(3 of 7)
Drexel's demise was greeted with little sympathy, even on Wall Street. Many experts regard the firm's fall, caused largely by the collapse of its $1 billion junk-bond portfolio, as a just comeuppance and a sign that Wall Street is entering a period of welcome sobriety. Drexel, after all, was more than just a tough competitor; it was viewed as a bad influence. Last year the company agreed to pay a $650 million fine and pleaded guilty to six counts of mail and securities fraud. As part of the settlement, federal prosecutors required Drexel to dump Milken, who now faces a 98-count fraud and racketeering indictment. "The era of extravagance and insanity has come to an end," says economist Pierre Rinfret, who runs a Wall Street consulting firm. "This is a breath of fresh air. Drexel got what it deserved. These guys could destroy the country. There is no rhyme or reason for what has been going on."
As its legacy, Drexel leaves behind a battered junk-bond market and hundreds of corporations staggering under debt. Last week the prices of junk bonds, some of which had lost as much as half their face value in recent months, rebounded as investment firms bought them up to reassure the marketplace about their stability. But in the long run, the overleveraging of America could spell trouble if the country plunges into a recession and profits tumble, leaving companies unable to meet their interest payments.
Junk bonds were a little-known security when Milken opened Drexel's Beverly Hills office in 1978. Seated at an X-shaped trading desk, Milken first peddled junk for small and medium-size companies whose weak credit ratings kept them from issuing bonds that paid lower interest rates. When investors snapped up the junk, Milken expanded the market for his new securities. The tireless promoter argued that the risk of a junk-bond default was scarcely greater than the risk for blue-chip corporate bonds. Since junk securities paid interest rates about six percentage points higher than conventional bonds, Milken found many high rollers willing to buy them.
By the mid-1980s junk had become so popular -- and Milken so powerful -- that corporate raiders could launch a bid backed by little more than one of Milken's trademark letters stating that he was "highly confident" of lining up the necessary financing. Just for the ominous letters, Milken charged fees as high as $3.5 million. Backed by Milken, Texas oilman T. Boone Pickens attacked Gulf Oil in 1984, forcing the energy giant to merge with Chevron and earning nearly $400 million from his seven-month raid. Later Milken bankrolled Carl Icahn in a $1.2 billion takeover of TWA. Supported by Drexel's bonds, the little-known firm Kohlberg Kravis Roberts became America's buyout king, acquiring 35 companies for more than $60 billion since 1976.
Junk bonds proved to be the ideal weapon for exploiting a weakness in corporate America that raiders were quick to detect. They saw that the stock market valued many large companies at prices well below what their assets would fetch if the companies were bought and broken up. By using junk bonds to build their war chests, takeover artists could pay a premium to shareholders and still hope to make a profit by dismantling a target company.