A RECENT EDITORIAL in the New York Times opened with these words: “Michael Milken is a convicted felon. But he is also a financial genius who transformed high-risk bonds junk bonds into a lifeline of credit for hundreds of emerging companies. Snubbed by the banks, these businesses would otherwise have shriveled …There is no condoning Mr. Milken’s criminality. But if overzealous government regulators overreact by dismantling his junk-bond legacy, they will wind up crushing the most dynamic parts of the economy.”
This reminded me of a story about Henry J. Raymond, the Times’ founding editor and a member of Congress. One day he was prowling the House floor, trying to arrange a pair on an important upcoming vote, so he could return to New York on business. Old Thad Stevens (one of my heroes) asked, “Why doesn’t the gentleman pair with himself? He’s been on both sides of the question already.” Raymond’s successors seem to be straining to be on both sides of the junk-bond question.
For my part, I’m ready to grant that Milken is (or was) a crackerjack salesman and a mighty cute operator. But a financial genius he was not. Certainly he was not the first investment banker (what an impressive-sounding job description!) to sell carloads of not-of-investment-grade securities (see “Junk Bonds and Watered Stock,” NL, March 24, 1986). Nor is the New York Times the first journal to discover virtue in such super salesmanship. Nor, I daresay, is this the first time the Times itself has made such a discovery. Junk bonds are a slight variation on a very old theme, played at least as early as the Mississippi Bubble and the South Sea Bubble, both of which burst in 1720.
I’m also ready to grant that a lot of emerging companies have been snubbed by banks, yet I rather wonder why. Having paid casual attention to some banks’ advertising campaigns, I was under the impression that nothing was more likely to make a banker’s day than an opportunity to lend a helping hand to a bright but inexperienced young woman with a new idea for a flower shop, or to a similarly energetic young man eager to play a part in the great drama of American business. If the banks weren’t seizing these opportunities, what were they doing with the money they persuaded us to deposit with them?
Well, one thing they did was make Milken’s junk-bond business possible. They were no big buyers of junk bonds themselves (although the savings and loans snapped up about a tenth of those issued). Instead, they supplied bridge loans. When Robert Campeau made his deals to buy the Allied and Federated department store chains, he did not put up much cash. He counted on selling junk bonds, and he knew that would take a little while, especially since it was important to wait for the moment when the market was right. The banks loaned him the money to bridge that gap. After the bonds were sold, the banks would be paid off, handsomely.
The trouble was, it turned out that the junk couldn’t be sold, at least not at the necessary price; so the banks involved couldn’t be paid off. They were stuck with nonperforming loans, and Campeau’s stores took refuge in bankruptcy. There are recurring rumors that one of the banks is on the verge of bankruptcy, too. Junk bonds aren’t doing a job the banks are falling down on; the banks are in fact doing the job indirectly by making all those bridge loans. The banks are essential players in the junk-bond game.
Not surprisingly, the Federal Reserve Board (which is responsible for the availability of credit) doesn’t see a problem here, anyhow. The Board has just reported: “There is little evidence that a ‘credit crunch’ is developing; the majority of businesses say they have not seen any change in credit terms and have had no trouble getting credit. Where credit tightening by banks and thrift institutions has been noted, however, it has mainly affected newer small businesses and the real estate industry.” A medical researcher would scorn that diagnosis as anecdotal. It doesn’t mean much to say a “majority” of businesses have no trouble with credit; 49 per cent could be having a lot of trouble.
Whatever the situation, we can be sure that the “newer small businesses” turned away by the commercial banks are also unable to find an investment banker ready to float junk bonds for them. The junk bond market being thin and precarious, a $3 million issue is about the smallest anyone will undertake. This assumes a company with upwards of $15 million or $20 million in annual sales. It is not the sort of stuff that made Milken notorious, but it is considerably more than can be expected from most newer small businesses.
A new small business has always had a tough time and always will, for the reason suggested by John Maynard Keynes. “If human nature felt no temptation to take a chance,” he wrote, “no satisfaction (profit apart) in constructing a railway, a mine, or a farm, there might not be much investment merely as a result of cold calculation.” Every new enterprise faces a high probability of failure.
Real estate, though, is a key industry. New Building Permits Issued is one of the “leading indicators” of the economy. No prosperity lasts long if real estate does not prosper. Moreover, we have great need of it. Not only do we have uncounted millions of homeless and ill housed; we are unable, in this supposedly family-oriented society, to provide enough affordable housing for young couples, employed and upwardly mobile though both partners may be.
Still, as everyone knows, real estate loans are prominent among the troubles of savings and loans and of commercial banks like the one pushed to the brink by the Campeau fiasco. Why do the loans go bad? Not because the housing is not wanted or not needed, and only partly because prices are too high. It is the high carrying charges that are to blame. Real estate loans go bad for the same reason junk bonds go bad. The interest rates are usurious. The usury affects real estate developers (another impressive job description) and contractors as well as potential buyers, and commercial construction as well as residential. High interest rates are a main factor of high real estate prices – and of high furniture and food and clothing prices, too.
Interest charges paid by the nonfinancial sectors of the economy are now in excess of 20 per cent annually. They were only 4.9 per cent of the GNP in 1950, rising to 7.2 per cent in 1960, to 10.1 per cent in 1970, and to 15.0 percent in 1980. These great leaps forward, culminating in today’s 20 per cent, didn’t just happen. They were carefully fine-tuned by the Federal Reserve Board.
Why did the Board members do it? They have certainly told us enough times. They’ve been fighting inflation. Unfortunately, the fight has not been remarkably successful. You can see that from the fact that the Consumer Price Index, which stood at 24.1 in 1950, reached 126.1 by last December-an increase of 523 per cent in the 40 years in question. (As I’ve remarked before, this figure seems to me too low; the food, clothing, shelter, transportation, education, medicine and entertainment I buy have all increased much more than that. But let that pass.)
HIGH INTEREST becomes a self-fulfilling prophecy. What is prophesied is the probable failure of the borrowers. The probability is a risk the lenders must protect themselves from. They protect themselves by charging even higher interest. That, naturally, increases the risk of failure.
Abstractly there is no end to the escalation of interest rates, for there is no end to the escalation of risk. Indeed, in a sort of Malthusian progression, risk increases geometrically while rates increase arithmetically. Actually, of course, the escalation does have an end, because potential borrowers are driven off. That may be prudence, but foreclosing production (or consumption) does not make for prosperity.
It all comes back to the nation’s monetary policy – its rates and rules and regulations. Deregulation, combined with tightened credit, results in escalation of rates. Escalation of rates discourages production and encourages speculation. Junk bonds are just one of the forms speculation takes. Junk bonds are the creation of the nation and of the Federal Reserve Board (which is, absurdly, an independent power), not of the genius of a super salesperson.
There is another issue here. The Times thinks that junk bonds are good because they force companies to become more efficient (and hence more “competitive”) in order to payoff the high interest charges. If this tale isn’t false, I wish somebody would cite a few shining examples.
There are certainly examples on the other side, Allied and Federated department stores being first among them. Both chains were long established. I know, because in the days of my youth I spent many gold-bricking hours waiting in their sample rooms to see buyers. They were also successful. They’re not successful now.
Furthermore, the usual test of efficiency is a fat bottom line, and the quickest way to fatten the bottom line is to fire some people and put a leash on the rest. But as John Kenneth Galbraith argued years ago in The Affluent Society, an economy that makes life unpleasant for people is something we don’t need. If the virtue of junk bonds is that they are a sort of handicap inspiring efficiency, why not try a different handicap by giving all the working stiffs a raise? It used to be said that management’s first test was meeting the payroll. Why wouldn’t meeting a bigger payroll be a better test than paying higher interest?