The return of high-risk optimism

By John Gapper

Only at the Milken Institute Global Conference would one song played between financial debates be Bob Marley’s “Three Little Birds”: “Don’t worry ’bout a thing, ’cause every little thing gonna be all right.”

That was the tune on Tuesday at the annual Beverly Hills talking shop of the research group founded by Michael Milken, the philanthropist, former disgraced banker and enthusiast for newfangled finance.

It was emblematic. There are alternating moods among the Wall Street bigwigs and corporate names that throng the Beverly Hilton hotel for the conference. One is: things are good. The second is: things are bad, and that is an opportunity.

The latter of these sunny moods was prevalent this week. But there were also showers of defensiveness. Nothing irritates Mr Milken, the pioneer of high-yield finance at Drexel Burnham Lambert in the 1980s, more than the idea that investors should shun risky securities.

On the face of it, the billions of dollars that banks lost in the US subprime mortgage crisis are evidence against him. The original loans that caused the trouble were to borrowers with junk credit ratings – in this case, homeowners rather than the growing companies with which Mr Milken and Drexel were associated. So he kicked off the conference with a restatement of his original insight (before he went to jail for securities fraud in 1990) that an investor is better off choosing a diversified portfolio of high-yield bonds than sticking to investment-grade bonds. The rewards of this, he found, outweigh the risks.

Mr Milken favours a no-holds-barred style of argument, tending to dismiss anyone who disagrees with him as an ignoramus. As a result, his defence of his position – set out this week in a 10-page paper – is too sweeping and has some weak points.

He points out that investment-grade securities have been at the heart of several trillion of dollar losses, including US railroads in the 19th century, “nifty fifty” stocks in the 1970s and sovereign debt in the 1980s. “History shows that, over hundreds of years, the largest losses occur in the highest-rated securities,” he says.

Well, yes, but it is unsurprising that the biggest losses occur in the biggest asset classes. Much less money is put into high-yield corporate bonds – or high-yield mortgage-backed securities – than in investment-grade securities. When things go wrong, junk investors lose less in absolute terms than their investment-grade fellows.

The second problem is that he places the losses suffered by banks on triple-A collateralised debt obligations in the same category as past investment-grade losses on, for example, Latin American sovereign debt.

At one level, this is correct. One of the attractions of CDO securities was that, by dicing up the cash flows from mortgages, issuers could create triple-A tranches to sell to investment-grade investors. That gave them access to the biggest pool of liquidity in US financial markets.

But it is odd to count CDOs based on subprime paper as just another investment-grade security. In fact, the underlying assets were junk and they were a kind of hybrid. The banks that structured these CDOs and agencies that rated them were painting triple-A lipstick on subprime pigs.

The third problem is that, even if we count CDOs as an investment-grade disaster, we do not know whether high-yield corporate bonds will escape more lightly. In fact, there is every reason to suppose they will also suffer heavily.

Banks have been stuck with about $300bn in loans for private equity deals that they were not able to syndicate to investors when the credit crisis struck. They are now selling the loans at discounts in order to clear them from their books.

This is only the start of the pain for high-yield. A recession could raise the default rate for high-yield loans from the current 2 per cent to between 5 and 10 per cent. The pitfalls in lending to companies with stretched finances and unpredictable cash flows would become plainer.

Still, Mr Milken’s overstatement of his case does not undermine his basic point: the illusion of investment-grade safety. He is correct that recent crises have demonstrated the flaw in buying low-yield securities, or combinations of securities, and using leverage to juice up the returns.

That brought down Long Term Capital Management, the hedge fund, in 1998. It was arbitraging small gaps in securities in a way that it thought involved little risk. It then applied leverage to its positions, only to be caught by Russia’s default.

Long Term Capital turned out only to be a rehearsal for the debacle of CDOs. Banks including UBS and Morgan Stanley kept investment-grade bonds based on subprime mortgages on their books, assuming that triple-A-ratings meant they were OK.

The advantage of high-yield bonds is that, while they are risky, they are obviously so. It is also a punt to place money into investment-grade bonds but the gamble is less evident. Not only are the credit ratings higher but demand from banks and investors also drives down yields to levels that indicate they are as safe as (safer, in fact, than) houses. Every so often that results in blow-ups. The eagerness of banks, hedge funds and investors to use leverage makes them more damaging when they occur. The past year fits neatly with previous episodes of huge losses on “safe” securities.

We do not yet know how losses in junk bonds will stack up against those in investment-grade securities. What we do know is that investment-grade securities have again proved vulnerable to loss. That does not prove Mr Milken’s thesis but it should put a smile on his face.