The Predators’ Ball (3 page)

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.