Wall Street has a penchant for taking good ideas to excess. During the latter part of the twentieth century, three important and useful asset classes made their market debuts: hedge funds, high-yield (junk) bonds, and securitized bonds. Before enjoying widespread acceptance in the markets, however, the development of each conformed to Warren Buffett’s three-stage progression for new financial ideas that grow out of control: first there is innovation, which is followed by imitation, and then ends with idiocy.
In 1949, Alfred Winslow Jones—a doctor of sociology who freelanced for Fortune magazine, generally writing on nonbusiness topics—conceived of a new investment strategy that combined two otherwise risky strategies in such a way as to actually minimize risk. One could take a leveraged position in a stock (borrowing extensively through margin accounts to buy it) and simultaneously take a counterposition in other stocks by selling them short. The end result was that the “long” and “short” positions largely offset each other’s risk—and produced substantial combined profit. Jones’s extraordinary success with this concept—the “hedge fund”—encouraged others to enter the game. By 1970, hundreds of copycat hedge funds were in the market and managing over $2 billion for a select group of very wealthy individuals and, later, for institutional investors trying to beat the market. Today hedge funds account for $2 trillion in investments, but based on their performance that may be at least $1 trillion too much. The typical fund overpromises and underdelivers—with the Long-Term Capital Management fund discussed in chapter 9 being a vivid example. And most funds enrich the managers through hefty fees, but contrary to the original Jones model, they do little to limit risk and, on average, perform no better for their investors than an ordinary portfolio of stocks and bonds.
Like hedge funds, junk bonds have become a near $2 trillion asset class. And while some question whether Jones is the rightful “father” of the hedge fund, no one questions Michael Milken’s paternity when it comes to junk bonds. While at Wharton studying for his MBA, he determined that a class of bonds called “fallen angels” provided outsized returns for investors who could understand and tolerate their risk. These were bonds that had once been given an “investment grade” label but that had fallen on hard times, been downgraded, and became ineligible for purchase by regulated insurance companies and other institutional investors. They later became known as “junk bonds.”
Milken’s insight was that the investment returns from those downgraded bonds would more than compensate the investor for taking the risk. When he left Wharton he began evangelizing on the merits of junk bond investing from a trading desk at the Philadelphia office of a firm that would shortly become Drexel Burnham Lambert. His proselytizing worked well enough to earn him a fortune at an early age and to spur him on to phase two: original-issue junk bonds. Rather than waiting for high-quality bonds to fall into noninvestment grade status, Drexel began to underwrite new issues of bonds for companies that, because their securities were less than investment grade, were unable to attract the attention of reputable Wall Street investment banking firms.
Milken arguably performed a valuable service by raising capital for companies that were previously shut out of the capital markets, and many of the companies Drexel sponsored became large and successful as a result. And there is a case to be made that when junk bonds were used to facilitate the wave of leveraged buyouts in the 1980s and 1990s, the targeted companies became tougher and more accountable to shareholders. But toward the end of his tenure at Drexel, Milken, in his zealous quest for “100 percent market share,” backed the junk bond issuance of a large number of questionable companies and takeover operators. His focus on quantity of business rather than quality of business corrupted Milken’s department—and his excesses culminated in a highly controversial prosecution that eventually led to his guilty plea and a two-year imprisonment.
Securitization was another idea that started small and served a valid and positive purpose, but later grew out of control—with disastrous consequences for the global economy. It all began in the 1980s with Lewis Ranieri, a bond trader with the Salomon Brothers investment house, whose financial innovation was to assemble pools of residential mortgage loans into a trust and then use the trust to issue mortgage-backed bonds. The idea was slow to catch on, but when the savings and loan industry went into crisis mode in the 1980s and had to unload mortgages in unheard of amounts to pay off depositors, business picked up. Mortgage-backed bonds became a staple of Wall Street, and at the high point investment bankers created some $12 trillion of new bonds by bundling mortgages from loan originators and transferring them to bond buyers. But a monstrous overextension of Ranieri’s creation became a major cause of the financial meltdown of 2008.