The Bear’s Lair: A world without Mike Milken

President Donald Trump last week pardoned Mike Milken, the effective originator of the junk bond market, who had been sentenced to 10 years in jail in 1990 for mysterious securities infractions. While I have considerable sympathy for Milken himself (not that he needs it, being worth $3.8 billion) I thought it worth performing the thought-experiment: would we indeed be worse off if he had never existed and the junk bond market had never appeared?

Junk bonds can be described simply as those that are rated below investment grade by the major rating agencies, Moody’s, Standard and Poor’s and Fitch. Investment grade bonds are rated AAA through A or BBB, the top four grades; junk bonds are rated BB, B or something beginning with a C or D (the latter are usually in some kind of default).

Technically, junk bonds have always existed, in a sense. The United States itself and its constituent states were junk credits before Alexander Hamilton sorted out its finances in the early 1790s. A predecessor of my old merchant bank, Erlanger & Co. issued £3 million of junk bonds for the Confederate States of America in 1863; they had an alternative payment mechanism in cotton, which required running the Union blockade on the Mississippi River. The issuer’s commission for the bonds was 19%, or £570,000, real money in those days, which explains why banks undertook such financings. Then in the 1920s, many “fast-growing” (often into bankruptcy the following decade) companies with overstretched balance sheets issued junk bonds.

The market then went into hibernation, consisting mostly of “fallen angels” – higher-rated issues that had fallen on hard times and been downgraded — and with only $10 billion outstanding when Mike Milken, a trader at the medium sized investment bank Drexel Burnham Lambert, discovered the market in the late 1970s. He built a sales and trading business in these bonds, pointing out that their default rates were on average lower than the increased yield you received through buying them.

In an era when equity markets were depressed and out of fashion, and yields overall were high, it was easy for Milken to build investor demand for junk bonds. Once this was done, he began to arrange new issues for companies with over-leveraged balance sheets. Then in the mid-1980s he invented the junk bond-financed takeover, which could be carried out simply with a letter from Drexel stating that they were “highly confident” of raising the money. By 1989, the amount of junk bonds outstanding was some $190 billion or 4% of U.S. GDP. At this point, it was a market focused almost entirely on U.S. corporations.

In 1990, the credit crunch caught up with the junk bond market and the Feds caught up with Milken. The next few years saw a wave of bankruptcies, invalidating the optimistic arithmetic that Milken had used to create the market. It appeared that junk bonds would go the way of conglomerates, savings and loans and other financial structures that had proved unsound when tested by a period of tight credit.

This did not happen. Junk bond issuance recovered in the middle 1990s, recoiled only modestly with the 2000-02 financial crash, expanded rapidly in 2003-07 into new areas, especially emerging markets and housing, then suffered another massive wave of defaults in 2007-09. However, in the last decade the market has surged again, to the extent that today junk bonds outstanding total around $2 trillion in the United States plus another $1 trillion internationally, for a total of 15% of U.S. GDP, nearly four times the market’s relative size at the Milken peak of 1989. There is in addition a similar sized market of “junk” bank loans, a category that barely existed in 1989, when standards of banking soundness were more reliable.

Thus junk bonds, an investment that had been considered thoroughly unsound for half a century from 1929, has continued expanding after Milken’s forced retirement, and is now at least four times as important a part of the financial system as it was at the peak of his bubble. It is no secret why this happened: from February 1995 the Federal Reserve abandoned all sense in its setting of U.S. monetary policy, and has become continually more expansionary, with lower and lower real interest rates and more and more money printing, from that day to this. This has artificially suppressed the default rate on junk bonds as well as artificially increasing the real return (because bond prices rise as yields fall, so any long-term bonds that do not default immediately are an attractive investment, bringing capital gains as well as income).

If we are to answer the question posed in the first paragraph, therefore, we must make an assumption about monetary policy during the period, or rather, look at two cases, one with monetary policy as it was actually managed and the other with a sound Paul Volcker-style monetary policy (or a Gold Standard) and interest rates remaining steadily above the level of inflation. We must also look at both sides of the question, thinking about the useful businesses financed through junk bonds, as well as the economic damage they have caused.

Proponents of junk bonds tout the successful companies that have been financed by them, such as MCI Communications, a pioneer in e-mail and optical fiber cable that was later acquired by WorldCom and shared in that company’s bankruptcy. More recently, Tesla Inc. (Nasdaq:TSLA) has taken advantage of the junk bond market, as have many of the smaller energy companies involved in the fracking boom (many of which defaulted when oil prices fell in 2014-16). Junk bonds are also often used in real estate speculations, especially common in the era of cheap money, and bore some of the responsibility for the housing finance crash of 2007-09.

The picture is thus mixed. Junk bonds are generally not useful for true entrepreneurship, which is small-scale and involves more human capital than fixed assets. They are thus less useful than equivalent amounts of venture capital, private equity and public equity in producing innovation and growth. Without them, some genuinely useful asset-heavy innovations, such as the installation of fiber-optic cable and the fracking boom, would have happened much more slowly than they did. However, to balance that we should take account of the economic damage caused by junk bond collapses, notably in the financial crisis of 2008 but also in the early 1990s. We should also make some allowance for the potential for financial crisis inherent in the current exceptionally large volume of junk bonds outstanding.

The trajectory for a Milken-less economy would have differed greatly depending on monetary policy. First, we should note that Milken developed his junk bond business during a decade when monetary policy was sound. After extremely tight money under Paul Volcker at the beginning of the decade with interest rates on long-term Treasuries peaking at around 14%, interest rates generally declined during the decade, but remained well above inflation rates through the early 1990s. However, stock prices were low, having declined by three quarters in real terms between 1966 and 1982, so even at high interest rates companies could finance leveraged buyouts and junk debt was less expensive to shareholders than additional equity issues.

Nevertheless, without Milken developing the necessary secondary market and trading infrastructure, it is unlikely that a junk bond market capable of financing LBOs would have emerged in such a tight-money decade. Hence the LBO boom of the late 1980s would have been much smaller, and some of the deals subsequently criticized, such as RJR/Nabisco, would not have taken place. Equally, leveraged buyout/private equity houses such as Kohlberg, Kravis and Roberts and its competitors would have remained relatively small, able to do only those deals that could be carried out with bank financing.

After 1990, the story bifurcates depending on whether 1995’s radical loosening of monetary policy took place. With the loosening, by the late 1990s stock prices were high and the level of financial innovation in derivatives, leveraged hedge funds (Long-Term Capital Management) and credit default instruments was huge. The period of stock market “irrational exuberance” after 1996 would thus surely have seen some other innovator developing an active junk bond market and using it for leveraged buyouts and other purposes.

The history since 2000 would then be very much as it has been in real life; different players would be more prominent and the LBO/private equity market would be less well developed than in our world (because of having missed out on the late 1980s) but by now junk bonds outstanding would be close to the $2 trillion at which they currently stand. Consequently, the change in the world by removing Milken would be fairly minor, and mostly limited to the 1980s, the decade in which he actually operated.

Now suppose Milken’s non-existence had caused Alan Greenspan to react after his December 1996 “irrational exuberance” speech with a tightening in monetary policy to cool speculation. Then when Long-Term Capital Management failed in 1998, he took the Fed’s traditional line and refused to bail out an over-leveraged speculative greed symbol, whose bailout benefited only the most unpleasant insiders.

Then the dot-com bubble would still have existed, but it would have been less large, and no junk bond market would have come into existence to accompany it (a period of bond market caution would have followed an LTCM bankruptcy). If after 2001 and again after 2009 Greenspan and Bernanke had pursued traditional monetary policies, keeping interest rates generally above the rate of inflation, there would have been no $2 trillion junk bond bubble today and no excess rise in asset prices or the stock market. Today the U.S. economy would be truly healthy, growing at more than 3% per annum after President Trump’s regulatory cutback and with annual productivity growth close to its historic levels of around 2%. Billionaires would be fewer and poorer, and ordinary people considerably richer.

It is not fair to blame Mike Milken for mistakes made by the Fed after he was incarcerated. But without him, and with a more sensible Fed, we would be missing very few worthwhile companies and would be generally considerably better off.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)