“Imperial Finance: A History of Empires”
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- Marc Andreessen on anti-trust, Robber Barons & Golden Age of Piracy.
- Niall Ferguson reveals which financial innovations produce empires.
- Tracy Alloway explains how political chaos impacts investors.
- Mike Green uncovers episodes of monetary debasement and inflation.
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ENROLL IN COURSE
While last week we covered the Panic of 1866 across the pond in Britain, today we return home for America’s first Great Depression: The Panic of 1873.
Transcontinental Railroad & The Civil War Railway Boom
The Panic of 1873 in American picks up largely where we left off in the Panic of 1857, with railroads at the center of yet another financial crisis. Railroads had already experienced rapid growth before 1861, but the US Civil War (1861-1865) took things to another level. From 1866 to 1873 some 35,000 miles of railway track were laid across America. In terms of their importance to the domestic economy, railroads had also become the largest non-agricultural employer.
The most notable railway line constructed in this period was completed at Promontory Point, Utah in 1869 : the Transcontinental Railroad.
The completion of this route was significant logistically and economically, but also psychologically. In this age of American expansion and conquering new frontiers, the completion of a transcontinental railroad inspired Americans to chase projects that they had previously considered impossible or too daunting. One man who was inspired by the transcontinental railroad was Jay Cooke, who is at the center of the 1873 crisis.
Before getting into Jay Cooke, however, it is worth briefly touching upon how railroads were financed, and the inherent issues with funding their construction.
One of the main drivers of railway panics in the 19th century stemmed from the nature of their financing. Constructing railway lines was a very costly endeavor, and provided no revenue in the short-term. It is expensive to build a railway, and the railway can’t make money until the railway is built. Not great. From the perspective of an equity investor, railways were not a particularly attractive business model until construction had ceased and revenue started flowing.
For this reason, many railroad companies in the 19th century relied upon loans and bonds for financing their operations. In a survey of 408 railways in 1872, The Commercial & Financial Chronicle found that only 159 of 408 (39%) railroads had issued equity. Within the 159 that had issued equity, only 6% of railways had equity that actively traded on the NYSE.
Railway financing became problematic when railroads became unable to repay their debts or defaulted on their bonds, which was all too common due to the large up-front construction costs and no revenue.
Jay Cooke & Company
One man at the center of railway financing and bond underwriting was Jay Cooke, America’s first investment banker. Jay Cooke had been crucial to funding the Union’s war efforts, marketing a staggering $500 million in bonds on behalf of the Union government.
Following the end of Civil War and riding off the high of his financing successes, Cooke searched for a new and equally grand project to take on. Inspired by the transcontinental railroad’s completion in 1869, Cooke decided his next project would be the Northern Pacific railway line, which would run from Minnesota to the Pacific North West. The Northern Pacific Railroad had been incorporated in 1864 but found it difficult to obtain financing from investors.
After so successfully marketing bonds on behalf of the Union government, Cooke believed he could be similarly successful in raising funds for this struggling railway line.
“It was Cooke’s conviction that another great link was needed to the northward – a connection between Duluth and Puget Sound. This was the Northern Pacific railroad, incorporated in 1864, but still far from completed. Jay Cooke determined to finish it and make it one of the great properties in the world.” (Wall Street People, Volume II)
The sales of Northern Pacific bonds were initially successful, but then began to slow down at an alarming rate as investors became more wary of railroads and their finances.
International Investment & Railroad Troubles
Investors had every right to be skeptical of railroads in the 1870s as the number of railroad defaults rose. This was partly due to the realities of railway financing outlined earlier, but also because of declining European investment, which had been a significant source of funding.
Until the early 1870s, Europe (and Germany in particular) had been a major investor in American railroads for a number of reasons. The Austro-Prussian War had sparked a “flight to safety” in American assets, but the low interest rates in Europe also meant that European investors had to “reach for yield” in riskier assets elsewhere. For many European investors, American railways were an attractive opportunity.
However, German regulatory changes regarding joint-stock companies in 1870 caused German investors to favor opportunities at home rather than abroad.
“The relaxation of German laws in 1870, leading to massive growth in the number of joint-stock firms in Germany, was undoubtedly a major impetus for investors there to focus on local firms rather than opaque US railroads thousands of miles away.” (Mixon)
In addition to the exploding number of joint-stock company investments available in Germany, American railroads also fell out of favor with German investors due to the rising number of frauds and bankruptcies. A survey of German bankers in 1873 stated:
“Doubtless the failure of a few properties had affected the values of the perfectly sound ones…”
In a similar vein, the American Consul in Frankfurt wrote in December, 1872:
“[German investors] can no longer be relied upon as a market for the securities of the railroad, cities, or even the states of the Union. So many railroad corporations have failed to pay their interest coupons… the buyer now considers everything American uncertain.”
Since many American railroads had relied upon the European market for raising capital, problems quickly started to appear.
The Credit Mobilier Scandal
The public’s confidence and perception of railroads at home in the United States, however, was shattered by a high-profile case of fraud and corruption at the highest levels of American politics: The Credit Mobilier Scandal. This scandal tarnished the transcontinental railroad feat because it exposed one of the two railway lines (Union Pacific) for fraud, after the public learned that Union Pacific had set up a shell company, Credit Mobilier, which significantly inflated the construction costs in order to obtain larger government subsidies.
“What Credit Mobilier did was relatively straightforward. It overcharged for its work. Stock in the company was held by the principals of Union Pacific, and also distributed to influential politicians to ensure the protection of the company’s privileges.
Depending upon the estimates that one accepts, it charged between two and three times the real cost of construction. The total cost of construction came to some $94M, against an estimated true cost of $44M, leaving some $50M ($4.8Bn) effectively unaccounted for.” (‘Engines that Move Markets’)
Since the company received more subsidies for building more track, the directors were incentivized to make the route inefficient. As one example, the Union Pacific / Credit Mobilier directors opted to take a winding “ox-brow” route in one section of the railway line that added almost 10 miles of unnecessary track merely to obtain more cash.
In the end, many politicians somehow escaped the scandal despite their clear involvement. One of which was future President James A. Garfield.
“When the New York Sun broke the story on the eve of the 1872 election, Speaker of the House James G. Blaine, a Maine Republican implicated in the scandal, set up a congressional committee to investigate.
The House censured two of its members who were involved in the scandal: Oakes Ames of Massachusetts and James Brooks of New York. But the affair also tarnished the careers of outgoing vice president Schuyler Colfax, incoming vice president Henry Wilson, and Representative James A. Garfield, all of whom were implicated (although Garfield denied the charges and was subsequently elected president).”
The Collapse of Jay Cooke & Co.
In September 1873 the situation was not looking good for Jay Cook & Co. Wild swings in the money market earlier in the month stemming from Jay Gould’s attempted corner meant that Jay Cook & Co. received significant withdrawal requests. The large and respected banking institution ran into trouble when it could not meet these large withdrawal requests, and could not obtain financing because no one would take their railroad securities as collateral.
On September 18, 1873 Jay Cooke & Co. closed its doors and announced it was suspending withdrawals:
“The immediate cause of suspension of Jay Cooke & Co. was the large drawing upon them by the Philadelphia house and their own depositors during the last fortnight. Both houses had suffered a large draw upon their deposits in consequence of the uneasy feeling which has recently prevailed, and which has affected, more or less, all houses closely identified with new railroad enterprises.”
The stock market fell 4.8% on September 18th, and declined another 7.9% on September 19th as more firms began to collapse. On the Saturday, September 20th, trading was halted after just one hour as the market fell 11.2%. For the first time in its history, the New York Stock Exchange closed its doors and would not resume trading until September 30th.
By 1877, 20% of American railroad track mileage was in receivership. Leading up to the crisis there was a series of railroad failures primarily consisting of smaller railorads that European investors had funded. When Germany and other European firms scaled back their US railroad investments due to new domestic opportunities (i.e. German join-stock boom), this caused financial strain and ruin for American railways. As railroads started to collapse and default, pessimism around railways grew.
The final straw for public confidence in railroads came with the Credit Mobilier Scandal revelations that exposed the fraudulent financials of Union Pacific and corrupt politicians in Congress. The negative perception of railroads lessened their appeal to investors, which made it increasingly difficult to obtain funding and/or find financiers willing to accept railway securities as collateral.
Eventually, as Northern Pacific’s debt load became burdensome and Jay Cooke & Co. was unable to obtain loans using railway collateral, the firm could not meet withdrawal requests and ultimately shut its doors.
This marked the beginning of the country’s first Great Depression, lasting six years. By the mid-1870s, 40% of American railroad bonds were in default, and European investors were estimated to have lost $600M ($50Bn) from 1873-1879 due to railroad bankruptcies and fraud.
“A startling 89 of the country’s 364 railroads crashed into bankruptcy. A total of 18,000 businesses failed in a mere two years. By 1876, unemployment had risen to a frightening 14 percent.” (PBS)
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Sources & Further Reading
The Crisis of 1873: Perspectives from Multiple Asset Classes
A Cliometric Investigation Into The Causes of The US Panic of 1873
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