Requiem for a Market Maker: The Case of Drexel Burnham Lambert and Junk Bonds

This article adds to both the financial intermediation and market microstructure literature by examining the market reactions surrounding the withdrawal of a major financial intermediary and market maker from a specific securities market. We examine the exit of Drexel Burnham Lambert (Drexel) from the junk bond market in 1990. At the time Drexel exited the market by declaring bankruptcy, it was the dominant market maker and underwriter of junk bonds. We examine the impact of Drexel's failure on direct and indirect holders of junk bonds by investigating the effect of Drexel's collapse on junk bond returns, and on the stock returns of a group of firms that, on average, held significant amounts of junk bonds. We find that the collapse of Drexel had a significant impact on junk bond prices in general, and a greater impact on the prices of lower-quality junk bonds in particular. We interpret this result to imply that the value of the liquidity services supplied by Drexel was higher for lower-quality junk bonds. Additionally, we find that junk bonds underwritten by Drexel, as opposed to other investment banks, experienced a significant decline in price over the months leading up to Drexel's failure announcement. This suggests that the monitoring services provided by Drexel for the bonds it underwrote would not be replaced easily by other financial intermediaries operating in the junk bond market. Our results also indicate that the stock returns of life insurance companies with relatively high junk bond exposure tended to be affected more negatively by Drexel's financial distress than the stock returns of life insurance companies with relatively low junk bond exposure.