This article is an excerpt from the Shortform book guide to "Liar's Poker" by Michael Lewis. Shortform has the world's best summaries and analyses of books you should be reading.
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What are junk-rated bonds? How did junk bonds become popular on Wall Street?
After mortgage bonds began to decline on Wall Street, junk-rated bonds were next on the market. But unlike how Salomon Brothers took advantage of mortgage bonds to make a penny, junk bonds would be used against the investment bank.
Find out how junk-rated bonds ended up hurting Salomon Brothers.
The Rise of the Junk Bond
The so-called “junk-rated bonds” had existed for decades but would be pushed to new heights by Michael Milken, head of the bond department at rival firm Drexel Burnham. In Liar’s Poker, Michael Lewis describes how Milken fostered the junk bond craze of the late 1980s and how he used it to fund a wave of hostile corporate takeovers, including one directed at Salomon Brothers.
(Shortform note: Milken’s career was plagued by scandals that escalated throughout the ’80s and beyond. In Den of Thieves, James B. Stewart writes that Milken, who was under constant scrutiny by the SEC, played a key role in a massive insider trading scheme. Shortly after Liar’s Poker was published, Milken pled guilty to fraud and conspiracy, was sentenced to 10 years in prison, and was banned from the securities industry for life. Though he only served two years of his sentence, the SEC fined him in 1998 for allegedly returning to securities work, and they again investigated Milken in 2013 on suspicion that he was continuing to do so. In 2020, President Donald Trump granted Milken a pardon, citing his philanthropic work in later years.)
Junk bonds are issued by companies in poor financial standing as a means to raise capital and keep themselves afloat. These bonds are “junk” because of their high default risk—if the issuing company goes bankrupt, the bondholders are left with nothing. Nevertheless, junk bonds can be attractive because of the high interest rates they offer. Investors who place a lot of money in junk bonds are betting that the profits from the bonds that pay off will be greater than the losses from the bonds that go bust.
(Shortform note: Despite the points Lewis lists in junk bonds’ favor, cautious investment experts say to avoid them. In The Essays of Warren Buffett, Buffett calls out junk bonds as speculative tools driven by the fantasy of easy money and criticizes their very existence for making financial crises worse. Nevertheless, in A Random Walk Down Wall Street, Burton G. Malkiel doesn’t discount junk bonds as an option for young investors with diversified portfolios because of their potential high rewards as well as young investors’ higher tolerance for risk.)
According to Lewis, mortgage bonds and junk bonds were alike in that Wall Street looked down on them as second-rate investments. Like Ranieri with mortgage bonds, Milken ignored Wall Street convention and grabbed as much of the junk bond market as he could. However, unlike Ranieri, Milken saw corporations as businesses, not just customers to be swindled. Using a team of financial researchers, Milken would calculate whether a struggling company was undervalued. If its assets were worth more than its stock price suggested, Milken could argue that its junk bonds weren’t risky and trade them to investors who often made a killing.
(Shortform note: Milken’s valuation strategy is similar to what Benjamin Graham suggests in The Intelligent Investor. Graham, however, is more concerned with stocks. He writes that if the market values a company’s stock less than the actual value of its combined assets, you should buy it because the stock will likely rise in value to reflect the true worth of the business. When it comes to junk bonds, Graham advises against them unless you have the opportunity to acquire them at a deep discount to offset their risk of default.)
By 1987, the junk bond market soared to over $12 billion in transactions as the mortgage bond market continued to falter. Lewis says that Milken needed more junk bonds to sell, so he partnered with a new breed of investor—the hostile takeover king. By identifying businesses whose stock was undervalued, Milken marked targets for potential takeover. He’d finance the purchase of a controlling stake in the company by selling junk bonds to pay for the stock, then when the target company was bought and its leadership ousted, its stock would plummet and its bonds became junk that Milken would trade to finance the next takeover.
Takeover Target: Salomon Brothers
As its profits teetered, Salomon Brothers came within a hair of falling victim to a hostile takeover bid. In September 1987, takeover magnate Ron Perelman (with funding from Milken) moved to grab control of Salomon. Lewis explains why Salomon was vulnerable, the threat Perelman posed to Salomon’s management, and how Warren Buffett came to their rescue.
When junk bonds took off in the latter 1980s, Salomon Brothers kept out of the market, but not for any well-thought-out reason. Lewis says it was mostly because Ranieri sabotaged any attempt by Salomon Brothers to join the junk bond business. Ranieri felt that bonds were his kingdom and that his power would be threatened by any attempt to steer the company away from his mortgage bond turf. As a result, Salomon missed out on participating in the takeover business, and after Ranieri’s firing, the firm was blindsided by Perelman and Milken turning the market against them.
(Shortform note: The reasons Lewis gives for Salomon staying out of the junk bond business suggest that the firm fell prey to valuing expansion over innovation. In Zero to One, Peter Thiel explains that innovation—which he calls “vertical progress”—leads to expanded opportunities and growth, whereas expansion without innovation only leads to competition for resources. Contrary to the attitudes prevalent on Wall Street, Thiel says competition is always destructive because businesses become so embroiled in power struggles that they lose sight of their objectives and make bad business decisions, such as Salomon staying in the mortgage bond game long after it had ceased to be lucrative.)
Buffett to the Rescue
When one of Salomon’s chief investors wanted to sell their shares, Perelman swooped in and made an offer to buy them with funding provided by Milken. Perelman usually fired the managers of the companies he took over, so Gutfreund scrambled to find another buyer to keep his position in the firm. The buyer he found was investor Warren Buffett, but Buffett saved Salomon to make a profit for himself, and he didn’t want shares in the business. Instead, Lewis writes that Buffett loaned Salomon Brothers $800 million so it could buy back its stock, a loan that Salomon would have to repay at 9% interest. Gutfreund’s job as CEO was secure, but the price would be paid by the firm’s shareholders until their debt to Buffett was cleared.
Perelman’s takeover attempt may have been motivated by more than simple greed. Lewis suggests that Milken may have urged the takeover because of his animosity toward Salomon’s CEO Gutfreund, a dislike that Gutfreund reciprocated. Milken’s Drexel Burnham had lured away many of Gutfreund’s former employees, and the rivalry between their two firms was one of the biggest on Wall Street.
The 1987 “Black Monday” Crash
No sooner had Salomon Brothers evaded one catastrophe when it and the rest of the financial world felt a shock unmatched since the Great Depression. On Monday, October 19, 1987, the global stock market crashed, wiping out trillions of dollars in investments. Lewis explains that the crash occurred at a particularly bad time for Salomon Brothers, how the firm missed its chance to turn losses into gains because of some questionable business decisions, and how some individuals did well in the misfortune.
Lewis writes that in the week before what would become known as the “Black Monday” stock market crash, Salomon chose to leap into junk bonds while simultaneously laying off 1,000 employees. Some entire departments were let go, including those in charge of money markets and municipal bonds, with no apparent rhyme or reason. Distrust within the company was at an all-time high, especially since the rank-and-file workers knew that the executives sitting on the board wouldn’t feel any negative effects from the layoffs.
Before Salomon had a chance to find its new footing, the stock market crash hit like a tsunami. Here, Lewis mentions a curious fact about stocks—when the stock market goes down, the bond market goes up. By firing so many of its bond trading experts, Salomon was left with very few people in a position to take advantage of this flip. One Salomon trader had happened to short the S&P index just before the crash, which luckily recovered a big chunk of wealth, but otherwise Salomon and most of its clients lost entire fortunes in the debacle.
There was one silver lining as Salomon Brothers’ stock dropped. Gutfreund, Lewis, and many other staff recognized that their stock was deeply undervalued (just as Milken had known the month before) and took the opportunity to buy their own company’s stock when it was selling at an all-time low. Lewis says that for him, his investment didn’t represent any faith or goodwill toward Salomon Brothers. It was simply a cold calculation toward wealth, which would surely follow when the stock price rebounded. In his heart, Lewis was ready to leave, and though he’d wonder if quitting was a wise decision, he had faith (as of his writing) that the business would do well and continue to make money for years to come.
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Here's what you'll find in our full Liar's Poker summary:
- A first-hand account of the pursuit of ill-gotten riches at the Salomon Brothers
- The boom and burst of the mortgage bond market
- Where there is room for ethics and level-headed investing
