Hubris Is the Sin of Angels--It’s Not a Federal Crime : Economy: Ignore the hysteria--Michael Milken’s junk bonds are not behind the S&L; crisis, the level of corporate debt and all other fiscal evils.
Michael Milken’s 10-year prison sentence can best be understood in two parts--as possibly a two-year sentence for the felonies he was actually convicted of, and an eight-year sentence for a new federal offense called “being a symbol of greed.”
Milken’s official crimes were, basically, falsifying records to accommodate punters such as Ivan F. Boesky, who were cheating their own clients and the government. Milken apparently didn’t benefit personally from his offenses, but they are still depressingly sleazy, and punishment was clearly called for. But by any previous standard, including all the other “insider trading” cases, Milken’s sentence is wildly disproportionate to his crimes, many times more severe than those meted out to people literally bringing home suitcases full of money from their illicit activities.
Milken inspired as much envy and enmity as awe and admiration. He was the symbol of the go-go ‘80s, the “junk-bond” king, the financier of the company takeover revolution, the man who made $500 million a year terrorizing the old-boy network in the executive suites and “white shoe” investment banks. Now, with his junk-bond empire tottering, recession looming and U.S. financial institutions in serious trouble, Federal Judge Kimba M. Wood apparently decided she couldn’t ignore the drumbeats for a heavy sentence--confirming the old adage that judges read newspapers. It is as if all the regrets for the excesses of the ‘80s can somehow be exorcised by heaping the blame on Milken’s head.
America is now either in a recession or slipping into one. The recession might be short and mild, but some economists fear it may be quite bad. Shaky conditions in American lending institutions--savings and loans, banks and insurance companies--could cause a credit crunch that would push a weakening economy over the edge into a deep depression. Financial institutions are shaky because they lent too much and not too wisely. Since unwise credit extension is practically synonymous with junk bonds, Milken stands guilty of wrecking the economy--Q.E.D.
It is helpful, as always, to look at the data. And, devil-theorists and drumbeaters notwithstanding, the case against junk bonds is far from proved.
To begin with, junk bonds have almost nothing to do with the S&L; crisis. Savings and loans got into trouble by investing in real estate--the business they know best. Nationwide, only about 1% of S&L; assets are invested in junk bonds. Of the 3,000-odd S&Ls; in the country, only about 160 ever owned any junk bonds at all. Just 11 savings and loans, including a couple of the noisiest failures, owned 70% of all the junk bonds owned by the industry, and that was a total of only about $9 billion.
The asset problems of the commercial banking system, again, have almost nothing to do with junk bonds. Commercial banks plunged into the real-estate market themselves about 1985, just as real-estate returns were dropping because of overbuilding. In the last several years, about 70% of all commercial loans made by banks have been for real estate. With office vacancy rates nationwide hovering around 20%, and retail space grossly overbuilt, commercial real-estate delinquencies are soaring. Banks are responding by curtailing lending to all their customers, including sound businesses. That is a worrisome development, but it has nothing to do with Milken or junk bonds.
But what about American businesses? Aren’t they bogged down with debt because of junk bonds? The answer is, not really. Total corporate debt service is about 20% of cash flows, up from 16% in 1980. Corporate debt dropped sharply in the 1970s, when interest rates shot into the double digits--it was just too expensive to borrow. The total effect of the “debt mania” of the 1980s has been to bring corporate debt ratios back to about the level that prevailed in the mid-1970s.
More important, research at Morgan Stanley shows that almost all debt growth for several years has been in so-called non-cyclical industries--like services and food and tobacco manufacturing--industries whose cash flows are relatively stable during recessions. Cyclical industries, like heavy manufacturing, have been steadily reducing their debt and have relatively low debt-to-cash-flow ratios. Some companies, of course, such as Robert Campeau’s department stores, have stumbled badly from taking on too much debt, and others will fail in the future, but it is simply not true that corporate America as a whole is wildly overleveraged.
Were junk bonds a rip-off of investors? Again, not really. Over the long term, junk bonds have underperformed stocks by a couple of percentage points. Total returns, including all defaults, have been about the same as for higher-grade bonds. Returns, that is, are considerably lower than Milken and his legions of loyalists hoped, but not out of line with those of other financial instruments. The boring point is that, overall, the markets did a respectable job in pricing junk bonds.
Finally, only a small percentage of junk bonds--probably well under 15%--were used to finance hostile takeovers. The vast majority were issued simply to finance corporate growth. Company treasurers chose junk bonds, not because of any magical spells weaved by Milken, but simply because they offered the best-priced credit in town.
At the same time, the benefits of junk bonds have been real. At the beginning of the 1980s, the stock market was grossly underpriced--the Dow-Jones average had not moved for almost 15 years. Banks generally refused to make long-term loans to businesses, and the bond market was open only to a chosen few. That was the credit gap that Milken filled with his junk bonds--and it was Milken’s “junk” that put companies like MCI Communications Corp. and Turner Broadcasting System Inc. on the path to growth.
The early waves of hostile takeovers, in addition, were a necessary corrective to slothful and pampered big-company executives. The chairman of Unocal Corp., typically, had a grand piano in his corporate jet. Takeovers and the threat of takeovers pared corporate staffs, scrapped the palatial offices and tied executive compensation more closely to performance.
A good idea became gross excess by 1986, as legions of pin-striped business-school graduates armed with personal computers turned corporate finance into a high-stakes casino. Milken, by all accounts, played the casino with both arrogance and abandon. Such market excesses have a way of flaming out on their own, and this one did: bringing down lots of overpaid yuppies, Milken, his employer, Drexel Burnham Lambert Inc. and, at least temporarily, the junk bond empire he created.
The late excesses of the junk bond market are a conventional story of hubris bringing down the mighty. But hubris has never, until now, been a federal crime.
