Whenever people discuss economic or financial instances of enormous profit, either due to innovative thinking or straight out fraud, the name Michael Milken is almost certain to come up. Known as the “junk bond king,” Milken may be individually responsible for revolutionizing the world of corporate finance and transforming a lagging nation in the 1980s to one with unprecedented economic development. Milken obtained his masters degree in business from the Wharton School of Business and claimed that he had a mission to democratize capital. While many banks were rejecting risky loan pleas and remained stringent on their credit policies, Milken reaped the benefits of this opportunity. He realized that the system of credit could be opened to more people by providing credit based on a company's upside potential instead of its past history. Milken was an executive at Drexel Burnham Lambert, Inc., where he utilized high-yield junk bonds for corporate financing. These risky issues that pay a high interest rate financed the growth of companies that could not get conventional backing. The list includes some outstanding successes: MCI, Viacom, Turner Broadcasting and others. In just a few years, Milken reshaped the financial world single-handily. He effectively created a bond market that eliminated traditional restraints and created a half-trillion dollar pool of capital. While economic sage Schumpeter realized banks’ role of development in the economy, channeling credit to more efficient innovators, Milken’s junk bonds provided the most efficient innovators with the necessary capital and the result was a financial and economic revolution. As might be expected, Milken’s success story does have quite a blemish. In 1989 a federal grand jury indicted Milken for violations of federal securities and racketeering laws. He was heavily fined and sentenced to prison for ten years, but in 1991 his sentence was reduced to two years in addition to a mandatory probation sentence of three years. Although not much has changed in the justice system, recent scandals by companies such as Enron and Worldcom have lead to more stringent policies. While critics of Michael Milken acknowledge his brilliance, they see him as the ultimate paragon of the greedy 1980s. However, how one man could create changes of this magnitude, and make nearly a billion dollars, is a story of American success and capitalism.
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When we as students were first introduced to the idea of bonds it was described as one of the safer and less risky securities that one can invest in. Even in our own textbook a bond is defined as “ a debt security that promises to make payments periodically for a specific period of time.” (Mishkin, 4) Then the question arises: how can this market of bonds be so risky? Well, first off, the corporate bond market is more risky that the government bond market-, which guarantees your investment. Within the corporate bond market there are different levels of credit ratings from AAA (the highest kind of credit ratings) and Baa and below (higher levels of risk, and these bonds are usually referred to as “junk bonds). As with any investment in a security the same rule applies- the higher the risk, the higher the payoff- or the harder the fall. This kind of high risk investing is for those that can afford it- for those so-called “high rollers”. One such “high roller” is David Matlin, the manager of Credit Suisse First Boston’s vulture fund. Mr. Matlin’s technique and strategy is not for the faint at heart- rather it’s as risky as it gets: his goal is simply to “buy cheap bonds in hopes of scoring big in restructurings.” (Forbes.com) As the Forbes article describes one of Matlin’s investments went south as he acquired $30 million worth of a company that dealt with home nursing. Only after he assumed control of the company did he learn of an accounting-fraud problem that ended up in his losing the entire $30 million. However for every ten misses- there is a hit: he has been able to average 40% returns annually since 1994. How has he been able to keep these returns coming in? Well, another one of his schemes is to gain a controlling position in the company by acquiring a majority of the company’s debt- thus this gives him command of the creditors committee (the committee which decides who gets what in the restructuring). A success story of this kind was his 1994 involvement with the hotel chain Days Inn. While details can be found at the Forbes website, one Matlin investment totaled an initial purchase of $45 million dollars, bought at 30 cents on the dollar- after the restructuring he exited with 100 cents on the dollar, or roughly $150 million. While David Matlin is only the newest of the “junk bond” players, the most famous of the crew would have to be Michael Milken. He was the pioneer of selling new public issues of junk bonds of companies that had not yet reached investment-grade status. Inevitably Milken found himself in trouble with the SEC for security law violations in 1989. (Mishkin, 268) Thus, overall the bond market is just as risky as investing in any other financial market. Furthermore we can see it’s not necessarily the market in which you invest, but rather the strategy you choose to implement, and your aggressiveness. The examples stated here exemplify two of the more aggressive investors of our time. Their “high roller” style is perilous and unsafe, but can in the end payoff. The law in the United States allows this risky behavior of buying these junk bonds- fundamentally it breaks no rules: wealthy investors are investing in below average securities. The SEC, however, is paying close attention to how and why these bonds are being bought- allowing no illegal dealings such as insider information and trading to take place. Junk bonds are similar to IPO’s in this sense; they are both risky investments with a world of opportunity to break the law.
· Mishkin, Fredric S. : The economics of Money Banking and Financial Markets