San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

Junk Bond Financing and Financiers

The Network of Junk Bond Financiers

Meshulam Riklis (Rapid-American)

Riklis is a man of flamboyance and some mystery. He immigrated from Israel to Minnesota about 1947. There were conflicting stories of his early life. Some said he was originally Hungarian, others that he grew up in Turkey, others that he fought against Rommel in North Africa. Riklis is apparently the source of all these stories. In Minneapolis-St. Paul he worked as a stock broker and became famous for his aggressiveness. Later he organized a group of investors to acquire two printing companies, Rapid Electro-type and American Colortype, which became his major vehicle for "wheeling and dealing," Rapid-American. In the late 1950's Riklis used Rapid-American to acquire many small and medium-sized firms. In most cases he acquired these companies paying little or no cash. He traded exotic kinds of securities, such as high-paying preferred stock, high-yield bonds, and convertible bonds. These securities are sometimes called "Chinese money" because they were used by another innovative financier named James Ling. Ling was not Chinese but his name appeared to be, hence the name Chinese money.

In 1967 Riklis began a campaign to acquire Schenley Industries, the distributor of Dewar's White Label Scotch Whiskey and other popular brands of liquor. Riklis fought off competing offers and finally gained control. The takeover involved paying the Rosenstiel family (who held controlling interest in Schenley) a premium in cash for their shares and giving the other stockholders a much lower amount not in cash but in junk bonds. Riklis pioneered the type of takeovers that KKR and Michael Milken carried out later. Riklis asserted that he never paid off a bond issue except with another bond issue. Riklis' bonds were not in good repute and there was a history of defaults.

Riklis later acquired the Riviera Hotel, a casino in Los Vegas. Riklis was accused of draining funds from some of his acquisitions, driving them into bankruptcy.

Riklis is also famous for being the husband of Pia Zadora, a beautiful model who made a few movies and adorned the pages of Playboy Magazine.

Milken and Riklis made acquaintance once Drexel Burnham junk bond operation became important. Riklis was very interested in Milken creating a secondary market for Riklis' low grade securities. It was getting more difficult to find someone who would take Riklis' bonds in trade for stock because they were so illiquid.

Carl Lindner ( American Financial Corporation)

Carl Lindner and his brother Robert used their family's dairy business to build a chain of convenience stores in Cincinnati, Ohio. From there they went into the financial and communications fields. Through their holding company American Financial Corporation (AFC) they control Great America Insurance, a holding company for a group of property and life insurance companies that constitute the twenty third largest insurer in the country. AFC owns the fourth-largest bank in Cincinnati and the second-largest savings and loan. The Lindners also control seventy shopping centers around Cincinnati. They once owned Bantam Books and the major newspaper of Cincinnati, the Cincinnati Enquirer. Charles Keating, also of Cincinnati, was a close friend and colleague of the Lindners.

Carl Lindner also had major investments in United Brands (formerly known as United Fruit), Gulf + Western (now Paramount Communications), Warner Communications, Kroger (a major supermarket chain in the eastern U.S.), and Penn Central.

Whereas the Lindner companies and financial institutions once operated on conservative, cautious principles they later became involved in riskier ventures. Lindner insurance companies began to invest in junk bonds and other Lindner companies began to issue junk bonds. The SEC noted that Lindner companies were the single largest filers of new issues of securities in the U.S. Lindner was repeatedly accused of self-dealing in the corporations under his control; e.g. having such a corporation give him a private aircraft. He became closely associated with Milken and the others in the junk bond field to the extent that his financial institutions invested in the junk bonds of of the others. He, like some the others, actively enraged in public relations efforts to present an image of fiscal propriety to the general public.

Victor Posner ( Sharon Steel)

Posner was raised in Baltimore, worked in his father's dry goods store, and early went into real estate. He was said to be a major slumlord in Baltimore, but retired to Miami Beach in his forties. He came out of retirement, perhaps because of threatened takeovers of companies he held. He acquired a number of smaller companies and then he managed, through the use of leverage, to gain control of the reputable manufacturing firm of Sharon Steel. Posner drew salaries from the companies he controlled to the extent that he was the highest paid corporate executive in the U.S. during the late 1960's and early 1970's.

Posner used bizarre forms of notes and stock, which he sold to institutional investors, to carry out the acquisition of substantial shares of companies such as Southeastern Public Service, National Propane, and a clothing maker Wilson Brothers. But the illiquidity of Posner's securities was becoming a serious problem. When Posner took over Sharon Steel he arranged for the employee pension fund to sell off its blue chip portfolio and invest in the junk bonds Posner had used to acquire other companies.

He was sued by the SEC for diverting funds from the public corporations he controlled to members of his family. Posner developed a philosophy of unconcern about such suits; if he had good enough lawyers he didn't need to worry. The lawyers, of course, would be paid for by the corporations he controlled.

In 1988 Sharon Steel went into bankruptcy.

Saul Steinberg (Leasco, Reliance)

Saul Steinberg at a very young age decided he wanted a career in finance. He managed to attend the Wharton School of Business while only an undergraduate and wrote a senior paper on the profit opportunities in computer leasing. IBM had had a policy of not selling computers but only leasing them. This policy was challenged by the Justice Department and IBM started to sell computers as well as lease them. In setting the lease rate IBM used a depreciable life of only four years. Steinberg realized that if the computers were depreciated over a longer period, say eight years, he could charge a far lower fee than IBM. The period for depreciation was not dictated by the physical life. The computers could easily become obsolete long before they wore out. Steinberg set up a company Leasco to carry out such a leasing operation. He tried to write the leasing contract so that the leasees would have to pay even if their leased computer became technically obsolete before the end of the lease contract. He further contracted for insurance against nonpayment on the lease. On the basis of such iron-clad leases Steinberg borrowed money to finance the purchase of computers. Furthermore, the accounting system put the present value of the lease payment on the books at the time the contract was signed. The accounting profit of Leasco looked quite impressive and the theory of the operation was acceptable to the financial world. The stock in Leasco traded at a price/earnings ratio of about fifty to one. With this inflated stock and a reputation as a financial wizard Steinberg was able to acquire many other companies, companies that were more conservatively valued.

In this way he acquired a very large insurance company Reliance in 1968 before he was thirty years of age. By the time the market had shown that the idea behind Leasco was not as solid as it seemed, Steinberg had acquired enough holdings and cash that his financial positions was only mildly affected. In 1969 he attempted a takeover of Chase Bank of Manhattan. The Rockefellers and the rest of the Establishment fought to prevent him from taking it over.

Like Riklis, Lindner, and Posner, Steinberg was often accused of self-dealing in the corporations that he came to control. His ex-wife charged that he used corporation money to renovate his apartment and to buy a jet aircraft.

By now Steinberg had learned that he could make money even from an unsuccessful takeover. After acquiring a substantial block of stock in a company he could demand "green mail;" i.e., pressure the company board of directors to pay a higher price for his stock than the general public could get. His acquaintance with Michael Milken gave him the clot to threaten companies with takeovers.

Laurence Tisch (Lorillard)

Laurence Tisch graduated with honors from New York University and went on to get his MBA at Wharton. After graduation Tisch served for three years during World War II in the Office of Strategic Services, which later became the CIA. After the war he joined his family in renovating old hotels. His family was a quite interesting one. His father had been an All-American basketball player. In contrast to the other members of the network of junk bond financiers there was no seediness or underhandedness involved in his or his families operations.

One major acquisition of the Tisch family was Loew's, a theater chain. In 1968 the Tisch family acquired the cigaret manufacture P. Lorillard, the makers of Kent cigarets. These companies were acquired with securities that were subsequently proving to be illiquid. This was putting the damper on any further acquisitions by Tisch. Milken's junk bond operations were important in providing liquidity to the junk bond market.

In 1974 Tisch gained control of a Chicago insurance holding company, CNA Financial using some cash and a lot of securities. This gave Tisch control over a large amount of investment funds. The cost of acquisition of an insurance company is the equity in the company, but the funds held are many times this equity. Tisch is now chairman of the network CBS.

A social note: A niece of Laurence Tisch married the son of Saul Steinberg in a wedding in which the flowers alone cost one million dollars.

Fred Carr (First Executive)

Fred Carr was the son of an immigrant from Hungary who established a produce business in New York City. Later the family moved to Los Angles where Fred grew up and attended Cal State Los Angeles. He drove a truck and started his own driveway repair business to help put himself through college. By his early twenties he was trading in the stock market. Later he founded a very successful mutual fund called the Enterprise Fund. In two years the funds under his management rose from $20 million to $800 million. He was usually at the top of the list of high gain performers in the mutual fund field. However, there were charges that he drifted from the straight and narrow; e.g. buying unregistered "letter" stock and reselling it to others without registering it. By 1970 he had lost his touch and Enterprise Fund ranked 339th out of 379 mutual funds in performance. He abruptly left the Enterprise Fund and SEC temporarily shut it down because of irregularities and chaos in the record keeping. It later reopened under the direction of Gerald Tsai.

In 1974 Fred Carr was asked to run financially troubled First Executive Insurance. Carr went to Michael Milken to get funds to stave off collapse and started marketing a new product called Single Premium Deferred Annuity. A buyer makes a payment now and starts receiving annuity payments a specified number of years in the future. This is great for an insurance company's cash flow in the immediate future. In return for the help Milken gave, Carr agreed to market junk bonds through First Executive.

The Single Payment Deferred Annuities (SPDA's) were a great success. First Executive had a total of $700 million of policies of all kinds when Fred Carr took control in 1974. By 1979 it was selling $1 billion worth of SPDA's each year. Saul Steinberg bought stock in First Executive and by 1981 had become the largest stockholder. First Executive began selling annuities to corporations linked to Milken to "refinance" their pension plans. The pension plans were declared "overfunded" and the assets sold off to be replaced by annuity contracts from Carr's First Executive. The contracts used in this refinancing were called "guaranteed investment contracts" (GIC's). The companies which bought these GIC's could count them as investment-grade bonds even though they were simply packages ofjunk bonds which First Executive guaranteed. By 1990 Carr's First Executives had $5 billion of GIC's outstanding. Institutions that otherwise would not have been able to hold junk bonds were allowed to once they were packaged and labeled as GIC's by virtue of First Executive's guarantee.

By the end of the 1980's First Executive was buying $2.5 billion of Drexel junk bonds each year. Furthermore, once First Executive had purchased a bond issue it gave those bonds a stamp of quality as being held by a major insurance company. Milken could also use First Executive as an example when trying to sell junk bonds to other insurance companies. Although there were other insurance companies which became important markets for Milken, Fred Carr was by far the most important player in Milken's junk bond game. First Executive had a representative at Drexel who bought anything Milken told him to, no questions asked. Milken and Carr also set up reinsurance firms together.

In 1980 insurance purchased about $22 billion in corporate bonds, by 1988 they were buying $180 billion.

The Savings and Loan Industry

The Savings and Loans were in difficulty long before Michael Milken came onto the American financial scene. Originally S&L's were restricted to holding mortgages on real estate. This restricted S&L's competitiveness with respect to bank which were not so restricted. But the interest rates that banks and S&L's could pay on deposits were regulated so S&L's did not have to match banks in a bidding contest on interest rates. During the 1970's inflation rates went up and interest rates followed. This was especially hard on S&L's, which had their assets tied up in long term mortgages paying low interest rates but had to pay high current rates to keep depositors. Fundamentally at that stage the S&L's became bankrupt, but every one wanted to postpone the inevitable. The government's actions in trying to stave off the bankruptcy of the S&L's turned a bad situation into a disasterous one. The Garn-St. Germain Act of 1982 removed most of the restrictions on what S&L's could hold. From 1982 they could hold stocks, bonds, real estate, and commercial loans as well as mortgages. But at the same time that the restrictions on what S&L's could hold were removed, the interest rates restrictions for banks were also removed. Nevertheless the Federal Government continued to insure S&L deposits. Depositors did not have to concern themselves about the safety of an S&L. S&L's were another financial institution, like insurance companies, where a relatively small investment in equity gave the buyer control over a much larger amount of investible assets. The purchase of an S&L with a billion dollars worth of assets might require only $30 million to buy up its equity. Within months of the passage of Garn-St. Germain members of Milken's circle were taking over S&L's using Drexel junk bond money. The S&L's then became major markets for junk bonds. A $30 million outlay for a S&L could easily lead to the sale of $500 million of junk bonds by Drexel for which it would charge a commission of $20 million. Some of the S&L's taken over by friends of Milken were:

Other S&L's, such as Columbia Savings in Beverly Hills under the direction of Tom Spiegel, joined the circle of junk bond buyers. By 1989 Columbia S&L had bought $10 billion in junk bonds. Spiegel's compensation for running Columbia was spectacular, $9 million in 1985. In addition, Milken let Spiegel in on some opportunities for spectacular capital gains, and, allegedly, for trading on insider information. By the late 1980's most of these S&L's were siezed by state or federal regulatory agencies.


In 1969 Perry Mendel, a developer in Montgomery, Alabama, decided to use some of his real estate to create a chain of day-care centers. Mendel brought in another Montgomery businessman, Richard Greengrass, to help him carry out his plan. The centers, called Kinder-Care, were a success and by 1987 employed 17 thousand people in 12 thousand centers. The gross revenue was $900 million with operating profits of $75 million (but a net profit of only $6 million).

In 1978 Mendel and Greengrass went to Milken to raise some capital. Milken convinced them to raise much more than they originally intended. They not only expanded Kinder-Care and bought up another chain, Sylvan Learning Centers, and expanded it, but also bought up an insurance company Pioneer Western. A few months later they bought CenterBanc, an S&L, in Florida. And then, they acquired American S&L in Miami. Mendel and Greengrass renamed their company Enstar. In the course of about 18 months a chain of day-care centers had been converted into a $3 billion banking and insurance company. This transformation had been financed by Drexel junk bonds, but strangely Enstar also bought $650 million in junk bonds. Enstar helped Milken finance the takeover Safeway, Revlon, and Gillette. In return, Milken let Mendel and Greengrass in on some very lucrative investments. The deals got shadier and shadier, and in 1991 Mendel and Greengrass were convicted of fraud by a federal court. Here is an example of one of their more outrageous ploys. Enstar sold the Kinder-Care portion of the company. In the selloff, Mendel and Greengrass told the Kinder-Care stockholders that they were giving them the day-care centers. They then announced that the IRS had objected to this transaction so the Kinder-Care stockholders would have to pay $4.75 per share to receive what they already owned. There had been no IRS objection.

The Default Rate on Junk Bonds

The Milken organization claimed the default rate on their high yield securities was only one percent. Critics claim the default was more like three or four percent. At this higher rate, junk bonds give a lower return than Treasury bills and no one would knowingly buy them. By 1983 there were hundreds of millions of dollars of junk bonds which had flatly defaulted. There were other cases where the default was concealed as an "exchange;" i.e., the bond was supposed to pay interest in cash but instead gave "stock" or "zero-coupon convertible bonds" or "payment-in-kind bonds" in lieu of interest.

The junk bonds market could have collapsed in the mid-1980's under the burden of the defaults and effective defaults, but Milken got a lucky break. Edward Altman of the Business School of New York University was hired by Morgan Stanley, the most pretigious investment bank in the U.S., to do research on the default rate on junk bonds. Morgan Stanley wanted to enter the obviously lucrative field of marketing original issue junk bonds. It made the mistaken presumption that Drexel's position in the field was based upon knowledge and research when, in fact, it was, in Benjamin Stein's words, based "upon years of mutual backscratching in the back alleys of finance." Altman computed the ratio of the face value of the bonds that actually defaulted in a given year to the total face value of bonds in existence in that year. Although this procedure might seem reasonable, it did not allow for the tremendous growth in junk bonds over the period. Suppose all of the junk bond issues default after five years. This would be a 100 percent default rate. But if the first year there is $100 million issued and the amount doubles each year then this would be the record Altman's method would show:

Year 1 2 3 4 5 6 7 8
Amount issued 100 200 400 800 1600 3200 6400 12800
Total Amount 100 300 700 1500 3100 6300 12700 25500
Default 0 0 0 0 100 200 400 800
Default Rate (%) 0 0 0 0 3.2 3.2 3.1 3.1

A default rate of around 3 percent and declining looks a lot better than the actual 100 percent rate. Altman did not count the default-equivalents of giving "securities" in lieu of money for the interest payments as defaults. Altman concluded that the default rate on junk bonds was between 1 and 1.5 percent in most years, and through Morgan Stanley this value was publicized. Drexel, of course, gave this estimate of the default rate further publicity. This erroneous figure was accepted because of the academic credentials of Altman and the prestige of Morgan Stanley. Altman studied all bonds with a rating below investment grade. This lumped together "fallen angels" with Milken junk bonds. He also made the unjustified assumption that the residual value of defaulted Milken junk bonds was the same as that of "fallen angels"; i.e., thirty five to forty percent. Despite these and other major flaws, Altman's studies were accepted by various institutions, including the U.S. government, as vindicating investment in the junk bond market.

In 1988 a team of financial analysts at Harvard University under the direction of Paul Asquith undertood a study of junk bonds. In contrast to Altman they focused on the default rates of bonds over the bonds lifetimes. They concluded, "Buying and holding all [junk] bonds issued in 1978 and 1979 produces cumulative default rates exceeding 34% by November 1, 1988...Cumulative default rates rise markedly as the time since issue increases and are 0-8% three years after issue, increase to 18% to 26% seven years after issue ... and exceed 34% eleven years after issue."

Instead of a one percent default rate per year the Asquith group found an average default rate of about 3.4 percent per year. At this default rate junk bonds were a poor investment and it was foolish and irresponsible for insurance companies, pension funds, banks and S&L's to hold them.

Michael Milken

Michael Milken was born in the Los Angeles area and grew up on the border between Encino and Van Nuys. His father was a very industrious man who was an orphan and worked his way through college in Wisconsin to become an accountant. Michael and his younger brother Lowell were good sons, helping their parents where they could and excelling in school and sports. Michael played varsity basketball in highschool and was the head cheerleader in other sports. He did his undergraduate work in business at UC-Berkeley during the period 1964 to 1968. While other students were indulging in the radicalism of the 1960's Michael was studying accounting and economics. It was at Berkeley that he discovered the work of Walter Braddock Hickman, entitled Corporate Bond Quality and Investor Experience, on the bond market from 1900 to 1943. Hickman did find that by some measurement the average yield on the lower quality bonds was higher than that of the higher quality bonds but not by very much. Milken exaggerated this difference and chose not to allow for the special effects the Great Depression of the 1930's and World War II had on the bond market. The Depression severely depressed bond prices so that any bonds bought at the depths of the Depression showed extraordinary gains. World War II and the Federal Government's creation of a managed economy meant there were no defaults on bonds during the war years.

Milken graduated in 1968 as a Phi Beta Kappa with a degree in business administration. After graduation Milken married and moved to Philadelphia to go to the Wharton School of Business at the University of Pennsylvania. While pursuing his regular coursework (reportedly with straight A's) he continued to investigate whether or not the bond market was pricing bonds of different risks efficiently. He left Wharton in 1969 to go to work for Drexel and three years later completed his MBA thesis. It was entitled, "Managing the Corporate Financial Structure." Stein characterizes it as, "an stonishing mishmash of basic, obvious facts," and "a lot of bluster to prove something everyone already knows."

At Drexel, later to become Drexel Burnham, Milken made contact with a number of prominent wheeler-dealers, such as Meshulam Riklis of Rapid-American and McCrory, Lawrence Tisch of Lorillard, and Carl Lindner of American Continental. Stein gives summaries of the careers of these financiers and others who became important to Milken in his career.


Benjamin Stein, License to Steal: The Untold Story of Michael Milken and the Conspiracy to Bilk the Nation

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