Junk Bonds and Watered Stock

Originally published March 24, 1986

INTHE 1920s, bond salesmen were admired and envied. Later, when Wall Street laid its egg, they became butts of bitter jests (“Where are the customers’ yachts?” asked a book by Fred Schwed Jr.). In the end, they were objects of opprobrium and scorn. Today’s bond salesmen seem to be following in their grandfathers’ footsteps.

Salesmanship is now marvelously subtle, combining an ancient rhetorical device with an even more ancient childhood game. Long before Aristotle wrote his Rhetoric, Greek sophists found that an appearance of frankness could help them win a bad case; openly admitting a superficial weakness or two could get them good marks for sincerity. And since long before the sophists, children have known how to tempt their peers with the challenge, “I dare you.”

The device and the game are joined in the term “junk bonds.” The immediate connotation is of shoddy goods or a tangle of broken machinery, old plumbing fixtures and wrecked automobiles, partly hidden by a tumbled-down board fence as unsightly as what it pretends to hide. A secondary connotation is of junk mail, which almost everyone hates. The junk bonds metaphor boldly accepts both connotations and thus disarms criticism. No one, it winks, is trying to fool anyone.

At the same time, these negative connotations are modified by some that are at least ambiguous.  Those who send out junk mail presumably think well of it. Paraphrasing Abraham Lincoln, one might conclude that God must love churches and charities that raise money by mail, since He made so many of them. For another example, junk food is eaten by an awful lot of people, who apparently have a tolerance, if not taste, for it; and purveyors of junk food make an awful lot of money, something the purveyors and buyers of junk bonds hope to do, too.

In addition, the term admits risk and so suggests sport. I dare you to run the risks that may lead to a big killing. Are you big enough to afford such risks? You say that the capitalist system depends on risk taking: Do you dare put your money where your mouth is?

Yet just as a paranoiac may have real enemies, junk bonds may be really bad. They may not necessarily be bad for the new owners of the corporations that issue them or for the purchasers or for the underwriters, but they are almost invariably bad for the corporations themselves; they are also undeniably bad for the morale of our society (see “The Faith of Fiduciaries,” NL, December 24, 1984) and for the tax collections that support our society.

In spite of all the present hype, junk bonds are not new. Practically every railroad issued bonds at usurious rates – and ultimately paid the penalty. Neither are junk bonds the first securities of “less than investment grade” to be widely marketed in the United States. Most of our giant corporations – including many of those now being raided – were originally papered together with such securities. The chosen instrument was different, and the metaphor was different, but the results were similar. Stock was issued instead of bonds, and the stock was said to be watered like cheap whiskey.

In Other People’s Money, Louis D. Brandeis, later a Supreme Court justice, told how the United States Steel Corporation was formed in 1901: “The steel trust combines in one huge holding company the trusts previously formed in the different branches of the steel business. Thus the tube trust combined 17 tube mills, located in 16 different cities, scattered over 5 states, and owned by 13 different companies. The wire trust combined 19 mills; the sheet steel trust 26; the bridge and structural trust 27; and the plate trust 36 …. Finally, these and other companies were formed into the United States Steel Corporation, combining 228 companies in all …. ”

The tube trust, when it was put together a few years earlier, had been capitalized at $80 million. Half of that was common stock, and half of the common “was taken by J.P. Morgan & Co. and their associates for promotion services; and the $20 million stock so taken later became exchangeable for $25 million of Steel Common.” The tubes plainly held a lot of water, as did the other trusts that went into United States Steel. Nor was this all. The rest of Steel Common was watered in its turn, with nearly one-seventh issued directly or indirectly to the promoters.

Although Brandeis doesn’t give all the gory details, I would wager that at least half of the original 228 companies were enticed to sell out at greatly inflated (or pumped up) prices. Some of the others may have been squeezed a bit, but the total paid for the 228 was almost certainly far greater than their entire net worth. Once you add it together you have United States Steel, the first corporation capitalized at a billion dollars, and pretty close to half of it was water.

In Morgan’s time, high-flying corporations were overcapitalized. Currently they are undercapitalized, a.k.a. leveraged. The shift is a function of the tax laws, though you may read many an analysis of takeovers without coming across a mention of the part played by taxes.

When U.S. Steel was floated, there was no corporation tax. Since earnings were not taxed, interest paid on bonds was obviously not deductible. Interest was a fixed expense. Dividends, on the other hand, were not fixed (except for some on preferred stock). You paid dividends when you were flush; otherwise not.  Therefore a prudent company got its money from stock, rather than bonds. Today, with the corporation tax at 46 per cent (assuming a corporation pays any taxes at all), and with interest payments deductible, a clever company will issue bonds instead of stock, and a clever raider will happily issue junk bonds paying 14-15 per cent in order to buy up stock earning 5-6 per cent. (For reasons why no interest should be deductible, see “The Bottom Line of Tax Reform,” NL, November 26, 1984) After the deduction, the new load on the company is only about 6-8 per cent, and before it becomes oppressive, the raiders will be long gone.

That the debt will eventually become oppressive, there is usually little doubt. The interest payments will have to continue in bad times as well as in good. As profits fall or disappear, so will the benefit from deductibility. The corporation’s cash flow will be soaked up by the high interest. Even a sluggish cash flow can quickly lead to bankruptcy. Of course, bankruptcy may now be sought to break a labor contract, whereupon the company may become solvent again. Guess who’s left with the short end of the stick?

This result of undercapitalization is, you may be astonished to learn, not substantially different from the result of overcapitalization. How was the water in Big Steel paid for? As the man might say, there’s no such thing as a free drink. If the capitalization was half water, Steel’s earnings on its real assets would have had to be twice “normal.” Without a research assistant, I can only suggest the outline: First, the owners of the original 228 companies were well paid. Second, J.P. Morgan and his fellow underwriters were very well paid. Third, those who bought the watered stock received “normal” dividends. Fourth, the price of steel was not grossly exploitative (steel rails stayed at $28 per long ton for more than 10 years).

Here someone is sure to cut in with the claim that U.S. Steel was more efficient than its 228 components had been. Evidence for this is the fact that most of the 228 were shut down, while the surviving units were expanded. But if those shut down were inefficient, why were they bought in the first place? The competitive system is supposed to let inefficient companies die.

The case for technological efficiency is, if anything, worse. In 1911, 10 years after the emergence of U.S. Steel, Engineering News reported: “We are today something like five years behind Germany in iron and steel metallurgy, and such innovations as are being introduced  by our iron and steel manufacturers are most of them following the lead set by foreigners years ago.” (That might have been written yesterday.)

The question remains: Who paid for the water? Those who didn’t immediately answer “Labor!” will stay after class and be given a quick review of the effects of mass immigration, Taylor System management, and courts that issued injunctions against labor unions as conspiracies in restraint of trade.

THE Federal Reserve Board’s new rule limiting the use of junk bonds to 50 per cent of the price of a takeover may put a momentary hitch in a few raiders’ plans. And some say the present run-up of the stock market will put an end to takeovers by increasing the amount of money needed. The run-up, however, has been caused by the drop in interest rates, which increases the capitalized value of every income-earning asset. (An asset that earns $10 is worth $100 when the interest rate is 10 per cent, and jumps in value to $200 if the rate falls to 5 per cent.) For this reason, the bond market has been rising, too; the interest that investment-grade bonds must pay is falling-and so are the requirements for junk bonds.

Should President Reagan be successful in cutting corporation tax rates (as seems likely), the deductibility of interest payments will become less important and watered stock will tend to displace junk bonds in takeover schemes. In other words, look for an upsurge in new blue-sky issues. R.R. Palmer tells us in A History of the Modern World of an 18th-century promoter who issued shares in “a company ‘for an undertaking which in due time shall be revealed.” Does anyone doubt that if Carl Icahn made such an offering today it would be oversubscribed tomorrow? Whatever happens, the financing of the American economy will still be largely an incidental function of speculation, or as Keynes said, of running a casino.

My first “Dismal Science” column (NL, September 7, 1981) was entitled “Speculation Will Undo Reaganomics.” The title displays an innocence on my part. I did not imagine that the Reaganauts’ intention was to make paupers and millionaires. Speculation continues to have the effects I discussed; I still find it hard to believe that decent people think it’s grand.

Since the Civil War days of “Betcha Million” Gates and Jay Gould, speculation has resulted in American enterprises paying too much for capital. Andrew Carnegie observed in The Empire of Business (1902) that “railway managers today are … directed to obtain a return on more capital than would be required to duplicate their respective properties.” It matters little whether the capital is paid for with dividends on watered stock or with interest on junk bonds. Either way, it is the working man and woman-the people who put that capital to work – who do the ultimate paying.

The New Leader

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