Michael Milkens Capital Seminar - Road to the Middle Class

REMEMBER Michael Milken? Back in the 1980s he was the Junk Bond king. Then he went to jail for... well it’s always been a bit uncertain what he did that was so bad.

But now he’s written an article for the Wall Street Journal. It’s a handy little talk on “Why Capital Structure Matters”

Nothing new here, Milken assures us. The same sort of panic and debt crisis we are suffering through today happened thirty years ago in 1974.

Thirty-five years ago business publications were writing that major money-center banks would fail, and quoted investors who said, "I’ll never own a stock again!" Meanwhile, some state and local governments as well as utilities seemed on the brink of collapse. Corporate debt often sold for pennies on the dollar while profitable, growing companies were starved for capital.

The point is, Milken says, that it is very important how anyone, a person, a government, or a corporation, arranges their capital structure, especially the mix of equity and debt.

It is madness, e.g., for a corporation to buy back its stock at the top of the business cycle with debt! Yet dozens of big companies made this mistake recently.

Particularly hard hit were some of the world’s largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy’s, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox).

Of course, there is no simple answer.

The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors — the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends.

During a credit expansion companies should start to build liquidity in order to be ready for the inevitable contraction (yes, but when do you start?). And companies with uncertain revenue should be especially wary of debt.

This is all very well, you say. But when should a company or individual acquire debt? The anser seems to be: in the years immediately after a significant contraction, like the 1974 crash and the current crisis. Presumably that is the time when people are risk averse and prefer fixed income securities to equities. And that means that debt is priced high with low returns and equities are priced low (and expensive for corporations).

Maybe all Milken is saying is that when stocks are down you should increase debt. But when stocks are high you want to be careful of leveraging up. Because, of course, if stocks decline, your high leverage becomes very high leverage.

If you ask me it all gets back to a rather simple notion. With equity, you are in a partnership. If the company does well, we all share in the profits. If the company does badly, then we all share in the hardship. But debt is different. When you borrow you say: if the project does well, then I trouser the profits and you just get your fixed income. But if the project tanks then we are all broke together. Somehow, I feel that there is something wrong with the debt proposition. As President Obama says: Share the Wealth.

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Christopher Chantrill blogs at www.roadtothemiddleclass.com. His Road to the Middle Class is forthcoming.