A Brief History of Doom

by Richard Vague

  At the end of the 1970s, America faced two major and causally related problems—high oil prices and high interest rates.

  The United States had become deeply reliant on oil through decades of cheap and plentiful supply. But by the early 1970s, the preponderance of production had moved overseas and the little-noticed consequence of this had been to cede market and pricing control to the largest overseas producers. They had banded together as the Organization of Petroleum Exporting Countries (OPEC), which itself was modeled on the oil production consortium in early twentieth-century Texas.

  Figure 2.3. United States: Private Debt Growth, 1980–1989

  Private debt more than doubled in the 1980s.

  Through OPEC’s influence, oil prices began to increase dramatically starting in 1973, both to fill OPEC coffers and as a result of Middle East displeasure with the United States in disputes surrounding the 1973 Arab-Israeli War and the 1979 Iranian Revolution.7 Under President Richard Nixon and then President Jimmy Carter, the United States had unsuccessfully tried to counteract these price increases with domestic price controls, which eventually led to domestic oil shortages and long lines of angry motorists at the gas pumps. So first under a chastened Carter and then under Reagan, domestic prices were deregulated, and soon domestic oil prices and profits rocketed to levels commensurate with those overseas. This resulted in a mad scramble to increase production within the United States as the 1980s began. U.S. exploration immediately exploded, attracting hundreds and then thousands to drill for more oil. The theory and hope, later forgotten, was that over time this increased production would increase supplies and bring down prices.

  The high oil prices that came with the 1973 war and the 1979 revolution had been a core driver of the insidious inflation in the 1970s. With Paul Volcker’s appointment as chair in 1979, the Federal Reserve resolved to stamp out this inflation with a dramatic increase in interest rates, pushing the Fed funds rate as high as 20 percent and both the ten-year Treasury bond and the three-month Treasury bill to 14 percent.8

  These ultrahigh interest rates devastated the savings and loan (S&L) industry, the main provider of the nation’s home loans. Most of the mortgages carried on the books of these S&Ls (also commonly called “thrifts”) were at a fixed rate with a thirty-year term. Many of those loans had been at a rate of roughly 6 percent, and the interest on savings accounts used to fund those loans was roughly 3 percent, giving rise to the pejorative that S&Ls were a 3-6-3 business: thrift executives booked deposits at 3 percent, lent them out at 6 percent, and were on the golf course by 3 p.m.

  But with spiking interest rates, thrifts had to pay interest rates to savings depositors that were much higher than this proverbial 3 percent, in fact, often more than the 6 percent they earned on their loans. They had to do this—or else risk losing their depositors to the new money-market mutual funds offered by Merrill Lynch and others that paid high rates. There was no good choice: either lose their deposits and fail—or keep their deposits by paying high interest rates and incur huge operating losses. To make matters worse, these thrifts were effectively stuck with their low-rate mortgages. With low fixed rates, those mortgages could only be sold at a steep discount to their principal value. If they sold them, they would have to take losses so dire that their net worth would have fallen below statutory minimums.

  Attempts to save the S&L industry began in earnest in 1980 and 1981 with the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), the Economic Recovery Tax Act of 1981 (Kemp-Roth), and certain actions of the Federal Home Loan Bank Board (FHLBB), the S&Ls’ chief regulator. DIDMCA allowed S&Ls and banks to pay market rates on their deposits, something they hadn’t been able to do since 1933, and thus keep those deposits.9 The next problem for S&Ls was how to dispose of their low-yielding, long-term mortgages and how to replace them with higher-yielding loans so they could become profitable again. This was addressed in September 1981 with FHLBB actions that allowed S&Ls to sell these underwater mortgages and amortize the loss on sales over ten years rather than take the losses immediately, and further allowing them to take losses against past gains. It was accounting magic.10

  The new rules ignited the market in the purchase and sale of mortgages, a previously quiet pursuit. Lewis Ranieri of Salomon Brothers, the top securities firm on Wall Street at the time, led the way. Salomon bought these mortgages from troubled thrifts and then resold them to investors or other thrifts. For a time, this was the most profitable activity for Salomon, and then for all of Wall Street, before junk bonds claimed that title. S&Ls had billions of dollars of mortgages to sell and very few buyers, so firms such as Salomon could name their price; S&Ls got only poor financial offers—offers that they took only because they had few alternatives and they could amortize the loss on the transaction. S&Ls then used the proceeds to buy replacement blocks of mortgages with a better yield.

  This was so profitable for Salomon Brothers that its appetite got bigger, and it bought increasingly large blocks of mortgages, which gave S&Ls more capacity to increase their lending activity. Mortgages, which had only grown 7.8 percent a year from 1980 to 1983, began to grow by more than 12 percent per year, from $1.1 trillion in 1984 to $2.1 trillion in 1989.

  Salomon’s innovations in this sector were legendary. They took the mere buying and selling of blocks of mortgages to another level with the 1983 invention of a bond composed of mortgages, called the collateralized mortgage obligation (CMO). If rated, institutions could buy CMOs. Congress soon aided this market by exempting investment banks from having to register these securities in each state.

  The FHLBB then reduced the S&L net worth requirement from 5 percent to 4 percent in 1980, and from 4 percent to 3 percent in 1982.11 In 1980, it also removed the limit on the amounts of brokered depositor, or “hot money,” an S&L could hold.12 Traditionally, S&Ls had raised deposits from customers in their neighborhoods, but that approach didn’t result in enough new deposits to fund aggressive loan growth. With brokered deposits, an S&L could hire a firm such as Merrill Lynch to sell its certificates of deposits (CDs) through its vast nationwide networks of stockbrokers, who made commissions on these sales. If S&Ls needed more deposits, they simply raised the rates they were willing to pay on these CDs. The Federal Savings and Loan Insurance Corporation (FSLIC) insured these deposits, so the customer didn’t have to worry about the soundness of a particular S&L. Brokered deposits removed a barrier to growth, and fast-growing S&Ls raised billions this way. Ultimately, this allowed for greater lending mischief.

  In September 1981, the FHLBB conjured more magic by permitting troubled S&Ls to issue “income capital certificates” to be purchased by FSLIC and included as capital,13 and in late 1982, it began counting “appraised equity capital” as a part of reserves. This allowed S&Ls to recognize an increase in the market value of their premises and thus build capital on the shaky foundation of current appraisals.

  In April 1982, the FHLBB made a momentous change to S&L ownership requirements: it allowed an S&L to be purchased by a single owner. Previously, the FHLBB had placed a premium on diverse, community-based ownership. It had required 400 or more stockholders, of which 125 were to be from the local community. Further, no control group could own more than 25 percent and no individual more than 10 percent.14

  The government did one more extraordinary thing for the S&Ls. In its eagerness to give them new streams of income to overcome problems in their core mortgage business, it empowered them to make commercial loans; most notably, it gave them more latitude to make commercial real estate loans. And that power would bring a decade of misery. With the Garn–St. Germain Depository Institutions Act of 1982, S&Ls were now permitted to lend up to 40 percent of their assets in commercial mortgages, up to 30 percent in consumer loans, up to 10 percent in commercial loans, and up to 10 percent in commercial leases.15 This expansion enabled S&Ls to invest in junk bonds, and many became active buyers. The act also eliminated the previous statutory limit on loan-to-value rat
ios, allowing more lax credit standards.

  Most institutions weren’t well qualified to manage these new businesses because they had little or no experience with them. The expanded powers and new authority tacitly allowed for conflicts of interest and vulnerabilities—namely, that opportunistic real estate developers could buy S&Ls and then loan money to themselves, as they had in the 1920s. And so they did—in spades. It was a blatant conflict of interest that often shaded into outright fraud.

  S&Ls also had fierce competition from banks. Together with the S&Ls need for earnings from commercial real estate, this created a boom in real estate that led to massive overbuilding. Commercial real estate (CRE) construction spending exploded in the mid-1980s. From 1981 to 1987, CRE lending more than doubled from $442 billion to $950 billion,16 and CRE loans grew from 14 percent of GDP to 20 percent in 1987 (Figure 2.4). Office vacancy during this period went from 4 percent to 16 percent, which soon brought record delinquencies (Figure 2.5).17

  David and Jean Solomon exemplified U.S. developers who overextended. In the early 1980s, they developed Tower 49, a forty-four-story office building with 600,000 square feet on East 49th Street in New York City, which they sold in 1986 for the then-record price of $301 million. Flush with this success, they immediately began development of three more major office buildings with more than two million square feet of space. But other builders, envious and inspired, followed their lead, and almost simultaneously added another five million square feet.18 There weren’t enough tenants to fill these spaces, especially after the 1987 stock market crash culled investment bank employees. The Solomons and their competitors were soon wiped out. From New England to Texas to California, other U.S. regions saw similar overbuilding with subsequent distress—not just in commercial real estate but also in housing, especially suburban housing.

  Figure 2.4. United States: Commercial Real Estate, 1979–1992

  Figure 2.5. United States: Office Vacancy Rate, 1979–1990

  The overbuilding rampage hit Canada and Britain too. Toronto-based Olympia and York became the world’s largest private real estate developer, and by the fall of 1990 was the largest private borrower in the world. Olympia and York had such an outsized reputation that lenders were reluctant to scrutinize company financials in advance of lending decisions or to tightly monitor ongoing performance, lest they be excluded from the lending group. In March, the company told its stunned group of ninety-one lenders that it would have to restructure about $15 billion in debt, and on May 14, 1992, teetering under the weight of its failing Canary Wharf project in London, it filed for bankruptcy protection. At the time, it was the largest restructuring ever for a privately held company, as well as “the largest bankruptcy in Canadian business history—and fourth largest bankruptcy in the United States.”19

  In this same period, another new development was in the making: junk bonds. The stock market had been anemic owing to the inflation and high interest rates of the 1970s. Though the Dow had briefly broken 1,000 in 1972, it had bounced around below that level for the rest of the decade. The trailing twelve-month stock price-to-earnings ratio of the S&P 500 fell below 7 during the 1970s, one of the lowest levels on record, and was still below 12 in 1982.20 This left company management highly vulnerable to a new breed of investors who wanted higher stock valuations and would use debt, deep cost cutting, and other means to get it.

  Volcker’s war against inflation using very high interest rates was succeeding, in the view of most economists. But it was proving a costly and painful battle, bringing the bitter recession of the early 1980s in which businesses suffered setbacks, unemployment vaulted to 10.8 percent,21 and real GDP fell by 2.6 percent in a mere six months. Ronald Reagan, using the campaign slogan “Let’s make America great again,” took office as president in January 1981. His administration was determined to jump-start the economy, and its preferred path was through tax cuts. Within seven months of Reagan’s inauguration, Congress had passed one of the largest tax cuts in U.S. history, the massive Tax Reform Act of 1981, better known as Kemp-Roth. Its provisions, especially those allowing accelerated depreciation for tax loss purposes, gave significant benefits to transactions involving real estate and mergers and acquisitions (M&A).

  Soon after its passage, however, government revenues fell as a percentage of GDP, doubling the deficit, and unemployment rates increased further, which sent lawmakers scrambling to lessen these tax benefits. The remainder of Reagan’s term brought repeated modifications to the tax laws—in both directions—but the tone had been set with Kemp-Roth, and that tone did not meaningfully change until 1987: the net impact of the tax law changes was to spur a significant increase in real estate and merger transactions.

  Private debt financed much of the M&A activity of the 1980s. Interest on debt was tax deductible, and dividends on equity were not. Because of this, from a pure cash-flow standpoint, a company could afford to pay far more interest on, say, $100 million in newly issued debt than it could in dividends on the same amount of newly issued stock.

  That fact, coupled with these new tax advantages, meant that the smart way for bold investors to increase the languishing stock price of a company with good cash flow was to buy the outstanding stock with a combination of debt and equity, taking it private in what was referred to as a “leveraged buyout,” or LBO. Company earnings could be used to pay off this acquisition debt over a few years. So by using debt, the investor would own the company for a mere fraction of what was already a lackluster price. Soon enough, the investor could take the company public or sell to another investor at a handsome profit.

  Typically, the debt used would be much greater than the equity used, which increased the risk associated with the acquisition transaction, so the interest rate the lender charged on this debt was high to account for this risk. The euphemism for high-risk debt when it came in the form of a bond was “high-yield security,” but it was more commonly referred to as a “junk bond.” Junk bonds grew from $10 billion outstanding in 1979 to over $189 billion outstanding in 1989. This was not the sole source of private lending growth in the 1980s, but it was a substantial one that illustrated the risk appetite of the decade.

  Since stock prices were low, the company could be bought cheaply. Since as inflation came under control market interest rates were declining, the cost of the debt would decline through time. Since the stock market was rising, the company’s stock could be taken public at a later date at a higher price. Fortunes were being made on just this simple formula. It was the best possible environment for an LBO, because in this environment an LBO would work even if the fundamentals of the company didn’t improve. If company fundamentals did improve through cost reductions or other means, or if non-core assets could be sold at favorable prices, then so much the better.

  Michael Milken of the investment bank Drexel Burnham Lambert was the legendary leader and innovator for this type of transaction. He had started in the 1970s by buying and selling junk bonds that had been high-quality bonds before the company became troubled. Since most investors steered clear of them, these bonds were called “fallen angels,” and Milken, reasoning that they often had more intrinsic value than the market assumed, profited handsomely.

  As the effectiveness and scope of Milken’s operation increased, he began underwriting and selling bonds that had a junk rating at issuance, especially as part of the financing of an LBO. This was his great innovation. These bonds weren’t fallen angels: they had never been angels to begin with. Because of the spectacular returns he obtained for his clients in these transactions, investor appetite for these bonds grew rapidly, and the challenge became finding enough underwriting opportunities to meet the demand. Inevitably, these LBOs started to involve ever-larger companies. But even this growth satisfied neither Milken’s ambition nor the growing demand. With his success, Milken had developed a network of loyal high-yield bond buyers that was far larger than any competitor’s, so he had a much greater capacity to complete new deals.

  It was
quite a machine. A CEO who successfully took his company private in an LBO using junk bonds sold by Drexel, or an investor who successfully bought a company using junk bonds sold by Drexel, made their companies available to Drexel to buy the bonds of the next such deal. In fact, Milken sometimes insisted that companies borrow more than they needed so they could use the extra funds to buy future Drexel offerings. Drexel’s growing menagerie of clients became buyers for future deals.

  This is where the S&L story and the junk-bond story converge. Historically, S&Ls had been prohibited from buying corporate junk bonds, but with their new Garn–St. Germain powers, they now had that ability and many became active buyers. Drexel took full notice of the new S&L powers, took the initiative to help interested CEOs buy S&Ls, and thus added to the network of grateful clients who would buy future bonds underwritten by Drexel.

  LBOs weren’t the only source of runaway lending growth, but they epitomized the era’s aggressive tone. Drexel’s machine was so successful that it was running out of deals to keep growing and satisfy Milken’s and his clients’ ambition. So Milken pursued increasingly larger deals, paid increasingly higher prices, and came up with a new way to use Drexel’s now-extraordinary capacity to underwrite and sell very large amounts of this high-yield debt: the hostile takeover. In a hostile takeover, one company attempts to buy another, but the management and board of that “target” company resist being acquired. So the prospective buyer makes its offer so attractive that the target company’s board is forced by its fiduciary obligation to accept the offer, however undesired it may be.

  Before the 1980s, hostile takeovers had been rare, but when they did happen, the prospective buyer was usually larger than the target company and was often in the same or a closely related industry. This changed in the Drexel era. Even a small company, or a management team without a company, could buy a large company in a Drexel-backed deal, given the firm’s extraordinary access to large amounts of funding.