The Federal Reserve Board is considering a proposal that would limit the use of high-yielding junk bonds to finance corporate takeovers.
Junk bonds are risky securities rated below investment grade by the bond-rating agencies. These bonds have become popular on Wall Street in recent years as a way to finance takeovers, although they also are used by small companies to raise capital for growth.
Critics of the use of junk bonds, including some Federal Reserve Board members, have warned that the explosion in junk-bond financing threatens the nation's financial system by adding too much risky debt to the balance sheets of corporate takeover targets. Fed spokesman Joe Coyne said that those concerns were not what had prompted the latest proposal, however.
Coyne said yesterday that no decision has been made about whether to restrict the use of junk bonds. However, he said the Fed is considering restricting their use in takeovers to 50 percent of the acquisition price. The Fed would accomplish this by making the bonds subject to existing margin requirements that already limit borrowing to finance stock purchases to 50 percent, Coyne said.
In takeovers, junk bonds (which are essentially a way of borrowing money) are used to acquire the stock of a target company, but up till now they have not been subject to the margin requirements. There are problems with the Fed proposal, Coyne acknowledged. For example, creative Wall Street financiers might develop new ways to use junk bonds in takeovers that would put them outside of the Fed's proposal. "That is one of the problems involved in all this that the board has to consider," Coyne said.
"I think they can write the new regulations broadly enough so that won't happen," said Nicholas F. Brady, chairman of the investment banking firm of Dillon, Read & Co. "The Federal Reserve already has a 50 percent margin requirement, and they ought to revise it so junk bond takeover financing is included."
Brady said he favors using junk bonds to raise capital for small, growing companies. However, he said the Fed should restrict the use of the securities in highly leveraged takeovers that leave target companies saddled with unhealthy layers of debt.
James Balog, vice chairman of Drexel Burnham Lambert Inc., attacked the Fed proposal yeterday, calling it "mystifying" and "incongruous." Drexel, the Wall Street investment banking firm that is the leader in junk-bond financing, mounted a successful lobbying campaign earlier this year that derailed legislative attempts to curb the use of junk bonds in takeovers.