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CHAPTER FIVE

Did You Hear the One about Donald Trump Walking into a Bank?

“Is not commercial credit based primarily upon money or property?”

“No sir,” replied J. P. Morgan. “The first thing is character.”

“Before money or property?”

“Before money or anything else. Money cannot buy it. . . . Because a man I do not trust could not get money from me on all the bonds in Christendom.”

—H. W. Brands, The Money Men

IN MANY WAYS, Donald Trump is best known today for his high-profile 2016 run for the office of president of the United States. But back in the 1980s, Trump was most famous for his skills in the area of property development. Those skills made him very rich.

What is interesting about the 1980s is that even though charitable giving grew from $77.5 billion in 1980 to $121 billion in 1989,¹ some in the commentariat dismissed those years of robust economic growth as the “Decade of Greed.” Trump’s unapologetic advertisement of his great wealth helped fuel their misplaced disgust.

Notable about Trump, and this shouldn’t be read as a pejorative, is that his accounting of his net worth was not necessarily how others perceived it. More to the point, Trump and those from whom he wanted to borrow did not share the perception of his creditworthiness.

I can’t repeat enough that for every borrower there is a saver. Furthermore, when an individual borrows “money,” he is not seeking dollars so much as pursuing the economic resources (credit) that dollars can command in the marketplace. In Trump’s case, he sought credit in the late 1980s in order to fund the revival of the Ambassador Hotel in Los Angeles.

A once grand hotel in the Wilshire District, a few miles from downtown Los Angeles, the Ambassador’s notoriety then had to do with something extremely tragic. On June 6, 1968, Democratic presidential candidate Senator Robert F. Kennedy was assassinated in the kitchen of the Ambassador.

In the aftermath of the assassination both the hotel and the surrounding area fell into long-term decline. But an entrepreneur sees potential where others see failure. That’s what makes the entrepreneur so central to positive economic evolution. Trump saw potential in a hotel and an area of Los Angeles that others had given up on, and he needed credit to animate his vision.

That’s where Security Pacific Bank came into the picture. The Los Angeles–based bank was the fifth largest in the United States at the time, and Trump sought a meeting with its newly appointed CEO, Robert H. Smith.

Smith was no stranger to big names in the world of business. Given the size of Security Pacific, and its lending potential based on that size, major players from various business sectors regularly courted him and the bank he ran. A few years earlier, Peter Ueberroth had approached Security Pacific about loan financing for an airline idea he had. Smith and his colleagues probably should have ended the discussion right there, when we consider the historical correlation between airlines and bankruptcy.

The fact that they didn’t speaks to a truism about credit that can never properly be explained by Fed officials playing around with interest rates. Ueberroth had an outstanding reputation. Having already built and sold a successful travel business, he perhaps had a sense of airlines that the average dreamer did not. His service as Commissioner of Major League Baseball increased his stature. He also oversaw the highly profitable 1984 Summer Olympics in Los Angeles.² Well connected, handsome, and in possession of a great track record, Ueberroth was the definition of good credit.

Yet he wanted a large loan to purchase Hawaiian Airlines. Airlines were, and remain to this day, heavily regulated. Additionally, volatile fuel prices substantially impact their profits, because oil is priced in a floating dollar that lacks definition. Stated plainly, airlines are the definition of bad credit. Their history is in many ways a history of bankruptcy.

Ueberroth planned to put a seasoned airline executive in charge of his purchase, partner up with a major airline, and eventually sell at a profit. It all seemed simple. And as Smith recalls, there was a strong desire among senior Security Pacific executives (including its then CEO, Richard Flamson) to do business with a prominent southern California personage like Ueberroth.

Ueberroth’s argument in favor of the deal was a classic credit story. As he explained it to Smith, Flamson, and others, “I’m pretty sure that the name alone—Peter Ueberroth—can pull the deal through with one of the major airlines. That’s the key.”³

So while the bank’s loan to Ueberroth didn’t measure up to its internal credit standards, it was made nonetheless. As Smith explained, “Security Pacific was paying a premium to be linked to the Ueberroth name, and there was a powerful windfall from such a prestigious involvement.”⁴

Unfortunately for Ueberroth and Security Pacific, the seemingly foolproof plan never lived up to expectations from a profits standpoint. The airline’s planes remained rather empty, the partnership with a major airline never materialized, and the odds of Ueberroth paying back what Security Pacific had loaned him plummeted. Smith referred to the deal as Security Pacific’s Heaven’s Gate (referencing a famous Hollywood film bust),⁵ and the bank eventually sold its loans for a fraction of their initial worth. Security Pacific had, in the words of Smith, bought into “the Peter Ueberroth name; the charisma, the stature, the pizzazz.”⁶

It was Smith’s experience with Ueberroth that informed his dealings with Trump a few years later, after his promotion to CEO. Having recently been burned by charisma, reputation, and track record, Robert Smith was a different man when Trump visited him than he was with Ueberroth a few years before. “When I first met with Trump he had already been heralded as a genius and seemed to be at the leading edge of everything,” Smith wrote. “Trump had a Clintonesque aura around him, the effervescent divinity of a studied deal-maker, and a categorical ability to communicate and inspire the belief of others in his personal vision. He no doubt could have been an evangelist.”⁷

Trump sought a $50 million loan (Security Pacific’s “house limit”) for his Ambassador Hotel revitalization plan. Although Smith didn’t explicitly reject Trump’s request, he was skeptical. After the meeting he relayed his misgivings to bank executives who were perhaps understandably bowled over by this most charismatic of businessmen. They wanted to figure out a way to finance Trump, given the prestige that would result from being his banker. Smith didn’t budge.

Smith said, “When a guy like Trump gets into trouble, he can no longer borrow, because no institution will lend to him.” He added, “As a lender, no matter how glamorous the person on the other side of the table is, you look to the borrower to have both primary and alternate sources of repayment. And, while Trump presented a financial statement with many million dollars of net worth, the ability of him to bail even this one project out was limited—because it was leveraged on an illiquid base of questionable value.”⁸ Smith ultimately lamented his failure to clearly communicate his skepticism about Trump’s creditworthiness. Remember, he didn’t explicitly turn him down. Apparently eager to do business with The Donald, other executives within the bank secured $10 million for Trump as part of “an initial study on the feasibility of restoring the Ambassador Hotel.” Smith “raised holy hell,” and with good reason. The property market swooned during the early 1990s, and as Smith predicted, Trump wasn’t able to make good on what he had borrowed. Smith went on to recall: “Two years later we wrote the whole thing off. It was a loss.”⁹

Fast-forward two decades, and Trump is claiming he’s worth $10 billion.¹⁰ That is certainly possible, but as Smith makes plain, value is subjective. It’s also no major insight to point out that value is biased.

In Trump’s defense, Trump understandably believes that the projects he’s involved with or has a stake in are winners. If he didn’t have an unshakeable belief in what he’s doing, then it’s probably safe to say he wouldn’t have the net worth (or outsize reputation) he has today.

While observable and empirical logic dictates that Trump’s net worth is quite high (Forbes estimates $4.5 billion), the same logic should also cause us to question the $10 billion that Trump regularly cities. Naturally, Trump’s valuation of his various ventures is not going to resemble outside estimates. Again, if he lacked a powerful belief in his projects, then they wouldn’t be projects in the first place.

It is not possible to know what’s on, or the value of, Trump’s balance sheet. Yet, Smith’s recall of Trump’s subpar creditworthiness is another reminder of the obnoxious conceit that drives economists at the Fed to presume to set the price of access to the economy’s resources. They can decree credit “easy,” but banks and other sources of credit don’t have to comply.

Trump can claim a net worth that would make loaning to him an apparent no brainer, and the Fed can flood banks with dollars (more on this in Parts Two and Three of this book). But banks, like any other business, would not remain in business for long if they lent in the way the Fed blindly presumes to set rates: as though we are all the same in terms of our ability to pay loans back. Accessing credit shouldn’t be the same for everyone, nor is it. The cost of access is different for every individual and every business. It’s difficult to tell how easily Trump could get a loan today. Still, Smith’s memory of lending to him in the late 1980s is a reminder that even the banks, heavily regulated by the Fed, don’t always march to the beat of the Fed’s simplistic drum rhythms.

Even better, new sources of credit constantly innovate around the Federal Reserve. While this will be discussed in greater detail in future sections of this book, for now it’s worth migrating to a form of finance that reached full flower around the same time that Trump rocketed to his early fame, high-yield finance. Readers may better know “high-yield bonds” as “junk bonds,” the latter being the pejorative members of the media attached to them long ago. Readers needn’t worry. There’s nothing complicated here.

To understand “junk” or “high-yield” debt, let’s first imagine you have $10,000 lying around. Next, imagine that actress Jennifer Lawrence asked to borrow it. As the world’s highest-paid actress, with 2015 earnings of $52 million,¹¹ you would be willing to lend her the $10,000 at a pretty low rate of interest. With earnings like hers, there would be little to no risk involved. Lawrence could secure the $10,000 repayment almost by virtue of getting out of bed in the morning.

But what if the high school son of a neighbor asked to borrow the $10,000 to buy lawnmowers for his new business venture? Eager to expand to several underserved neighborhoods quickly, he needs the credit for lawnmowers that he’ll then lend to contract workers who will pay him for their use.

It may be a great idea, but it’s also possible that the borrower could lose interest or grow discouraged quickly. Figure the borrower has no credit to speak of other than his business idea, and odds are he lacks a track record of success, which Lawrence has in spades. The risk of lending the $10,000 to him is logically much greater. The loan may well be made (figure Lawrence would have all manner of credit sources lining up to lend to her), but only at a rate of interest that reflects the risk involved. That, in its most basic form, is high-yield finance.

Enter Michael Milken. His name was needlessly sullied in the 1990s for having spent time in prison for alleged violations relating to “insider trading” (something the SEC, Congress, and the courts still can’t even define¹²). Yet Milken would be one of the faces on any Mount Rushmore meant to lionize the greatest capitalists ever.

Without getting into too many details, it is worth quoting Payback, by Daniel Fischel, a professor of law at the University of Chicago: “There is no evidence that [Milken] did [commit any crimes], and certainly no evidence that he engaged in any conduct that had ever before been considered criminal.”¹³ Economic growth depends on information, and those who possess information that others don’t should be cheered on for making markets more informed by virtue of trading on it. But government officials, most notably future New York City Mayor Rudolph Giuliani, eventually secured a plea deal from Milken for acts that had never before been considered criminal. (He was worried about family members whom the feds were going after.) Yet, the government could never produce any notable evidence of wrongdoing in the first place. But I digress.

Before the government forced Milken out of the investment industry altogether, and before he went to work for Drexel Burnham, a third-tier investment bank, Milken attended the University of Pennsylvania’s Wharton School of Business. While at Wharton, the performance of “low-rated” corporate bonds came to fascinate the MBA student. In particular, he discovered that Jennifer Lawrence–equivalent corporations with powerful track records were overrated in terms of creditworthiness relative to newer companies that lacked a long earnings history. Basically, he found that lawnmower start-up equivalents were less risky than was broadly assumed. And so a market was discovered.

While top-tier banks and investment banks continued to secure finance for blue-chip companies like Exxon, AT&T, and GE, Milken went to work finding credit for newer, lower-rated companies. He also found investors willing to invest in their riskier debt in return for a higher interest rate of return. Basically, Milken found finance for the lawnmower concepts.

His discovery that past performance wasn’t always a predictor of future performance (remember when Renée Zellweger and Cuba Gooding were A-list actors?) meant that he could bring investment banking services to the blue chips of tomorrow. As Fischel describes, “Whole industries—including gambling, telecommunications, and healthcare—were financed in significant part with high-yield bonds.”¹⁴ The list of companies that were the result of Milken securing them access to credit includes MCI, CNN, Turner Broadcasting, and Occidental Petroleum.¹⁵

What’s important here is that while the Fed seeks to influence credit by exchanging dollars for bonds held by banks, which can then lend the dollars, Milken was sourcing credit for companies that banks traditionally passed over. As of 1988, at which time “junk bonds” had a much better reputation, these high-yielding instruments were but 1 percent of savings and loan assets.¹⁶ More than 95 percent of corporate debt for companies with earnings greater than $35 million (and a 100 percent of debt for companies with earnings less than $35 million) is rated “junk.” Milken’s innovation was securing more credit for them to grow.¹⁷ A banking system that the Fed interacts with, and that is naively seen as the source of economy-wide credit, hasn’t historically tangled with this aspect of the credit market, which suggests that banks are increasingly irrelevant to our economic health.

Importantly, Milken was not done. Thanks largely to financing from traditional banks and investment banks, U.S. corporations had purchased all manner of companies unrelated to their core mission. Others had become top heavy in terms of unaccountable executives enjoying excessive executive perks and had consequently grown somewhat flabby by the 1970s. Milken’s innovation involved backing upstarts largely shunned by the blue-chip banks (think Carl Icahn, T. Boone Pickens, Reginald Lewis—the first black CEO of Fortune 500 company Beatrice Foods) eager to restructure corporations that were operating at a fraction of their potential. This included “breaking up” large-for-large’s-sake corporations by selling pieces to investors with a stated objective of running the business lines purchased more effectively. These “hostile” takeovers performed by Icahn, Pickens, and other outsiders were similarly shunned by establishment banks, mainly because the blue-chip firms these “corporate raiders” eyed for necessary restructuring were often the banks’ clients. Milken had created yet another market, and he was a magnet for credit.

Milken was so successful at discovering companies worthy of both finance and take over that investors lined up to participate in his deals. Fischel writes:

Drexel became known as a firm that could, if necessary, finance a takeover bid by raising billions of dollars within a matter of hours. Its reputation was so formidable that a Drexel-backed deal for billions of dollars could go forward even if no money had been raised. All that was necessary was a letter from Drexel announcing that it was “highly confident” the funds would be available when needed.¹⁸

Although Milken frequently backed companies and individuals who lacked a track record, his own track record of financing the companies of tomorrow and the fixers of the companies of today made him a brilliant credit risk. So confident with Milken were the sources of credit that they would back his deals based on his word alone.

With Milken, reputation coalesced beautifully with talent such that he was the ultimate credit risk. Milken rates discussion not only for how willing sources of credit were to entrust him with billions worth of access to the economy’s resources but also because he was raising money for the breed of business entities for which traditional bank credit was either always “tight” or not available at all.

The Fed lives in an unreal world in which it believes it can render access to resources cheap almost literally by waving a magic wand. But as we know from the first chapter, when those in government, projecting power that is not their own, decree the prices of anything artificially cheap, scarcity is the inevitable result. Thankfully, the Fed’s power over credit is not remotely absolute. If it were, geniuses like Milken who financed those for whom credit was never going to be easy wouldn’t have been able to access it at all.