The Predators’ Ball (44 page)

Of all Milken's ready pools, Atlantic Capital was the one about which other investors, even those close to Drexel, knew the least. While other buyers sometimes used Street names, probably no other buyer went by as many names or used as many subsidiaries in these deals as Atlantic Capital. (In Revlon, there were commitments to buy bonds not only from Atlantic Capital Corporation, but also from these related entities: Worldwide Trading, SSC III Corporation, Garrison Capital Corporation and First Oak Financial Corporation.)

In its 1984–85 heyday, Atlantic Capital had at least $3–4 billion to invest. While First Executive's investment pool was somewhat larger, First Executive, like all insurance companies, had to submit a list of all securities in its investment portfolio to the state insurance commissioner at the end of each year. By the fall of '86, in fact, the New York State Insurance Commissioner (who had jurisdiction over Carr's Executive Life in New York, a smaller subsidiary of the California company) had indicated that he was considering imposing a limit on the amount of junk bonds an insurer could buy.

Similarly, Tom Spiegel's $3 billion pool at Columbia Savings was overseen by increasingly critical regulators at the Federal Home Loan Bank Board. And by the fall of '86 those regulators indicated that they expected to propose regulations that would limit thrifts' junk-bond investments in some way—perhaps by limiting the amount that could be invested in a single company, or by requiring that investments be spread among various companies and industries. Tom Spiegel and Fred Carr had enjoyed great license for years, but theirs were not wholly unmonitored investments. Atlantic Capital's were.

Atlantic Capital's game was the brainchild of a former investment
banker in municipal finance at Shearson named Peer Wedvick. In the early eighties, when interest rates went sky-high, single-family mortgage revenue bond issues began to proliferate, since financing a home in the private sector had become extremely expensive. Typically, in these housing deals, a municipality would sell its bond issue and invest in an investment contract with the proceeds (which would remain in that investment contract until they were needed to purchase mortgages). That contract, which had to be provided by an institution with a high investment-grade rating, promised to pay a certain rate of interest on the funds, and to repay the principal in an allotted period of time. In most of these housing deals, the bulk of the funds were moved out of the investment contracts and used either to purchase mortgages or to repay the bonds, generally within three years. However, some of the funds (approximately 10 percent) were invested in a debt-service reserve fund for the full term of the bond issues (usually thirty-plus years).

Wedvick's idea was to sell these investment contracts to the municipalities and—somehow—make a big spread between the rate he had to pay and what he made on his investments. An arbitrage. All he needed was an institution with a high investment-grade rating, and a crackerjack investment strategy.

An AA rating was provided through a Mexican named Rodrigo Rocha, who in 1981 had taken over a Bermuda-based reinsurance company, Clarendon. Rocha's cohort at Clarendon was Eerki Pesonen, then chairman of Kansa General Insurance Company in Helsinki, Finland. Kansa owned about 35 percent of Clarendon. Kansa was also a member of a pool of reinsurers for First Stratford, the reinsurance company formed in 1982 and owned primarily by a Milken group and First Executive. Most important, Kansa had an AA rating from Standard and Poor's. So Atlantic Capital was created, as a subsidiary of Clarendon. Atlantic Capital issued the investment contract, which was backed by Clarendon, which was covered by a “cut-through” agreement (assuming liability) from Kansa.

That, however, was only half the farrago. The other was an investment strategy. And that, as Wedvick and Rocha soon discovered, they did not have. When they started selling these investment contracts in 1982, they invested the money in Treasuries, which they attempted to hedge. “They lost their asses on that,” recalled one former Drexel executive. “I remember going to a cocktail party
in '84, and Rodrigo was introducing his hedge guy from Stanford, who had all these computer models. About four or five months later, I heard they took a really big hit.”

By mid-'84, they had moved to Milken's junk (bonds and preferred stock). Now they were making a spread of at least 400–500 basis points (there are 100 basis points in one percentage point), sometimes as much as 1,000. They would promise a return of 8 percent or so and then invest the money in junk that was paying 13–18 percent. Guy Dove came to be their trader—and Milken's man in the shop. It was rumored at Drexel that Milken had an equity stake in Clarendon through his investment partnerships. But those partnerships were essentially run as blind pools, so even those at Drexel who had money in them generally did not know what their investments were.

It was great while it lasted. Wedvick, who had reportedly been making no more than $70,000 a year at Shearson in his pre-Atlantic Capital days, now was said to be making about $10 million a month. His lifestyle lent credence to the talk. “I saw Peer not long ago,” one friend remarked, “and he was driving a Rolls Royce. But it was only one of them [that he owns].” When Wedvick married in early 1985, Drexel threw a bachelor party for him in Las Vegas and flew in friends and key clients. It was an extravaganza worthy of someone who was said at the time to be Milken's biggest client.

In these bond deals, it was typically the underwriter who decided which bidder would be awarded the investment contract. Major commercial banks and insurance companies flooded this market in the early eighties. But in California, where Atlantic Capital was most active, no institution could compete with it. There was no disclosure required as to how the funds would be invested, and most underwriters who accepted Atlantic Capital bids apparently looked to the AA rating and not beyond. Of a half dozen interviewed by this reporter, all said they did not know the money was being invested in junk bonds.

One asserted, “For about two years, they [Atlantic Capital] were tearing up and down the state, getting any deal they wanted—it was almost impossible
not
to do business with them. And for a long time they managed to keep it very quiet, the rates they were getting. I remember I was with Peer in a restaurant in early 1985, and I said, ‘Peer, how
are
you doing this?' And he said, ‘We've got the best options guy in the country.'

“I can't say what they were doing was illegal,” this underwriter concluded. “But it certainly failed the good-faith test.”

If the underwriters were ignorant of how the money was being invested, FGIC (Financial Guarantee Insurance Company), the bond insurer which insured some of Atlantic's investment contracts, was not. One analyst at FGIC says, however, that it was their knowledge of Atlantic's investment strategy that caused them to limit the coverage to $300 million. What was worrying, this analyst adds, was not only that Atlantic was putting the money into junk, but that it was also committing a cardinal investment sin. Like the S&Ls which had borrowed short-term money and lent long, and so got caught when interest rates skyrocketed and had to pay more for their money than they were receiving on their long-term loans, Atlantic Capital had borrowed short (most of these funds had to be repaid in three years) and lent long (the securities they bought typically had maturities of ten years or more).

“It was a game of musical chairs,” this analyst said. “They were using the new money that came in to make payouts on the old contracts. They weren't liquidating the securities. So there was certainly the risk that if interest rates had risen, in the end there would not have been enough money in the securities [whose price would have fallen] to make the payouts. Or if there had been any big defaults [in the junk issues]. But there weren't.”

By the fall of 1985, it was essentially over. Standard and Poor's finally exerted sufficient pressure on Kansa that that company refused to extend its “cut-through” agreements to any new investment contracts. Atlantic Capital stopped selling these contracts (it had sold about one hundred) by the late fall of '85. Within the next year, Pesonen, who had led Kansa into the foray with Rocha and Clarendon, left Kansa to join Clarendon full time in its London office. He was replaced by a new chairman and management from outside the company who vowed to refocus Kansa on its domestic, rather than international, activities. And in December 1986 Standard and Poor's downgraded Kansa from AA to A – (a substantial downgrade) in large part because of its relationship with Atlantic Capital and its concern about Atlantic Capital's investment portfolio. Standard and Poor's noted, however, that Kansa had already taken steps to allay its concerns. “In particular, Kansa General's intention to no longer reinsure new exposures of its one-third-owned Clarendon Group will reduce over time the overall role in
the company's portfolio as those exposures run off.” Many of the bonds which had been backed by these contracts would also be downgraded by early 1987, so the bondholders were left with devalued bonds.

Dove too by 1986 had shifted his base of operations to Clarendon's London office. In December 1986, U.S. District Judge Owen Panner granted a preliminary injunction to the Princeville Development Corporation, allowing it to block the attempts to acquire control of it by Dove (through Garrison Capital Corporation, affiliated with Clarendon), Charles Knapp (through Trafalgar Holdings) and others.

Among his other findings, Panner cited numerous disclosure violations by Garrison, including its having failed to disclose that it was acting as part of a group, in an attempt to seize control of Princeville. Panner also found that, while Dove and Knapp were posing as only sources of financing for the tender offer for Princeville, in fact that financing—through the issuing of warrants—would place between 40 and 90 percent of the equity in Dove's and Knapp's hands. The offer to purchase was fraudulent, Panner found, inasmuch as Princeville shareholders “were prevented from discovering that managerial control of Princeville . . . could pass to persons with, at best, dubious pasts: Dove and Knapp.”

For Dove, Atlantic Capital was surely a once-in-a-lifetime kind of opportunity. Like other members of the Milken network, Atlantic Capital benefited enormously from the halcyon financial times in which it operated. Because Atlantic Capital's gamble on interest rates was so great, the superb economic climate probably meant the difference between striking it rich and suffering a disaster. For others—companies which had issued mountains of debt, for example—the climate may have meant the difference between scraping by and prospering. But for everyone in this magnificently orchestrated, highly interdependent production—and for Milken, its maestro, most of all—timing was key.

I
N THE VERY BEGINNING
, from 1973 to 1977, when Milken's universe extended no farther than to the next trading area, he had controlled the members of his small, clannish group with the investment partnerships. As the junk market began to take shape, he controlled some of the buyers, some of the issuers. The larger that market grew, the more important it became to him to control the whole, the more he conceived it in fact his responsibility to do so—because there was more opportunity for error, more that needed constant fine-tuning, so much more to protect; one tremor could be costly. And as Milken's power grew, commensurate with his creation, the opportunities for abuse in the name of control, of expansionism, of disciplining the intransigent, of uprooting the indolent entrenched, also increased. It was for the greater good. He remarked to someone once that there was no corporate democracy in this country and there never would be unless it was forced. Milken was, self-appointed, the enforcer.

It is axiomatic that the more powerful one is, the easier control becomes. As Milken became exponentially more powerful than the vast majority of his clients, many would not challenge him. And so he could gouge them, freely. As one Drexel employee said, “Mike is always saying, ‘If we can't make money from (that means overcharge) our friends, who can we make money from?' ”

Norman Alexander, the chairman of Sun Chemical Corporation, met Milken in the midseventies when Milken sold him some of Riklis' Rapid-American bonds. “I remember meeting Mike in Schrafft's, and him showing me all the companies [whose bonds he
was trading] on one sheet,” recalled Alexander. “He had made a market in these bonds. He had organized himself among the players so that he could take you out when you wanted to be taken out—either because he had the capital or because he had the place to put it.”

Alexander added that through the last fifteen years, that liquidity has remained constant. “So far, he's always been there, and he's been able to provide whatever oil was needed.”

Once the original-issue market started, Sun Chemical became one of Milken's early issuers, doing a $50 million offering of junk bonds in 1978. Alexander remained a satisfied customer of Milken's through the years, investing personally in some of the superlever-aged acquisitions when they came along. On these deals, he said that he, like many others, tends not to read “the fine print.” Alexander explained, “The investment is made largely on your confidence in Mike's ability to appraise the value of a deal.”

Alexander is a longtime admirer of Milken, but he did register one muted complaint. In 1986 Drexel was selling a small company for him. It was charging him a commission fee that he estimated was double what other investment bankers would have charged him. But he did the deal with Drexel anyway. “Because if I didn't,” Alexander recalled, “the next time I would say, ‘Mike, you have to get me out of Revlon,' or ‘You have to get me out of Boesky,' he would say, ‘Oh, and for twenty-five thousand you went somewhere else?' So, you see, you tend
not
to go somewhere else.”