the financial system. Before Milken there was a common view that high default risk bonds would not be attractive to the investing public, at least at interest rates that would be acceptable to the borrower. This view supposedly rested on the nature of the skewed outcomes offered by the instrument. The maximum return that an investor was perceived as obtaining is capped by the coupon and face value, but the loss could be as large as the principal invested (Hickman, 1958). Milken attempted to disprove that view.
Before development of the junk bond market, U.S. corporations that could not issue securities in the public debt market would borrow from commercial banks or finance companies on a short-term to intermediate-term basis or would be shut off from credit. With the advent of the junk bond structure, financing shifted from commercial banks to the public market.
In essence the junk bond market shifted the risk from commercial banks to the investing public in general. There appeared to be several advantages to such a shift. First, when commercial banks lend to high credit risk borrowers, that risk is accepted indirectly by all U.S. citizens, who may not wish to accept that risk. The reason is that commercial bank liabilities are backed by the Federal Deposit Insurance Corporation. If high credit risk corporations default on their loans, causing an FDIC bailout, all taxpayers eventually have to pay. The liabilities of other investors (excluding thrifts that did invest in junk bonds) are not backed by the U.S. government. Hence the risks of this investing are primarily accepted by the specific investor group willing to accept them.
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