Drexel was making its fortune in junk bonds, and that stung. We were supposed to be Wall Street’s bond traders. We were in danger of losing that distinction, however, for our managers had failed to see how important junk bonds would become. They thought junk was a passing fad. That was easily their single most expensive oversight, for it precipitated not only a revolution in corporate America, and a giddy free-for-all Wall Street, but the take-over attempt of my firm, and for that final effect it is worth pausing for a moment to examine. I did. Junk bonds are bonds issued by corporations deemed by the two chief credit-rating agencies, Moody’s and Standard & Poor’s, to be unlikely to repay their debts. “Junk” is an arbitrary but important distinction. The spectrum of creditworthiness that has IBM at one end and a Beirut cotton trading firm on the other has a break somewhere in the middle.

At some point the bonds of a company cease to be investments and become wild gambles. Junk bonds are easily the most controversial financial tool of the 1980s; they have been much in the news. But they are not, it should be emphasized, new. Companies, like people, have always borrowed money to buy things they haven’t had the cash to afford. They also borrow money because, in America at least, it is the most efficient way to finance an enterprise; interest payments on debt are tax-deductible. And shaky enterprises have always wanted to borrow money. At times, as when the turn of the century robber barons built their empires on mountains of paper, lenders have been surprisingly indulgent. But never as indulgent as today. What is new, therefore, is the size of the junk bond market, the array of rickety companies deeply in hock, and the number of investors willing to risk their principal (and perhaps also their principles) by lending to these companies. Michael Milken at Drexel created that market, by persuading investors that junk bonds were a smart bet, in much the same fashion that Lewie Ranieri persuaded investors mortgage bonds were a smart bet.

Throughout the late 1970s and early 1980s  Milken crisscrossed the nation and pounded on dinner tables until people began to listen to him. Mortgages and junk made it easier to borrow money for people and companies previously thought unworthy of the funds. Or, to put it the other way around, the new bonds made it possible for the first time for investors to lend money directly to homeowners and shaky companies. And the more investors lent, the more others owed. The consequent leverage is the most distinctive feature of our financial era. In her book The Predators’ Ball, Connie Bruck traced the rise of Drexel’s junk bond department (Milken reportedly tried to pay the author not to publish). The story she tells begins in 1970, when Michael Milken studied bonds at the University of Pennsylvania’s Wharton School of Finance. He was blessed with an unconventional mind, which overcame his conventional middle-class upbringing (his father had been an accountant). At Wharton he examined fallen angels, the bonds of one-time blue-chip corporations now in trouble. At the time fallen angels were the only junk bonds around. Milken noticed that they were cheap compared with the bonds of blue-chip corporations even considering the additional risk they carried. The owner of a portfolio of fallen angels, by Milken’s analysis, almost always outperformed the owner of a portfolio of blue-chip bonds. There was a reason: Investors shunned fallen angels out of a fear of seeming imprudent. It is a remarkably simple observation. Like Alexander, Milken noticed that investors were constrained by appearances and, as a result, had left a window of opportunity open for a trader who was not. Thus the herd instinct, the basis for so much human behavior, laid the foundation for a revolution in the world of money.

Milken began his career that same year, 1970, in Drexel’s back office. He pushed his way onto the trading floor and became a bond trader. He wore a toupee. Even his friends said it didn’t fit him properly; his enemies said it looked as if a small mammal had died on his head. The parallels between Milken and Ranieri are striking. Like Ranieri, Milken lacked both tact and couth, but not confidence. He was perfectly happy to stand apart from his colleagues. Milken sat in a corner of the trading floor while he created his market, ostracized until he made too much money to be anything but the boss. Also like Ranieri, he built a team of devoted employees.Excerpted from ‘Liar’s Poker’ by Michael Lewis, pages 249 -251