A Case Study in the New Financial Physics
Drexel Burnham Lambert’s slow dissolve in the acid bath of liquidation provides more than just a juicy 1980s allegory of greed, hubris and excess. It offers crucial insights into the underlying challenges of managing innovation and how the most successful innovations can lead to the most spectacular disasters.
As sleazy and felonious as many people argue that the investment bank and its junk bond guru, Michael Milken, were, the practical reality was that Drexel, for a time, was Wall Street’s most brilliant innovator--as entrepreneurially influential as a Sun Microsystems in computers or a Genentech in biotechnology. As former Undersecretary of the Treasury George Gould puts it: “The rise of Drexel was a reshuffling of the competitive deck in Wall Street and the money-raising function.”
Milken and Drexel Chief Executive Frederick H. Joseph took Joseph Schumpeter’s definition of innovation quite literally--a form of “creative destruction.” With its swaggering arrogance, its “highly confident” funding letters, Milken’s X-shaped trading desk and its Byzantine networks of bond buyers and sellers, Drexel’s junk bond machine could instantaneously raise billions in capital and shove previously impenetrable Fortune 500 behemoths “in play.” The junk bond market--cresting at more than $200 billion--completely reshaped the ecology of finance.
“Junk was the initial spark that lit the fire under Drexel,” says Harvard Business School professor Samuel Hayes III. “It was the kernel of value at Drexel. Milken basically ran with that one idea. It’s like the Japanese taking the transistor and building a whole slew of electronics products out of it.”
Junk--excuse me, “high-yield”--bonds were the silicon chips of finance, and Drexel wanted to be IBM, Apple and Microsoft all rolled into one. For the right fee, Drexel would cheerfully customize securities for its clients much as an Intel or Motorola will help customize computer chips for its valued clients. Drexel was both symbol and substance of a new era of financial innovation--innovations that completely transformed capital markets all over the world.
“There’s been a revolution in the technology of finance of which Drexel was only a small part,” asserts Joseph Grundfest, a recently retired commissioner at the Securities and Exchange Commission who now teaches at Stanford Law School. Emergent telecommunications networks, powerful computers and new quantitative theories of finance all reshaped the ways capital was created, invested, grown and destroyed.
For example, says Grundfest, many investment analysts believe that “options are the quarks of finance; they’re the building blocks of all other financial instruments.” The new financial physics helped spawn innovations like program trading and portfolio insurance, which are controversial in their own right.
These revolutions in the science and technology of finance completely overturned more traditional notions of market value, and that completely redefined traditional relationships between buyers, sellers and intermediaries.
Indeed, Gould asserts that “junk bonds spawned the bridge loan”--the practice of investment banks actually lending money to their clients to complete a deal. Traditionally, investment bankers had been intermediaries and agents for their clients. The new generation of financial innovations like junk bonds and bridge loans helped turn investment bankers from agents into principals. That, Gould and Hayes agree, set the stage for a host of conflicts of interest ranging from excessive fees to insider trading.
What’s more, many of these innovations were as much driven to generate profits for the investment banking house as effectively serve the client base. The result is a bunch of investment bankers behaving like the Cape Dogs of Finance: growling, snarling and gnawing on the bones of offerings and acquisitions until every scrap of revenue has been scarfed down and digested into fees.
This irresistible lust for revenues not only spawned conflicts of interest, it drove normally rational investment bankers--particularly those at Drexel--to push their innovations above and beyond the point of diminishing returns. These bankers were more interested in making money than making markets.
Gould--who as a co-founder of Donaldson, Lufkin & Jenrette, is from a kinder, gentler albeit less innovative era of investment banking--points out that junk, payment-in-kind and zero coupon bonds are “perfectly admirable innovations” that were turned into financial freaks by bankers more loyal to their bonuses than to their clients. “The line between innovation and foolhardiness is probably a thin one,” he ruefully notes. Nothing exceeds like excess.
Other bankers believe that these “innovations” created more harm than benefit. “Financial innovation is not worth a damn if it fails to reduce the cost of capital,” says Peter Rona, president of IBJ/Schroder, the U.S. subsidiary of the Industrial Bank of Japan. “Drexel and other innovators managed to double America’s cost of capital over the last decade; that’s why Drexel failed.” Which puts American companies at a competitive disadvantage to their Japanese and European counterparts.
Like a Silicon Valley firm, Drexel became a little too enamored of its own technology. “Drexel began to pay more attention to the issuers of its securities--and their fees--than to the insurance companies and institutions that bought them,” says George Anders, who is completing a book on leveraged buyout moguls Kohlberg Kravis Roberts & Co. “They were producing securities that were out of touch with what the world needed.”
Combine that with Washington’s ruling last year compelling key financial institutions to divest their junk bond holdings and you have a financial innovation that becomes the debt market’s equivalent of an albatross.
As superb an innovation as the junk bond was, the combination of conflict of interest, insider trading, fee-driven excess and customer insensitivity proved absolutely lethal. Drexel’s demise should be a warning to every American financial institution that is counting on innovation to give them the edge against their better-heeled Japanese and European competition.
“We are in an era where innovation is going to continue at a remarkable pace,” insists Grundfest of Stanford and the SEC, but the challenge is to profitably manage that innovation process. Drexel is no doubt doomed to become a Harvard Business School case study in how to build and lose a multibillion-dollar financial franchise based on innovation.
For all those budding young MBAs thinking of finance as a career, the lesson of that case study can be found in this paraphrase of an old Wall Street epigram: Bulls can make money, bears can make money, but pigs, no matter how clever and innovative, still get slaughtered.
