high yield (junk) bonds (ii)

what went wrong

1.  Junk bonds began to be used as a substitute for bank financing–but to a large degree by takeover specialists targeting either mediocre industrial companies or consumer staples firms of any stripe.  In both cases, more efficient management would boost cash flow enough to service the massive debt incurred in the acquisition.  Fear of the required debt service would act as a powerful motivator toward greater profitability.

Arguably, the substantial change of control among underperforming companies during the 1980s that junk bonds made possible laid the groundwork for the industrial renaissance the US experienced in the early 1990s.

Nothing wrong with that.

But in some cases, rapacious acquirers went further.  They targeted well-funded employee pension plans, replacing a conservative investment menu with a diet of exclusively junk bonds.  Others, particularly in the natural resources area, forced the acquired firms to operate for maximum near-term cash generation.  Timber companies, for example, harvested 3x-4x the usual number of trees every twelve months–leaving no time for replacement trees to grow.  As a result, companies went out of business; employees found their pension plans, after the junk bond collapse, unable to meet obligations.  The acquirers just walked away with the cash they’d drained from the firms.

Drexel also pleaded no contest to SEC charges that it illegally supported acquirers through stock manipulation and by helping them avoid 13-D reporting requirements.

2.  By the end of 1986–maybe a little later–Drexel and Milken had done all the junk bond/leveraged buyout deals in the US that made any economic sense.  What to do then  …close up shop or continue to do junk bond deals, even though they made no sense and might ultimately fail.  Drexel/Milken chose curtain #2.

By early 1989, the consequences were becoming evident.  Junk bond default rates were rising sharply, depressing junk bond prices.  To my mind, October 13th of that year marked a tipping point.  That’s when the media reported the failure of a proposed $6.75 billion leveraged buyout of United Airlines.  This was the first big junk bond deal not to get done.  Psychology changed decisively for the worse.

That’s when retail investors, who had been sold junk bonds on the idea that they had all the return potential of stocks plus all the safety of bonds, found out their dark side   ..if nothing else, how illiquid they are.  Junk bonds fell, on average, by about 30% in the following months.  Some investors also found out, to their sorrow, that up until that time their mutual funds had been pricing their holdings at what proved to be unrealistically high levels.

3.  We can all understand, though not condone, why Drexel/Milken would want to continue to sell dud junk bonds.  It’s what they did.  But why would any professional buy them (I know I characterized bond fund managers as not being among the best and brightest in my Friday post, but you;;d think they’d catch on eventually)?

The Federal government had an answer.  It was that Milken and Drexel bribed prominent junk bond fund managers to look the other way and take part in bad deals for their clients.  The Wall Street Journal had an in-depth investigative series on this issue in 1990.  I’ve been unable to find in the the WSJ online archives, however.

The government was unable to prove its case.  A New York Times article and one from the LA Times that describe the charges are the best documentation I can find.

Personally, it feels to me that the government was right, but that it had no way of getting any of the small number of people who would have been involved in a scheme like this to testify against themselves.

still, a revolutionary idea

By the early 1990s, the junk bond market had revived, though on a firmer footing as a result of the government action.

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