The S&L Fiasco: Michael Milken Was Not The Bad Guy -- The Dad Gummit Was

Excerpted by John "Birdman" Bryant


From THE CREATURE FROM JEKYLL ISLAND BY G. EDWARD GRIFFIN (American Media, 1998) From the chapter HOME, SWEET LOAN pp. 78-81

ACCOUNTING GIMMICKS ARE NOT FRAUD We must keep in mind that a well managed institution would never assume these kinds of risks or resort to fraudulent accounting if it wanted to stay in business for the long haul. But with Washington setting guidelines and standing by to make up losses, a manager would be fired if he didn't take advantage of the opportunity. After all, Congress specifically said it was OK when it passed the laws. These were loopholes deliberately put there to be used. Dr. Edward Kane explains: "Deception itself doesn't constitute illegal fraud when it's authorized by an accounting system such as the Generally Accepted Accounting Principles (GAAP) system which allows institutions to forego recording assets at their true worth, maintaining them instead at their inflated value. The regulatory accounting principles system in 1982 added even new options to overstate capital.... Intense speculation, such as we observed in these firms, is not necessarily bad management at all. :In most of these cases, it was clever management. There were clever gambles that exploited, not depositors or savers, but taxpayers." The press has greatly exaggerated the role of illegal fraud in these matters with much time spent excoriating the likes of Donald Dixon at Vernon S&L, and Charles Keating at Lincoln Savings. True, these flops cost the taxpayer well over $3 billion dollars, but all the illegal fraud put together amounts to only about one-half of one per cent of the total losses so far. Focusing on that minuscule component serves only to distract from the fact that the real problem is government regulation itself.

JUNK BONDS ARE NOT JUNK Another part of th distraction has been to make it appear that the thrifts got into trouble because they were heavily invested in "junk bonds." Wait a minute! What are junk bonds, anyway? This may come as a surprise, but those held by the S&Ls were anything but junk. In fact, in terms of risk-return ratios, most of them were superior grade investments to bonds from the Fortune-500 companies. So-called junk bonds are merely those that are offered by smaller companies which are not large enough to be counted among the nation's giants. The large reinvestors, such as managers of mutual funds and retirement funds, prefer to stay with well-known names like General Motors and IBM. They need to invest truly huge blocks of money every day, and the smaller companies just don't have enough to offer to satisfy their needs. Consequently, many stocks and bonds from smaller companies are not traded in the New York Stock Exchange. They are traded in smaller exchanges or directly between brokers in what is called "over the counter." Because they do not have the advantage of being traded in the larger markets, they have to pay a higher interest rate to attract investors, and for that reason, they are commonly called high-yield bonds. Bonds offered by these companies are derided by some brokers as not being "investment grade," yet, many of them are excellent performers. In fact, they have become an important part of the American economy because they are the backbone of new industry. The most successful companies of the future will be found among their ranks. During the last decade, while the Fortune-500 compa- nies were shrinking and eliminating 3.6 million jobs, this segment of new industry has been growing and has created 18 million new jobs. Not all new companies are good investments-the same is true of older companies-but the small-company sector generally pro- vides more jobs, has greater profit margins, and pays more dividends than the so-called "investment-grade" companies. From 1981 to 1991, the average return on ten-year Treasury bills was 10.4 per cent; the Dow Jones Industrial Average was 12.9 per cent; and the average return on so-called junk bonds was 14.1 per cent. Because of this higher yield, they attracted more than $180 billion from savvy investors, some of whom were S&Ls. It was basically a new market which was orchestrated by an upstart, Michael Milken, at the California-based Drexel Burnham Lambert brokerage house.

CAPITAL GROWTH WITHOUT BANK LOANS OR INFLATION One of the major concerns at Jekyll Island in 1910 was the trend to obtain business-growth capital from sources other than bank loans. Here, seventy years later, the same trend was developing again in a slightly different form. Capital, especially for small companies, was now coming from bonds which Drexel had found a way to mass market. In fact, Drexel was even able to use those bonds to engineer corporate takeovers, an activity that previously had been reserved for the mega-investment houses. By 1986, Drexel had become the most profitable investment bank in the country. Here was $180 billion that no longer was being channeled through Wall Street. Here was $180 billion that was coming from people's savings instead of being created out of nothing by the bank, In other words, here was growth built upon real investment, not inflation. Certain people were not happy about it. Glenn Yago, Director of the Economic Research Bureau and Associate Professor of Management at the State University of New York at Stony Brook, explains the problem: "It was not until high yield securities were applied to restructuring through deconglomeration and takeovers that hostilities against the junk bond market broke out.... The high yield market grew at the expense of bank debt, and high yield companies grew at the expense of the hegemony of many established firms. As Peter Passell noted in The New York Times, the impact was first felt on Wall Street, "where sharp elbows and a working knowledge of computer spreadsheets suddenly counted more than a nose for dry sherry or membership in Skull and Bones." The first line of attack on this new market of high-yield bonds was to call them "junk." The word itself was powerful. The financial media picked it up and many investors were frightened away The next step was for compliant politicians to pass a law requiring S&Ls to get rid of their "junk," supposedly to protect the publlc,. That this was a hoax is evident by the fact that only 5% ever held any of these bonds, and their holdings represented only 1.2% of the total S&Ls assets. Furthermore, the bonds were performing satisfactorily and were a source of much needed revenue. Never- theless, The Financial Institutions Reform and Recovery Act, which was discussed previously, was passed in 1989. It forced S&Ls to liquidate at once their "junk" bond holdings. That caused their prices to plummet, and the thrifts were even further weakened as they took a loss on the sale. Jane Ingraham comments: "Overnight, profitable S&Ls were turned into government-owned basket cases in the hands of the Resolution Trust Corporation (RTC). To add to the disaster, the RTC itself, which became the country's largest owner of junk bonds ... flooded the market again with $1.6 billion of its holdings at the market's bottom in 1990.... So it was government itself that crashed the junk bond market, not Michael Milken, although the jailed Milken and other former officials of Drexel Burnham Lambert have just agreed to a $1.3 billion settlement of the hundreds of lawsuits brought against them by government regulators, aggrieved investors, and others demanding "justice." " Incidentally, these bonds have since recovered and, had the S&Ls been allowed to keep them, they would be in better financial condition today. And so would be the RTC. With the California upstarts out of the way, it was a simple matter to buy up the detested bonds at bargain prices and to bring control of the new market back to Wall Street. The New York firm of Salomon Brothers, for example, one of Drexel's most severe critics during the 1980s, is now a leading trader in the market Drexel created.

REAL PROBLEM IS GOVERNMENT REGULATION So the real problem within the savings-and-loan industry is government regulation which has insulated it from the free market and encouraged it to embark upon unsound business practices. As the Wall Street Journal stated on March 10, 1992: "If you're going to wreck a business the size of the U.S. Thrift industry, you need a lot more power than Michael Milken ever had. You need the power of national political authority, the kind of power possessed only by regulators and Congress. Whatever "hold" Milken or junk bonds may have had on the S&Ls, it was nothing compared with the interventions of Congress." At the time this book went to press, the number of S&Ls that operated during the 1980s had dropped to less than half. As failures, mergers, and conversion into banks continue, the number will decline further.




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