Junk Bonds: a Financial Revolution That Failed : Wall Street: The economic highfliers of the 1980s’ growing economy are a peril in the downturn of the ‘90s.
In his meteoric career, Michael Milken achieved something rare in history: He helped shape the economic times in which he lived, times in which U.S. society piled on debt as never before.
Yet the famed financier--sentenced Wednesday to 10 years in jail for securities fraud--did not market his high-risk, high-yield junk bonds in a vacuum. Powerful forces led to the fast-money excesses of the 1980s, and different pressures now bear down on corporate executives and consumers, as debt becomes dangerous in a frail economy.
“The main difference is that a good deal of optimism has evaporated about the future of the American economy,” said Robert M. Solow, a Nobel laureate in economics at the Massachusetts Institute of Technology.
The glee that permeated the financial world in Milken’s heyday of the 1980s has turned to gloom in the 1990s. Big investment firms have imposed layoffs. A looming recession spreads fear and threatens companies that used Milken-style financing. The junk bond market, an extraordinary innovation for firms in need of cash, is comatose.
From today’s sober perspective, it is hard to imagine the fateful overlap of political and economic forces that fueled the explosion of money-making by Milken and other financial operators in the 1980s.
“There hasn’t ever been anything like it,” Paul R. Krugman, an MIT economist, observed. Pundits have dubbed the 1980s the Age of Greed, but the truth is more complex. Krugman added: “There wasn’t a sudden decline in the moral fiber of the United States. There was an explosion of opportunity for people who were fast on their feet to make money fast--maybe by cutting a few corners.”
One requirement for fast money was a fast-growing economy. Starting in 1982, the nation charged out of its last recession and into a decade of heady growth. A second requirement was a strategy, a way for investors to gain an edge. In this respect, junk bonds played a key role, opening up a new source of financing for takeovers.
The effect was revolutionary: An older generation of corporate executives had taken pride in keeping their companies out of debt. But, in the 1980s, debt became smart. Advocates pointed out that interest payments on debt were tax deductible, indirectly making the government a partner in the strategy.
A whole new generation of investors and executives jumped on board: “All of a sudden, they caught on, and they caught on with a vengeance,” said Dennis E. Logue, a financial economist at the Amos Tuck School of Business Administration at Dartmouth College.
As the decade went on, much of corporate America was hit with takeover threats. Billion-dollar deals, once unheard of, became increasingly common. The junk bond market grew tenfold, peaking at $40.8 billion in 1986, according to IDD Information Services in New York.
The regulatory environment, meanwhile, was supportive. Officials of the Ronald Reagan White House believed in leaving business alone, a view that included tolerance of mergers and takeovers, the use of junk bonds and other creative ways to finance deals.
The White House message seemed to be: Debt is OK. The federal budget deficit ballooned from $73 billion a year at the beginning of the decade to over $200 billion a year in the mid-1980s, as spending went up and tax rates went down. Overall, the amount of debt owed by the federal government more than doubled in the decade to more than $2.6 trillion, according to the Commerce Department.
“Reagan issued the biggest junk bond of all,” Stephen S. Cohen, co-director of UC Berkeley’s Roundtable on the International Economy, argued.
In this climate, innovative financiers--some inspired by Milken, no doubt--trotted out an array of new money-raising options with such exotic names as bridge loans and mezzanine financing.
Junk bonds were a genuine “financial innovation,” said James Van Horne, a finance professor at Stanford University. But, as the 1980s wore on, and the economy continued to churn forward, they were increasingly used for unwise deals that enriched a cadre of investment bankers, lawyers and corporate executives.
By 1986, “virtually any dumb deal could get done,” Van Horne said.
Ordinary consumers also were taking a more relaxed approach to balancing their budgets. Like previous generations, baby boomers, as they reached adulthood, sought to buy homes and fill them with furniture, appliances and other products for their youthful families.
Sales of luxury products boomed, but so did less costly household items on the shelves of Wal-Mart and other stores.
By the end of the decade, consumer installment credit--reflecting credit cards, store loans and other borrowing--more than doubled, exceeding $700 billion, according to the Commerce Department.
What was going on? In part, people were giving a vote of confidence to continued economic growth. An index of consumer confidence prepared by the University of Michigan soared by more than 50% from the depths of the last recession to the boom year of 1984 and remained high through the rest of the decade.
“It was a sign of confidence and optimism in the future--and also a willingness to take risk,” Solow said of the public’s willingness to go into hock.
And, in part, members of the public had learned a lesson in speculation from the inflationary 1970s. In the 1970s, people who stretched their pocketbooks to buy costly houses usually came out well, because inflation raised the value of their investment while in effect cutting their debt, Krugman said. That was because their loan payments stayed constant as their incomes grew.
“In effect, the explosion of personal debt in the ‘80s was a delayed response to what the ‘70s taught people,” he said.
There’s a catch, however. Such debt or leverage works best when the economy is rising. Payments remain tolerable as long as income holds up. But, when profits and incomes are squeezed, the debt payments can be ruinous.
“Everybody decided to kite the game--and it doesn’t work,” said Berkeley’s Cohen. “It only works at first.”
The first real chill rippled through the junk bond market in 1986, with the emergence of an insider trading scandal that focused on speculator Ivan F. Boesky but soon led to Milken’s firm, Drexel Burnham Lambert. By 1987, junk bond sales were on the decline.
That year, interest rates rose sharply and fears spread that the U.S. economy was due for a recession. Then, in October, the stock market crashed. Junk bond sales fell by $5 billion, the first annual decline for the market since 1981.
Since then, the market has plunged as a growing number of debt-saddled companies have suffered distress, including Southland Corp., owner of 7-Eleven stores, the retail empire of Campeau Corp., Western Union and Revco.
In 1989, the number of merger and acquisition deals dropped for the first time in a decade--a decline that has continued this year at a 16.6% rate over 1989, according to IDD Information Services.
Overall corporate debt, a much larger figure than junk bonds, has been growing at a much slower rate for two years, the Federal Reserve reports.
Debt financing “is a wonderful idea on the upside,” said Robert Dunn Jr., an economics professor at George Washington University. “As long as we had this enormous upturn in the economy, leverage made a lot of sense. What we’re seeing now is a downturn, which is going to make that leverage seem vicious.”
Recently, concerns have intensified about the troubled financial system--including savings and loans that relied on junk bonds and claims by business that credit is hard to come by. Commercial real estate and construction are in trouble, layoffs are on the increase and the art of rescuing troubled companies has become one of the financial world’s few growth areas.
Consumer confidence, meanwhile, has fallen to its lowest levels in several years.
It all makes for a drastically different mood from the jolly 1980s.
“Is some bankruptcy lawyer the toast of the town?” asked A. Gary Shilling, a New York economist. “Today he’s in the driver’s seat.”
The atmosphere in executive suites is changing as well.
“I think people are going to say, ‘Hey--I want a strong balance sheet,’ ” said Shilling, who has dubbed the 1980s “the decade of greed, glitz and growth.”
Consumers also face pressure to spend cautiously, although the statistical evidence is not yet clear. If history is a guide, the plunge in consumer confidence might lead to greater savings in the coming months. More basically, the aging baby boomers will be under pressure to save more for things like their children’s college educations in the coming years.
Are such shifts temporary? Maybe not: A less freewheeling attitude toward risky borrowing may be rooted in long-term causes, said MIT’s Solow. “It reflects the fact that the United States is becoming just one among several modern economies and not a leader,” he said.
Milken’s departure parallels the shift in mood, a shift many may approve of. Yet, the 1980s were a time of robust economic expansion and job creation. While Milken’s economic legacy includes a list of wounded corporations, it includes others that profited handsomely from his techniques.
For many companies, his imprisonment is not happy news. Said Krugman: “There’s no reason to think that a system without Michael Milken is all that good either.”
Times librarian Tom Lutgen contributed to this story.
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A DECADE OF DEBT
In the 1980s, the high-yield junk bond market pioneered by Michael Milken rose to a stunning peak before collapsing. Personal savings, meanwhile, flagged during the decade. Junk Bonds (Public junk bond issues in billions of dollars) 1980: 4.3 1981: 3.4 1982: 4.6 1983: 11.4 1984: 15.8 1985: 19.3 1986: 40.8 1987: 35.8 1988: 30.1 1989: 27.8 1990: 2.4 Personal Savings Rate (Savings as a percentage of disposable income) 1980: 7.1 1981: 7.5 1982: 6.8 1983: 5.4 1984: 6.1 1985: 4.4 1986: 4.1 1987: 3.2 1988: 4.2 1989: 4.6 And throughout the U.S. economy, there was an explosion of debt at the government, corporate and consumer level. Federal Debt (Gross debt outstanding in billions of dollars) 1980: 914.3 1981: 1,003.9 1982: 1,147.0 1983: 1,381.9 1984: 1,576.7 1985: 1,827.5 1986: 2,130.0 1987: 2,355.2 1988: 2,614.6 1989: 2,881.1 Business Debt (Domestic corporate debt, in billions of dollars) 1980: 828.8 1981: 926.6 1982: 970.0 1983: 1,049.4 1984: 1,223.9 1985: 1,362.4 1986: 1,570.6 1987: 1,724.6 1988: 1,899.5 1989: 2,064.8 Household Debt (Consumer installment credit, in billions of dollars)1980: 302.1 1981: 315.5 1982: 330.4 1983: 374.5 1984: 449.5 1985: 526.5 1986: 581.5 1987: 618.2 1988: 671.4 1989: 674.7 Source: Federal Reserve, except junk bond chart (IDD Information Services).