"JUNK BOND" LEGISLATION AND DEPOSITORY INSTITUTIONS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP87M00539R002303820008-3
• Release Decision: RIPPUB
• Original Classification: K
• Document Page Count: 15
• Document Creation Date: December 22, 2016
• Document Release Date: September 24, 2010
• Sequence Number: 8
• Publication Date: June 20, 1985
• Content Type: MEMO

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- " EXECUTIVE SECRETARIAT -
ROUTING SLIP
For direct response BY COB 25 Jun.,
24 Jun 85
Dore
3637 no-en
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4 I' Executive Registry
85-
C-)
WASHINGTON
June 20, 1985
MEMORANDUM FOR THE ECONOMIC POLICY COUNCIL
FROM: ROGER B. PORTER IV
SUBJECT: "Junk Bond" Legislation and Depository
Institutions
On Monday, June 17, a paper on "'Junk Bond' Legislation
and Depository Institutions" was circulated to Council members.
The paper concerns several bills that would restrict the use
of high-yield securities in takeover attempts that have been
introduced in the Congress in recent weeks. These bills are
of three basic types:
1. Imposing a moratorium on the use of high-yield secur-
ities to finance most hostile takeovers.
2. Disallowing a deduction from taxable income of inter-
est paid with respect to debt incurred during a hostile take-
over regardless of whether the debt is in the form of a bank
loan or of debt securities and regardless of whether it is
high-yield or investment grade.
3. Imposing either a permanent ban or statutory limita-
tion on high-yield security purchases by federally-insured
depository institutions.
1. Is the use of high-yield securities in corporate
takeovers, which has the effect of increasing corporate debt-
equity ratios, potentially harmful to the economy so as to
require a Federal legislative response?
2. Does the purchase of such securities by institutions
whose obligations are insured by the Federal Government under-
mine the safety and soundness of the financial system or
expose the Federal Government to undue risk of financial loss?
The paper distributed on Monday included an analysis
of these issues. From that analysis, it appears that these
bills would serve principally to inhibit hostile takeover
threats to large corporations. Insofar as they would have
this effect, all three types are inconsistent with the
position on corporate takeover legislation approved by the
President.
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Some of these bills may move soon in the Congress and
the Administration will need to respond rapidly. Secretary
Baker has requested that I poll council members to ascertain
if they have any objection to the Administration opposing
these bills.
If you do not approve of the Administration opposing
these bills, please notify me by close of business on Tues-
day, June 25, 1985.
A copy of the memorandum circulated last Monday is
attached along with a copy of the Administration Position
on Corporate Takeovers approved by the President last March.
cc: Donald T. Regan
Alfred H. Kingon
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EXECUTIVE OFFICE OF THE PRESIDENT
OFFICE OF MANAGEMENT AND BUDGET
WASHINGTON, D.C. 20503
JUN 171985
MEMORANDUM FOR THE ECONOMIC POLICY COUNCIL
FROM: DOUGLAS H. GINSBURG M2
Administrator for In o mation
and Regulatory Affairs
SUBJECT: "Junk Bond" Legislation and Depository
Institutions
Several bills have been introduced in this Congress that would
restrict the use of high-yield securities.1 One form of
restriction would impose a moratorium on the use of "junk bonds"
to finance most hostile takeovers. A second form would disallow
a deduction from taxable income of interest paid with respect to
debt incurred during a hostile takeover regardless of whether the
debt is in the form of a bank ]3oan or of debt securities, whether
"junk" or of investment grade. A third form would impose either
a permanent ban or statutory limitations on "junk bond" purchases
by federally-insured depository institutions.
1 High-yield securities (also known as "junk bonds") are
generally defined as publicly traded debt instruments that are
either unrated or rated below the top four ratings by Moody's
Investors Service or Standard and Poors Corporation.
2 5.975 (Domenici), H.R. 2400 (Richardson)
3 S. 420 (Boren), S. 476 (Boren), S. 632 (Chaffee), H.R. 1003
(Jones), H.R. 1100 (Jones), H.R. 1553 (Dorgan), H.R. 2476
(Pickle). H.R. 1553 and H.R. 2476 would apply to friendly as
well as hostile takeovers of large corporations only. Treasury's
Assistant Secretary Pearlman has testified in general oppositi?nn
to the tax bills before both the Senate Finance Committee and the
House Ways and Means Committee (see Attachment A).
4 S. 975 (Domenici S. 1286
(DOmenici), S. 1016 (Proxmire),
H.R. 2400 (Richardson), H.R. 2476 (Pickle).
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These proposals all raise two basic issues:
o Is the use of high-yield securities in corporate takeovers,
which has the effect of increasing corporate debt/equity
ratios, potentially harmful to the economy so as to require
a Federal legislative response?
o Does the purchase of such securities by institutions whose
obligations are insured by the Federal Government undermine
the safety and soundness of the financial system or expose
the Federal Government to undue risk of financial loss?
Our review of the relevant evidence leads us to conclude that the
answers are negative. The bills described above would serve
principally to inhibit hostile takeover threats to large
corporations. Insofar as they would have this effect, they are
inconsistent with the President's position on corporate takeover
legislation (see Attachment B). They would also deprive
depository institutions of legitimate investment opportunities
that.may be preferable to alternative opportunities. The
analysis that follows addresses the two basic issues identified
above.
THE "LEVERAGING OF CORPORATE AMERICA" IS NOT DRIVEN BY JUNK BOND
FINANCED HOSTILE TAKEOVERS
As an initial matter, it is useful to note that corporate debt-
equity ratios are not out of line with recent economic
experience, and that much of the talk about dangerous leveraging
of the corporate sector has little foundation in fact. Moreover,
to the extent that debt-equity ratios have risen, high-yield debt
securities are not responsible for most of that increase.
According to data gathered by the Federal Reserve Board,
aggregate corporate debt-capitalization ratios, measured on a
market-value basis, stood at 42.2% by year-end 1984 (see Table 1,
attached). Currently, the Federal Reserve estimates that,
because of the recent increase in stock market values, aggregate
debt-capitalization ratios stand at about 42.0%. Although the
year-end 1984 figure represents an increase of 4.2 percentage
points over 1983, recent ratios are in line with the experience
of the 1970's and the most current ratio is lower than
debt-capitalization ratios experienced in five of the last
ten years.
Issuance of high-yield securities has increased greatly in recent
years. Of the $59 billion in public straight debt high-yield
bonds outstanding, about 40% have been issued during the last two
years (1983--$8.5 billion; 1984--$15.8 billion). Such securities
account for an increasing share of both new corporate bonds end
new. corporate borrowing (25% and 10%, respectively, in 1984).
 Nevertheless, all high-yield securities still make up only a
small part (4.5%) of corporate debt outstanding; those that
are related to hostile takeovers make up a much smaller part.
Critics of junk bond financed hostile takeovers cite a. net
decline in corporate stock issuance of $90 billion in 1984 as
evidence that such takeovers are doing serious damage to'the
economy. Since all of the high-yield securities issued in 1984
could account at most for only 17.5% of that decline, it is clear
that the principal sources of the increasing leverage are not
junk bonds, but rather bank and finance company loans, commercial
paper, and other bond issuances. These sources are fungible
with junk bonds and can be issued for all the same
purposes--corporate growth, leveraged buyouts (going private
transactions), financial restructuring, and takeovers (hostile or
friendly).
Although it is likely that the threat of a junk bond financed
takeover has stimulated some mergers or leveraged buyouts, as
well as the financial restructuring of some companies, it is
impossible to assess the magnitude of their influence in these
areas or to conclude whether they represented sound business
judgment. What can be said is that these transactions were
entered into by sophisticated investors risking either their own
money or money for which they are responsible. They have every
incentive to structure their deals so as to make them work, and
not to enter into over-leveraged investments.
Federally-insured institutions are not heavily invested in
high-yield securities. Bank regulators indicate that they
believe bank holdings of high-yield securities are not
significant, although none of the regulators currently collects
data on a regular basis that address the question directly. The
FHLBB staff, based on a recently completed survey, estimates that
S&Ls hold about $5 billion of such securities (about one-half of
one percent of total S&L assets of $1 trillion), concentrated
mostly in ten large State-chartered S&Ls. Although pension funds
also hold over $1 trillion in assets, a recent survey of over idd
pension fund managers found that only 3.3% invest any of their
assets in high-yield securities.
A reasonably diversified portfolio of "junk bonds" appears to
a good investment. High-yield securities generally yield bet~? :
300 to 500 basis points above comparable maturity U.S. Treasury
obligations. Although the default risk on these securities i:;
greater than for investment grade securities, all studies of
which we are aware have concluded that the high-yield interest
rate premiums have historically been more than adequate to o::
the additional risk of default. These studies covered varyir:;
periods from 1900 to 1984, but focused mostly on the last
ten years. There may be somewhat greater risk in the bonds
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issued recently for leveraged buyouts and takeovers. It is much
too soon, however, separately to evaluate the additional risk, if
any, that takeover-related loans may pose.
Morgan Stanley estimates that the default rate on straight
high-yield securities was 1.6% (160 basis points) annually
from 1974 to 1984. Actual losses resulting from default were
significantly lower because defaulted bonds do not become
valueless. Morgan Stanley found that defaulted bonds trade at an
average of 41% of, par shortly after default. The value-adjusted
default rate is thus about 1.06% per year, substantially below
the 490-580 basis point: premium to government bonds that Morgan
calculates was available over the same period.
Notwithstanding this rosy historical outlook, the nature of the
high-yield debt outstanding may be changing significantly with
the dramatic growth in volume between 1977 and today. The
degree of leveraging in recent takeovers, leveraged buyouts, and
restructurings is probably greater than that faced by the
operating company issuers of the past. Thus, it may be
inappropriate to extrapolate without qualification from this
historical record and to conclude that takeover-related junk
bonds will match the default experiences of. past issuances.
It would also be inappropriate, however., to conclude that
takeover-related junk bonds will not have a similarly positive
record. These bonds are sold in competition with other
high-yield instruments, and if they did not offer an adequate
return, they would not be purchased by the highly sophisticated
investors who buy most "junk bonds." Because of the dominance of
these sophisticated investors, they, not the smaller investors
such as S&Ls, set the terms of these public securities. Moreover
the equity investors have every incentive to make the deal
successful, since they would lose their investment first in
a failure.
Finally, the risk presented by high debt-equity ratios is often
relatively short-lived. Target companies often restructure
themselves by selling off assets and paying down their debt,
or undertaking refinancings that result in a lower debt burden.
Current Federal law provides adequate authority to protect the
Federal Government. The general rule for investment in corporate
debt securities by federally-chartered depository institutions
and State banks that are members of the Federal Reserve System is
that they may not invest in securities that are rated below
"investment grade." Therefore, they are not allowed to hold
low-rated (junk) bonds as investment securities. They are
5Morgan Stanley estimates that low-rated straight public debt
outstanding has grown from $8.5 billion in 1977 to $41.7 billion
at the end of 1984. New issues during the same period have grown
from $1 billion to $15.8 billion annually.
 allowed to own unrated (junk) bonds (subject to a prudent
judgment rule) and obligations that may be transferred to their
commercial loan portfolio, but they rarely do so.
National banks and federally-chartered thrifts may not invest
more than 10% and 15%, respectively, of their capital plus
surplus in a single issue. In addition, federally-chartered
thrifts are subject to a limitation on aggregate commercial loans
of 10% of assets.
Likewise, State-chartered nonmember banks generally must limit
investments to securities that are either investment grade or, if
unrated, are "prudent." They are also subject to FDIC examination
standards that may, on a case-by-case basis, revalue unrated
securities or those below investment grade at market value.
State-chartered thrifts are subject to State law, which generally
parallels Federal law in this area except that some major States
(e.g., California) have different limits on the percentage of
commercial loans a thrift may hold in its portfolio.
State-chartered thrifts are also subject to the same single
issuer limits as Federal thrifts--15% of capital plus surplus.
The FHLBB is presently considering additional rules to limit
thrift investments in high-yield securities.
Both bank and thrift regulators already have the statutory
authority to restrict or prohibit any unsafe or unsound practice
that is likely to cause substantial dissipation of the assets or
earnings of an institution, or seriously to weaken its condition.
In addition, both the Vice President's Task Group on Financial
Services Regulation and the CCEA have recommended that
legislation be developed to enable the regulators to vary deposit
insurance premiums based on objective or market-based
determinants of risk.
One other source of potential Federal exposure is through pension
funds guaranteed under ERISA. Pension funds are limited in their
investments by a "prudent investor" standard that, given the
results of the myriad studies of risk and return, should require
only a reasonable amount of diversification and due diligence in
order to enable them to invest significantly in high-yield
securities. The employer, however, stands between the pension
fund and the Federal Government; the Pension Benefit Guaranty
Corporation (PBGC) would be exposed to loss only if an employer
were unable to meet any unfunded liability arising from a
default.
A prohibition on federally insured depository institutions'
purchase of junk bonds is unlikely to have any beneficial eU ect
on depository institutions. Although it would stop depository
institutions from investing in "junk bonds," it would not stop
them from extending the same credit in the form of a commercial
loan. Indeed, the commercial loan may be more risky since it is
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not likely to be readily marketable and is not subject to the
more extensive market judgement that publicly traded securities
undergo.
We have not seen any evidence to indicate either that depository
institutions in general are heavily invested in these
instruments, or that the investments are unduly risky. Moreover,
the Federal regulators already have the authority to deal with
individual problems should they arise. A prohibition will not
improve the safety and soundness of depository institutions; it
will merely cause the market for high-yield securities to be a
little smaller--by about 5-10%. Furthermore, it would remove
from the institutions a legitimate investment option that may be
less risky than other available options.
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DEBT-TO-CAPITAL RATIOS
NONFINANCIAL CORPORATIONS
Year
Debt (Par) 1
Equity (Current)
Debt (Par) 2
Equity (Market)
Debt (Market) 3
Equity (Market)
1961
29.12
27.82
26.09
1962
29.81
31.32
29.78
1963
30.81
29.43
28.01
1964
31.21
28.49
27.38
1965
31.73
28.58
27.38
1966
32.17
32.62
30.26
1967
32.76
29.25
26.69
1968
33.55
28.69
26.25
1969
33.44
33.47
29.33
1970
33.66
35.35
32.43
1971
33.63
33.33
31.83
1972
33.45
32.46
31.22
1973
32.86
40.38
38.23
1974
30,48
51.27
47.67
1975
29.36
44.28
41.86
1976
29.12
42.59
42.16
1977
29.27
46.68
45.65
1978
29.14
48.66
46.67
1979
28.52
47.01
44.13
1980
27.45
41.17
37.58
1981
27.72
45.27
41.18
1982
28.58
43.71
41.55
1983
28.88
40.89
38.76
1984
32.20
44.38
42.23
1. Debt is valued at par, and equity is balance sheet net worth
with tangible assets valued at replacement cost.
2. Debt is valued at par, and equity is market value of outstanding
shares:
3. The market value of debt is a staff estimae based on par value
and ratios of market to par value of NYSE bonds; equity is market
value of outstanding shares.
Source: Based on Board of Governors of the Federal Reserve System,
Flow of Funds.
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Attachment B
MEMORANDUM FOR THE PRESIDENT
FROM: THE CABINET COUNCIL ON ECONOMIC AFFAIRS
SUBJECT: Corporate Takeovers
There has recently been much attention focused on corporate
takeovers and the need for any Federal legislation restricting
such activities. A House subcommittee is currently holding
hearings on takeovers and has asked the Administration to testify
on March 12. This memorandum presents the Cabinet Council's
findings on the value of takeovers and recommendations for an
Administration position on possible Federal legislation.
Background
Mergers and acquisitions occur because of, among other
factors, the belief that the combined company can operate more
efficiently than two companies operating separately. In friendly
mergers and acquisitions, which account for the overwhelming
majority of such transactions, both parties agree on these
benefits. In hostile takeovers, managers of the target company
(the company being acquired) oppose the transaction because they:
(a) fear the loss of their jobs; and/or (b) believe their
shareholders would be better off if the company remained
independent or merged with a different company.
In. a hostile takeover, a bidder typically buys a significant
percentage of the target company's stock and offers to pay other
shareholders a premium for their shares. The bidder seeks to
obtain enough shares, usually 51 percent, to gain control of the
target company. The target management seeks to prevent the
bidder from gaining control, typically through defensive tactics
such as litigating against the bidder or buying the shares
already owned by the bidder.
Last year, the Senate passed amendments to the banking bill
restricting certain takeover activity, while the House
considered, but did not pass, separate legislation. The
Securities and Exchange Commission (SEC) proposed restrictive
legislation last year, but recently indicated it will oppose such
legislation this year. While there will be pressure from some
segments of the business community for restricting bidder tactics
and from stockholder groups for restricting defensive tactics,
the likelihood in this session of Federal legislation restricting
takeovers appears to be limited.
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Principal Findings
The Cabinet Council on Economic Affairs has conducted a
detailed study which examined two central issues: (1) the
economic impact of takeovers and the extent of abuses; and (2)
the appropriate Federal role, if any, in correcting these abuses.
Based on this study, the Cabinet Council has approved
recommending to you a statement of the Administration's position
on corporate takeovers to guide Administration testimony on this
issue. A copy of the proposed statement is attached. The
principal findings of the Cabinet Council study are:
1. Corporate takeovers generally benefit the economy by
enabling companies to achieve efficiencies, shift assets to
higher valued uses, and police management conduct.
2. To the extent there are abuses in the takeover process,
it appears shareholders need protection from the management of
the target company, rather than from the bidding company.
Because managers may primarily be interested in keeping their
jobs, they may oppose a takeover bid that is in the best
interests of the shareholders of the target company.
3. There is great capacity through the market, the States,
and the courts to correct these abuses. There is no compelling
evidence that these checks are inadequate. The market can react
through changes in corporate charters. Institutional investors
are starting to oppose target managements that resist takeovers.
The States can pass laws governing abusive defensive tactics.
The courts are able to distinguish between abusive and legitimate
uses of defensive tactics by considering the unique facts of a
particular case.
4. Only if there is a serious market failure of national
dimensions should the Federal Government then consider taking
appropriate steps to curb the potential for abuse. This position
is shared by the chairman of the SEC.
The Council also considered the three major arguments made by
critics of takeovers:
o Takeovers reduce competition. By reducing the number of
competitors in an industry, takeovers increase the
likelihood of higher prices than what a more competitive
market would have produced.
However, the Department of Justice and Federal Trade Commission
actively oppose mergers and acquisitions, whether friendly or
hostile, that threaten to reduce competition.
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o Takeovers financed by borrowing divert capital from more
productive uses. When a bidder borrows bank funds for a
takeover, it ties up money the bank could have lent to
companies making "real" investments, instead of simply
pursuing "paper profits."
Takeovers result in real benefits of greater efficiency, and not
simply the pursuit of paper profits. Moreover, when a bidder
buys shares in the target company, the funds are not diverted.
The shareholders selling their shares to the bidder in turn
invest these funds in the economy.
o Hostile takeovers force managers to focus on short-term
protection against takeovers, rather than on long-term
investments.
This argument overlooks the point that the best means of avoiding
hostile takeover attempts is to maximize shareholder wealth,
which reflects the long-term competitive prospects of the
company. If the stock market does not think a company is making
good long-term investments, the price of the company's share will
fall, making it more vulnerable to takeovers.
The Cabinet Council on Economic Affairs unanimously recommends
that you approve the attached Administration position on
corporate takeovers.
Approvl2_ @j is approve
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PROPOSED ADMINISTRATION POSITION
CORPORATE TAKEOVERS
I. Corporate takeovers perform several beneficial functions
and are generally good for the economy.
II. The Williams Act represents a compromise between the
desire to afford target shareholders and managements
adequate disclosure and a reasonable period of time in
which to evaluate offers, and the needs of the competitive
markets in securities and in corporate control to operate
with a minimum of government regulatory interference. We
have not seen sufficient evidence that the existing
provisions of the Williams Act are inadequate to achieve
their purpose.
III. Various limitations on bidder activities have been
proposed, but a need for additional restrictions
on bidders has not been demonstrated.
IV. Target company shareholders need and have protection from
abuses by target managements in conjunction with contests
for corporate control.
V. State law, enforceable in the courts, governs the
permissible terms of corporate charters, management
contracts, and managers' and directors' fiduciary
obligations, each of which may serve to check management
abuses. From existing state statutes and decisions of
state and Federal courts, however, it is unclear whether
state law is adequate to portect target company share-
holders from abuses by target management. As new
defensive tactics evolve, moreover, existing protections
may prove inadequate.
VI. The balance between management's need to act expeditiously
in the interest of the corporation and the shareholder's
right to call that action into account should be resolved
at the level closest to the problem and the relevant
facts--by the corporation, its owners, and managers in
the first instance; by state law, if necessary; and, by
Federal law only as a last resort. If there is a serious
market failure of national dimensions, then the Federal
Government should consider taking appropriate steps to
curb the potential for abuse. Otherwise, the Federal
Government should take no step towards the establishment
of Federal corporation law to govern relationships between
shareholders and managers.
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VII. While matters of corporation law have traditionally
been the subject of state rather than Federal jurisdiction,
the Federal Government should play an informat4onal role
by making public the best information about critical
issues that shareholders are likely to face in many
corporate change of control contests.
VIII. The Federal Government should also carefully consider
the unintended effects that other Federal policy
decisions may have on merger and acquisition activity.
To the extent that these Federal decisions encourage
more or less merger and acquisition activity than
otherwise would have taken place in a free market,
resources may be misallocated.
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