American financier and philanthropist Michael Milken spoke to a standing room audience at lunch yesterday at the 15th annual CLSA Investors' Forum. The test to any such speech is that there is still a standing room audience at the end. And there was.
His talk covered too many topics to encapsulate in one article: from the value of education and healthcare and how that carries through to human capital in business, to the importance of long-term strategies, and on to a look at how heterogenerous our regions and institutions have become. Milken backed up his statements with historical points and catchy figures. And he spanned the globe from Pakistan’s growing population (and thus education challenge) to Mexico’s bourse and the comparative differences between New Jersey and Mississippi.
But it was when Milken turned to his thoughts on credit that people put down their forks and Coca-Colas and picked up their pens to scribble notes. Milken almost single-handedly created the market for high-yield bonds (also called junk bonds) during the 1970s and 1980s – he says in his bio that he also created more than 3,200 companies and millions of jobs. But he was also sent to prison on finance-related charges. These days, he is chairman of the Milken Institute, an economic think tank. So he’s got experience and has had time to think on the matter.
He started out with this simple statement: “Credit is what counts, not leverage. Investing in debt securities depends on credit. If you’re leveraged eight or 10 to one in an asset class that declines by 5% to 10%, you don’t have staying power in a mark-to-market world.”
He went on to explain that the same rules apply to companies. “For some companies with significant business risk and volatility, even 10% in debt might be too much. For others in mature businesses with low volatility, as much as 80% debt in their capital structure might be appropriate,” he noted.
His second key point: “Most loans to real estate are not – and never have been – investment grade.” And that’s because they carry a great deal of credit risk. When it comes to real estate, “for investors and lenders, it’s really heads you lose, tails you lose”. The reasoning is simple: If prices rise, the borrower keeps the gain. If prices fall, the lender is stuck with a long-term depreciating asset. If interest rates rise, the value of the loan depreciates as the “real” average life of the asset is extended. If interest rates fall, the borrower will prepay the loan.
He went on about interest-rate risk and volatility. “Rates are never predictable and, in my view, the idea of borrowing short and lending long is simply not a business,” says Milken. “In the early 1980s, almost all of the most-conservative financial institutions in the world were bankrupt on a mark-to-market basis because of increases in rates on government bonds.”
And that led him to his fourth point, which is a reminder that rating is not credit. He argues that long-term ratings have not been a good predictor of credit quality. So you shouldn’t invest based on ratings. Milken points out: “In the first 70 years of the 20th century, the debt of AA-rated railroads had defaults 200% higher than that of B-rated industrial companies. And in recent years, hundreds of billions of dollars in losses and write-downs have occurred in AAA- and AA-rated securities and their derivatives. With Microsoft’s recent AAA-rating on its commercial paper, there are now a total of only six US industrial companies with that top rating. Yet, in 2007, Standard & Poor’s rated 1,295 new securities issued by financial companies or financial derivatives as AAA. This was 45% of all new securities rated by S&P. Based on current projections, the losses on just last season’s (2007) issuance of AAA financial securities might exceed all the losses on non-investment-grade debt issued in the last decade,” argues Milken.
His next point was to remind investors that sovereign and government debt is, for the most part, not investment grade, particularly in emerging nations – a statement which elicited a few chuckles of agreement. “Throughout history, governments regularly defaulted on their debts. Those countries that didn't default often hyper-inflated their currencies, which had a similar effect,” Milken says. He used Latin America as an example, noting that for a century and a half, foreign capital had poured into Latin America only to be rewarded by one default after another. Of the numerous examples he provides on this point, perhaps the funniest is Argentina, which as he says, “owns some kind of record with six defaults or ‘reschedulings’ of debt terms in the 175 years beginning in 1830”.
And so he sums up this viewpoint by noting that compared to sovereigns, loans to businesses are far less risky. “Compared to other equivalently rated assets, industrial companies have almost always had relatively few defaults,” he says.
His next major point is that the value of debt securities underpins all capital markets. As Milken points out, as the relative yield on debt goes up, the value of equities goes down, and so this is the best independent verification of value in any system.
But his last point – which he underscored with a big screen print out of these words, is perhaps the simplest and so relevant to our current global economic picture: “You can survive a lot of mistakes in running a business – except one: running out of liquidity.”
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