The Predators’ Ball (42 page)

Six months later, Grant was eating crow. In May 1985 Rupert Murdoch, the publishing magnate, bid $2 billion for the Metromedia television stations (not the radio stations). And he agreed to assume the whole Kluge debt—and pay some $650 million besides—for the television assets. In a mere six months, the value of the stations had appreciated by $650 million. This, Grant noted rightly, had added vitality to the already prevalent investment outlook that assumed not a recession but prosperity, that counted on something good just around the corner to make the balance sheet balance.

Hot on the heels of Murdoch-Metromedia came Storer Communications, at $1.93 billion further testament to this kind of investment faith. Like Metromedia, Storer did not have enough money to meet its fixed charges out of cash flow, and like Metromedia it contained a healthy quantity of zero-coupon bonds (one third of the total) in its mix of securities.

The zero-coupon bond was vital to these deals. Sold at a discount from its face value, it requires no interest payments (hence, “zero-coupon”) until maturity, when the annual accrued interest and the principal are paid out. Drexel had pioneered the heavy use of zero-coupon bonds in junk deals (especially in the communications industry) where the company in the foreseeable future could not make its interest payments. The day of reckoning for many of these deals, with securities issued in 1985 and 1986, would be years away.

Now, in early fall 1986, Grant was still in print, and unswerving.
He articulated a theory of a credit cycle in debt expansions, in which a gradual shift from vigilance to recklessness in lending and borrowing takes place, and he postulated that the current cycle had reached the reckless, or manic, phase. In this phase, the public competes frenziedly for securities of higher and higher yield—and poorer quality.

Using the junk mutual funds as a benchmark, Grant pointed out that as recently as 1982, only 45 percent of the funds' holdings had comprised bonds rated single B– or lower (or not rated at all); and as of mid- 1986 such securities made up 68 percent of those funds' portfolios. Edward Altman, a finance professor at New York University who wrote a book entitled
Investing in Junk Bonds,
also asserts that credit quality of new issues—after improving over the 1978-to-1984 period—began to deteriorate in 1985. And Gail Hessol of Standard and Poor's asserted in
Business Week
in November 1986 that within the junk universe the new issues were at the lower end of credit quality.

It was noteworthy that at the same time that junk was becoming junkier, it had been comprising a growing percentage of the entire corporate-debt market. A total of $50 billion of junk was issued in 1985–86. Junk rose from 11 percent of the total corporate debt issued in 1982 to 24 percent in 1985. (This does not include all the debt that was downgraded into the junk nether regions—$20 billion over the 1985–86 period—much of it as a result of takeovers and buyouts.) By year-end 1986, the junk market had grown from $15 billion a decade earlier to about $125 billion.

If the quality of junk was deteriorating, one would expect there to be an increasing number of defaults—although the junkiest of issues, being the most recent, would not yet have had time to go into the can. For the period 1978 to 1985, the average default rate as a percentage of the junk debt outstanding was 1.222 percent. The year with the highest default rate was 1982, with 3.12 percent. Nineteen eighty-five, by comparison, had only 1.68 percent. But then in July 1986 came the fall of LTV Corporation, the largest bankruptcy ever, which helped to produce a 1986 default rate of 3.394 percent—marginally higher than the 1982 rate and the highest ever since 1970, when Milken was a newly hired researcher and trader of arcane bonds at Drexel Firestone. While 1985 had seen a par (face) value of defaulting debt of $992 million, in 1986 it was $3.2 billion.

LTV—whose defaulted debt had been underwritten by Lehman,
not Drexel—caused some nervousness among junk-bond investors. But there was no rush to sell from institutional investors, no large withdrawals from the fifty or so high-yield funds investing about $20 billion—in other words, none of the panic that leads to distress selling, that triggers further panic, that causes a market to collapse. And within about two weeks, the junk market rallied to its pre-LTV state.

Thus LTV was perceived as, and quickly became, an isolated event. It was one that caught even Milken off guard, since he had not believed that a major steel company would go into bankruptcy. When one of Drexel's senior investment bankers told a client that Milken had taken an $11 million loss on LTV, the client—in perfect synch with the Drexel mood in summer '86—quipped, “Lunch money.”

It is true that by the fall of 1986 there was a growing chorus of business analysts worrying about the amount of debt in this country and the signs of strain it was causing—in the increasing numbers of loan defaults, bankruptcies, bank failures and savings-and-loan closings. By the end of 1986, total debt—federal plus other borrowing—would top $7 trillion, up nearly $1 trillion in one year. Debt would total 1.7 times gross national product, the highest such ratio since the worst years of the Depression. The market-value debt-to-equity percentage—a key measure of the corporate-debt burden—was 71.4 percent for 1985; that compared with 35.3 percent in 1961, 46.7 percent in 1971, 91.1 percent in 1974, and 70 percent in 1981. But the concern of these business analysts tended to be global—running the gamut from federal debt to corporate to consumer—and was not focused particularly on Milken and his enclave in Beverly Hills.

It could not reasonably be, because there debt was not a problem, leverage was not a problem, the thrifts that were failing were not Milken's protégés, and the deals that were going into default in the main were not his, either. Many of the most highly leveraged acquisitions that he had backed were now refinancing their debt at lower rates. Taking advantage of the surging bull market, many were replacing straight bonds with either convertible bonds or equity; “Equitize,” in fact, was the new slogan at Drexel. By the end of 1987, Drexel would say that almost $22 billion in public high-yield debt had been retired in 1985–87, during which time about $99 billion of such debt was issued.

Despite these signs of growing stability in Milken's empire, the Isaiahs of the financial world were still proclaiming that the Milken experiment had worked so far only because interest rates had gone down and the stock market had continued to soar, but when the next recession came, they declared darkly, that empire would be shown to be made of mirrors. Some of Milken's rival investment bankers too suggested that he—with the help of his and his group's capital, and Drexel's, and that of his ever-ready inner circle—had been able to create the
illusion
of a thriving supply-and-demand market, by fixing the trouble spots and providing liquidity when and where it was needed. When the recession came, they predicted, even Milken at the controls, with all his machinations and his billions of dollars of capital, would not be able to forestall a tidal wave of defaults.

In the fall of 1986, however, that recession—which was indeed the necessary test for Milken's grand design—was nowhere in sight. And the critics, who in the face of Milken's success had begun to sound niggling, were all but drowned out. A spate of magazine articles about Milken appeared, rivaling each other in the lavishness of their praise.
Forbes,
which in 1984 had featured a cover showing Milken and his favored (Fred Carr, Tom Spiegel, Saul Steinberg and others) riding a merry-go-round, with an accompanying article by reporters Allen Sloan and Howard Rudnitsky that detailed the interlockings of his network, now published a piece (by the same reporters) laced with admiration and entitled “A One-Man Revolution.”
Business Week,
with Milken on its cover, quoted Harvard Business School professor Samuel Hayes comparing Milken to J. P. Morgan and ran an editorial headed “Junk Bonds Deserve a Little Respect.” For
Institutional Investor,
the headline said it all: “Milken the Magnificent.”

Even
The Economist,
that sober periodical, gave its imprimatur to Milken's accomplishments in November 1986. In an editorial, “In Defence of Raiders,” its editors essentially sided with the President's Council of Economic Advisers. The editorial declared that the raiders in their junk-bond-financed acquisitions were helping to make American business leaner and more competitive, instituting operating efficiencies through better management. The assumption of debt, it noted, is not necessarily profligate but can, in fact (as Milken had been repeating in his tireless litany year after year), impose a most wondrous discipline.

All these plaudits did nothing to mellow Milken or soften his iconoclastic edge. Overriding confidence, the utter conviction of his rightness, had been his insignia even when he was a twenty-two-year-old summer intern at Drexel Firestone in Philadelphia and wanted to bring salvation to that firm's beleaguered back office. Now, after more than a decade of having preached his unorthodox gospel about low-rated bonds, after having pioneered their issuance, eliciting first the disdain and later the antipathy of the corporate establishment, Milken had the certitude of the proven prophet. That he had been so right about so much (while others were so wrong) was a point that no one who listened to the few speeches he had given in early 1986 was allowed to ignore.

His recurrent theme was “perception versus reality,” or, put more bluntly, how he could see what most of the world could not. Self-serving as it was, he had in fact built his legendary career and fortune upon this ability: first, in seeing the creditworthiness of companies that the rating agencies deemed junk, and later in seeing the undervalued assets of companies that were candidates for buyouts or takeovers.

His was the clairvoyance of the outsider. He held himself apart from the mainstream. He had become both prophet and engineer of change. And that was why, he believed, resistance to his endeavors had lately been so violent.

“We're faced with change,” Milken told a group of money managers in Boston in February 1986. “And all of us have resisted this change. Our regulators have resisted change, our politicians have resisted change, portfolio managers have resisted change, traders have resisted change, salesmen have resisted change.

“. . . We're not willing to recognize that James Dean, in the movie
The Giant [sic],
was really the person who was financially strong, not Rock Hudson. . . . That many of our money-center banks today are financially weak, even though we might perceive them to be strong. That many of the insurance companies in the United States that are considered to be mavericks are the strong insurance companies today, not the weak. That many of the savings and loans, who have used different investment techniques, and different ways to build their capital structures, will be the survivors and the strong savings and loans of the future, not the weak. Why [are they not accurately perceived]? Because their customs, their methods, their personalities, their people, are not the way they
were . . . in the past, and are not immediately accepted. . . . Often, what's old is weak and what's new is strong.”

The common perception is that capital is scarce, Milken declared in his timeworn message, but in fact capital is abundant; it is vision that is scarce. In a favorite exercise, Milken offered example after example of disastrous investments of excess cash made by those blue-chip companies rated triple A, the companies he had always disdained.

The major international oil companies have had from $2 billion to $7 billion in excess cash for a ten- to twenty-year period, he said. Exxon squandered perhaps as much as $3 billion in its foray into information systems. Standard of California made an $8 billion bid for a company named American Metal Climax which, had it been accepted, would have caused Standard to lose $12 billion. Atlantic Richfield lost in excess of $2 billion in the metals business. “So we see here,” Milken drew the moral, “excess capital is not strength. It leads to the opportunity of weakness.”

But if one has vision, the results are very different. While Milken had not mentioned them by name, his star protégés, Columbia Savings and First Executive, were clearly in mind when he spoke of those savings and loans and insurance companies that are today's mavericks and would be the strong institutions of the future. Now he tallied his triumphs:

“Even though
Forbes
magazine would have us believe otherwise, Mr. Perelman, who runs Pantry Pride today, seems to have had the ability of knowing what to do with his money. . . . In the last six to seven years, not only has he taken a few million dollars and purchased MacAndrews and Forbes, and then bought Wilbur Chocolates, and then took the company private, and then bought Consolidated Cigar, and then bought Technicolor, but [he] has subsequently invested money in Pantry Pride. . . . Pantry Pride was only selling at three and three quarters before Mr. Perelman took it over, and is now selling somewhere between eleven and twelve—in a matter of less than one year. Why? Because a management team has been brought to bear, which was willing to take the risk, who had the vision of value, and to find the backing of you in this room and other institutional investors around the country, willing to loan them money with the understanding that they had to commit to repay your interest and principal, and have the vision or foresight, which was the scarce resource, to identify those assets that
are undervalued in the marketplace, the difference between a perception and the reality, and to use your money wisely. . . .

“Forbes
magazine (I don't mean to dwell on their articles) recently wrote about two people who run a company called Triangle, who took advantage of the poor unsuspecting public, I don't know how, and bought National Can. Anyone in this room, anyone at Drexel Burnham, anyone could have bought National Can. . . . It required a downpayment of one hundred million dollars in equity, four hundred ninety million dollars in debt. Today the company will make in 1986 probably one hundred forty to one hundred fifty million dollars from operations, and the stock of the public company that bought it has increased fourfold.