"Tin Men"

Some may remember the movie Tin Men. Set in Baltimore during the 1960s, the main characters, Danny DeVito and Richard Dreyfuss, make a living selling aluminum siding for houses. They are part of a quickmoney operation that leaves customers possibly defrauded and certainly disillusioned. The main plot pits the two against each other in a brawl that eventually destroys DeVito’s marriage. The camera periodically cuts to a courtroom where hearings are held of the shenanigans used to entice customers. DeVito and Dreyfuss are oblivious to the proceedings even though the dubious operation is front-page news. Their battle for one-upmanship, DeVito’s wife, and aluminum-siding sales completely ignores the noose that eventually falls on them, after testimony has condemned them. Whatever crimes (if any) they committed are incidental in political circles, compared to the image contrived of the bureaucrats doing their all to protect the Little Man. One could deduce that devious practices were old hat by the time the authorities decided to act, possibly having collected their own booty before feigning disgust and doling out retribution.

There is little that is new in the current private-equity, hedge-fund, prime-broker, rating-agency, derivative mixture. The question seems to be how the borrowing and leveraging will end. If past is prologue, it will be the politicians who will shut the door. This will be (at least, it always has been) after the tide has turned. (The nature of legislation is reactive.) The current boom is coagulating into the same, dark mixture that drowned the market twice before – in the late 1960s and the late 1980s. The timeline of the earlier periods is repeating itself today: the limited attraction of a new bull market, the massive attraction of an aging bull market, the publicity drawn to victors in a moribund bull market, the overinvestment and overleveraging of funds that lead to a bear market, criminality, and bankruptcy. It is the latter two developments so essential to political involvement: these are tangible (and inevitable) developments. Poor coverage ratios and the structure of payment-in-kind bonds will not make the Congressional docket.

On December 31, 1949, the Dow Jones Industrial Average traded at a price-to-earnings ratio of 7.6:1, with a dividend yield of 7.1%. The yield on the AAA-rated long-bond was 2.7%. The most heavily shorted stocks were automobile manufacturers. The stock market was of limited attraction. It peaked in 1966, swooned, rose, unravelled in 1969, recovered in the early 1970s, then collapsed in 1973 and 1974. The smart money stood aside as the young and restless came to dominate activity. In 1967, Richard Jenrette, co-founder of Donaldson, Lufkin & Jenrette, defined the "great garbage market", in which old stalwarts like GM and GE were ignored. The public was drawn to United Convalescent Homes and Minnie Pearl’s Chicken System, Inc. New hedge funds opened nearly every day. By 1969, trading volume on the New York Stock Exchange of over 20 million shares a day forced the market to close on certain afternoons.

Conglomerates were the fashionable contraptions composed of unrelated businesses that were better operated under one roof. At least, that was the current wisdom. When they burst into prominence, the public was caught by such surprise, the New York Times was at a loss for words: its society pages would clumsily classify the victors as "conglomerateurs". Until this need to classify arose, a conglomerate was a rock. These rocks were diamonds, in the speculating public’s view.

Of most importance, as in all financial structures, were the foundations. The foundations grew less stable as they carried more weight. Rising trading volume and the insatiable appetite of hedge funds were a worry, though the bulls thought just the opposite. In 1968, 4,500 mergers were consummated (far more than in any previous year), and 26 of the largest 500 companies were absorbed into conglomerates.

What follows is a case study of an illusion. In a populist age, accumulation of money and companies makes for a fragile empire. Those clever enough to leverage their capital – financial and intellectual – may look upon their fiefdom as a fortress. In the end, they have no more power than the political establishment permits. The establishment is willing to concede much (political and financial interests are often aligned), but those who fly the highest risk the fate of Icarus.

The case of Saul Steinberg v. The Establishment fits the chronological pattern, financially and sociologically, that we see today. At the age of 21, Steinberg started a computer leasing business. It took him three months to lease his first computer. "Ideal Leasing" was incorporated in 1962. In 1964, with earnings of US$255,000 and revenues of US$1.8 million, Steinberg took his re-named "Leasco" public. By 1966, profits had jumped to US$2 million. Leasco stock soared. Steinberg used the stock to buy a flock of companies. He started acquiring shares of Reliance Insurance Company, an established, Philadelphia propertyand- casualty insurance company. With an ever-rising stock price, he took control over the next 11 months. Now, 80% of Leasco’s revenues were from insurance and 20% from leases.

This was only possible because the public had grown stark, raving mad over Leasco stock: the establishment’s back was against the wall. Leasco appreciated 5,410% over the five years (1964 through 1968). For simple comparisons to later periods, this may be regarded as money loaned with very little chance of cash repayment (in the form of security appreciation, profits, coupon payments, dividend payments).

Steinberg, now 29 years old, set his sights on a large bank – "a New-York, money-center bank with international connections". He threw darts and Chemical Bank was the target, the sixth-largest commercial bank in the United States.

The leader of Chemical, William Renchard, Princeton graduate, member of the right clubs, director of a half-dozen major corporations, trustee of several hospitals and civic organisations, was not pleased. Nor was the board of directors, which included the chairmen of AT&T and of du Pont, the president of IBM, a member of the executive committee of Texaco, and a former president of the New York Stock Exchange.

Steinberg prepared a tender offer, then called Renchard. Renchard suggested they meet for lunch. He sent his car for Steinberg; they met at Chemical Bank’s executive dining room. Of this duel, John Brooks wrote: "there was a sense of backs to the wall, of barbarians at the gate …". The phrase, attributed to the late 1980s, was already in play.

To thwart the barbarian, Renchard engaged the law firm of Cravath, Swaine & Moore. Cravath drafted legislation, then sent it to both Albany and Washington. The new laws would specifically prevent a nonblank taking over a bank. Governor Rockefeller (whose brother David ran the Chase Bank) urged the New York Legislature to adopt such a bill. A similar bill was sent to Senator John J. Sparkman of the Senate Banking and Currency Committee. Renchard called William McChesney Martin, chairman of the Federal Reserve, known as the "Boy Wonder" when he was chairman of the New York Stock Exchange. Renchard apprised Martin of the situation. Leasco stock fell to US$115 – it had been US$140 before the bid was announced. The stock started to fall the day the tender offer was announced – quite unexpectedly, given speculators’ fever for more and bigger conglomerates. Did the Establishment manipulate the stock market? The question was asked by many.

Steinberg next received a letter from the Justice Department. The letter did not suggest that such a transaction would violate anti-trust laws, but that, "questions under these laws are raised thereby, particularly under Section 7 of the Clayton Act". (The reader may look it up; no doubt, Steinberg needed outside counsel, too.) Steinberg stewed over the situation at a hotel in Dorado Beach (owned by Laurence Rockefeller) before going to Washington where he met with several members of the Senate Banking and Currency Committee and with members of the Federal Reserve Board. Steinberg found his timing was poor: "The nation’s legislators were in a grimly anti-conglomerate, anti-takeover mood."

Steinberg – brash and irrepressible as he was – lost his nerve when he met with Senator Sparkman. As Steinberg relates, Sparkman said: "By the way, have you seen the bill I’m going to introduce against bank takeovers? (Calling to his secretary) Miss -, where’s the bill the lawyer from Chemical Bank sent in? I want to show it to Mr. Steinberg."

Concurrently, the conglomerate craze was ending in caricature. The hostile takeover of Hartford Fire Insurance Company by International Telephone and Telegraph (ITT) was notorious for several reasons – one being Lazard Freres’ advisory fee of well over US$1 million.

Northwest Industries (clothing, pesticides, steel) attempted to buy out B.F. Goodrich. Goodrich volleyed with the standard retaliation tactics – it changed its accounting method, it went on a buyout spree of its own – then it, too, took the line of defence that no amount of financial heft can defeat – it turned to the politicians. The Ohio Attorney General issued an injunction against the merger; the Justice Department brought an antitrust suit to block it.

By analogy, DeVito and Dreyfuss are fighting each other and not reading the headlines. How might this end? On the simplest level, the math stopped working. Smoke-and-mirrors cannot hide an investment unable to pay its bills. When the foundations buckled, a few – and then the many – asked themselves whether the very idea of conglomerates made sense. From a non-mathematical perspective, the ambitions grew too large, the conglomerateurs too vulgar, the hoi polloi got stiffed, and the politicians decided to act. Time magazine spoke for the many. The March 7, 1969 cover asked: "Takeovers in High Gear: Threat or Boon to U.S. Business?" (Pictures of "LTV’s Ling", "Gulf & Western’s Bluhdorn", and "Textron’s Miller" adorned the cover: You know Time’s answer.) Late in the same year, the cover asked: "Will There Be a Recession?" In June 1970, answer to the previous question in hand, Time queried: "Is this Slump Necessary?"

Without the volume and intensity pursuing conglomerates, the stock market deflated. Once "liquidity" reversed (to employ the current word that defines markets that will never fall), it was over. Between January 1969 and October 1970 (roughly the period of the Time triptych), the 28 largest hedge funds lost 70% of their assets. Between November 1969 and November 1970, about 100 brokers and financial firms disappeared. They either became insolvent or were absorbed. (New laws followed to protect the Little Man; the legislators were a bit late.) The Dow only fell 36% between December 1968 (from 985) to May 1970 (to 631), but, as in 2000, the fever ran elsewhere. Dun’s Review constructed indices of the ten leading conglomerates, the ten leading computer companies, and the ten leading technology companies. During that period, these indices fell 86%, 80%, and 77%, respectively.

The garbage market expanded and Wall Street polluted the tank with risky (or worthless) securities. John Brooks told the story of a rising star at a Wall Street firm who fell on the losing end of several court judgments after passing bad cheques. The firm continued to promote him. As the stars grew more powerful, they flaunted it; as egos grew, they needed to do the biggest deal. In the wake of Saul Steinberg’s fall, the 29-year-old reflected, "I always knew there was an establishment – I just always thought that I was a part of it."

If he had been watching the front covers of Time, Steinberg would have known he was too late.

The 1980s differed as a matter of degree, and probably of criminality, but not of substance. The story is well known. What started as a good idea ended in buffoonery. Michael Milken’s group at the investment-banking house of Drexel Burnham educated the world, then dominated it, in the fertile laboratory of junk bonds. The gluttonous, self-enriching LBO overdose in the second half of the 1980s was different than the refinancing of American corporations of the first half.

The first takeover of a public company by a private-equity firm was in 1979, when Kohlberg, Kravis, Roberts & Co. (KKR) bought machine-tool maker Houdaille for US$355 million. This was also the first LBO. It took over a year to find financing, as well it might. The idea of buying a company by loading its balance sheet with debt was new.

It was the meeting of junk bonds and the private-equity firm that created the LBO boom. The early financings were responsibly packaged to permit the companies so structured to cover their debt payments out of projected earnings. In 1980, only 10% of junk bond offerings were for purposes of acquisition; by 1984, this proportion had leapt to 45%. By 1983, future profits (before depreciation and taxes) were projected to be 20% less than annual debt payments. Companies are often forced to make expedient decisions under such pressure. Since workers are the largest expense at most companies, they go.

Saul Steinberg made his own contribution to the English language when he, in effect, blackmailed Disney into paying him US$60 million to call off a takeover bid in 1984. Thus, the very-eighties term "greenmail" came into being. The politicians were growing restless. Legislation mimicking the Chemical-Bank, protection program was drafted. Delaware became the most controversial state in the union with its deep, statutory moat that separated company management from demanding shareholders. An antitakeover measure proposed by Congressman Dan Rostenkowski contributed, to some unknown degree, to the stock market crash of 1987.

After the crash, the stock market recovered, but easy liquidity did not. The deals grew larger, though, with ever more ingenious bonds to finance these monuments to braggadocio. The early Milken bonds included equity participation by the bondholders. From there, the road was trod to zero-coupon bonds and, finally, to payment-in-kind bonds when the company paid nothing at all. It simply issued additional bonds at the imaginary coupon payment date: thus, the "payment-in-kind". These were generally worthless. At about this time, Michael Milken appeared on the front cover of BusinessWeek. The cover story quoted a Harvard Business School professor who compared Milken to J.P. Morgan.

In 1988, "entrepreneur" (as he was now known) Saul Steinberg paid US$2 million for his daughter’s wedding at the Metropolitan Museum’s Temple of Dendur. This was not a bad thing since it preceded the "tipping point" (to borrow the title of Malcolm Gladwell’s book). But the mood was changing. The catch-phrases – "yuppies", "the decade of greed", "Reaganomics" – were repeated endlessly. They offered little in explanation but provided a leitmotif as the public grew disenchanted.

In early 1989, Kohlberg, Kravis paid US$30.9 billion for RJR. This was a very big number. It is difficult for an outsider to assess the efficiencies of such combinations, but they cause anxiety and disorientation. Sneaker jobs were going to Asia. This jumble of numbers and worries is often what we live by. The smorgasbord did not appeal to the tastes of the public or the politicians.

The temper in Washington, already agitated by the growing control of "financial buyers", grew hostile as the RJR deal gathered greater attention. (The term "financial buyer" was used to differentiate these deals from "corporate buyers" or "strategic buyers." Corporations were priced out of the merger business.)

Kohlberg, Kravis, and Roberts gathered 400 dealmakers and lawyers at the Pierre Hotel to celebrate. The guests were congratulated for making over US$1 billion in fees. This did not include the junk bond sales and bank loans. Given the times, the dinner received publicity and it was seen as being in poor taste. Michael Milken’s party for Drexel Burnham clients has gone down in history as the "Predator’s Ball".

Even as the borrowing bubble was peaking, it had already started to deflate. (The analogy in 2007 might be the cracks in the CDO market as private equity continues on its merry way.) In September 1988, Campeau Corporation disclosed a severe cash crunch. Junk bond prices plunged. On December 7, a Drexel Burnham trader turned government witness against the firm. By the end of the month, Drexel Burnham agreed to settle insider trader investigations and paid US$650 in fines. Clients fled the firm. Early in 1989, Michael Milken was indicted on 98 counts of fraud and racketeering.

The junk bond market was stunned, maybe not so much by the problems at Drexel Burnham, but because demand for junk bonds withered. Junk bond issues rose from US$2 billion in 1980 to over US$200 billion in 1988. There was little thought given to market "liquidity", since buyers could always be found who wanted more. But this was not to be so. On October 13, 1989 a proposed US$6.79 billion management-union buyout of UAL Corporation collapsed. This caused the stock market "crashette". (The stock market was priced for junk bond-financed buyouts above the value of companies.) Takeover-stock specialists lost US$1 billion on paper. Eric Gleacher, Morgan Stanley head of mergers and acquisitions, was quoted by the Wall Street Journal: "There was a tremendous backlash caused by the RJR deal. It was the biggest blowup we’ve had … in this cycle" of the merger business. In December, KKR placed one of its companies into Chapter 11 proceedings – Hillsborough Holdings, the first ever bankruptcy filing by a KKR company. The mystique of LBOs was collapsing – lost jobs and bankruptcy were not in the propaganda filing of the "takeover artists".

The changing times were evident when Saul Steinberg spent US$1 million at a Southampton summer party in 1989. This was half the cost of the wedding but caused an uproar. Party guests told an inquiring press of their outrage. Other guests noted that the outraged looked mighty pleased at the party. (The rise and fall of Jay Gatsby may come to mind.) The New York Times wrote an editorial about "Plutocrats and Moralizers". John Kenneth Galbraith followed by quoting Thorstein Veblen. Such consumption is within "the higher stages of the barbarian culture". Soon after, a best-selling book would immortalise the KKR and RJR Nabisco deal: Barbarians at the Gates.

Fred Sheehan

July 5, 2007

The Daily Reckoning