The Predators’ Ball (4 page)

By the early seventies, Wall Street was littered with dead and dying firms. The recession of those years crippled the securities markets, and spiraling inflation then delivered the death blow to many smaller securities firms, which had limited resources. Between 1968 and 1975 over 150 firms were absorbed or closed. And by 1972, Drexel Firestone was in critical condition.

F
OR
B
URNHAM AND
C
OMPANY
the financial crisis meant opportunity. The firm had been founded in 1935 by I. W. (“Tubby”) Burnham II, the son of a physician and grandson of the founder of I. W. Harper Gin, a distillery. Tubby Burnham's grandfather wanted his offspring to work for a living and so gave them no money once
they were grown; when Tubby Burnham asked him for $100,000 to start a brokerage firm in 1935, his grandfather replied that he would loan him the money—but it was only a loan. Indeed, when he died he left his entire estate to a wildlife refuge and park, the Bernheim Forests, in Kentucky, and he stipulated in his will that the $100,000 with which his grandson had started his brokerage business should be repaid. It was.

By 1971, Burnham and Company was a small brokerage house, with about forty-two partners and capital of $40 million. It had a good research department, and its international equity (stock) arbitrage and retail businesses were decent. While it was undistinguished, the firm had always been profitable. Burnham husbanded its capital strictly.

At that time Wall Street adhered to strict procedural rules designed to perpetuate the establishment, and none was more inviolate than “bracketing,” which refers to the order in which underwriters are listed in tombstone ads announcing securities offerings. The top spot was reserved for the special-bracket firms, then came the major bracket, and then the submajor and regional brackets. The higher the bracket, the bigger the underwriter's role in the offering—so it was not merely a matter of status, but of dollars.

In 1971, in the special-bracket elite were Dillon, Read and Company; the First Boston Corporation; Kuhn, Loeb and Company; Merrill Lynch, Pierce, Fenner and Smith; Morgan Stanley and Company; and Salomon Brothers. After that came about seventeen major-bracket firms, and then twenty-three submajors. Burnham and Company, a submajor, decided that the only way for the firm to establish an investment-banking presence was to acquire a major-bracket franchise.

That was what Drexel Firestone had. In addition, it had close to $1 billion under management, some investment-banking clients and cachet, and about $10 million of Firestone money.

Burnham paid visits to Gustave Levy, who had built Goldman, Sachs, and Robert Baldwin, the chairman of Morgan Stanley, which was a cousin to Drexel Firestone. Both men said they would support a merged Burnham and Company and Drexel as a major-bracket participant. The Drexel name, however, had to come first. As one former Drexel director remarked, “It was a classic case of the last gasp of the old guard—insisting on getting first billing.”

“If I had called it Burnham, Drexel, we'd still be a submajor,”
Burnham confirmed. “I remember I told my mother about it, and she said, ‘How can you? The firm has been Burnham since 1935.' I said, ‘Mother, I want this. It will be worth millions to us.' ”

It would, of course, be worth not millions but billions, and would raise the little Burnham and Company from the nether regions of Wall Street to its zenith of money and power less than fifteen years later—before it all threatened to come undone. But in 1973 Burnham had no idea that the value of Drexel Firestone resided not in its major-bracket franchise but in one rather odd, intense figure segregated off in a corner of the trading floor. The juxtaposition of the names was the most costly part of the transaction for Burnham. Beyond that, he paid book value (the capital its partners had invested in it), mainly with subordinated debentures.

Now Drexel, home to the kind of white Anglo-Saxon Protestants who took their genealogy seriously, not only had a Jewish trader peddling schlock bonds but had been taken over by a Jewish firm. Although Burnham and most of the top executives of the firm were Jews, Robert Linton, who became the firm's chairman in the early eighties and who changed his name from Lichtenstein, demurred slightly at this characterization of Burnham and Company. “It was not a Jewish firm in the sense of an Ira Haupt or a Newburger [other brokerage firms],” Linton declared. “None of the top people practiced their religion. I mean, we weren't lighting candles. My family came to this country in 1770.”

Burnham was curious about whether there were
any
Jews at venerable Drexel Firestone, and he asked its president, Archibald Albright, who told him that there were three or four (out of 250). “He said, ‘They're all bright, and one of them is brilliant. But I think he's fed up with Drexel, and he may go back to Wharton to teach. If you want to keep him, talk to him.' ” One of Burnham's advisers recalls that Albright told Burnham he would have to give this young man a substantial piece of the action to keep him.

Burnham called Milken that day and asked him why he wanted to leave. “He said, ‘They won't give me capital.' He had a five-hundred-thousand-dollar position overnight.”

Burnham gave Milken a position of $2 million, which was a large amount of trading capital in 1973. That year Milken made $2 million for the firm, a return of 100 percent. The next year Burnham doubled the capital. According to one Drexel executive, Milken received 35 percent of his small group's trading profits as a bonus,
to be distributed as he saw fit. This fixed percentage had no cap, and it would remain unchanged over the next fourteen years.

Milken told his boss, Edwin Kantor, who was in charge of all fixed-income trading, that he wanted to create an autonomous unit, with its own sales force, its own traders and its own research people: the high-yield- and convertible-bond department. Selling these low-rated bonds, he explained, was more like selling stocks than it was like selling high-grade bonds. If a bond was rated triple A by a rating agency, institutions bought them based on that rating—not on the salesman's pitch about the company. But to convince an investor to buy a bond with a C rating you had to tell the company's story. You had to know the company's management, its product, its balance sheet, its earnings trend and cash flow—just as you would in trying to sell the stock of a little-known company. You had to convince the investor that the rating agency had been too hidebound, or too cursory, or too blind to see that there was ore to be mined in this foundering company's bonds. And, finally, you had to persuade the investor that an analysis of the assets showed that if the worst happened and the company went into default, there was a safety net of value below which the bonds could not fall.

As one competitor of Milken's commented later, “Mike was the first to come up with the idea that he wanted a specialist—a salesman who lives and dies in this one specialty.”

At another firm, Milken's desire for such an autonomous, self-contained unit might have incited turf battles and been too disruptive to be allowed. But Drexel Burnham was so embryonic, its territory so unclaimed, that Milken got what he wanted. And while it was true that these bonds were a specialty product that could benefit from a specialist's expertise, it was also true that having his own unit would satisfy Milken's powerful desires for secrecy and for control. These bonds, moreover, which in the main did not trade on any public exchange with electronic trading screens flashing prices, but in private transactions, trader to trader, were his perfect medium.

Milken would in effect create his own firm within the firm of Drexel Burnham, one which its members would refer to simply as “the Department.” He laid the groundwork for that autonomy in 1973. From the very beginning, Milken made it mandatory that a certain portion of his people's profits were reinvested in trading
accounts which he ran. It was a system of forced savings, in which these salesmen and traders were able to watch—from a distance—their wealth accumulate. With the kind of return Milken got, no one really had much to complain about. On the other hand, if one decided to leave him on less than amicable terms, as one trader would, there might be difficulty in getting one's money out. It was a powerful disincentive to taking any secrets from Milken's operation to a rival firm.

O
VER THE NEXT
several years, Milken began to cultivate a group of increasingly satisfied customers. There were a handful of institutions, like Massachusetts Mutual, and discount-bond mutual funds, including Keystone B4, Lord Abbott Bond Debenture, and National Bond Fund. These tended to play the market according to Hickman, going for the yield over time in large, diversified portfolios.

There was also David Solomon, of First Investors Fund for Income, known as FIFI. FIFI was converting its high-grade-bond fund (with bonds that had suffered in the recession) to a high-yield fund in 1973, at about the time that Solomon was employed to manage it. According to former members of Milken's group, Milken soon took Solomon in hand, and the returns on Solomon's portfolio showed the effect. In 1973, the return on this fund's portfolio was minus 14.02 percent; by 1975, it was plus 39
¹
/
₈
percent, according to Lipper Analytical Services. In 1975 and 1976, it was the number-one performing bond fund in the United States. Almost overnight, Solomon was transformed into a seeming portfolio wizard. But, especially in the first few years when Solomon was a neophyte in this field, Drexel employees claimed it was Milken who pulled Solomon's strings.

While portfolio managers played for the yield, Milken always played—for himself, his colleagues, the firm and a growing body of wealthy individuals—for the upside. In the seventies, in near-bankruptcies and also bankruptcies (where only a portion of the bond's value is lost), that upside could be enormous. As Hickman had noted, “Corporate bonds were typically undervalued in the market at or near the date of default. As a result, investors selling at that time suffered large losses, while those purchasing obtained correspondingly large gains.”

This was not an original concept. The renowned trader Salim “Cy” Lewis of Bear, Stearns had made a fortune buying the bonds
of bankrupt railroads in the forties. Milken would follow in Lewis' footsteps by buying Penn Central bonds, on which he and his clients made killings. Milken, however, bought not just in one industry as Lewis had but across the whole landscape of troubled companies; as default was thought to be near and bondholders panicked, Milken was there to pick up the distress-sale merchandise, often at ten and twenty and thirty cents on the dollar.

Milken was also buying the bonds of the near-bankrupt real-estate investment trusts, known as REITs. Many of these trusts had issued investment-grade public debt which had now sunk as low as ten cents on the dollar. The REITs were much like mutual funds except that instead of stocks their portfolios consisted of real estate or financial instruments associated with realty, such as mortgages or leases. These trusts had grown out of the 1960 legislation that provided effective exemption from the corporate income tax for qualified trusts—the thought of Congress having been that this would provide the small investor with an opportunity to have an ownership interest in real estate. The REITs grew gradually through the sixties, and then they skyrocketed. In 1968 their total assets were $1 billion; in 1969, $2 billion; in 1974, $20.5 billion.

That year, the party ended. When the recession hit, the growth and earnings at many REITs slowed dramatically. However, the debacle was not all-inclusive; some REITs continued to perform well through the midseventies. Some faltered but came back. Milken analyzed them and chose those that he thought would either make it or have a liquidation value of, say, seventy-five cents on the dollar—so they were a bargain at twenty cents. “What we did with the REITs was to create a kind of unit trust for certain customers,” Kantor said. “We would say, ‘Take ten or fifteen of these—if just two of them make it, you'll do great.' And they did.”

Not all of Milken's gambles received Tubby Burnham's blessing. Burnham had survived and prospered by being conservative with his capital, and some of the paper Milken bought made him nervous. When he could, Kantor made himself the buffer between Burnham and Milken. “I insulated Mike,” Kantor declares. “I got the calls on Sunday morning—‘What are you
doing?' ”

At one point Burnham ordered Milken to get the firm out of the REITs, and Milken formed a syndicate among his colleagues, customers and himself to buy out the firm's position. “Mike and the rest made a fortune on that,” Mark Kaplan, who was then the
president of the firm, said later. Milken was also doing well in the deal he had struck with Burnham. Kaplan recalled that in 1976, Milken and his principal trader, Charles Causey—with whom he was then in a fifty-fifty partnership—each received $5 million in compensation.

Among Milken's early, delighted customers were Carl Lindner, Saul Steinberg, Meshulam Riklis and Laurence Tisch. Tisch, Steinberg and Lindner bought mainly for their insurance companies' portfolios. Often it was the debt and equity of each other's company that they were buying. Lindner, for example, through American Financial, had been the second-largest shareholder of Steinberg's Reliance Financial through much of the seventies. He also became a major shareholder of Riklis' Rapid-American in the midseventies. And he was in the late seventies the second-largest shareholder in Tisch's Loews Corporation. The four were generally friendly business associates, though they may have been personally rivalrous. In an SEC deposition in 1982, Lindner would remark of Tisch, “You know Larry, he's worth a billion and a half dollars, he and his brother, and you'd think that he was looking for cigarette money most of the time.”

Of the four, Tisch would be the only one who would distance himself from Milken in later years, as Milken's machine grew ever more gargantuan and controversial and Tisch began to affect the role of elder statesman. While Tisch would remain personally aloof from Milken and his junk bonds, however, the insurance company Tisch had taken over in a hostile raid in the seventies, CNA, would continue to invest heavily in them. Milken would testify in a deposition taken by the SEC in October 1982 that there were extended periods during the preceding two and a half years when he spoke to CNA's portfolio manager every day. Moreover, Tisch's son, James Tisch, would be an investor, along with the Belzbergs, in a risk arbitrage partnership, Jamie Securities, run by John Mulheren—who took enormous positions in takeover stocks (many of them Drexel-backed deals) and was, of all arbitrageurs, probably closest to Ivan Boesky.