Meeting Michael Milken
Doug Watson met Michael Milken in 1988. Dubbed “junk bond king,” for creating a market for new-issue speculative-grade bonds, Milken had arguably been the most important person in US capital markets for several years. His innovation supplied more and cheaper financing to small and growing companies and led to a leveraged buyout boom. Doug witnessed a demonstration of Milken’s genius, but also clues that presaged Milken’s downfall a few months later when he was indicted on 98 counts of securities fraud, tax evasion, mail and wire fraud, and racketeering.
My boss and I flew out to Los Angeles to meet Michael Milken in the summer of 1988. Tom McGuire was the head of the Corporate Department of Moody’s Investors Service which rated the debt of industrial companies, financial institutions, utilities, structured finance entities, and sovereign countries. I ran structured finance ratings, but was soon going to oversee industrial company ratings, including those of companies whose debt we rated below investment grade. Officially, these were speculative-grade bonds, but, in the vernacular of the day, they were “junk bonds.”
Bear in mind that this story occurs before Sarbanes-Oxley, before Dodd-Frank, before the regulatory oversight of Wall Street that we know today. There were not the accounting rules and oversight, operational oversight, and regulatory review that exist today. In comparison to today, it was “the wild west.”
In my opinion, Michael Milken was at that time the most powerful person on Wall Street. He oversaw research, underwriting, sales, and secondary market trading of speculative-grade bonds at Drexel Burnham. He created the modern new-issue market for speculative-grade debt. You must go back decades, to the 1920s, to find significant issuance of speculative-grade bonds before Michael Milken. At the beginning of the 1980s, most junk bonds were “fallen angels,” bonds that when originally issued were rated investment grade, but that had declined in credit quality until credit rating agencies like ours downgraded them to speculative grade.
Milken changed that by creating both a supply and a demand for originally issued speculative-grade bonds. What was interesting to me was how it all worked together. He went to industrial firms that financed themselves through bank loans and said “You can use the capital markets to finance yourself instead. With bond debt, you can expand your business, grow your territory, and grow your product line. And the strict restrictions bank leaders place on borrowers will be replaced by easier terms available in the bond markets.”
Another source of speculative-grade issuance was LBOs or leveraged buyouts. Milken’s “highly confident letters,” attested to Drexel’s ability to sell a corporation’s debt. These letters allowed financial and strategic buyers to engage in friendly or unfriendly takeovers of targeted companies using vastly higher levels of leverage than had been typical. Milken’s new-issue business disrupted commercial banks’ monopoly on speculative-grade-company financing and staid, perhaps under-performing, management at investment-grade targeted companies.
To sell the junk bonds he underwrote, Milken went to savings-and-loans and insurance companies and explained the virtues of this new market. His argument to potential investors was that although this debt had a greater risk of default and loss, the greater yield on the debt more than offset the risk. He showed that historically a well-diversified junk bond portfolio outperformed investment-grade bonds on an after-loss basis.
To a very large extent, Milken created and controlled both sides of the market. It was very, very profitable, the most profitable business at Drexel. His position of power within Drexel is illustrated by the lucrative profit-sharing deal he cut with his firm. According to Kurt Eichenwald, Milken’s compensation exceeded $1 billion over a four-year period in the 1980s, with more than half of that coming in 1987, the year before I met him.
Senior people at Drexel thought he was over-compensated and tried to renegotiate the deal. But when Milken threatened to leave the firm and take his business with him, senior management backed down and Milken's position of power within the firm was cemented. In a variety of disputes between Milken’s Los Angeles office and Drexel’s New York headquarters, Milken almost always prevailed.
What personality characteristics got him to the top of the Wall Street heap? First, he was a genius, or is a genius; he’s still with us. Second, his work ethic, and the work ethic he inspired in others, was phenomenal. Even if the stories are exaggerated, they are still illustrative: In his days as an analyst, he wore a surgeon’s headlamp so he could read 10-Ks on the 4am bus he took to work. He could recall minute details of the copious financial reports he read, and his analyses of the reports proved prescient. He once agreed to talk to a journalist if the journalist came to his house at 7am on a Saturday. When the journalist arrived at Milken’s house, there was already an anteroom full of people waiting to speak to Milken. Milken’s LA office had an extraordinary electricity bill because his people ran the lights, computers, and air conditioning 24/7 while they worked.
The third characteristic that propelled him to the top was his charisma and magnetism. It was very clear in our meeting that there was only one person who counted in Drexel’s LA office and that was Michael Milken. The story of my meeting with him will illustrate this. He was totally self-confident. His innate self-confidence was strengthened because he had seen the possibility of junk bonds and made it happen according to his vision.
There was a humorous exception to his self-confidence and disinterest in what others thought. He didn't want people to know that he was bald. He had a toupee and, unfortunately for Milken, it wasn’t the best toupee. You could see it wasn’t his hair. As he fell from grace, the press was merciless on this point, going out of its way to raise the fact, such as referring to him as “the bewigged financier.” Journalist also exaggerated the story of the surgeon’s headlamp, saying Milken wore a miner’s helmet with an attached lantern.
This was Milken’s status in the financial world when Tom and I flew from New York to Los Angeles to meet him at his office. As a credit analyst, I had two areas of concern. The first was the companies that Milken and junk bonds were funding. How were the risks of increased debt being handled at these companies? Milken’s financing had set these companies free from the constraints of commercial banks, but what new mechanism prevented excess debt?
The second of my concerns was the credit quality of Drexel itself. Milken was known as the absolute driver of Drexel, not only in terms of profits, but also in terms of strategy and direction. Given this unique situation with one person in charge of a huge chunk of Drexel’s business and profits, his operation was where the greatest exposures and risks would reside. I wanted to understand how Drexel decided whether to underwrite a speculative-grade deal. What were their standards? What were their limitations on risk taking?
Tom and I got to the Wilshire Boulevard office at midday and the meeting started with Milken giving us a tour of the trading floor. As we went around the trading floor, every once-in-a-while he’d say “this is so and so. He trades this or that; this industry or that.” That was the closest we got to talking to anyone other than Milken the entire visit.
But because Milken was on the trading floor, people would run up to him and ask him questions. They had some problem, a client problem or a trading problem. These problems weren’t simple; they were relatively complex. Michael Milken would say to the person, “Okay, just tell me the issue here. Summarize it.” The person would then try to explain the problem. Most often, they didn’t offer a solution of their own. And Milken would decide. It was amazing to me that he would hear a little summary of the problem and immediately say, “This is what we're going to do.” Boom. Whoever came up said, “Yup. Okay. Done.” I was struck by the complexity and amount of money at stake, and Milken making a decision in literally 20 seconds. The other thing that came out of this was that nobody else made decisions, or even suggested a decision. Decisions came from Milken.
I wondered how this could be an effective decision-making process. It seemed vulnerable to significant mistakes. Another thing that came to me was that this really is a one-man show! As I said, Michael Milken was not only a genius, but also had charisma and magnetism. These attributes were clearly on display during our tour of the trading floor. Everybody just wanted to know what Michael thought and whatever Michael thought must be right. Finally, the tour showed he was spread phenomenally thin. Again, significant mistakes could be made.
After the tour, we went into a meeting room. Mind you, it’s summer in Los Angeles, we were a little jet lagged from the trip, but we haven’t been offered so much as a glass of water or cup of coffee. Tom and I were given seats on one side of a good-sized conference table. Michael Milken sat alone on the other side and an associate sat a little bit behind Milken away from the table. But at one end of the room was a kind of bleacher set-up, with two levels. There sat four to six people, probably junior analysts or summer interns.
The person near Milken turned out to be there to take notes, but not notes on the meeting Milken was having with us. Occasionally, Milken would have a thought about something totally disconnected, irrelevant to what he was saying to us. He’d turn to this person, who was just sitting there waiting for this, and say, “Tell so-and-so that we’ve got to do this, that, on this particular deal.” The guy would take all this down and I’ve no doubt after the meeting he ran around the office distributing Milken’s commands to the intended recipients. Milken wanted somebody to capture his thoughts so they wouldn’t be lost. The guy was a combination stenographer and messenger service for Milken.
Meanwhile, all eyes of the bleacher people were riveted on Milken. They never looked at us or anywhere else. They just looked at him and took down everything he said. Their pens were always moving.
Milken was literally accomplishing three things at the same time. He dealt with us and explained how the business worked and why it was so good. If something crossed his mind, a task he needed to get done, he could assign it, and be sure that it would be followed up on. And he was providing wisdom to the bleacher people who had the privilege of being in the room while Milken spoke. It was more like having an audience with Michael Milken than a meeting.
The meeting started to turn into a Milken monologue about why the high yield/junk bond market is so good for society. But I had my purposes: to better understand the credit risk at Milken’s corporate borrowers and the credit risk at Drexel itself. At this point in my career, I’m experienced in getting bankers, CFOs, and CEOs to address my concerns. So, occasionally, I’d say, “Michael, excuse me for interrupting” and ask a question. Milken would deal with my question curtly and return to his monologue. Eventually, I got a sharp kick under the table, which was Tom telling me, in no unsubtle way, that he didn’t want any more of my questions.
If this had been a more normal meeting, Tom would have joined me in trying to turn Milken to our credit agenda. But given the show that we were seeing, Tom was a little irritated with my efforts to do so. He told me later, “I wanted to understand how his mind worked and what made him tick.” As we left the building, Tom said to me, “We’ve just been to Jonestown!”
This meeting occurred when Milken was at the peak of his power and almost immediately before his fall. The year before the meeting, 1987, his compensation had totaled $550 million. Only nine months later, in March 1989, Milken was indicted on 98 counts of securities fraud, tax evasion, mail and wire fraud, and racketeering. He eventually pleaded guilty to six counts of securities fraud, was sentenced to 10 years in prison, served two years, and paid $1 billion in fines and settlements. Drexel agreed to a $650 million fine in December 1988.
There’s credit and management lessons to be learned here. Drexel was the only firm Milken worked at after Wharton business school. He joined the firm at age 23 in 1969 and was head of bond trading two years later at 25. No doubt his rise would not have been as fast at a major firm, which Drexel was certainly not in 1969. No doubt he would have been under more scrutiny at a major firm. But Milken alone made Drexel into a major firm. Because of this, he was given a lot of rope. Moving his operations to Los Angeles literally separated him from New York headquarters.
There’s a risk of having so much power invested in one person with that one person being acknowledged as the know-all of everything by those that work in his world. And Milken definitely had his own world.
The default statistics Milken used to attract junk bond buyers were from an era when that market was dominated by fallen angels. The statistics weren’t so meaningful for bonds originally issued as junk and created with new underwriting standards. Junk bonds also fell victim to their own success as more and more were created and underwriting standards fell. In 1989, Drexel got stuck holding bonds it couldn’t sell and lost $40 million. In 1990, the firm couldn’t roll its commercial paper, lost its bank credit line, and filed for bankruptcy. The speculative-grade default rate rose to 10% in 1990 and 9% in 1991; higher than what the extra yield on junk bonds could make up for. Two big customers of Milken’s, Columbia Savings & Loan and Executive Life Insurance Company, were shut down by regulators in 1991.
But I go back to what Milken insisted on talking about at our meeting: the social benefit of the high yield market. This “social benefit question” is something I ask my students about at Pace University: “was it all worth it?” Milken created a new capital market and capital market solutions generally are more efficient than bank intermediation, which is why fixed income capital markets have grown so much. This was a worthy goal. After the losses of 1990, the new-issue high-yield bond market resumed its growth, and it is an important source today of capital to US companies. In fact, capital market execution has made further inroads into bank lending, with 65% of bank-originated loans held by non-banks. Despite the downfalls experienced by Drexel, its customers, and Milken personally, the market envisioned by Milken has endured.
Doug Watson had a 23-year career at Moody’s in charge of various debt ratings, including those of structured finance entities, industrial companies, and US states and municipalities. He was then Chief Underwriting Officer at Financial Security Assurance for 12 years. He currently offers credit advisory services as an independent consultant and teaches business and finance courses at Pace University.
Michael Milken increased his philanthropic endeavors after prison. These include Faster Cures/The Center for Accelerating Medical Solutions, the Milken Family Foundation, the Melanoma Research Alliance, the Prostate Cancer Foundation, the Milken Institute, the Milken Scholars Program, the Epilepsy Research Awards program, Mike's Math Club, the Center for Public Health, the upcoming Milken Center for Advancing the American Dream, and other organizations.
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