Junk bonds, subprime and the pepper crises: Investor behavior follows pattern

July 17, 2009

In his classic work of economic history, "Manias, Panics and Crashes," Charles Kindleberger argued that asset bubbles follow a predictable pattern.

A new opportunity or technology sparks investor euphoria. Asset prices quickly rise to an unsustainable level. Then suddenly, people stop buying, and panic ensues. The more people who leave, the faster values plummet.

So it is with real estate and subprime mortgages today, and so it was with junk bonds a generation ago.       

Real estate prices, of course, have fallen around the country, and some subprime borrowers have defaulted on their loans. That combination has led to financial pain on Wall Street and Main Street. Junk bonds -- corporate bonds rated as non-investment grade by Moody's and Standard & Poor's -- followed a similar trajectory in the 1980s and early 1990s. First, they soared in popularity, feeding a binge for corporate buyouts. Then they sank, saddling some borrowers -- the companies that issued the bonds -- with debts that they couldn't afford and some investors, with shrunken portfolios.

Excessive issuance and lack of attention to risk evaluation in both subprime mortgages and junk bonds ended up causing serious financial troubles. Lately, mortgage-backed securities (bonds created from pools of mortgages) and derivatives have contributed to the woes of such big banks as Citigroup and Bank of America. Junk bonds likewise dragged down some savings and loans in the 1980s. The S&L crisis, during which hundreds of S&Ls failed because of a combination of bad investments, ill-conceived regulations and a changing economy, and the subsequent federal bailout cost taxpayers about $150 billion.

Making good money from junk

Yesteryear's junk-bond woes may provide lessons for today's subprime troubles. But to understand how you have to know a little history.

One man is largely responsible for modern junk bonds. His name is Michael Milken, and he popularized the bonds in the 1980s while working at an investment bank named Drexel Burnham Lambert.

Before Milken junk bonds weren't common. Back then, a company would stumble into trouble, and ratings agencies would downgrade its debt. "They were the bonds of companies like Penn Central Railroad, which had once been Triple A-rated but fell onto hard times," says James F. Smith, an economist with ParSec Financial in Asheville, N.C.       

Milken realized that investors could make good money with junk. Because of their greater risk, the bonds provided higher yields to investors. Sure, the company behind a particular junk bond was more likely than the average to end up bankrupt. But Milken noticed that, if an investor assembled a diversified portfolio of junk bonds, he could reduce his risk -- and still enjoy the higher return, compared with investment-grade bonds.

Milken and his sales force at Drexel talked up these benefits to investors, and Drexel soon became a leading underwriter of junk bonds, helping companies secure financing by issuing the securities. Thanks to Milken, a legion of small and medium-sized firms, many of them previously shut out of Wall Street, sold junk bonds, and eager investors scooped them up.

"That brought credit to a whole new set of companies," says Robert Mittelstaedt, dean of the W. P. Carey School. "Subprime mortgages have done the same thing -- they've brought credit to a bunch of people who couldn't get credit before."

Where Milken financed companies, subprime mortgages have enabled folks with impaired credit or other financial blemishes to buy homes. Some of these people have lately defaulted on their loans, but plenty more continue to make their payments on time.

Some of the shaky corporate upstarts that Milken backed eventually matured into well-known firms, Dean Mittelstaedt points out. His clients included long-distance operators like MCI, cable-TV providers like Turner Broadcasting and casino developers like Steve Wynn, creator of The Mirage, Treasure Island and The Bellagio in Las Vegas. Milken also backed corporate raiders -- that is, investors who used his bonds to finance hostile takeovers.

"Harley Davison is a junk-bond success story," says finance Professor L. Wendell Licon. "It's hard to imagine now, but Harley was on its last legs then. It got a reorganization plan and needed financing and had to issue junk bonds. The plan worked, and that's one of the main reasons that Harley's around today." 

From junk yard to jail yard

Milken was eventually ensnared in a federal investigation of insider trading and other financial crimes. In 1990, he pleaded guilty to another offense and agreed to pay $200 million in fines. He served about two years in prison. The junk bond market's fortunes followed those of its creator. For a while, amid all the bad publicity surrounding Milken, the market slumped.

In the meantime, it became obvious that not everyone who'd bought Milken's bonds understood their perils. Among those investors were a slew of S&Ls, including Centrust in Miami and Lincoln Savings and Loan in California.

"The S&Ls had just been deregulated," Licon says. "They'd gotten pretty aggressive and were offering high rates on deposits." They couldn't pay those rates out of the return that they were getting from home mortgages -- their traditional source of income. They began to cast about for higher yields. "Junk bonds gave them the juice that they needed."

What then happened bears eerie similarities to the plight of the big banks today. Early on, the S&Ls that bought Milken's bonds had been portrayed as trailblazers bringing a new kind of smarts and sophistication to a stodgy business. But as the junk-bond market sank, it dragged some of the S&Ls down with it. Federal regulators eventually seized Centrust and Lincoln, along with hundreds of other S&Ls. They partly blamed bad investments in junk bonds for some of the failures. That, plus Milken's legal troubles, contributed to junk bonds falling out of favor. 

Eventually, the junk market rebounded. Today, it's a respectable form of financing for less credit-worthy companies, and many investors make junk bonds part of their portfolios. "Milken basically invented a financing market that still exists and has become a major source of funding for a wide range of companies," Mittelstaedt says. (Milken, for his part, returned to finance after his release from prison and also became one of the country's leading backers of cancer research.)

What the pepper market revealed about human nature

Despite how dire the subprime mortgage market looks today, it, too, will eventually return and regain some measure of respectability. "There will always be a low-end of the mortgage market," Dean Mittelstaedt notes. "There will be a higher-risk market that's charged a higher rate."

 A few years may elapse before that market gets re-established, in a substantial way, because of the extent of today's problems and the foolishness of some lenders.

"Subprime mortgages were completely disconnected from any rational evaluation of the risk," Mittelstaedt says. "Why would you take someone's word that they have a job and loan them $500,000 and not demand any documentation of their income or assets? That's lunacy. Those so-called no-doc loans should be illegal."     

Regulators are already stamping out the worst of the subprime practices, and the Obama administration has proposed an overhaul of the country's financial rules.

But no amount of new rules will abolish human nature, Mittelstaedt warns. Investors, in their optimism and occasionally greed, have ridden the cycle of booms and busts for as long there've been markets, and they'll continue to do so. As folks fret about today's financial crisis and recession, they should recall the Pepper Crisis of the 17th century.

"Pepper was a highly valued, scarce asset then," he explains. "It had to be shipped from South Pacific to Europe. That took months, and there was all of this risk -- shipwrecks, piracy, people falling sick at sea. But Europeans decided that they liked pepper and were willing to pay a lot for it. So prices went through the roof, and everybody started investing in ships. More and more expeditions took place, and more and more pepper came back. Then the market crashed. It was simple supply and demand."

"People will always go after things that they want, and they will almost always overshoot," he adds. "In the 17th century, it was pepper. In the '80s, junk bonds. Today, it's subprime mortgages."

Bottom Line:

  • Charles Kindleberger's 1978 book which described speculative stock market bubbles was reprinted in 2000 after the dot com bust, and it applies to the subprime crises as well.
  • The junk bond market of the 1980s and '90s followed a similar trajectory as the run up and crash fueled by subprime loans.
  • Michael Milken, who popularized junk bonds in the 1980s, realized that investors could make good money with junk. Because of their greater risk, the bonds provided higher yields to investors.
  • Some of the shaky corporate upstarts that Milken backed eventually matured into well-known firms, including long-distance operator MCI, cable-TV provider Turner Broadcasting and Harley Davidson.
  • The subprime mortgage market will eventually return and regain some measure of respectability serving the low end of the mortgage market at a higher rate.
  • The Pepper Crisis of the 17th century illustrates that investors have ridden the cycle of booms and busts for as long there've been markets, and they'll continue to do so.