The Predator’s Ball
1 The Miner’s Headlamp
AT 5:30 A.M. each weekday in the early 1970s, a bus pulled up to a stop in Cherry Hill, New Jersey, and a young man lugging a bag that bulged with papers mounted its steps. He was making the two-hour commute to New York City, where he worked at the investment-banking firm of Drexel Firestone. The train would have provided a more comfortable and faster ride; but, for those very reasons, it also offered more opportunity to meet other Wall Street acquaintances. They would want to engage in the kind of idle small talk that commuters share to pass the time. The thought must have been intolerable. He did not wish to be rude, but he wanted no interruption.
As soon as he had settled into his seat, being sure to take one with an empty one adjacent, he unloaded a mountain of prospectuses and 10ks (annual Securities and Exchange Commission filings) onto the seat next to him. On winter mornings the sky was still pitch black and the light on the bus was too dim for him to be able to read. He wore a leather aviation cap with the earflaps down; he had been bald for years, and although he wore a toupee his head always felt cold on these frosty mornings. Now over his aviation cap he fitted a miner’s headlamp—strapped around the back of his head, with a huge light projecting from his forehead.
Michael Milken was as anomalous at the impeccably white-shoe Wall Street firm of Drexel Firestone to which he traveled each day as were the low-rated bonds that he traded there. He came from a middle-class Jewish family. He had no aspirations to climb any social ladder. He was painfully uncomfortable, moreover, in most
purely social situations. He was oblivious to appearance—not caring what kind of car he drove, or what kind of clothes he wore, or whether his aviation cap and miner’s headlamp made other passengers stare at him. Milken was occupied, at every moment, with his own thoughts, and those thoughts were riveted on the bonds.
Milken had grown up in the well-to-do, largely Jewish enclave of Encino in Los Angeles’ San Fernando Valley. His father, Bernard Milken, was an accountant; from the time he was ten Michael watched at his father’s side as he prepared tax returns. A boyhood friend, Harry Horowitz, recalled that the kinetic quality so marked in Milken in later years was present when he was young. Even as a teenager he slept only three or four hours a night. He was a high-school cheerleader. And then as in adult life he eschewed all stimulants—no drugs, alcohol, cigarettes, coffee or carbonated beverages.
He graduated from Birmingham High School in neighboring Van Nuys in 1964 and then attended the University of California at Berkeley, graduating Phi Beta Kappa in 1968. While that campus was roiled with the protests of the militant left, Milken majored in business administration, managed a few portfolios for investors and was active in a fraternity, Sigma Alpha Mu.
Milken married his high-school sweetheart, Lori Anne Hackel, and headed east to the Wharton School, the University of Pennsylvania’s business school. Horowitz, visiting him during Milken’s first week at Wharton, attended an orientation dinner with him. The two were a little taken aback by Milken’s fellow students, Ivy League graduates dressed in navy blazers and smoking pipes, and they in turn were struck by the two Californians. “They were making fun of us, though in a sort of nice way,” Horowitz recalled. “And I remember Mike told me that evening that he was going to be number one in his class.” Milken did have straight A’s, but because he was short one paper he did not graduate with his class. He later co-authored a paper with one of his professors and received his M.B.A. degree.
Milken had come to the Philadelphia office of what was then called Drexel Harriman Ripley to apply for a summer job while he was at Wharton, in 1969. Anthony Buford, Jr., then a director of Drexel, recalled that a professor at Wharton, Robert Hagin, recommended Milken for the job. “Bob told me, ‘This is the most astounding young man I’ve ever taught,’ ” said Buford.
Buford was involved in a corporate-planning effort, analyzing all aspects of the firm. Like many other firms in the late sixties and early seventies, Drexel Harriman Ripley was struggling to weather the crisis of the “paper crunch,” in which back-office systems buckled and sometimes collapsed under the burden of trades, and records of stock and money delivered and received were lost. When Milken arrived, Drexel was in the throes of making the transition in its back office from the clerk with the green eyeshade to computers. Milken, who had spent the previous summer at the accounting firm of Touche Ross, was dispatched to the troubled area.
While he quickly believed he had divined the solution to the problems, his plan was not implemented. Most of the people in the back office from whom Milken tried to garner information had no more than a high-school education but many years’ worth of experience at their jobs. “Mike was like a bull in a china shop,” recalled a former Drexel executive. “He was terribly arrogant. And he didn’t have the facility to shroud his ability, couldn’t keep it from being threatening and abrasive. This army of operations people were so far beneath him in intellectual powers that he couldn’t deal with them, he could only beat on them. Soon their attitude was, Go talk to somebody else. So he never was able to unlock the system.
“Mike’s difficulty, gigantic, was that he simply didn’t have the patience to listen to another point of view,” this former executive continued. “He would assume he had conquered the problem and go forward. He was useless in a committee, in any situation that called for a group decision. He only cared about bringing the truth. If Mike hadn’t gone into the securities business, he could have led a religious revival movement.”
Whatever his interpersonal shortcomings, Milken was recognized as so high-powered intellectually that he was moved on from the back office to do other special projects, as assistant to the firm’s president, Bertram Coleman, and then his successor, James Stratton. He worked at Drexel part time throughout his two years at Wharton.
Perhaps his most significant contribution to the firm was his analysis of its securities-delivery system. Drexel, like many Wall Street firms, used to ship securities from city to city and borrow the price of the securities until they were delivered. That delivery often took as long as five days. Milken realized that delivery should be made overnight, thereby cutting the period of interest payment
from five days to one. According to its vice-president of operations, Douglas Clark, that idea saved the firm an estimated $500,000 annually.
When he left Wharton in 1970, he was hired full time at Drexel, to work in the Wall Street office as head of research for fixed-income securities; from there he moved into sales and trading. While Milken’s academic record was superb, he lacked all the other requisites—Ivy League school, social standing, physical presence—for acceptance at one of the premier firms on the Street, such as Goldman, Sachs. Drexel, while it was in a state of decline, at least had a major-bracket franchise. Besides, Milken tended always to stick with what was familiar. He had already spent two years working at Drexel; he would stay there.
Drexel prided itself on its lineage. It had been founded in 1838 in Philadelphia by an established portrait painter with financial acumen, named Francis Drexel. In 1871 the firm of Drexel, Morgan and Company was opened in New York; these two firms were later consolidated into a single partnership, engaging in both commercial and investment banking, under the name of J. P. Morgan and Company in New York and Drexel and Company in Philadelphia. The two firms epitomized the elite in investment banking, though Drexel was overshadowed—as was every firm and every financier—by the legendary J. P. Morgan, so formidable that he is credited with saving the United States Treasury from collapse in 1895 and averting a Wall Street panic in 1907.
With the passage in 1934 of the Glass-Steagall Act, which mandated the separation of investment-banking activities from commercial banking, J. P. Morgan and Company and Drexel and Company became entirely separate organizations. The Morgan firm opted for commercial banking and is now known as Morgan Guaranty Trust Company. Drexel stayed in investment banking. In 1966, Drexel merged with Harriman Ripley and Company.
The Philadelphia-based Drexel was strong in money management and in research, while the New York–based Harriman Ripley and Company had blue-chip investment-banking clients. It should have been a perfect marriage. But, like so many mergers of investment-banking firms which would occur over the next two decades, this one was fractious. Some key partners of both firms left, taking clients and capital. By 1970, Drexel Harriman Ripley investment banker Stanley Trottman later recalled, “we were afraid to open the paper every day—for fear we’d see yet another deal for one of
our clients filed by someone else.” That year Drexel Harriman Ripley was able temporarily to stanch the hemorrhaging by obtaining an infusion of capital—$6 million—from the Firestone Tire and Rubber Company. It changed its name to Drexel Firestone.
When Milken arrived as a full-time employee in its bond-trading department, Drexel still had some portion of its once-encyclopedic gilt-edged client list intact. Those triple-A credits, however, held no lure for him.
The universe of corporate bonds that Milken was entering consisted mainly of “straight debt”—bonds whose holders receive fixed-interest payments, typically every six months, until maturity, when the interest is repaid. A much smaller, more arcane part of the market consisted of convertible debt—bonds whose holders have the option to exchange them for other securities, usually stock. Corporate bonds are rated by rating agencies, such as Standard and Poor’s and Moody’s. Those companies with the strongest balance sheets and credit history, the elite of corporate America, are rated triple A. When they issue bonds in order to raise debt capital, the interest those bonds pay is not much higher than that of risk-free U.S. Treasury bonds. These are known as “investment-grade” companies.
A bond that is issued as investment grade and is subsequently downgraded because of a perceived deterioration in the company’s condition trades at a discount from its face, or par, value. Below-investment-grade bonds are rated Bar or lower by Moody’s, BB+ or lower by Standard and Poor’s, or are unrated. In the early seventies, these were known as “deep-discount” bonds or “fallen angels.” Also inhabiting this netherworld were those bonds known as “Chinese paper,” which were issued in the course of highly leveraged acquisitions by the conglomerateurs of the sixties.
It was these discounted bonds, both straight and convertible, some of them selling as low as ten or twenty or thirty cents on the dollar, that fascinated Milken. He had been under their sway since the sixties, when he began investing in them with money given him to manage by some of his accountant father’s clients. To persuade them to entrust him, a college student, with their money, Milken made a deal in which he would take 50 percent of all profits and 100 percent of all losses. Years later he commented (as reported in The Washington Post) that this arrangement had given him “a healthy respect for principal.”
Milken encountered the Hickman study while he was at Berkeley.
W. Braddock Hickman, after studying data on corporate bond performance from 1900 to 1943, had found that a low-grade bond portfolio, if very large, well diversified and held over a long period of time, was a higher-yielding investment than a high-grade portfolio. Although the low-grade portfolio suffered more defaults than the high-grade, the high yields that were realized overall more than compensated for the losses. Hickman’s findings were updated by T. R. Atkinson in a study covering 1944–65. It was empirical fact: the reward outweighed the risk.
Milken said in an interview with this reporter that the Hickman study “was consistent with what I had been thinking about for a long time.” It also represented the kind of thoroughness that won Milken’s respect. “Hickman had studied every bond for forty-three years,” Milken remarked. “He had done very thorough, original work, without machine support and the kind of data bases that would be available today.”
While Milken had been entranced with these low-rated bonds before he found Hickman, Hickman lent legitimacy to the gospel Milken began to preach at Drexel Firestone. In the summer of 1970, Drexel published listings and commentary on convertible and straight high-yield bonds—something rarely if ever done before on Wall Street, and the result of Milken’s labors. Hickman had documented this discontinuity in the market, but it was Milken who had the conviction and the nerve to take a retrospective, academic thesis and to play it prospectively as a trader and salesman at Drexel Firestone—giving much-increased liquidity to these bonds that had heretofore been only lightly traded. Before Milken, most institutions that bought them had socked them away until maturity.
Milken found his métier researching and trading these bonds. First he learned everything he could about the companies whose bonds he would be trading, preparing for his hours on the trading desk as though it were orals. Then he was ready to make his bet.
Explaining their allure, Milken said, “The opportunity to be true to yourself in high-yield bonds is great. It is not like buying a stock. With a stock, its value is generally dependent upon investors’ collective perceptions of the future. No matter how much research you have done regarding a particular stock, you don’t have a contract as to what the future price will be. But with a high-yield bond there is a date certain in the future when it matures, and if you hold it to maturity and your analysis is correct, you will be correct
in your calculation of your yield—and you do have a contract as to future price. One is certain if you’re right. The other is not.”
“Trading was perfect for Mike,” one former Drexel executive remarked. “You have to assess the many complex forces at work on a particular transaction. And then the question is, do you want to do it at this price—and do you have the guts to act on it? For Mike, it’s not even a guts question. It was religion. If he didn’t act on it, he was being unfaithful to his God.”
Most of his colleagues, however, looked askance at Milken and his low-rated bonds. “The high-grade-bond guys considered him a leper,” a former executive of the firm recalled. “They said, Drexel can’t be presenting itself as banker to these high-grade, Fortune 500 companies and have Mike out peddling this crap.”
While they ostensibly objected to his merchandise, some of his colleagues apparently had antipathy for the peddler. Stanley Trottman recalls that the two high-grade-bond salesmen most vociferous about Milken and his low-grade wares were virulent anti-Semites and wanted Milken moved to another floor; when they failed in that, he was segregated off in a corner of the bond-trading floor.
But while Milken was proving Hickman’s theory by making consistent profits on this much-disdained paper, those who scorned it, and him, were losing their shirts. When one of these high-grade-bond salesmen finally took his case to an executive of the firm, arguing that Milken should be fired, the executive responded, as he would later recall, “Let me ask you something. Milken on a modest capital base is making money, while your high-grade department on a large capital base is losing it. Now, whom should I fire?” Milken stayed, and, not long afterward, his antagonist left.
By the early seventies, Wall Street was littered with dead and dying firms. The recession of those years crippled the securities markets, and spiraling inflation then delivered the death blow to many smaller securities firms, which had limited resources. Between 1968 and 1975 over 150 firms were absorbed or closed. And by 1972, Drexel Firestone was in critical condition.
FOR BURNHAM AND COMPANY the financial crisis meant opportunity. The firm had been founded in 1935 by I. W. (“Tubby”) Burnham II, the son of a physician and grandson of the founder of I. W. Harper Gin, a distillery. Tubby Burnham’s grandfather wanted his offspring to work for a living and so gave them no money once
they were grown; when Tubby Burnham asked him for $100,000 to start a brokerage firm in 1935, his grandfather replied that he would loan him the money—but it was only a loan. Indeed, when he died he left his entire estate to a wildlife refuge and park, the Bernheim Forests, in Kentucky, and he stipulated in his will that the $100,000 with which his grandson had started his brokerage business should be repaid. It was.
By 1971, Burnham and Company was a small brokerage house, with about forty-two partners and capital of $40 million. It had a good research department, and its international equity (stock) arbitrage and retail businesses were decent. While it was undistinguished, the firm had always been profitable. Burnham husbanded its capital strictly.
At that time Wall Street adhered to strict procedural rules designed to perpetuate the establishment, and none was more inviolate than “bracketing,” which refers to the order in which underwriters are listed in tombstone ads announcing securities offerings. The top spot was reserved for the special-bracket firms, then came the major bracket, and then the submajor and regional brackets. The higher the bracket, the bigger the underwriter’s role in the offering—so it was not merely a matter of status, but of dollars.
In 1971, in the special-bracket elite were Dillon, Read and Company; the First Boston Corporation; Kuhn, Loeb and Company; Merrill Lynch, Pierce, Fenner and Smith; Morgan Stanley and Company; and Salomon Brothers. After that came about seventeen major-bracket firms, and then twenty-three submajors. Burnham and Company, a submajor, decided that the only way for the firm to establish an investment-banking presence was to acquire a major-bracket franchise.
That was what Drexel Firestone had. In addition, it had close to $1 billion under management, some investment-banking clients and cachet, and about $10 million of Firestone money.
Burnham paid visits to Gustave Levy, who had built Goldman, Sachs, and Robert Baldwin, the chairman of Morgan Stanley, which was a cousin to Drexel Firestone. Both men said they would support a merged Burnham and Company and Drexel as a major-bracket participant. The Drexel name, however, had to come first. As one former Drexel director remarked, “It was a classic case of the last gasp of the old guard—insisting on getting first billing.”
“If I had called it Burnham, Drexel, we’d still be a submajor,”
Burnham confirmed. “I remember I told my mother about it, and she said, ‘How can you? The firm has been Burnham since 1935.’ I said, ‘Mother, I want this. It will be worth millions to us.’ ”
It would, of course, be worth not millions but billions, and would raise the little Burnham and Company from the nether regions of Wall Street to its zenith of money and power less than fifteen years later—before it all threatened to come undone. But in 1973 Burnham had no idea that the value of Drexel Firestone resided not in its major-bracket franchise but in one rather odd, intense figure segregated off in a corner of the trading floor. The juxtaposition of the names was the most costly part of the transaction for Burnham. Beyond that, he paid book value (the capital its partners had invested in it), mainly with subordinated debentures.
Now Drexel, home to the kind of white Anglo-Saxon Protestants who took their genealogy seriously, not only had a Jewish trader peddling schlock bonds but had been taken over by a Jewish firm. Although Burnham and most of the top executives of the firm were Jews, Robert Linton, who became the firm’s chairman in the early eighties and who changed his name from Lichtenstein, demurred slightly at this characterization of Burnham and Company. “It was not a Jewish firm in the sense of an Ira Haupt or a Newburger [other brokerage firms],” Linton declared. “None of the top people practiced their religion. I mean, we weren’t lighting candles. My family came to this country in 1770.”
Burnham was curious about whether there were any Jews at venerable Drexel Firestone, and he asked its president, Archibald Albright, who told him that there were three or four (out of 250). “He said, ‘They’re all bright, and one of them is brilliant. But I think he’s fed up with Drexel, and he may go back to Wharton to teach. If you want to keep him, talk to him.’ ” One of Burnham’s advisers recalls that Albright told Burnham he would have to give this young man a substantial piece of the action to keep him.
Burnham called Milken that day and asked him why he wanted to leave. “He said, ‘They won’t give me capital.’ He had a five-hundred-thousand-dollar position overnight.”
Burnham gave Milken a position of $2 million, which was a large amount of trading capital in 1973. That year Milken made $2 million for the firm, a return of 100 percent. The next year Burnham doubled the capital. According to one Drexel executive, Milken received 35 percent of his small group’s trading profits as a bonus,
to be distributed as he saw fit. This fixed percentage had no cap, and it would remain unchanged over the next fourteen years.
Milken told his boss, Edwin Kantor, who was in charge of all fixed-income trading, that he wanted to create an autonomous unit, with its own sales force, its own traders and its own research people: the high-yield- and convertible-bond department. Selling these low-rated bonds, he explained, was more like selling stocks than it was like selling high-grade bonds. If a bond was rated triple A by a rating agency, institutions bought them based on that rating—not on the salesman’s pitch about the company. But to convince an investor to buy a bond with a C rating you had to tell the company’s story. You had to know the company’s management, its product, its balance sheet, its earnings trend and cash flow—just as you would in trying to sell the stock of a little-known company. You had to convince the investor that the rating agency had been too hidebound, or too cursory, or too blind to see that there was ore to be mined in this foundering company’s bonds. And, finally, you had to persuade the investor that an analysis of the assets showed that if the worst happened and the company went into default, there was a safety net of value below which the bonds could not fall.
As one competitor of Milken’s commented later, “Mike was the first to come up with the idea that he wanted a specialist—a salesman who lives and dies in this one specialty.”
At another firm, Milken’s desire for such an autonomous, self-contained unit might have incited turf battles and been too disruptive to be allowed. But Drexel Burnham was so embryonic, its territory so unclaimed, that Milken got what he wanted. And while it was true that these bonds were a specialty product that could benefit from a specialist’s expertise, it was also true that having his own unit would satisfy Milken’s powerful desires for secrecy and for control. These bonds, moreover, which in the main did not trade on any public exchange with electronic trading screens flashing prices, but in private transactions, trader to trader, were his perfect medium.
Milken would in effect create his own firm within the firm of Drexel Burnham, one which its members would refer to simply as “the Department.” He laid the groundwork for that autonomy in 1973. From the very beginning, Milken made it mandatory that a certain portion of his people’s profits were reinvested in trading
accounts which he ran. It was a system of forced savings, in which these salesmen and traders were able to watch—from a distance—their wealth accumulate. With the kind of return Milken got, no one really had much to complain about. On the other hand, if one decided to leave him on less than amicable terms, as one trader would, there might be difficulty in getting one’s money out. It was a powerful disincentive to taking any secrets from Milken’s operation to a rival firm.
OVER THE NEXT several years, Milken began to cultivate a group of increasingly satisfied customers. There were a handful of institutions, like Massachusetts Mutual, and discount-bond mutual funds, including Keystone B4, Lord Abbott Bond Debenture, and National Bond Fund. These tended to play the market according to Hickman, going for the yield over time in large, diversified portfolios.
There was also David Solomon, of First Investors Fund for Income, known as FIFI. FIFI was converting its high-grade-bond fund (with bonds that had suffered in the recession) to a high-yield fund in 1973, at about the time that Solomon was employed to manage it. According to former members of Milken’s group, Milken soon took Solomon in hand, and the returns on Solomon’s portfolio showed the effect. In 1973, the return on this fund’s portfolio was minus 14.02 percent; by 1975, it was plus 391/8 percent, according to Lipper Analytical Services. In 1975 and 1976, it was the number-one performing bond fund in the United States. Almost overnight, Solomon was transformed into a seeming portfolio wizard. But, especially in the first few years when Solomon was a neophyte in this field, Drexel employees claimed it was Milken who pulled Solomon’s strings.
While portfolio managers played for the yield, Milken always played—for himself, his colleagues, the firm and a growing body of wealthy individuals—for the upside. In the seventies, in near-bankruptcies and also bankruptcies (where only a portion of the bond’s value is lost), that upside could be enormous. As Hickman had noted, “Corporate bonds were typically undervalued in the market at or near the date of default. As a result, investors selling at that time suffered large losses, while those purchasing obtained correspondingly large gains.”
This was not an original concept. The renowned trader Salim “Cy” Lewis of Bear, Stearns had made a fortune buying the bonds
of bankrupt railroads in the forties. Milken would follow in Lewis’ footsteps by buying Penn Central bonds, on which he and his clients made killings. Milken, however, bought not just in one industry as Lewis had but across the whole landscape of troubled companies; as default was thought to be near and bondholders panicked, Milken was there to pick up the distress-sale merchandise, often at ten and twenty and thirty cents on the dollar.
Milken was also buying the bonds of the near-bankrupt real-estate investment trusts, known as REITs. Many of these trusts had issued investment-grade public debt which had now sunk as low as ten cents on the dollar. The REITs were much like mutual funds except that instead of stocks their portfolios consisted of real estate or financial instruments associated with realty, such as mortgages or leases. These trusts had grown out of the 1960 legislation that provided effective exemption from the corporate income tax for qualified trusts—the thought of Congress having been that this would provide the small investor with an opportunity to have an ownership interest in real estate. The REITs grew gradually through the sixties, and then they skyrocketed. In 1968 their total assets were $1 billion; in 1969, $2 billion; in 1974, $20.5 billion.
That year, the party ended. When the recession hit, the growth and earnings at many REITs slowed dramatically. However, the debacle was not all-inclusive; some REITs continued to perform well through the midseventies. Some faltered but came back. Milken analyzed them and chose those that he thought would either make it or have a liquidation value of, say, seventy-five cents on the dollar—so they were a bargain at twenty cents. “What we did with the REITs was to create a kind of unit trust for certain customers,” Kantor said. “We would say, ‘Take ten or fifteen of these—if just two of them make it, you’ll do great.’ And they did.”
Not all of Milken’s gambles received Tubby Burnham’s blessing. Burnham had survived and prospered by being conservative with his capital, and some of the paper Milken bought made him nervous. When he could, Kantor made himself the buffer between Burnham and Milken. “I insulated Mike,” Kantor declares. “I got the calls on Sunday morning—‘What are you doing?’ ”
At one point Burnham ordered Milken to get the firm out of the REITs, and Milken formed a syndicate among his colleagues, customers and himself to buy out the firm’s position. “Mike and the rest made a fortune on that,” Mark Kaplan, who was then the
president of the firm, said later. Milken was also doing well in the deal he had struck with Burnham. Kaplan recalled that in 1976, Milken and his principal trader, Charles Causey—with whom he was then in a fifty-fifty partnership—each received $5 million in compensation.
Among Milken’s early, delighted customers were Carl Lindner, Saul Steinberg, Meshulam Riklis and Laurence Tisch. Tisch, Steinberg and Lindner bought mainly for their insurance companies’ portfolios. Often it was the debt and equity of each other’s company that they were buying. Lindner, for example, through American Financial, had been the second-largest shareholder of Steinberg’s Reliance Financial through much of the seventies. He also became a major shareholder of Riklis’ Rapid-American in the midseventies. And he was in the late seventies the second-largest shareholder in Tisch’s Loews Corporation. The four were generally friendly business associates, though they may have been personally rivalrous. In an SEC deposition in 1982, Lindner would remark of Tisch, “You know Larry, he’s worth a billion and a half dollars, he and his brother, and you’d think that he was looking for cigarette money most of the time.”
Of the four, Tisch would be the only one who would distance himself from Milken in later years, as Milken’s machine grew ever more gargantuan and controversial and Tisch began to affect the role of elder statesman. While Tisch would remain personally aloof from Milken and his junk bonds, however, the insurance company Tisch had taken over in a hostile raid in the seventies, CNA, would continue to invest heavily in them. Milken would testify in a deposition taken by the SEC in October 1982 that there were extended periods during the preceding two and a half years when he spoke to CNA’s portfolio manager every day. Moreover, Tisch’s son, James Tisch, would be an investor, along with the Belzbergs, in a risk arbitrage partnership, Jamie Securities, run by John Mulheren—who took enormous positions in takeover stocks (many of them Drexel-backed deals) and was, of all arbitrageurs, probably closest to Ivan Boesky.
Meanwhile, Lindner, Steinberg and Riklis would become among the most devoted stalwarts of the Milken empire.
Lindner and Steinberg—who is about twenty years younger than Lindner—had followed somewhat similar career paths. Both were outsiders, who had amassed their own fortunes, and who had
forever alienated the establishment with their onslaughts on major banks. And both acquired property- and casualty-insurance companies which would assume significant stock positions (in Steinberg’s case, sometimes with hostile intent) in other major companies.
Lindner, a secretive, publicity-shy Cincinnati financier who did not finish high school, had built a milk-store business into a major supermarket chain and then had invaded the financial world—where his prize catch in 1966 was Cincinnati’s Provident Bank, one of the pillars of the city. He had continued on his financial-service acquisition trail, acquiring a major property- and casualty-insurance company, Great American. By 1974, about the time he began buying bonds from Milken, his mammoth holding company, American Financial Corporation, had equity of $192 million and debt of $692 million: a debt-to-equity ratio of roughly 3.5 to one.
One Drexel employee maintains that officials at Drexel had turned Lindner down as a client about six months before Milken met him and began doing business with him, because they were worried about Lindner’s reputation. He was known then to be the target of an SEC investigation, and he would be charged by the SEC with violating anti-fraud and anti-manipulation provisions of the federal securities laws in 1976 and in 1979. But Milken is said to have persuaded others at the firm to overcome their compunction, and by the midseventies Lindner became Drexel Burnham’s biggest client, both in trading and in corporate finance. He would also become, of all Milken’s clients, the one Milken would respect the most.
Steinberg had started a computer-leasing business, Leasco, when he was just a couple of years out of Wharton, in 1961. That very profitable company’s stock had soared in the heady stock market days of the late sixties, making it possible for little Leasco to take over the conservative, 150-year-old Reliance Insurance Company, nearly ten times its size, by tendering to its shareholders a package of the highly valued Leasco paper.
Then, in a far more audacious move—one which rocked the corporate establishment, stirred currents of anti-Semitism, and foreshadowed the kinds of epic struggles that Milken would finance some fifteen years later—Steinberg in 1969 had targeted for conquest the $9 billion Chemical Bank. By the time he surrendered, those who had so effectively combined against him included not only the directors and management of Chemical, but most of the
banking business, Governor Nelson A. Rockefeller and the legislature of New York State, and members of the Federal Reserve Board and the Senate Banking and Currency Committee.
Riklis had never set his sights on a major bank, but he was every inch the renegade. Like Steinberg and Lindner, he had created his own fortune, relying on leverage, invention, keen business acumen and a disdain for the unwritten as well as some of the written rules. Like Lindner, Steinberg and Riklis by the midseventies signed consent decrees with the Securities and Exchange Commission—a standard securities-law-enforcement plea bargain—in which they neither admitted nor denied their guilt but agreed to desist from violations of securities laws in the future or face criminal-contempt charges.
An Israeli emigrant, Riklis had started out with a stake of just $25,000, buying and combining small companies in the 1950s. By the time he met Milken in about 1970, Riklis controlled a conglomerate, Rapid-American, which had sales of close to $2 billion. It included such companies as International Playtex, Schenley Industries, Lerner Shops and RKO–Stanley Warner Theatres. What Riklis had done was acquire one company and then use its assets to acquire the next, and that company’s to acquire the next, in ever larger circles. He acquired these companies by issuing mainly bonds, or debt, in exchange for the company’s stock. As Riklis liked to say, Rapid-American owed its success to “the effective nonuse of cash.”
The major difference between Riklis’ debt-laden acquisitions and those of Milken’s later acquirers was that Milken’s chosen would issue the bonds for cash and then give the cash to the shareholders, while Riklis would issue the bonds directly to the shareholders. Both Riklis and his successors a generation later, however, would be using to their advantage the same debt-favoring provision of the U.S. tax laws: interest (on bonds) is deductible, but dividends (on stock) are not. Therefore, assuming roughly a 50 percent corporate-income-tax rate, a company that can pay shareholders a rate of return of 7 percent on dividends can just as easily pay 14 percent interest on subordinated debt, because it can deduct the interest.
“I started this thing,” Riklis would claim in an interview in 1986. “When Mike entered the market [in about 1970], I already had over a billion dollars of these bonds outstanding.”
Riklis’ method of dealing with the day of reckoning on all this debt would also be used in later years by many of Milken’s issuers.
Riklis has been the master of the exchange offer. In order to postpone the date of repayment of principal, he would offer a slightly more attractive bond—with a longer maturity—to his bondholders. And after another few years he would offer another. “You have to do the exchange,” Riklis declared. “Otherwise the bonds will come due!” On several occasions, he has reportedly commented that his bonds will never be repaid in his lifetime.
After years of encountering resistance from the SEC to his taking his company private, Riklis worked out the guidelines with the SEC’s then head of enforcement, Stanley Sporkin, in 1980—and proceeded to take Rapid-American private. He was followed, in short order, by Lindner, who took American Financial private, and Steinberg, who did the same with Reliance. According to one former employee of Reliance, all three transactions were influenced by Milken. Since these three members of Milken’s coterie sometimes owned each others’ debt and/or equity, Drexel became the nexus for a lot of trading activity among them at this time. A 1982 SEC investigation explored, among other things, trading that had occurred in the securities of these and other companies from January 1980 through May 1982. The investigation was closed without any action being brought by the SEC.
Some of the earliest buyers of the high-yielding Rapid-American bonds Milken was hawking remember frequent meetings with Riklis, Milken and about a half-dozen buyers at the Pierre Hotel in the early seventies. At that time, Milken had only about twenty-five different issues to trade. There were fallen angels—including the airlines’ busted convertibles (securities whose underlying equity is trading far below the bonds’ conversion price) and “Chinese paper” like Riklis’, which had been issued in the context of an acquisition.
They also remember when Riklis’ companies got into trouble in the midseventies and his bonds went down to twenty and thirty cents on the dollar. Riklis had recently been divorced, his personal life was a nonstop party, and his attention had strayed from business.
At that time, Milken, Drexel, and Milken’s customers are said to have owned about $100 million of Rapid-American’s debt. Before Milken, debt holders had traditionally been a passive lot. But Milken made it his habit to accumulate with his fellows such enormous positions that he could demand attention from heads of companies. Sometimes it worked and sometimes it didn’t; when Milken
in the midseventies went to lunch with Sanford Sigoloff, then head of Daylin, and announced how much of that company’s debt he owned and what he thought Sigoloff ought to be doing with the balance sheet of the company, Sigoloff replied that the last time he had checked he was chief executive officer of the company, and that lunch was over. But Riklis was more desperate and more receptive. Milken gave him a business plan. As Riklis recalled:
“Mike said, ‘You’re working for me. You own a lot of the equity in your companies, but I own your debt. And your equity is not worth the paper it’s printed on unless your bonds are valuable. Riklis is working for Milken.’
“If you say that Mike rescued me, it would be wrong,” Riklis continued. “But if you say Mike chaperoned me, it would be right. He oversaw everything that I did. He had to—in order to know whether he should sell these bonds or not, and what was the bargain price. He had to be constantly monitoring what we were doing.”
Over the years, Riklis became a friend and a great fan of Milken, whom he considers “a creative genius.” “All my dealing with Drexel,” Riklis said, “is based on the fact that Mike exists in Drexel.”
Riklis claims that the word “junk” to describe these low-rated bonds originated in one of his and Milken’s early phone conversations, in about 1970. “He looked at my bonds and he said, ‘Rik, these are junk!’ And I said, ‘You are right! But they pay interest, and they sell at a discount.’ Mike called them junk bonds, he created that name, unfortunately as a joke to start with. Today he would like to get rid of that joke, but sometimes it’s very difficult.
“Today, Mike would kill to have everybody know it as a high-yield bond, but it’s too late, so he might as well accept it,” Riklis concluded. “A pogrom is a pogrom.”