Markets and Morality
Or Arbitragers Get No Respect
Markowitz,Harry M.Wall Street Journal: May 14, 1991. pg. A.2
Usually the only thing I lecture on lately is portfolio theory, but this time I think it best if I make an exception. I have decided, instead, to discuss questions of right and wrong, especially as applied to participants in financial markets. Now, you know as much as I do about right and wrong. So, this afternoon I will be an equal opportunity speaker: I will explore a subject on which the audience knows as much as the speaker.
There are many obvious ways in which a society's rules of right and wrong influence its quality of life. Where littering is not frowned upon, all live in a world of litter. Where "excuse me" and "thank you" are passe, all live in a rude world.
The consequences of rules of right and wrong are sometimes subtler. A few years ago a friend asked me to have dinner with him and a Russian emigre mathematician. I was disturbed to hear the mathematician predict that the Gorbachev reforms would not succeed. "The basic problem is the Russian people's attitude toward profit," he explained. "If there are goods one place that are needed someplace else and someone makes a profit moving these goods from the one place to the other, he is considered greedy and evil."
In fact, the Gorbachev reforms did not succeed. When economic collapse had proceeded far enough, Mikhail Gorbachev froze bank accounts, causing much distress among those who had managed to save anything. The purpose was to frustrate those Mr. Gorbachev said were the true culprits: the blackmarketeers. Thus in Mr. Gorbachev's mind, or at least in his words to the Soviet people, the source of the Soviet ill was the greedy, evil people who seek to benefit from the misfortunes of others by moving goods from where they are to where they are needed, not out of altruism but out of avarice.
My own views are much closer to the gospel according to Adam Smith. The invisible hand is clumsy, heartless and unfair, but it is ever so much more deft and impartial than a central planning committee. Consequently, I am troubled by the indiscriminate way many Americans use "greed" as an explanation of economic events. For example, the cover of "Liar's Poker," a book about Salomon Brothers, shows a dollar bill with a picture of John Gutfreund, head of Salomon. Inscriptions on the dollar include "In Gutfreund We Trust" and "Wall Street Greed." The back cover of "The Predators' Ball," about Drexel Burnham Lambert and Michael Milken, contains part of a New York Times review, which says the book "dramatically captures the philosophy of greed that has dominated Wall Street in the 1980s."
The blanket condemnation of the "greedies" of the 1980s fails to distinguish between the complaint that too many people sought to maximize their own well being, as Adam Smith would have us all do, legally, and the complaint that too much leverage was used in the 1980s. If the latter is the true complaint, the blanket condemnation of "the greedies" fails to ask whether the reason for excess leverage was the fact that slick salesmen disguised the true risks of the junk bonds they sold. Or was it that unwise laws structured institutions so that they were induced, and sometimes compelled, to take high risks?
The blanket condemnation of the greedies of the 1980s blurs other important distinctions. It lumps together people who were remarkably stingy with those who were remarkably generous, either with public donations to good causes or with quiet private help to others in need. It lumps together those whose sole interest in life was the winning of the finance game, as measured by their accumulating wealth, and those who played the game well, accumulated fortunes, but found time for other interests. It lumps together those who committed well-defined crimes and deserved the punishment they got, and perhaps more, with those who were arrested conspicuously, left waiting for the next round of charges, then had their cases dropped as a big mistake; and those whose crimes had been civil offenses before, but now were elevated to criminal offenses.
I'd like to examine some of these distinctions more closely, but before that I'd like to correct two misimpressions I may be giving. First, you may think that I think that maximizing well-being is the same as maximizing wealth. But I believe that most people find that once some moderate needs for food and shelter are satisfied, it depends more on how you spend your time than on how much money you make.
Second, since I have emphasized the efficacy of markets as compared to bureaucrats, you may think I think that markets can run themselves. This is not the case. Laws and law enforcement are needed to assure me that the meal I buy is not poisoned and the airplane I fly on is well maintained; that those who manufacture things for my use pay their full costs, including the costs of cleaning up the mess they make; that if I deposit money with a bank or pay a premium to an insurance company the banker or insurer will not go to Las Vegas to gamble with my money.
These two things now said, let's return to the alleged greedies of the 1980s. I would like to organize my remarks around two product areas of major importance in the 1980s. One is mortgage bond products as pioneered at Salomon Brothers; the other is junk bonds -- that is, high-yield, high-risk bonds, whose market was dominated by Mr. Milken at Drexel.
"Liar's Poker" is the story of Salomon Brothers as told by Michael Lewis, who entered the firm early in 1985 as a young trainee and left it three years later when he decided making that much money wasn't that important. When he speaks generally, he speaks of the greed that permeated and dominated Salomon Brothers. When he describes specific individuals and actions we find that some are mean and some kind, some are stingy and others generous, some you can trust and some you cannot. The individuals seem no more nor less than human.
Mr. Lewis considers his to be a tale of greed. I view the same events and find in them the triumph of two great ideas: Adam Smith's invisible hand at its clumsy but beneficent best; and option-pricing theory as applied and enhanced by the "rocket scientists" whom Salomon Brothers had gathered.
The mortgage-backed bond did not become a great source of profit for Salomon Brothers until the 1980s, but its cause was championed within Salomon Brothers by Bob Dall as early as 1977. By February 1979, Lewie Ranieri, who had started in the mailroom, was officially placed in charge of mortgage operations. Eventually the mortgage bond business blossomed, thanks in part to a tax break passed in 1981 that made it highly desirable for savings and loans to sell their old mortgages and use the proceeds for other investments, even the mortgages sold by other S&Ls.
In the following years the market grew. It also changed character. Mr. Lewis quotes Samuel Sachs, longtime mortgage bond salesman, as saying: "They wheeled in the rocket scientists, who started to carve up mortgages into itty-bitty pieces. The market became more than the five things that Lewie {Ranieri} could hold in his brain at any one time."
Mr. Lewis contrasts the refinement of analysis that lay behind some mortgage products with the crudeness of some of the traders who bought and sold these products. My own view is that the fact that the invisible hand could work its magic through mere humans is an essential part of Adam Smith's insight. Not many thousands of years ago, men like this would have clubbed each other over hunting rights. A few hundreds of years ago they would have hacked each other with axes and swords. Now they yelled at trainees while they brought together the supply and demand of home mortgages on a world-wide scale.
At first, Salomon Brothers had a great advantage over other investment banks in the mortgage product area. This advantage was temporary. Bright young people could see that they were bringing millions of dollars of profit to Salomon Brothers, and felt that their annual bonuses should reflect this. This conflicted with Salomon caps on bonuses as a function of how long the person had been there. But other investment banks were delighted to bid away many of Salomon Brothers' young stars. As other investment banks built their own capabilities, customers gained the ability to shop around. In short, I take the story of mortgage products at Salomon as an example of Adam Smith's thesis that individuals seeking their own self-interest through the marketplace will promote the common good, even if some of them are crude.
Now let us turn to the junk bond market under Michael Milken at Drexel. I find Connie Bruck's detailed account in "The Predators' Ball" quite plausible and will use it as my principal source. In the 1980s Michael Milken engaged in illegal and near-illegal behavior as a regular part of doing business. Part of this behavior had as its purpose the suppression of competition in the junk-bond business.
For example, in 1985 the board of Wickes decided to do a debt underwriting through Salomon Brothers, which had been trying to break into the junk-bond business. After Mr. Milken learned of the forthcoming underwriting, Saul Steinberg, a close Milken associate, accumulated 10.4% of Wickes's stock, and duly reported this to the SEC. Then Mr. Milken had a Saturday breakfast meeting with Sandy Sigoloff, president of Wickes. According to a Wickes director, "Mike told Sandy what Saul held, what Drexel held, and how, when you combined that with whatever other pockets Mike might have placed stock in, it meant they would have control of the company." In the next few days Drexel became co-manager and then sole manager of the Wickes underwriting.
Ms. Bruck notes that if Mr. Steinberg, Drexel and perhaps "other pockets" did plan to act in concert, they were in violation of securities laws by not filing with the SEC as a group. Ms. Bruck also provides other examples of "the brass knuckles, threatening, market manipulating Cosa Nostra of the securities world."
A small part of Mr. Milken's illegal or near illegal activities involved his association with Ivan Boesky. My dictionary defines greed as "excessive or reprehensible acquisitiveness." The word is so overworked that I hesitate to use it. But it does seem that Mr. Milken was as excessively acquisitive as one could get, and Mr. Boesky about as reprehensible. Since Mr. Boesky is usually associated with the words "greed," "insider trading" and "arbitrager" I cannot resist saying a few words in defense of the perfectly respectable business of doing arbitrage. This is in part self-defense since, for three years, I was in the arbitrage business.
In index arbitrage, the arbitrager looks for moments in time when the price of a futures contract for a stock index is out of line with the appropriate sum of prices of the individual stocks that make up the index. The arbitrager then buys the one and shorts the other. This would tend to keep prices in line. Admittedly, this may seem like a rather fussy fine tuning of the price system; but it seems, at least to me, to be a good thing rather than a bad one to have prices of related things be closely linked.
Ivan Boesky practiced merger arbitrage or risk arbitrage. A simplified example will serve to illustrate. Suppose that Company A agrees to buy Company B, and B agrees to be bought. A agrees to exchange one share of its $150 stock for each share of B's $100 stock. Upon the announcement of the deal, let us assume that A's stock stays at $150 while B's rises to $140. If you owned neither stock, and you were sure that the deal would go through, you could assure yourself a $10 profit by shorting (that is, selling) one share of A at $150 and buying one share of B at $140. This procedure would be safer than just buying a share of B, since the price of both A and B might fall.
But there is one risk: Sometimes deals do not go through. Thus inside information is very valuable to the merger arbitrager, but it is not legal to act upon. It is much less likely that any kind of inside information would be of value to other sorts of arbitragers.
The proposition "inside information is especially useful to merger arbitragers" does not imply the proposition "all merger arbitragers use inside information." For a reduced sentence Ivan Boesky implicated Marty Siegel among others, and Marty Siegel implicated three arbitragers in prominent positions. The three were arrested with great fanfare, one being led away in tears and handcuffs.
One of the three was eventually convicted of having learned that a merger might not go through for which he had an arbitrage, and acting on this information. This was indeed a crime, or at least a securities law violation, and deserved some kind of punishment. But it was not a pattern of buying and selling inside information as with Messrs. Boesky, Siegel and Levine. As for the other two arbitragers arrested, after much delay it was decided that no charges would be brought, that there had been a miscommunication between Mr. Siegel and the prosecutors. I agree with those who feel that if the prosecutor had been less politically motivated he would have prepared his case first and made his arrests second.
Returning to Michael Milken and the junk market, as we noted already Mr. Milken engaged in illegal activities, in part to maintain a near monopoly in junk bonds. One use of this monopoly was to obtain high fees for junk-bond underwritings. Implicitly, part of the fee was in the form of warrants -- the right to buy the issuing company's stock at a fixed price, which would prove highly valuable if the stock price rose. Frequently Drexel insisted that the warrants were needed to induce prospective buyers to buy the bonds. In fact, most warrants went to Drexel employees, favored clients, and investment partnerships controlled by Mr. Milken.
But the chief complaint about junk bonds was not that Drexel charged too much for them but that they were used for destructive purposes, that they weakened the American economy. I believe this to be true, but there are exceptions.
Only a small minority of companies command investment-grade ratings from the bond-rating services. The junk-bond market provides a major source of capital for the rest. Clearly this market serves a useful purpose in bringing together supply and demand for such higher-risk and therefore higher-yield securities.
The chief complaint about junk bonds is that they were used to finance highly leveraged deals -- management buy-outs or hostile takeovers. The extent of the leverage is illustrated by Ms. Bruck's description of Nelson Peltz's 1985 hostile takeover of National Can, financed by Mr. Milken's junk bonds: "Five hundred sixty-five million dollars was a towering debt load for $100 million of equity to carry. And Peltz pointed out that even the $70 million from Triangle, at the equity base, came from its earlier offering of junk. . . . `We called it equity here, but it was debt over here. Do you understand the leverage in this deal? It was eleven to one!'"
Part of the standard takeover strategy is to attempt to reduce the debt once the target firm is acquired. In some hostile takeovers the stock of the company is sufficiently undervalued as compared with the underlying assets that a corporate raider can buy the company at a high price (compared with the stock's recent market price), sell off pieces of the firm, pay off most of the debt and thus acquire the core business for almost nothing.
In general in such situations, either the market has set an irrationally low value on the company or, as corporate raiders often contend, the market reflects the poor way entrenched management uses resources. This point is well taken. Such raids, and the threats of such raids, tend to put a boundary on how inefficient management can become in corporations where no individual or small group considers itself the company's owner. But in highly leveraged deals such as Mr. Peltz's takeover of National Can, the sale of inessential assets still leaves the company highly in debt.
Another source of debt reduction is the company's cash flow. To increase the cash flow the raider, now owner of the company, reduces research, employment and maintenance. Sometimes, some of this makes the firm more efficient. But based on the levels of debt that had to be paid down, I imagine that the raiders, now owners, of the highly leveraged companies had to cut back research, maintenance and staff to the point where firm value fell.
If so, then somebody had to lose. Who? Not the old stockholders, since they were bought out at a favorable price. Not Drexel or Michael Milken, since they received large fees plus warrants. Not the raider, since he took a highly advantageous gamble. If things went well, his bet would have a high payoff. If it went poorly, for the most part it was not his own money that was at stake; and, in the meantime, he enjoyed the perks of his large enterprise.