Financial innovation and entrepreneurship in the United States

¶ … finance and financial entrepreneurship. The basis of the article is on a discussion that was held on this subject among four leading lights of financial entrepreneurship in the United States - Michael Milken, Lewis Ranieri, Richard Sandor and Myron Scholes. These people are famous in their own right and have had a sizeable role in financial entrepreneurship in the U.S. over the last 20 years. We have first discussed their achievements to get a clear idea about their personal achievements. This would certainly give a clear idea of what is possible in the U.S. today. They are of course interesting characters and one has to remember that the ideal entrepreneur of the 21st century cannot be thought of as an updated version of Henry Ford. After the discussion of the people, the meeting and the discussions held there are summarized. Based on the total information collected, we have come to the defense of the Thesis Statement.

Thesis Statement

Financial Innovation is again poised to take off causing disbelief among the skeptics, who do not think anything new is likely to succeed in the present economic environment. A new group of innovators is coming up but their origin is unknown.

Introduction

It was felt that innovation was gradually slowing down. Four of the biggest innovators in the U.S. recently met at the Milken Institute Annual Conference in Los Angeles where the Wharton schools was a participant. The same question was asked to four titans from that period. The panel on financial innovation included Michael Milken, Lewis Ranieri, Richard Sandor and Myron Scholes. It was moderated by Glenn Yago, director of capital studies at the Milken Institute, a West Coast business and public-policy research institute. According to them, Miller gave a correct picture about the period mentioned, but the situation is changing now. Now let us look first at the people who gave this opinion.

Michael Milken

Michael Milken is often referred to as the junk bond king. He first opened up the bond market for the risky companies to the capital market and those companies were not even looked at by the investment banks. He earned enormous amounts of money - in 1987, it is said he earned $550 millions. Two years later he was caught and spent 22 months in jail. Milken was junk bond king at Drexel Burnham Lambert and his partner was Gary Winnick. They changed corporate takeovers and financing by the use of high-yield junk bonds. At the height of his success in the 1980s, Milken's personal wealth was legendary. As per the government, Drexel paid Milken $296 million in 1986 and $550 million in 1987. In 1989 a federal grand jury indicted Milken for violations of federal securities and racketeering laws. He pled guilty to securities fraud and related charges in 1990, but the government dropped the more serious charges of insider trading and racketeering. Milken was fined and sentenced to prison for ten years at first, but in 1991 his sentence was reduced to two years plus three years probation. After he was convicted he had become one of the most hated men in the U.S. After his release, Milken has worked on his public image with the alacrity that he had earlier used so successfully in the financial sector. (www.radford.net/news)

The Secret World of Mike Milken:

In December 1986, U.S. Attorney Rudolph Giuliani made an extraordinary deal, probably unprecedented in American justice. I suppose the name sounds familiar. The deal was with Ivan Boesky, the Wall Street arbitrageur, who had admitted using stolen information to make over a $100 million. In return, he was allowed to plead guilty to only a single count of securities violations, and permitted to keep secret his foreign bank and brokerage accounts, even if they had been enriched by his criminal activity. Also, the accounts in his wife and children's name were not touched. This accord was not done by Giuliani's alone: it was approved by the U.S. Attorneys in both Washington DC and Los Angeles. What Boesky offered to give in return for this was information about the secret dealings of Michael Robert Milken. After his statements, Milken was convicted. His punishments we know about. The question remains, does this speak very highly about Milken.

One of the things that Milken seems very interested now is redwoods, or is it? Remember he was always a secretive man and he may not have told everything to Boesky. The fate of the largest unprotected redwood forest in the world may now rest in the hands of a surprising savior, the Federal Deposit Insurance Corporation. Since the 1985 MAXXAM took over Pacific Lumber, the redwood ecosystem known as the Headwaters Forest, located in Humboldt County on California's North Coast are under attack. All attempts at protecting them have failed - lawsuits, direct action, legislative efforts. MAXXAM seems to have a ravenous appetite for redwood lumber. Now many environmentalists and community activists are laying store by the FDIC. The federal agency may be able to acquire the redwood forest as partial or full payment for the $548 million outstanding claim against the United Financial Group (UFG), a holding company for United Savings Association of Texas (USAT), a failed savings and loan controlled by MAXXAM and its chief executive officer, Charles Hurwitz. Hurwitz has agreed to transfer part of the Headwaters Forest to federal government control, but he is insisting on a much higher payment than environmentalists are proposing. A company he controls UFG owes $548 million to the government but he has asked the government to pay him $600 million cash for a small grove of redwoods. If the offer is refused, he has threatened to destroy the forest. "If the federal government does not purchase the Headwaters Forest, Pacific Lumber will go ahead with its timber operations," says the MAXXAM Director of Public Relations Scott Lamb. (www.radford.net/news)

Hurwitz had paid approximately $900 million for 196,000 acres owned by Pacific Lumber. If his proposal to sell 4,500 acres for $600 million is accepted by the government, Hurwitz would get a profit of more than 2,800%. His threat would be taken seriously by people who know him. The company has already cut hundreds of trees in the old-growth grove of Owl Creek on holidays and weekends when state regulators were not working, in violation of the California Board of Forestry cutting regulations twice in 1992. Both times the cutting had to be stopped through court injunction. Under their current plans, MAXXAM will harvest all the remaining old-growth redwoods it owns within the next 14 years. Many of the trees in the Headwaters Forest are as old as 2000 years. The cornerstones of this unique ecosystem depend on species diversity and a continual recycling process interlocking life with death. When a 300-foot redwood falls, it becomes a nurse log for the new seedlings to grow. The seedlings grow right out of the nurse log, which provides nutrients to the new trees as it decays. As the older tree falls, it also creates a canopy break in an otherwise shady forest. The nurse log also provides the essential sunlight.

When forests are cut for the logs, this ecological recycling process does not happen and thus seriously threatens the forest's ability to regenerate. When loggers remove cut trees, the nutrients that the trees would have returned to the soil are removed at the same time. The soil itself will also be lost when it rains because it no longer has trees holding the soil in place. As topsoil is depleted, desertification begins. The redwood forests even today support a diverse array of animals including California black bear, mountain lion, Pacific fisher and steelhead trout. But, logging is taking a severe toll on the forest wildlife. Many rare and endangered species also live among the redwoods of Humboldt County. They are the northern spotted owl, marbled murrelet, pacific giant salamander, tailed frog and coho salmon. Their survival also depends on a diverse and healthy old-growth forest. Carl Ross, co-director of Save Americas Forests, the nation's largest grassroots forest protection organization, says, "If we fail to protect these last stands of redwoods, we will lose one of the greatest wonders of the living world for all time. Less than 4% of native redwoods are still standing, and that tiny percentage is being hacked and cut for the last shred of money that can be sawed from their red roots. If we allow the extinction of these largest of all living things, we will be condemned as a society that knew the price of everything and the value of nothing." (www.radford.net/news)

The redwoods of Humboldt County are a long way from Houston, and United Savings Association of Texas situated at Houston. If the FDIC decides to pursue the connection, then only the Headwaters Forest may survive. There was no need for worry about the Headwaters Forest before Hurwitz took over the Pacific Lumber Company. This family-run business maintained one of the most economically and environmentally sound timber companies in the United States. Pacific Lumber did not clear cut. It generally left standing 30 to 50% of the timber in a harvested area. This created a natural canopy break for new growth, while keeping much of the soil stable, thus increasing the forests growth potential. Like the trees, the company was also very generous to its employees. Pacific Lumber provided housing at below market rates to employees and did not layoff staff despite downturns in the timber market. The company also funded a very generous pension fund.

Pacific Lumber's strength was the cause of its weakness. The pension fund was over funded by $60 million due to its policies. Also, because of its sustainable cutting practices, the company held tremendous assets in the form of old- growth redwoods. These trees could be liquidated quickly. Assessing Pacific Lumber in 1985, Charles Hurwitz decided it was ripe for a takeover, and he picked it up in the fall of that year. As soon as he completed the takeover, Hurwitz collected the extra money from the pension fund. He also doubled the rate of cutting of trees to pay off the loans and junk bonds that he used to fund the takeover. If there was any doubt about Hurwitz's intentions and his beliefs in preserving the sustainability of his new company, he cleared it up in his first meeting with the workers of Pacific Lumber by saying that there is the golden rule that he who has the gold rules.

The story of MAXXAM's takeover of Pacific Lumber is rather complicated with intrigue, shady dealings and questionable business practices thrown in. MAXXAM announced that it would make a cash tender offer for Pacific Lumber on September 30, 1985. Drexel, Burnham, Lambert structured the financing. The financing was made up of a $300 million short-term loan from the Irving Trust Company and $450 million dollars worth of junk bonds sold by Michael Milken's high-yield bond department at Drexel Burnham. Shortly after the offer was made by MAXXAM, the New York Stock Exchange (NYSE) started an investigation into the heavy volume of trading in Pacific Lumber stock which took place in the days before MAXXAM made its offer public. A House Energy and Commerce Subcommittee on Oversight and Investigation report stated that the NYSE investigation uncovered significant evidence of insider trading and parking stock. The evidence obviously was not enough for any civil or criminal actions to be brought against MAXXAM or its associates for their activities related to MAXXAM's purchase of Pacific Lumber.

The NYSE investigation, the subcommittee's report and subsequent congressional hearings all would lead most to believe that stock parking took place. Parking stock is the practice of buying stock for another party in order to conceal the real identity of the true or eventual owner. If Hurwitz had someone buy the stock for him, he could have slowly collected Pacific Lumber stock anonymously and at a lower price than after the company was put "into play." This means that it became known a single party was accumulating large blocks of the company's stock. This action would normally drive the price of stock up almost immediately. Boyd Jefferies, former chairperson of the Los Angeles brokerage firm Jeffries Group, Inc. had later pleaded guilty to parking stock for Ivan Boesky. He had accumulated 539,600 shares of Pacific Lumber stock. He later sold the shares on September 27 to MCO Holding Company, a Hurwitz-controlled enterprise. This large purchase gave Hurwitz enough stock to begin the hostile takeover of Pacific Lumber which he commenced three days after MCO purchased the stock from Jefferies. (www.radford.net/news)

Hurwitz and Jefferies have denied any prior agreement to park stock of Pacific Lumber, but Energy and Commerce Committee Chair John Dingell, D-Michigan, and Representative Ron Wyden, D-Oregon, have looked into the agreement and concluded in October 1987 that it was unlikely that the sale took place without a prior agreement. The stock was sold well below the trading price on September 27, 1985 and there is no reason for this to occur unless there was some prior agreement. There had been a lot of trading even before the Hurwitz offer, and naturally, the stock price had already started rising. On September 27, the price of Pacific Lumber stock in the exchanges was close to $34 per share. In what could be seen as a very philanthropic stock sale ever seen on Wall Street, Jefferies sold the Pacific Lumber stock at $29.10 rather than its market trading price of $34. The discount sale was not ascribed to a prior agreement but only because of the fact that Boyd Jefferies had got up on the right side of the bed and was in a good and generous mood that day.

But even such a generosity was not enough to ensure the financial stability of the company after the takeover. The interest payments on the junk bonds Hurwitz and MAXXAM used to finance the takeover were not due for four years as per the terms of the bonds. It was clear soon after the purchase of Pacific Lumber that it would be difficult to cover the terms of the bond. The annual interest payment to be made on the junk bonds was more than the normal profits made by Pacific Lumber. So, it was necessary to make the bonds even more attractive to potential bidders than they originally were. (Blume, and Donald, 1987) MAXXAM accordingly made an announcement that it would terminate the pension plan and sell most non-timber assets to pay off the bank loan. MAXXAM also declared it would increase the timber cutting rate to pay off the junk bonds. This financial innovation was thus the real reason for the timber cutting.

It was not very easy to get the control of the pension fund. (Atkinson, 1967) According to William Bertain, a lawyer who had represented shareholders in Pacific Lumber and residents of Humboldt County in a suit against Pacific Lumber against the policies of Pacific Lumber, the company tried to protect the pension fund. It had declared that the pension funds which had the excess $60 million would vest directly to the employees and retirees in the event of a hostile takeover and not the person taking over the company. To collect this $60 million MAXXAM launched a suit against Pacific Lumber. Then the Pacific Lumber board of directors agreed to an uncontested takeover. MAXXAM in turn agreed to defend the Board if a suit was launched against the board as having breached its fiduciary duty to the shareholders. MAXXAM also increased the price of the stock by $1.50 a share. This meant a total increase of approximately $33 million to be paid by MAXXAM. But since takeover was now uncontested, MAXXAM had access to the $60 million excess in the pension fund, as it did not go to the employees and retirees. In the end MAXXAM came out $27 million richer, and Pacific Lumber directors came out richer at the expense of the employees and retirees. Hurwitz was later sued by the U.S. Department of Labor and employees for investing Pacific Lumber pension fund with the now-failed Executive Life Insurance Co. This was done as Executive Life issued junk bonds and financed the Pacific Lumber takeover by MAXXAM. That case is still not decided. All the junk bonds and other financing of this entire deal seemed to be concentrated on collecting the extra $60 million and the grown trees.

Three years after the MAXXAM takeover of Pacific Lumber, another company controlled by Hurwitz, United Savings Association of Texas, failed. The circumstances of the failure are not clear. The MAXXAM spokesperson, Lamb claims that "United Savings Association of Texas's decline can be attributed to a decline in the Texas real estate market." (www.radford.net/news) That company had a deep involvement in Michael Milken's junk-bond schemes. This also may be an important factor in the collapse of the company. When this company had failed in 1988, Hurwitz and his financial innovations had already been noticed by the regulators. In 1971, the Security and Exchange Commission launched a case against Hurwitz for alleged stock manipulation. He was also charged by New York State regulators as having looted Summit Insurance Company. Hurwitz was not proven guilty in either case. In the three years before the company failed, USAT purchased more than $1.3 billion worth of junk bonds underwritten by Drexel Burnham. At the same time, the Milken group raised about $1.8 billion for Charles Hurwitz and his takeover ventures. This includes the takeover of Pacific Lumber, as per the case launched by Federal Deposit Insurance Corporation against Michael Milken. It may be that Michael Milken was a part of this entire scheme.

The FDIC has also held the United Financial Group (UFG) that the company and its officers as liable for breach of fiduciary duty for wrongfully failing to maintain the net worth of a failed savings and loan. The FDIC also alleges that USAT was used by Hurwitz to aid Michael Milken's scheme to manipulate the junk bond market. Was he also a part of Milken's schemes? The FDIC has also accused UFG of wrongfully causing USAT to pay dividends to UFG. When USAT failed, MAXXAM owned approximately 22% of USAT and 28% of United Financial Group, the holding company. Charles Hurwitz was then the chairman of both MAXXAM and UFG when USAT failed. (www.radford.net/news)

The questions of propriety surrounding the takeover of Pacific Lumber and the collapse of USAT may provide the solution for the preservation of the Headwaters Forest, as Congress and environmentalists try to fashion a response to Hurwitz's demands. However, the question we have at this juncture is the extent of involvement that Michael Milken and his innovations had in these entire events? Are these the type of innovations that Milken created to garner money? It is clear that Hurwitz was an associate of Milken; otherwise the FDIC has no basis in launching a case against Milken. (www.milkeninstitute.org) The two together have already committed an unethical act in taking over $60 million from the employees and retirees of Pacific Lumber. Definitely, the directors of Pacific Lumber were a part of that deal, but in ethics, two wrongs do not make a right. The other objective seems to be destroying the American redwoods - these are a heritage of the United States even if we forget about ecology and the rest of the environmental considerations. We know that some people think that ecology and the other so-called fashionable terms are only a front for their incompetence in other spheres, but this is a case for American pride. Does this generation have the right to destroy some things that have been here even before the founding fathers came to this country? The matter of saving the redwoods is now being seriously considered by the legislators and others. Let us all hope that a solution will be found.

Lewis Ranieri

Lewis Ranieri helped create the multi-trillion-dollar mortgage-backed securities market which radically altered the landscape of American investment. He is a highly respected professional. His bio data reads "Lewis S. Ranieri is the founder and prime originator of Hyperion Partners L.P. And Hyperion Partners II L.P. (Hyperion) and Chairman or director of various Hyperion entities. He is also Chairman and a member of the Board of Directors of Hyperion Capital Management, Inc., a registered investment advisor, and is Chairman and a director of the following funds registered under the Investment Company Act of 1940: The Hyperion Total Return Fund, Inc., The Hyperion 2002 Term Trust, Inc., The Hyperion 2005 Investment Grade Opportunity Term Trust, Inc. And The Hyperion Strategic Mortgage Income Fund, Inc. (pending registration). Prior to forming Hyperion Partners L.P., Mr. Ranieri had been Vice Chairman of Salomon Brothers Inc. (Salomon) and worked for Salomon from July 1968 to December 1987. He also serves as Chairman, Chief Executive Officer and President of Ranieri & Co., Inc., a private investment advisor and management corporation. He is also a director of Delphi Financial Group, Inc. And Reckson Associates Realty Corp. Mr. Ranieri has served as a director of Computer Associates International, Inc. since 2001, and was appointed lead independent director in 2002." (Computer Associates Executive Bios Lewis S. Ranieri.htm) He is obviously a professional and highly respected in the business. But can he really be called an innovator? If he is not, that does not take away his image as an excellent executive. But, an executive is always calling the shots at the risk of the owners, and not risking his own money. He certainly does not qualify to be called an entrepreneur in my opinion. I leave it to the reader to judge. In my opinion, he was used in the conference as a window dressing.

Richard Sandor

Richard Sandor had started the futures market on U.S. Treasury bonds and other interest rate products in the mid-1970s. He is now devising markets for environmental commodities. Richard Sandor has been called "the father of financial futures" ever since the 1970s. He has helped in the development of the Chicago Board of Trade's Treasury futures contract. He is a former professor at the University of California at Berkeley and a lecturer at Stanford. He has held senior positions at Kidder Peabody, Drexel Burnham Lambert, Banque Indosuez and the Chicago Board of Trade. He is now the chairman and CEO of Environmental Financial Products, a Chicago-based company specializing in the environmental, financial and commodity markets. Sandor is also a senior adviser to PricewaterhouseCoopers on greenhouse gases emissions trading, a visiting scholar at Northwestern University, and chairman of the board of Hedge Financial, a subsidiary of CNA that seeks to bridge the gap between the reinsurance and capital markets. He is renowned for his theories and developmental work in the capital market.

Myron Scholes

The fourth participant was Myron Scholes. He co-invented the Black-Scholes options pricing formula with the late Fischer Black and Robert Merton. He was awarded the Nobel Prize in 1997 for his effort.

Myron Scholes is a double alumnus of the University of Chicago, having earned both his M.B.A. (1964) and Ph.D. (1970) degrees from the University's Graduate School of Business, where he was later a faculty member for 10 years. He receives the award for work he did to explain the pricing of stock options with the late Fischer Black, also a former faculty member. Scholes is the 69th Nobel laureate to have studied or taught at the University of Chicago. Since the Economics prize was established 29 years ago, 19 of the laureates have been Chicago faculty or alumni, including five who are currently on the faculty. Scholes shares the award with Robert C. Merton of Harvard University, who extended and generalized the work of Scholes and Black. Merton received an honorary degree from the University of Chicago in 1991." (Scholes, 1997)

Nobel laureate Merton Miller was Scholes' thesis advisor and the chairman of his Ph.D. examining committee at Chicago. Miller also won the Nobel himself in 1990. He is Robert R. McCormick Distinguished Service Professor Emeritus in the University's Graduate School of Business. "I feel about Myron's award the same as I would if it had been won by one of my children," Miller said. "This is well-deserved, and I am extremely gratified by his recognition." (Scholes, 1997)

Scholes had been working for Miller from 1961 when he was a new M.B.A. student. Miller was looking for assistance in computer work for help with one of his research projects Scholes helped analyze Miller's data, and simultaneously became interested in research himself."Myron suddenly developed a real passion for research," Miller said, "and it was soon no longer enough to help others with their research-he wanted to do his own... Myron was part of a great group of students, including several others who may well be honored with the Nobel... He was always a very ingenious student, but there is one other sense in which I hope I had a good influence on him, I always stressed how important it is to be able to clearly communicate your ideas, whether in writing or through public speaking. He has become excellent at both, to the benefit of his colleagues and the wider public." (Scholes, 1997) The two Nobel laureates have worked together on a number of projects.

This close association is seen from a book Miller had on his bookshelf. This was a book on writing by a fellow University of Chicago faculty member, English professor Joseph M. Williams. It was a gift from Scholes, who had written on it "Thank you for sparking my interest in studying style and good writing." (Scholes, 1997) Apparently Scholes had a good training in Chicago. Miller certified the quality of education saying "We take economics seriously here, and we are passionate about its relevance. It isn't just a classroom trick to us, but something that has real meaning and that pervades life. I think we convey that to our students, and I think this is another example of what effect that has on them." (Scholes, 1997)

After receiving his Ph.D. At Chicago, Scholes became a member of the faculty of the Graduate School of Business at Chicago for 10 years until 1983. Then he accepted his appointment at Stanford University. Scholes was awarded the Nobel Prize having developed a pioneering formula for the valuation of stock options, an important mechanism for managing risk in financial markets. The Nobel committee had felt that this work has had profound importance for economic valuations in many areas and will also help in the future to generate new financial instruments and facilitate more efficient management of risk in society and the world.

The work "has provided us with completely new ways of dealing with financial risk, both in theory and in practice. Their method has contributed substantially to the rapid growth of markets for derivatives in the last two decades... The scientific importance extends to both the pricing of derivative securities and to valuation in other areas...including currency options, interest rate options and options on futures." This was the written opinion of the committee. (Scholes, 1997) "This contribution to the pricing of derivatives-which include both futures and options-was founded on the other most important contribution to finance, the Miller-Modigliani theorems of capital structure," said George Constantinides, the Leo Melamed Professor of Finance in the University's Graduate School of Business. The Miller-Modigliani theorems led to Nobel prizes for both authors. (Scholes, 1997)

Because many types of economic contracts and decisions can be viewed as options, the work by Scholes has been applied even to investments in buildings and machinery. The industries salute to the relevance of the work of Scholes and Black is the explosive growth in options trading at such places as the Chicago Board Options Exchange. They introduced trade in options in April 1973, which was one month before publication of the option-pricing formula. Today, thousands of traders and investors use the formula every day to value stock options in markets throughout the world and in Chicago. The Nobel committee wrote: "Such rapid and widespread application of a theoretical result was new to economics. It was particularly remarkable since the mathematics used to derive the formula were not part of the standard training of practitioners or academic economists at that time...The ability to use options and other derivatives to manage risks is quite valuable. For instance, portfolio managers use 'put' options to reduce the risk of large declines in share prices. Companies use options and other derivative instruments to reduce risk. Banks and other financial institutions use the method developed by Black, Merton and Scholes to develop and determine the value of new products, sell tailor-made financial solutions to their customers, as well as to reduce their own risks by trading in financial markets." (Scholes, 1997)

Today, mathematicians, economists and computer experts are extending the work to find alternative ways to value options. "This work is the cornerstone of serious mathematical analysis of financial markets," said Robert Zimmer, a professor of mathematics and associate provost at the University. "It and the work that comes out of it are exactly what we are teaching these new master's degree students." (Scholes, 1997)

Glenn Yago

To know Glenn Yago better, let us look at his opinion on junk bonds. First his definition- "Junk bonds, also known more respectfully as high-yield securities, are debt instruments that are issued by corporate borrowers and which the major bond-rating agencies say are less than 'investment grade." (Encyclopedia of Economics) He goes on to say that a corporate bond is considered "junk" if it is rated as BaA or lower by Moody's or Ba3 or lower by Standard and Poor's bond-rating services. Bond ratings measure the risk involved with the bonds. What this means is that it measures the chances that the issuer will be unable to make interest payments or repay the principal. The more risk a bond carries, the lower will be its rating. Bonds with more A's are less risky than bonds with fewer A's, and the highest rating (for Standard and Poor's) is AAA, or triple-A. (Encyclopedia of Economics)

Credit risk is based on a large number of factors, many of which are linked to performances by the company in the past. Some of the largest corporations, such as IBM and General Motors, and even the U.S. government have been at times below investment-grade rating. Even today many companies that have become household names like, for example, Time Warner and Duracell, are rated as being below investment grade. Many company bonds are in the junk bond category. The bonds of 95% of U.S. companies with revenues over $35 million -- "and of all companies below that amount -- "are rated non-investment grade or junk. (Roach, 1989) This forces these companies to pay higher rates of interest on their bond issues than the corporations whose bonds are treated as investment grade bonds. That is for non-investment-grade bonds are also called high-yield bonds.

Until the late seventies all new bonds sold publicly to large groups of investors had to be investment grade. The only publicly traded junk bonds were ones that were originally issued as investment grade bonds and had subsequently been devalued in ratings because the financial strength of the issuing companies had deteriorated. Up until then, companies with ratings below investment grade could raise new money only by borrowing from banks or through what are called private placements. A private placement is the sale of bonds directly to an investor such as an insurance company. Private placements are not registered with the Securities and Exchange Commission, and because of that, the original purchasers cannot easily resell them to other investors. These bonds have never been viewed as junk bonds. Publicly issued bonds, on the other hand, can be traded freely. (Encyclopedia of Economics)

In 1977 Bear Stearns and Company, a New York investment house underwrote the first and original issue junk bonds. This was the first public sale of new bonds with a junk rating. They were soon followed by Drexel Burnham Lambert. They financed seven companies that had previously been shut out of the corporate bond market and not been permitted to issue bonds. By 1983 over a third of all corporate bond issues were junk bonds, and the great majority of these were new issues. Within a period of six years, the entire shape of the market changed and junk bonds became a relatively easy way of raising money for companies that were not in good shape. (Encyclopedia of Economics)

At this stage let us remember a few basic principles in financial management. Return is always associated with risk. We have to decide the rather subtle difference in accepting risk and encouraging greed. A bank is an institution in the business of borrowing money and lending money. It provides for the fact that some loans will be good, some not so good or mediocre. In certain cases, the bank also knows that some creditors will not be able to pay back the loan and go bankrupt. Most individuals who invest money on the stock market do it basically to increase their return. They know that safer avenues of investment are available, but they will offer less returns, and in their quest for greater returns, they turn to the risky choices like junk bonds. Can we really consider this a wise investment strategy, or shall we call it greed? When greed and not investment becomes the reason for investment, it will bring with it the ill health of greed. This is probably the homely philosophy behind the troubles in the junk bond market. (Goodfriend, Marvin; Parthemos; James, Summers, 1980)

As already stated, the junk bonds grew at a very fast pace. Most of the time, the high interest they carried held enormous appeal for borrowing companies because publicly issued bonds typically carry lower interest rates (because they are more easily resold - according to Yago). Yago does not talk about the safety factor. They also carry lower rates of interest than private placements. An educated opinion would be that this is natural, since private placements have to be made to financial organizations that know the art or science of finance and cannot be fooled easily. The junk bonds also tend to impose fewer restrictions on the actions of the borrowers. This again is a natural consequence as the man selling the bond is primarily interested in collecting the money - he could not care less about what the fellow does with the bond later.

Yago seems to be a great fan for junk bonds and in his note he says: "For another, research by economists showed that junk bonds ought to have great appeal to investors. W. Braddock Hickman, T.R. Atkinson, O.K. Burrell, and others examined the bond-rating systems and their impact on bond pricing. These academics were the first to quantify the actual risk premiums (the higher interest rates) paid to various bond investors. They were particularly struck by the fact that low-rated debt earned a high risk-adjusted rate of return. In other words, the interest-rate premium on low-rated debt was higher than was justified by the added risk of default. Therefore, someone who bought a diversified portfolio of these risky bonds would do better than someone who bought investment-grade bonds, even after deducting losses on the bonds that defaulted. Michael Milken of Drexel Burnham trumpeted these insights to his firm and his customers, with stunning success." (Yago, 1991)

He recommends the path of junk bonds for many companies facing major structural economic changes in the eighties due to foreign competition, technological shifts, and deregulation. I do not understand how this increases their capacity to pay higher interest rates. He felt that they needed capital for economic adjustment. This is again a fundamentally wrong concept. Capital is the part of financing that requires the highest returns, and one of the fundamental indicators of the health of any company is ROI or return on investment. Naturally, increase in capital will only worsen the financial position of the companies, instead of improving them. It will also reflect in all financial analysis that any analyst will do and should do.

Bank loans, restrictive private placements, or stock offerings which diluted the share holding were the only source of capital prior to the rise of the high-yield market. (Goodfriend, Marvin; Parthemos; James, Summers, 1980) This again was but natural as only the experts should decide whether the sick company should get a second chance. Companies are like people and treated as such by Income Tax. Under certain conditions, letting a company go under is probably the best solution. But suddenly the high-yield market came up with enough funds to provide the funding alternative. He then goes on to accept the facts which came up by the inherent laws of finance "That golden age of junk financing lasted roughly a decade and built to a virtual frenzy of new bond issues in 1988 and 1989. That resulted, in 1989 and 1990, in an unprecedented number of defaults by junk bond issuers and the bankruptcy of Drexel Burnham. Almost overnight the market for newly issued junk bonds disappeared, and no significant new junk issues came to market for more than a year. In the wake of that shakeout and the scandals involving Drexel Burnham, junk bonds have been blamed for a broad range of troubles in the economy, including huge losses by commercial banks, the savings and loan crisis, high unemployment, low productivity growth, and almost everything else that seems amiss in the U.S. financial world." (Encyclopedia of Economics) suppose his loyalty makes him say that the facts do not support such assertions. He however agrees that "a major bankruptcy of companies that went through leveraged buyouts or made acquisitions with junk bonds has fostered the general impression that they are responsible for many economic woes." (Yago, 1991) Then he provides a subterfuge with irrelevant discussions on employment, growth, productivity, sales, etc. These are all irrelevant to the financial considerations. They do talk about the energy and spirit of the new management. This will happen when any new management takes charge. Remember movement is a sign of life and the newer the life is; the greater will be the movement. Older managements are slower because they have tried a lot of things and have the experience in running the organization. The new management does not and reworks the circle many a time.

The other factor was the rise of high-yield securities which accompanied the general growth of debt securitization. This is the combining of loans into packages and securities that represent claims on the interest and repayment of principal on those loans are issued for investment. Debt securitization has developed marketable investment instruments out of such everyday borrowings of individuals in the form of home mortgages and credit card debt. This is a much safer instrument as people are normally careful about the loans they take. Well bankruptcy is not exactly a desired end for any individual in the American society. Also, in general people are honest, and society lives on that premise. I am sure that all Americans believe that their countrymen will take the maximum care to repay their personal loans. If so, then this security should be safe.

It is true that junk bonds have a very bad reputation. For one thing, top managers of investment-grade companies have felt for years that they are the embodiment of reckless excesses of Wall Street. This is because junk bonds were used by corporate raiders to gain access to the public debt market. (Blume, and Keim, 1987) This in turn, enabled them to mount assaults on the largest corporations in the United States. This makes it almost sure that on Wall Street junk bonds will be an anathema, at least for a while. In 1988 and 1989 Wall Street firms were financing deals that many observers had said were bound to fail. But investors supported even the shakiest junk bonds. Now let us know the reason for Mr. Yago's support of junk bonds. Glenn Yago is director of capital studies at the Milken Institute in Santa Monica.

Problems and the solutions

The show we are discussing about was obviously a Milken show, and it started off with Yago asking Ranieri about the big problems he saw in the U.S. mortgage market in the early 1970s. The answer was naturally the limited availability of funds. Baby boomers were then coming of age and needed funding and housing. It was unlikely that the thrifts could meet the demand, he said. At the same time, the cost of capital required for housing made affordability a pipe dream for many willing entrepreneurs. The challenge was to put together a system by which enough dollars could be made available so that almost anyone who wanted a mortgage could get one. But, this required creation of a secondary market for securitizations of residential mortgages so banks could manage their loan portfolios and diversify risks efficiently. Creating this market also meant changes in the laws so institutional and other investors could invest in this new asset class and absorb the risk being shed by others. (Altman, 1990)

Sandor took a summarized and academic view of the process of innovation. He made the point that structural change is often the necessary catalyst for the development of any market, and those markets had the tendency to happen and evolve with the changes in time. In the late 1960s and early 1970s, the structural change that occurred was due to changes in interest rates. Earlier, the general assumption was that interest rates don't change. But at Stanford University in the 1960s, he said, you could look out the door and see that changes were taking place. This gradually changed the reigning belief that interest rates wouldn't become volatile gradually began to shift.

Once the initial structural change occurs, making a new market possible, continued Sandor, uniform standards for the "commodity" in question must develop and legal instruments must be formed. Then come exchanges and forward markets, futures and options exchanges, and finally over-the-counter markets, which offer what he called "deconstructed products."(www.financialInnovations.html) Milken approached the question of innovation by asking the down to earth question of what makes a community prosper. He noted that innovation creates jobs, financial independence, economic growth, entrepreneurship and so on. What he meant by innovation was the availability of credit. In the 1980s, he said, "I saw a lack of understanding of credit. A country was considered the best credit... And small businesses were [considered] the worst credit." (www.financialInnovations.html) According to him, this mistaken view shut companies that weren't established out of the capital markets, making it impossible for them to raise funds efficiently or expand their businesses. The first half of the puzzle, said Milken, was to create a high-yield bond market, investors, and the statistical data to show investors that they could get a good long-term rate of return. The second half was to understand the capital structure of a company.

Milken felt that one must realize that securities "exist on a continuum from senior debt to options," and that a company must manage its balance sheet 'as its fortunes change.' What's important, he went on, is the understanding that debt "has many characteristics and that debt becomes [similar to] equity as credit deteriorates and more like countries as it improves." (www.financialInnovations.html) The mid-1980s, he added, was the window when the United States was most open to new financial instruments. That's when Sun Microsystems, Oracle and Microsoft went public; not incidentally, in his view, job growth accelerated in step with the changes taking place. He felt that at that time a lot of innovation and entrepreneurship had taken place.

Scholes mentioned that financial innovation occurs when lower-cost solutions are developed to address clients' problems, he noted. The resulting services or products enable markets to become more efficient. In particular, increases in computing power in the 1960s and 1970s and greater sophistication in measurement greased the rails of innovation. When he started in finance in the late 1960s, the importance of measurement was an open question. Back then, there was no way the performance of pension funds, to be measured. Then he talked about the hive of modeling activity that took place after he and Fischer Black built their options-pricing model, which fueled the growth of the derivatives market. He explained that once there was a theory greater innovations could occur from the theory. Advances to the model by other people extended the frontier of financial engineering. Having an options pricing technology was the building block that enabled investment banks and brokerages to design products. Sandor mentioned that innovation frequently occurs in huge lots with products meant for the wholesale markets, because they are not patented. On Wall Street, the day you put out a new product, there are other people who copy it and come out with their products. The only way for firms to the monetary rewards of financial innovation is to keep on inventing. (Altman, 1990)

The choice

The moderator then steered the conversation to the barriers of innovation. Once a social problem is identified, he asked, what are the challenges and barriers to developing a private-sector approach to addressing the problem? In the mortgage market, said Ranieri, the obstacle was regulatory. "The innovation was that we had to find a way to make the assets finance themselves shorn of a balance sheet," he explained. In effect, he and others had to invent securitization in the mortgage arena. It took 15 years of writing laws and getting federal exemptions and in the process they made a series of "devil's bargains," (www.financialInnovations.html) This is important, he added, since people now tend to forget about those compromises.

All legislation necessarily has to create rules and institutions. In 1984 Congress passed the Secondary Mortgage Market Enhancement Act. These were a set of rules for doing business, as Ranieri put it. But in so doing the bigger issue that had to be solved involved the tax code. This was to get Congress to give all asset-backed securities their own section of the tax code. That plan didn't work, said Ranieri, because the Treasury Department and the Office of the Comptroller of the Currency "were willing to accommodate us for housing but unwilling to accommodate us beyond that." Eventually the bill had to be changed and applied only to housing. The Tax Reform Act of 1986 was duly passed, permitting Real Estate Mortgage Investment Conduits, or REMICs, with multiple structures to be tax-exempt and allowing Real Estate Investment Trusts to invest in mortgage-backed securities. The devil's bargain, in Ranieri's view, was that the law applied to housing but left commercial real estate and credit cards receivables, for example, out in the cold, with no recourse to the efficiencies of the capital markets.

The development of interest rate futures also needed a regulatory battle and changes in the enabling legislation. "In the 1970s, the only regulator that could have handled financial futures, bonds and so on was the SEC," said Sandor. "But the model they had didn't really work because they had enormous transactions costs - prospectuses and things that wouldn't apply to futures." (www.financialInnovations.html) Then, two things occurred. Those who favored trading in financial futures got Congress to update the list of tradable commodities, and added the word "intangible" to the description of regulated commodities. This allowed the trading of futures on equity indices, Treasury bonds and other underlying instruments that did not fall into the category of "tangible" commodities such as wheat, onions, soybeans and pork bellies.

The other change was that in 1974 Congress overhauled the Commodity Exchange Act of 1922, and created the Commodity Futures Trading Commission. It then granted the CFTC exclusive jurisdiction over futures. (Altman, 1990) This did not cover futures on single stocks and narrow-based equity indexes. So, they had to wait for a decision for 20 years till the CFTC and Securities and Exchange Commission sorted out jurisdictional issues. Last year, finally, the regulators allowed these products to begin trading.

Debt denied to some industries

In the corporate debt market, also, regulation was the main obstacle to change, noted Milken. A series of regulations made it impossible for institutional investors to buy bonds from other institutions or to swap one bond for another, and it took a long time for a pension fund or insurance company to be able to sell a bond before it reaches the period of maturity and be in a position to buy another bond. This highlighted two problems, said Milken. First was the widespread inability to understand numbers and measure things, as Scholes had observed. "Everybody looked at investments based on the past, not the future," said Milken. "Everybody looked at credit based on the past, not the future." They looked at reported earnings, not cash flow, and credit analysis didn't exist, even in the most sophisticated companies. Moreover, there was little desire for transparency. Companies didn't want to be rated because they didn't want to hear that they were a single-B or double-B. "In the public market, when you started getting rated, and judged, you started having to measure performance," he said. (www.financialInnovations.html)

Another problem was due to the lack of education. There was little general understanding about what access to capital meant, and there was great resistance to change. Even now resistance continues. "We're still seeing statements made that it isn't okay for a farmer to hedge against prices in his wheat," said Milken. "We are protecting ourselves from the things that protect us and allow us to survive." In his view, the backlash against derivatives and other complex products is misplaced. "This is a constant vigil," he added. "Not just in Mexico but in the United States today." Ranieri agreed. In South America, as in other parts of the developing world, he said, grudging progress is being made in the area of risk management and derivatives. "It is politically difficult to get them to see the benefit," he said. "They see only the disequalizing of the embedded power bases rather than the long-term benefit." He pointed to another basic issue in developing countries: property rights. "You can't securitize something when you can't put a lien on it," he noted. (www.financialInnovations.html)

The Future

Looking forward, all the panelists agreed that there is enormous potential for unprecedented innovation. Innovation could potentially transfer large sums of wealth to new, developing countries. Milken noted that the biggest commodities haven't yet been tapped: air and water. And in their case, it's possible to have one's cake and eat it too, by owning the asset and getting a tradable environmental benefit from it.

Sandor is now chairman of the newly formed Chicago Climate Exchange, which plans to begin trading greenhouse gas emissions in North America in a voluntary private program this fall. As he described it, once carbon dioxide emissions rights and biodiversity credits become established, a country like Costa Rica could extract value from eco-tourism because of its tropical rain forests, as well as from the "hidden" carbon sequestration credits that counter global warming. But he also accepted that for these programs to work globally, property rights are critical. Although the real value of these assets is not known, Sandor mentioned that the Economist had estimated that annual trading in carbon rights could reach $60 billion to $1 trillion per year by 2012. Water, he speculated, may be as valuable a commodity as energy in a century. Moreover, the spillover benefits in terms of peace, natural resources and conflict resolution in the Middle East and elsewhere are immense. Ranieri pointed out that the financial industry is having more success in new-product areas like the environment in developing countries rather than developed countries. He pointed to the cap-and-trade program in greenhouse gas emissions in Mexico. The reason is that while property rights are less developed, the idea of public goods faces fewer obstacles. The financial industry, he said, "may make market forces work in a very unusual way by starting someplace you would normally not go to first." (www.financialInnovations.html)

Scholes took up the challenge and mentioned that "we've seen nothing yet in our own country," and that financial innovation remains in an "embryonic" stage. From where he sits, new areas for financial innovation include low-income transaction processing, such as sending money overseas and refinancing loans; the funding of large-scale projects, and saving money for the future. More inventive risk-sharing and risk reduction for companies as well as individuals will also come about in the future, he predicted. Another function of finance is the understanding of pricing and valuation signals that help people make decisions and reallocate assets in the economy. More work can be done in this area to make markets more transparent. And finally, academics and modelers can work to reduce market frictions like asymmetric information (www.financialInnovations.html).For Sandor, seeding the future to allow and encourage all manner of innovation depends on education. Education is the "single biggest building block we need to further ideas," and the key is getting academics involved and getting these new ideas into the curriculum, both here and in developing countries. (www.financialInnovations.html)

Conclusion

Well what does all this signify? We have seen that there has been a lot of innovation carried out by the four people who have been discussed above. They met recently and feel that there is a lot of scope for innovation and the deciding factor for all the innovation will be education. Here, may be a fine distinction needs to be made between innovation and entrepreneurship. They were all innovators, but may be only Michael Milken can be called an entrepreneur, because he put his own money in the business and also collected a lot of money - whether fair or foul is another matter. So, may be the time has come when the definition of an entrepreneur will have to be changed - in the twenty-first century. The money requirements for investment are too large today for one person to bear it all. May be the leader of a shared ownership company going in for innovation may also be called an entrepreneur. In that case, all the above can be called entrepreneurs, and there is enough scope even according to them for entrepreneurship in the coming years.