Economics 434 Theory of Financial Markets

1. Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

2. MM-II “Cost of equity capital” is a linear function of the debt/equity ratio “Cost of debt capital” is whatever the going interest rate is

3. Cost of Capital • For debt – just rate of interest on the debt • For equity – “the required rate of return” - paradoxical • If equity is cheap that means the required rate of return is high • If equity is overvalued, the required rate of return is low

4. Types of Financing • Bank Debt • Private Placements • Insurance cos • Mutual funds • Public Debt • High Grade Investment Debt • Subordinated Debt • High Yield Debt • ABS Debt

5. High Yield Debt • Until 1978, all high yield debt had been originally investment grade corporate debt that went bad • Drexel (1978) initiated the high yield debt public offering market

6. The “New Offering” High Yield Debt Market • At first, simply “lower credit” public offerings of debt • Participated in only by Drexel Burnham • Other Wall Street firms refused to participate

7. The LBO Activity in the 1980s • Leveraged Buyouts • Done by “Corporate Raiders” • Financed by • At first, banks • Later, Drexel and high yield debt

8. The Rise of Drexel Burnham • In 1980 Drexel Burnham was a small beautique • By 1987, Drexel Burnham was the most powerful and profitable firm in Wall Street

9. Guliani on the attack • July, 1987 Boesky pleads guilty • Probe moves to Milken and others • Early 1988 Drexel reports record earnings • Early 1988 -- $ 24 billion in RJR bonds financed by Drexel • Fall of 1988 Govt charges Drexel with Rico • Drexel takes bankruptcy

10. Early 1989 • Milken reaches plea agreement • Lowell will not be charged • Pleads guilty to “parking” securities • Sentenced to 3 years and $ 200 million fine

11. Early 1990 • Goldman, Morgan Stanley, Merrill Lynch, Salomon Smith Barney • Enter the “high yield” business • Put in charge – all former Drexel employees

12. High Yield Business • Grew enormously from early 1980s to today • Still growing • Spreading to non-US • Returns far better than stocks

13. The End