as Drexel continued to proclaim its innocence, it piled up costs estimated at $1.5 billion in lost revenues and legal and advertising expenses.

In December, 1988, reversing its ground, Drexel agreed to plead guilty to six felonies and pay a record $650 million to resolve history’s biggest securities fraud investigation.

Even as Milken continued to assert his innocence, Drexel agreed last April to force him out and submit the firm to unprecedented government supervision as part of a settlement of civil charges brought by the Securities and Exchange Commission.

For the last 10 months, Drexel has had a new SEC-approved top management determined to remake the firm’s image into one of a model of integrity. In the free-wheeling trading room where Milken presided for 10 years, “compliance officers” stood by to challenge suspicious trades. More than a hundred lawyers, accountants and consultants prowled Drexel’s offices to ensure the rules were obeyed.

The firm’s top brass, led by Chief Executive Frederick H. Joseph, have continued to insist that Drexel could survive the damage to its image, the costs of the long legal fight and the loss of its most important employee. Drexel’s goal in recent months has been to diversify from its junk bond business to become a major player in other lines as well.

But no amount of optimism could overcome the firm’s problems. Since the junk market began to weaken in September, it has been clear that the firm is no longer able to raise as much money as it wants, as it had during the golden days of the mid-1980s.

Nor has Drexel’s junk bond operation been able to support the falling prices of bonds by lining up other buyers.

Key clients, whose loyalty to Milken once held them to the firm, have drifted to other junk bond operations. And, although Drexel cut its work force to 5,300 from a peak of 11,000, the company still has relatively high costs because of the unusually high salaries it offers.

The firm has suffered because some employees have quit and taken their investments in the firm with them. And it has the continuing costs of its legal defense, which came to $75 million last year.

But the weakening of the junk bond market that began in September represented the most crushing blow. The assets of Drexel’s parent company include a hefty share of junk bonds issued by clients whose fortunes recently have weakened, such as SCI Television, Gillett Holdings, Resorts International, Braniff and Integrated Resources.

Last year, Congress compounded Drexel’s troubles by passing the savings and loan bailout package. The law, signed by President Bush in August, requires thrifts to sell off their junk bond inventory within five years--and the sooner the better.

The thrifts, who hold about 8% of all speculative grade bonds, began selling just as the market began to seriously weaken. Their selling, of course, depressed prices further and reduced the liquidity of the bond markets.

“Automatically, by passing the law, Congress reduced the net worth of a lot of companies, and Drexel was one of them,” said a high-ranking Drexel executive, who asked to remain unidentified.

Bond Prices Fall

The average junk bond price dropped about 15% last year and has fallen an additional 5% so far this year. Those declines have in turn worsened Drexel’s problems by reducing Drexel’s ability to sell the junk bonds it holds and prompting a cut in the ratings of its short-term IOUs, called commercial paper.

Drexel was forced to mark down the value of its junk bond inventory sharply in December, and then again in January. Each time, lenders grew more worried.

Last week, the crisis worsened as Drexel could not find a way to refinance $200 million in commercial paper that was coming due and was forced to pay it off. On Monday, Drexel’s parent was able to repay $30 million in notes only by borrowing from its brokerage subsidiary.

And, with another $200 million coming due before the end of the month, Drexel executives were forced to announced Monday that they were looking for a merger partner or investor. On Wall Street’s trading floors, a number of investment houses immediately announced that they would not do business with Drexel, for fear they would not be repaid.

Monday night, Drexel executives huddled with their bankers in hopes of receiving a last-minute $400-million loan. The 11th-hour meetings were monitored by officials of the Federal Reserve and Securities and Exchange Commission, but not entirely for Drexel’s well-being.

“I don’t think there is a whole lot of concern for Drexel,” an SEC official said Tuesday. “I think the concern is for who they might take down with them.”

By Tuesday, it was clear that Drexel’s plea for new loans had not succeeded with the banks, which included Citibank and Manufacturers Hanover Trust. As junk bond prices fell further, Drexel announced that it had defaulted on $100 million in borrowings. Late Tuesday, it sought bankruptcy court protection for the parent company.

Firm’s Final Days

A high-ranking Drexel executive described the firm’s final days as “almost a perpetual motion machine . . . . You could see (the end) coming. You hoped something would stop it, but nothing did.”

Drexel’s failure recalled the fall of E. F. Hutton & Co., the once top-ranked brokerage house that lost all credibility on Wall Street in 1987 after it was prosecuted for a check-kiting scheme. Hutton was soon forced to merge with Shearson Lehman.

“In this business, you are what people perceive you to be,” said Samuel Hayes III, a professor at the Harvard Business School. “If there’s a crisis of confidence and people think you may not be good for your commitments, your business can stop dead.”

Around Drexel’s Beverly Hills office on Tuesday, employees were “numb . . . completely in shock,” one of Drexel’s top merger specialists said. “Yesterday, we really believed we would find short-term financing and a buyer.”

The investment banker said those who had stayed with the firm and kept some of their earnings in Drexel stock would now be penalized as the shares’ value dwindled. He said he had borrowed money to buy the stock, and now, facing unemployment, feared that his bank would call his loan.

Yet, despite his anger and despair, the banker described the proud feelings he had while working at Drexel. “We had an awesome ability to perform--we were hugely appreciated and respected, or hated,” he said, adding: “The next step is down.”

Staff writers Jane Applegate in Los Angeles and Douglas Frantz and Tom Redburn in Washington contributed to this story.