Junk Bonds: A Drexel Burnham Lambert Legacy

 

Ares is an investment firm which has $37 billion of funds invested in private equity, high-yield bonds and other corporate debt. Canyon Partners, an alternative-investment firm that manages $18 billion. Imperial Capital, is a boutique investment bank.

So what do these investment firms have in common?

All three firms can trace their origins to Drexel Burnham Lambert, an investment bank that collapsed into bankruptcy in 1990, fatally wounded by an insider-trading scandal.

 

Ares is an investment firm which has $37 billion of funds invested in private equity, high-yield bonds and other corporate debt. Canyon Partners, an alternative-investment firm that manages $18 billion. Imperial Capital, is a boutique investment bank.

So what do these investment firms have in common?

All three firms can trace their origins to Drexel Burnham Lambert, an investment bank that collapsed into bankruptcy in 1990, fatally wounded by an insider-trading scandal.

In a story by The Economist:

Michael Milken, Drexel’s most talented and best-paid financier,was sentenced to ten years in prison after pleading guilty to six counts of securities fraud. His sentence was later commuted and he was released after serving 22 months.

He was also forced to pay much of the huge bonuses he earned at Drexel in fines and settlements.

For much of the 1980s Drexel was the hottest firm in investment banking, thanks to its dominance of the market for high-yield corporate bonds, or junk bonds, of which Mr Milken was king.  Drexel used its muscle in high-yield bond trading, which Mr Milken had built up in the 1970s, to push into other areas of investment banking such as mergers and acquisitions and underwriting.

By 1986 Drexel, which in its long history had not previously threatened to join the financial elite, was Wall Street’s most profitable firm.

But Drexel slumped under the weight of legal battles and the $650m fine it agreed on with the American government to settle an investigation of alleged securities fraud. When Mr Milken was forced out at the end of 1988, the firm lost its biggest source of revenue.

However Drexel has left three enduring legacies:

• a junk-bond market that has grown at least sevenfold since the firm’s demise;
• the firms and industries, from gambling to cable television, that owed their rapid expansion to the investment bank’s junk bonds;
• and the influence of the “Drexel diaspora”, the young MBA graduates who worked in the 1980s under Mr Milken, on the finance industry in Los Angeles and elsewhere.

In 1990 the outstanding stock of junk bonds  was about $150 billion. Now the total is over $1 trillion. 

Like all other credit, the junk-bond market was badly damaged during the recession. But it has bounced back, just as it did in the early 1990s and early 2000s. This year new issuance has surged: with around $200 billion raised in America already, the total for 2010 is sure to be a record.

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The Reopening of the Junk Bond Market

The reopening of the junk-bond market has also afforded medium-sized firms access to credit again. The businesses that have tapped the market are a cross-section of corporate America: airlines, clothing manufacturers and retailers, health-care providers, drug firms, restaurant chains, oil-exploration firms and semiconductor manufacturers.

The market’s revival has been helped by fewer defaults on high-yield bonds. The default rate on junk bonds stayed above 8% for 14 months in 2009-10, according to CreditSights, a research firm. That compares with 20 months in the previous two recessions.

Junk bonds, once despised, are now mainstream. [quote]“Milken and Drexel took high-yield bonds from a cottage industry to one of the cornerstones of the financial industry,” says Howard Marks, one of Mr Milken’s early customers and now chairman of Oaktree, a Los Angeles firm that manages around $75 billion in funds, much of it in high-yield bonds and related investments.[/quote]

Junk-bond issues also offered a new way for many small but growing firms, which had been starved of capital by stodgy commercial banks and sniffy investment banks, to finance themselves. “The bread-and-butter business was catering to guys like Craig McCaw or Steve Wynn or John Malone or Ted Turner,” says Mr Messina.

“None of the firms we financed were pure start-ups,” says Ken Moelis, who worked in Drexel’s corporate-finance team in Los Angeles and who started Moelis & Co, an investment bank, in 2007. Rather Drexel found money for small firms which had enough cashflow to meet interest payments to grow bigger.

Some industries were not well-suited for debt finance: the mobile-phone business did not generate much upfront cash and cable-TV firms had big start-up costs before subscription revenue flowed. One solution was to “over-fund” firms, to raise more capital than they needed so that they could make their initial interest payments. Another trick was to use zero-coupon bonds, on which interest payments are deferred until the principal comes due.

Not all Drexel’s corporate customers were thrilled with the price extracted for this service. Some felt that Drexel cut too good a deal for itself and for Mr Milken’s loyal junk-bond investors. Drexel’s fees on junk issues were 3-4%; less than 1% was typical for investment-grade bonds. Drexel’s bankers often demanded equity warrants for themselves and their buyers to sweeten the deal.

The desire to maintain Mr Milken’s hold on high-yield marketmaking may explain why Drexel’s bankers were loth to share deals with other investment banks. If competitors issued lots of junk bonds, that would undermine Mr Milken’s sense of who held what bonds and make control of the market harder. The firm gloried in thwarting rivals and in stealing business from under the noses of a Wall Street “elite” it viewed as snooty and indolent.

The firm had plenty of enemies who welcomed its downfall.

Yet unloved as it was, Drexel changed the face of corporate finance and of Wall Street. [quote]“These days with firms, such as Google and Apple, everyone takes dynamism for granted,” says Mr Moelis. “But Mike Milken started out in the 1970s when capitalism was struggling. In those days, there was very little innovation. Along comes Drexel, a firm with a visionary purpose, and suddenly you could get capital.” [/quote]Before 1977, when new junk-bond issues took off, says Mr Marks, non-investment-grade bonds were thought of as “bad” investments, at any price.

Nowadays a bad credit can be considered a prudent investment if it is available at the right price.

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The Drexel Burnham Lambert Legacy

With Mr Milken at its centre, Drexel’s Beverly Hills operation became a magnet for the best business-school graduates in the late 1980s. That cohort of financiers is still active.

Some Drexel alumni are found today in New York. Rich Handler, a junk-bond trader in Drexel’s Los Angeles office, moved with 35 or so colleagues to Jefferies, a local investment bank; they took their knowledge of high-yield bonds and investors with them. Mr Handler is now Jefferies’s chief executive but the bank has long outgrown its Los Angeles and high-yield roots. In 1990 it had 400 employees. It now has around 3,000, of whom 200 are based in Los Angeles: the headquarters these days are in New York.

Another alumnus is Leon Black, founder of Apollo, a corporate-credit firm with $55 billion under management. Apollo is based in New York, where Mr Black also spent his Drexel years.

Drexel’s financiers were not altruists; they were dealmakers.

But in their search for profit they also brought about a democratisation of credit. Firms that previously had to rely on conservative banks or expensive equity were given access to fixed-interest funds in capital markets by the investors that Mr Milken and his junk-bond traders had cultivated.

This was a boon to the American economy: limiting capital to investment-grade firms limits economic progress. If a firm can pay the rate for its risk, it should get the money it needs.