Chapter 7. Junk Bonds

“Greed is alright, by the way. I want you to know that. I think greed is healthy. You can be greedy and still feel good about yourself.”

Ivan Boesky, speaking at the University of California, Berkeley, May 18, 1986

Junk bonds and securitized mortgages took from bankers the businesses of lending to risky companies and mortgage lending, and gave them to the markets. This drove a wedge between those who bear the risk of a loan and those who decide to make the loan, and encourages risk-taking. As a result, mortgage rates moved in line with other markets, cresting and crashing in unison with them.

The most widely recognized investor of the 1980s was not a businessman at all, but the actor Michael Douglas. As the fictional arbitrageur Gordon Gekko, his “greed is good” speech in the 1987 movie Wall Street summed up an era of excess in finance that resonated in popular culture. The era seemed to end with the disgrace of key financiers and the recession of 1990—but its innovations proved durable and are still central to the market drama two decades later.

Greed always drives Wall Street. What made Wall Streeters wealthier in the 1980s was something more prosaic: financial engineering. The taming of inflation led to lower and steadier interest rates, spurring financial innovations. Academic theories spurred investors to diversify into new kinds of assets. And deregulation allowed markets to peel off yet more business from banks, who hurried into new investments.

The most important breakthrough came in 1984 when the Reagan administration allowed banks to package mortgage loans into bonds and sell them to investors. This created a liquid market where mortgages could be traded, and moved power over housing finance into the markets. Until then, mortgage-lending still discernibly followed the model set in Victorian Britain, where it was built around “building societies”—mutual organizations that took in savings and made loans they monitored carefully, collecting mortgage repayments from door to door. This was inefficient and costly, but minimized defaults. Country after country, from the United States with its “Savings and Loans,” to Spain in the 1970s, to Mexico in the 2000s, funded its emerging middle class this way.

Enter Wall Street. A mortgage is a clearly written financial contract, in which the borrower undertakes to make a certain flow of cash payments. The right to receive these payments can be sold to someone else (along with the risk that the homeowner defaults or repays in full ahead of schedule). If you put together enough mortgages, diversification comes to the rescue of due diligence. Broad statistical patterns help to predict the default rate, along with moves in the economy that most investors already spend much time trying to predict. The guiding principle, yet again, is “safety in numbers.” Scrutinizing each borrower is impossible, but if you own enough mortgages, so the theory goes, it is not necessary either.

Once politicians gave them the go-ahead, investment banks started buying large blocks of mortgages from mortgage-lenders, many of whom were struggling with the high rates of the Volcker years, packaged them together, and used them to back bonds. Buyers of the bonds would receive the interest payments paid by the ultimate borrowers. As mortgage payments tend to be secure, the deal made sense for them—a slightly higher return than they could get on a treasury bond, in return for slightly greater risks.

Fannie Mae and Freddie Mac, the former Federal National Mortgage Association and Federal Home Loan Mortgage Corporation, were pivotal players. Fannie was formed during the New Deal as a government mortgage bank, charged with stimulating the housing market, but President Lyndon Johnson sold it off in 1968 in an unsuccessful attempt to keep the federal budget in balance. Despite being a quoted company, whose managers needed to make a profit for shareholders, it continued to be a “government-sponsored” entity—meaning, as far as many were concerned, that it still had an implicit guarantee if anything went wrong with its mortgages. When they took on mortgage bonds and sold them on the market, therefore, traders assumed that those bonds carried the federal government’s guarantee. The proposition here was a slightly higher return than a treasury bond, and no extra risk. That meant Fannie and Freddie had to pay less interest on bonds and could therefore bid more to buy up mortgages from others, propelling the market. The ambiguous implicit guarantee helped to encourage Fannie and Freddie’s managers, and their investors, to take excessive risks.

The presence of Fannie and Freddie in the market had unforeseen consequences. As lenders found it hard to compete with them, they would look in areas where Fannie and Freddie could not go, such as “jumbo” mortgages too expensive to qualify for federal help, and subprime mortgages for people with bad credit histories.

As a result of the innovation, the risks of default were no longer born by those who decided to make the loan in the first place. Instead, the lending officer who made the loan could sell the risk to someone else. Principals had once again been separated from agents.

The investment bankers who acted as agents did not always take their responsibilities wholly seriously, a process immortalized by Michael Lewis’ tell-all Liar’s Poker,¹ probably the most entertaining book on finance ever written. In it, Lewis told the story of his years as a salesman at Salomon Brothers, the firm that led the mortgage-backed market, where mortgage traders would raucously gamble with each other throughout the day. Investment bankers grew obscenely rich. The banks that originated the loans also gained from securitization, as this took mortgages and their attendant risks off their balance sheets. They would take the money generated from selling the loans, and move on to something else.

The idea spread to the UK and much later to continental Europe, where there was less need for securitization as borrowers were more conservative and banks tended to be stronger. Critically, the technology worked as intended. It made it easier to finance mortgages and to spread risks, helping people buy their homes. But with the splitting of principals from agents, there was the risk that swings between greed and fear could change the affordability of buying houses—a profound building block of the economy.

Banks also lost control of another key function, lending to small or risky businesses, thanks to another market innovation: the junk bond. Like index funds, junk bonds (known officially as “high-yield bonds”), traced their origin to an entrepreneurial financier armed with academic research.

Michael Milken, of the investment bank Drexel Burnham Lambert, got the idea for junk bonds while studying economics as an undergraduate. He read a paper by Walter Braddock Hickman,² an academic who later became a Federal Reserve governor, which showed that from 1900 to 1943, a diversified portfolio of low-grade corporate bonds out-performed higher-quality blue-chip bonds, without greater risk. A subsequent study for the years of 1945 to 1965 came to the same conclusion.

The key was diversification, or another form of “safety in numbers.” Buy enough different low-grade bonds, which must pay a higher rate of interest to persuade investors to buy them, and enough of them survive without default to leave the investor better off than in blue-chip bonds, which pay less interest. As with investing in emerging markets, risky investments that normally require a prohibitive amount of research can be palatable if financiers package enough of them together.

There was a flaw in the theory. Before the war, low-grade bonds were an unusual phenomenon. Generally, they had been issued by companies which had strong credit at the time, only later to fall on hard times. Rather than being regarded as an asset class, they were created by accident, but buying them at their lowest ebb worked out in the long run. It was not clear that the same would hold true of large amounts of bonds from companies that had bad credit at the time they issued them.

Nevertheless, Milken saw the opportunity. Persuade enough high-risk companies to issue debt, and investors could more easily be persuaded to enter the market in search of higher yields. Persuade enough investors to take the plunge into junk, and companies would be encouraged to issue. Once a market had been established, it would be easier for them to raise finance, improving smaller companies’ overall prospects.

It worked, and Milken became the wealthiest financier on Wall Street. “Junk” bonds democratized markets. Demand for them grew so great that they became offensive weapons, as companies used high-yield bonds to make acquisitions that the market would not previously have been prepared to finance. Arguably such forces lay behind Barbarians at the Gate, the closest approach financial journalism has yet made to a Dickens novel³, which told the story of how the food-and-tobacco conglomerate RJR Nabisco was bought by a consortium of investors for $25 billion in a deal financed by high-yield debt. More than two decades later, it remains the most expensive buy-out of any company. RJR was hobbled by the huge interest payments it took on, but the deal made many financiers richer.

Junk bonds also won away yet another function from banks. Traditionally, loans to high-risk companies were made by bankers who could get close to the companies, talk to the managers, tour the premises, and act almost as low-grade consultants. Now, rather than do homework on the risks they were taking, investors could buy a range of bonds, and safety in numbers would see them through—some bonds would default, but most would survive. Yet again, a sensible insight from academia convinced investors that they had tamed risk.

Displaced bankers even fueled the demand for junk bonds. Savings and Loans, U.S. mortgage lenders, had plentiful cheap finance from deposits but found it hard to put the money to good use because other mortgage lenders, financed by the capital markets, could undercut them. Wall Street salesmen had the answer. They started selling them high-yield bonds which, at least in theory, should behave a lot like mortgages.

Several critical elements for the disaster of 2007–2008 were therefore in place. Prices in several sectors of the economy were now entrusted to the market, not bankers. Banks were at even more of a loose end. Junk credit could be traded. Mortgages could be traded. All that remained was to put the two together, and trade junk mortgages.

The market survived, even though the problems with junk bonds soon grew apparent. As several highly leveraged companies admitted they could not meet the huge interest payments they had taken on, junk bond prices tumbled by 11 percent in 1989. At the decade’s end, Lipper Analytical Services reported money invested in junk-bond funds had grown by 145 percent since 1980. This sounded good but was worse than the 202 percent earned by investment-grade corporate bonds, or even the 177 percent made by virtually riskless U.S. treasury bonds. Almost one quarter of companies for which Drexel had issued junk bonds from 1977 onward defaulted by 1990—an exceptionally high failure rate.⁴ This contributed to a horrible crisis for the Savings and Loans, many of whom turned out to be guilty of fraud, and they required a big government bailout in the recession of the early 1990s.

Milken himself went to prison, successfully battled cancer, and enjoyed a renaissance as a philanthropist. The story of his rise and fall even became the subject for an experimental ballet. But the American excess of the 1980s had nothing on the speculative madness that took over Japan at the same time. And Japan’s crash, perversely, was to offer Americans a plentiful new source of cheap money.

In Summary

Junk bonds and securitized mortgages:

• Continued the decline of banks and the rise of markets.

• Split principals from agents.

• Gave lenders an incentive to take risks.

• Made financing far easier to find.

• Tied in the interest rate on mortgages more closely with other markets.