(FORTUNE Magazine) – WHAT DID HE KNOW, and when did he know it? These questions hover over Fred Joseph, co-chairman and CEO of Drexel Burnham Lambert. Michael Milken, who ran Drexel's high-yield bond operation in Beverly Hills, faces a 98-count criminal indictment for securities fraud and other felonies, one of many insider- trading scandals that rocked Wall Street. Joseph says he was appalled and surprised by the organized nature of the crime wave. In retrospect, he admits to ''surprising naivete.'' Perhaps. But why, then, after vowing that Drexel was innocent of insider- trading and stock-parking charges, did he negotiate the firm's guilty plea to six felonies and agree to pay a $650 million penalty? Is his move to sell off Drexel's retail brokerage business and part of its municipal bond operations related? In an exclusive conversation with Colin Leinster, a member of FORTUNE's board of editors, Joseph answers these questions, recalls how hard it once was to get Milken's attention, and paints a self-portrait of a man who sometimes yearns for solitude.

''I don't know what I would consider my worst moments over the past couple of years, nor do I really know what all of it has done to me. I do know that frequently I woke up with my stomach churning. But very often, what seemed horrible at the time turned out to be manageable. On the other hand, it was sometimes impossible to look at early, often sketchy, information and realize the full implications down the road. I am satisfied that our major decisions were right at the time we made them. We decided to settle with the government and pay the $650 million because of the risks of litigation. The settlement was the only survivable alternative. But we reached that agreement only after the U.S. Attorney changed some of the terms. We weren't kidding when we announced at first that we were not going to settle. There were a number of items in the earlier proposal that were absolutely unacceptable. For example, we were asked to waive attorney-client privileges. It was a matter of principle: The board was prepared to risk an indictment that would probably have destroyed the firm rather than act in a way that was unfair to our people. The U.S. Attorney agreed to drop the waiver and to make a significant number of other changes. We ended up with a settlement that is less unfair than the one we rejected. But it is one that allows us to continue in business. The board made that decision, just as it decided to get out of retail brokerage and other businesses. This strategy to shrink the firm came out of talks that went on for about four months among Drexel's senior people, culminating in a two-day meeting in April. We spent a lot of time listening to people with alternative strategies, waiting for them to reach their own conclusions. In the end, they were close to unanimous in deciding to focus on the professional and wholesale end of the investment banking and brokerage business. These changes will reduce the staff by more than one-third, cut revenues by 8%, and, on a pro forma basis, increase operating profits by 25%.

I learned a lot about participatory management while serving as a line officer in the Navy. I was on the Exultant. You have a lot of collateral duties on a mine sweeper, none of which you know much about. I was mine- sweeping officer, gunnery officer, deck officer, supply officer, commissary officer. What I learned was that the chiefs and the first-class petty officers knew way more than I did about each subject. Similarly, the people running the different Drexel businesses know much more about each one than I do. My view of my job at Drexel is to make professionals perform. Our investment bankers are very bright, and they are pretty highly motivated. The trick is to harness that drive as opposed to allowing it to become the adversarial, competitive spirit that pervades some other securities firms and tears them apart. We will make participants in meetings tell us what they like about someone else's creative idea before they are allowed to tell us what is wrong with it. Our culture considers it a failure when we can't find a solution to a problem. I AM APT TO ASK a lot of questions before saying yes or no. If a disagreement has to be resolved, I let it brew and lean on the principals to find agreement, although I think I can be very decisive when I have to be. The firm is quick to make, and does not second-guess, underwriting or trading decisions. People have said that some of Drexel's problems stem from the fact that the company is bicoastal, and that the New York people didn't always know what was happening in Beverly Hills. I don't think that is valid. We've got branches to manage in Tokyo, London, Hong Kong, California, and New York. If somebody wants to do something wrong, they can do it right here on the 11th floor ((Drexel's executive floor at 60 Broad Street)) about as easily as they can in Hong Kong.

Admittedly, morale was better in the past than it has sometimes been in the past two years. And now that we are reducing the number of employees to about 6,000, from about 10,000 a year ago, the people who have been displaced are obviously unhappy. We were all traumatized by the need to end our business relationship with so many friends. We did not look to get top dollar for the retail offices, but we tried instead to maximize continuing job opportunities. Eventually, we think we will have placed about 75% of those who are leaving. | Of course, if we place 75%, we've still got 1,000 people theoretically without jobs, and that is terribly distressing. The company has also tried very hard to treat Mike Milken fairly during all of this, while also handling our other obligations. Sometimes some of the choices have been impossible. Michael has been a long-term colleague, and you have got to feel very sad about the pressure he's under and its effect on him and his family. I remember the first time I met Michael. He was on the phone and very frenetic. That was in 1974, the year I joined Drexel as co-head of the corporate finance department, so he'd have been about 28 and I was 37. An investor I respect told me I ought to go find this very smart young man who was trading bonds for us at that time. I went down to the trading floor, introduced myself, and got into a very strange, disjointed conversation. I was pitching the idea that we probably could do a lot together. He was very friendly, but he had one ear on me and one on the phone, executing trades, watching the tapes, quoting prices to people on the other end, and telling his own people what to do. This went on for some time, and I couldn't be sure if he paid any attention to what I'd been saying. But I kept at it and I finally got to know Michael. I became convinced that he was brilliant, and I've never changed my mind about that. I don't know how you measure a brain, but his is at the extreme end of the spectrum. In my opinion, he could solve some of the major financial problems of our lifetime, whether it be the savings and loan mess or the Latin American debt crisis. We never had dinner with our wives, that sort of thing. And as far as I recall, we never even had lunch alone together. But Michael and I did talk on the telephone. It's hard nowadays, but I think we're both trying to maintain a personal relationship. SUE, MY WIFE, and our five children ((age 18 to 27)) have been extremely supportive. I have a working dairy farm in New Jersey about an hour away from my home, and I've been able to go there most weekends. I don't have to talk business with my neighbors other than the local farmers, who have an ongoing curiosity about interest rates. I've noticed over the past 20 years that the things I do for hobbies are things you tend to do alone. I hunt, fish, and work at my forge. I started doing metalworking about 20 years ago, making wire sculptures. Ultimately, I set up a forge in the barn at the farm, and I really enjoy doing blacksmith's work. You can make practical things. I like hard physical work, and I've gotten to be a reasonably confident smith. I used to make things and wonder who to give them to. Now it's come to where I have more demand than supply. My wife has had some furniture hardware on order for about three years. I've got the trigger on a cow-watering hook that local farmers have asked me to fix. Recently I was repairing drain covers for the farmer whose herd grazes on my farm. Working with red-hot iron sure needs 100% concentration, which helps take my mind off work. I was born in Roxbury ((a Boston neighborhood)) and went to public schools while my father ran a refrigerator repair business after World War II. He couldn't really make a living at it. In fact he failed because if he repaired your refrigerator, he apparently felt you had a lifetime guarantee on his work. He would always go back and do the repair job one more time. He has very strong ethical and religious concepts. After his business failed, he started to drive a cab. He really enjoyed that. He drove for Checker Taxi, which is the biggest cab company in Boston, and he was the shop steward for the Teamsters. He drove till he was 71, when he retired. MY MOTHER IS more complex. She's much feistier than my father and very strong willed. She went to college in the 1930s on a scholarship, which was a big thing then, and when I was a kid, she worked as a dental hygienist. She had firm opinions about what I should do, and I didn't always do it. I suppose that's true for a lot of teenagers. I went to Harvard on scholarships and worked nights driving cabs and trucks. Harvard was fine with her. But I boxed in college, and she strongly disapproved of that. I volunteered for the Navy, and that was anathema to her. I don't think either of them approved when I went on to Harvard business school. My mother always wanted me to be a doctor. I wanted to be an investment banker because I was totally taken with the opportunities to learn about creative finance. Since I knew that all the job interviewers would ask why I had chosen this field, I outlined in my head a pretty intelligent, albeit wordy, answer. The eyes of the first nine people glazed over halfway through my reply. No. 10 was John Shad ((Drexel's new chairman and a former SEC commissioner)), and he cut me off in the middle to pick up on what I was saying. I remember thinking: 'Son of a gun, this guy listens.' He hired me to work at E.F. Hutton, and I was more or less his ) associate for five years, putting deals together with him. Then I became a partner and did them on my own. In 1970, John lost out to Robert Foman to be the next CEO. I didn't like that, and remember thinking that merit had little to do with the result. I decided I didn't want to work at Hutton anymore so I went to Shearson. In 1974, the same year the company merged with CBWL-Hayden Stone, I was made chief operating officer. But I wanted to make better use of my management and corporate finance experience so I decided to move to a firm where the investment banking activity had yet to reach its potential. Drexel was my first choice. Burnham & Co. had bought it the year before, and the banking departments of the two had not coalesced very well. So here was an opportunity to buy in low. I had some ideas about how to build an investment banking business, essentially by finding niches where you could bring some high added value to financing a company and make a business out of it. Investment banking is funny. You do one transaction, then you do another of the same type and then a third. Maybe then you've got a business. Do ten, and it is a business. Our early niches were restructuring troubled REITs and working on equity offerings for companies that were small or troubled. That later developed into high- yield bond offerings that we found filled a very important financing need. In those days there was no long-term fixed-rate capital for most unrated corporations except private placements with insurance companies. The press has a view that Wall Street's caste system pushed us into high- yield bonds because that was the only way we could crack the establishment. I disagree. The old investment banks that had merged to form the firm were very prestigious in their day. It is true, however, that when I came here in 1974, the investment banking business was losing standing very quickly. But the turnaround I envisioned had nothing to do with the caste system. It had to do with the necessity of having a competitive advantage when we went after a transaction. We couldn't persuade a knowledgeable CEO to do business with us unless we could show him why he really should. Over a period, we moved from REITs into the cable TV industry, and then into the airlines. Sometimes we did it with new products. For instance, we developed the initial-offering high-yield bond and then the high-premium convertible bond. We did two dozen of those deals before anybody else really got into them. Timing and communication were always key. The high-premium convertible, for example, came out of the discussions that Michael and I had in late 1980. He said his buyers were going to stop buying new high-yield issues since they were all falling in price because of rising interest rates. We concluded we couldn't keep increasing the yield to meet rising inflationary expectations, but we had to provide the investor with an inflation hedge. We talked about indexed bonds or revenue-participatory bonds, but as that got too complicated, we decided to use equity kickers instead. The high-premium convert was sold as a high-yield bond with an inflation hedge. We are still practicing that sort of expertise, as the $5 billion we raised privately for RJR Nabisco demonstrates. Our high-yield market share of public and private offerings for the first six months of this year will be over 60%. In the future, we will have to operate with the compliance people proverbially looking over our shoulder, which is part of the agreement we reached with the SEC. That won't impede our day-to-day business dealings because the SEC is not interested in our business risks, which is where we have to move quickly. So I don't see a problem. In fact, we've always operated on the premise that compliance with security laws was absolutely mandatory. But there's no company in history with a bigger stake than Drexel in making sure that no legal or regulatory mistakes are made in the future. So I'm happy to go along with a higher level of scrutiny. Drexel must be the Caesar's wife of Wall Street.''