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… Or Did JWhat did Morgan’s men really do? by Leslie Hannah, Department of Economics, University of Tokyo. [email protected] Department of Economics, University of Tokyo, 7-3-1 Hongo, Bunkyo-ku, Tokyo 113-0033, Japan.
What did Morgan’s men really do? ABSTRACT J. P. Morgan & Company’s key positive contributions to New York’s financial development around 1900 were based on European precedents: managing crises (absent a central bank), publishing audited accounts (absent regulation), curbing the (abnormal) American propensity to corporate bankruptcy, suppressing the market in plutocratic control (abrogating voting rights to mimic the professionalism of European corporate governance) and (more innovatively) applying to industrial corporations the financial structures of railroads. There is no support for De Long’s suggestions that Morgan directors added value and enabled the USA to achieve exceptionally high levels of divorce of ownership from control. Market power and conflicted deals that would have been criminal in London, not superior information signalling, explain why Morgan made higher profits in New York than in London. “Currency, banking and finance have always been the stumbling blocks of American industry. Again and again they have brought it to utter grief. If the Americans had natural aptitude for finance they would have given themselves long ago a sound currency and banking system…. The Wall Street oligarchy has no counterpart in Europe and its existence here is inconceivable…. The American…. gorgeous style of capitalisation may not serve him so well on this side of the Atlantic as it has done on his own.” Lawson, American Industrial Problems, 1903, pp. 23, 222, 392.
J. Bradford De Long’s 1991 essay, “Did J. P. Morgan’s men add value?”, returned a positive answer: the bankers added value before World War One, by reliably monitoring management and certifying investments, on what soon became the world’s largest stock exchange.1 The thesis was thoughtful, stimulating and struck a number of responsive chords. As the editor of the influential NBER volume in which it first appeared pointed out, it fitted the emphasis in the new industrial economics on information imperfections and the institutions devised to reduce them. 2 For Chandlerians, here was another source of America’s remarkable twentieth century economic success, revealing the financial dynamic behind the replacement of personal capitalism by modern, professional management hierarchies. For Chicago, the article had a different appeal. Government meddling, it seemed, had destroyed an incipient American universal banking system, which might earlier have forged the superior performance that America’s investment bankers, newly unshackled from such ill-judged restraints, are now achieving. The international aspects of the thesis - De Long suggested lacklustre London could not match Morgan’s achievement, but Berlin could – appealed to British “declinists” (here was another cause of falling behind) and to analysts of the German miracle (confirming Gerschenkron’s, bank-guided, development planning). De Long’s essay thus appealed to a remarkably eclectic range of tastes and was widely cited, overwhelmingly with approval. It also spawned spin-offs, such as Carlos Ramirez’s demonstration that Morgan’s men added liquidity.3 Yet, the original article came with wise reservations from a commentator, Charles Sabel, and the author cheerfully admitted some perplexity in interpreting his results. His text is replete with low R-squareds, high standard errors, adjectives like “fragile” and phrases like “the test is weak.” His own claims for the speculative piece were, at least in parts, quite tentative and modest. And he had a lot to be modest about. Revisiting some of the same issues, I start out from a fundamentally different perspective: one that contemporaries would, perhaps, have found easier to
1 De Long, “Did J. P. Morgan’s Men.” I have asked Professor De Long to clarify ambiguous
points, but have received no reply. 2 Temin, ed., Inside, pp. 4-5. 3 Ramirez, “Did J. P. Morgan’s Men.”
recognise. It is closer in spirit to Lance Davis’s classic, comparative article, emphasising the relative underdevelopment of New York.4 Morgan is here seen, not so much as a misunderstood visionary foiled by politicians in his attempt creatively to forge a brighter future, but more as laboriously dragging New York up to stock exchange standards that were already established in Europe. Morgan’s high fees and $68 million business fortune at his death in 1913 were not primarily a reward for leading edge signals to investors. Rather, they reflect weak competitive forces in an underdeveloped market. As part of the process of catch-up, elementary copying of European institutions and standards could sometimes yield spectacular results. VALUE ADDITION OR WATER SUBTRACTION? De Long’s first test found “that the presence of a Morgan man on the board of a corporation increased its value by about 30 per cent.”5 It was based on the twenty companies – three utilities, nine railroads and eight others – that the Pujo Committee allegedly identified as having Morgan (or affiliated Drexel) directors in 1913, though the population studied is, in fact, a sample of less than half such firms.6 The “increase in value” is the extent to which the average price of the firm’s common stock in 1911/12 exceeded total book value: more precisely, the extent that that was the case for Morgan companies relative to a control group of similarly-sized companies. Since the total book value in his denominator includes assets financed by bonds and preferred stock, as well as by the common in his numerator, it is possible that some of the Morgan effect derives
4 Davis, “The capital markets.” Perhaps Davis’s work is so persuasive, because, unlike much
writing on the subject, it always seems to show an intuitive empirical appreciation of the
mismatch of asset pricing theory (which sees no agency problem in handing money to a
financial institution) and corporate finance theory (which seems to be about nothing but the
agency problems of handing money to a firm), a conundrum tellingly pinpointed by Franklin
Allen (“Do financial institutions”). 5 Temin, ed., Inside, p. 5. 6 Pujo (Report, pp. 57-65) identified 43 firms with Morgan directors, and De Long admits (p.
225) to two of the omitted 23, for which he says “satisfactory data” were “unavailable.” There
is data on one of these two - the Pere Marquette Railroad – and on many of the 21
unmentioned ones in the Commercial and Financial Chr nicle. Pere Marquette’s common
stocks were near worthless and its predicament derived from a serious Morgan misjudgment,
see Hungerford, Men, p. 220.
simply from higher leverage in Morgan firms. Fortunately, Ramirez (incidentally to his main purpose of investigating liquidity among De Long’s firms) provides an alternative, measure of the Morgan effect, with debt and preferred in the numerator. His estimate of the Morgan premium is 14%.7 This suggests that around half the premium comes from higher leverage, a factor not discussed by De Long. On standard Modigliani-Miller grounds, Ramirez’s 14% is the better estimate. It is worth examining the logic of this “value added” by Morgan’s men more closely. Use of the market-to-book ratio might imply that the book value is its underlying value – established, say, by an independent accounting valuation – and a higher market value demonstrates the effect of management monitoring or stock quality certification. But De Long is perfectly aware that contemporary accounting standards were primitive: indeed, he notes Brandeis’s belief that the “money trust” watered stock, so that book values could be massively exaggerated. The conclusion he draws from this is that: “It is particularly striking that Morgan companies have high ratios of earnings to book values, given that Morgan companies are reputed to have had abnormally high book values.”8 This is surely a misreading of contemporary opinion: implying that Morgan was the only alleged member of the “money trust” and had a particular propensity to water stock, while the generality of American companies in his control group did not. Yet even Morgan’s worst enemies could not reasonably accuse him of greater stock watering or more misleading accounting than the typical Wall Street operator of the day. The Bureau of Corporations, in its careful forensic accounting assessment of the water in the constituents of US Steel, noted that there was much less water in Morgan’s flagship Federal Steel promotion than in the four steel companies promoted by W. H. Moore.9 Pujo’s grand inquisitor, Samuel Untermeyer, did not make a habit of praising Morgan trusts, but offered the unsolicited compliment that “the United States Steel Co. was really the leader of the industrial world in making full and complete statements of its affairs to its stockholders and the public.”10 In Europe, the commercial codes typically prescribed some minimal accounting standards and there were some legislative safeguards against watering of stock in public issues. Thus European stocks were quoted below par when incompetent directors ran a firm down, but, generally,
7 Ramirez, “Did J. P. Morgan’s Men,” p. 669. 8 De Long, p.222. 9 Bureau, Steel Industry, p. 16. See also Nelson, Merger Movements, p. 99. 10 Pujo, Hearings, p. 385.
around the turn of the century were above par.11 By contrast, in the United States there was inter-state competition to lower corporate disclosure and governance standards to the bottom: in the early twentieth century being won by New Jersey, though soon trumped by even lower Delaware standards.12 Lying to investors in prospectuses about prices paid and the valuation of assets was treated casually in America. As John Moody pointed out, the American financier, Whittaker Wright, had done no more in London than he had got away with at home, but over there he was behind bars.13 In New York, therefore, stock-watering was routine and it was perfectly normal for US common stocks to be quoted below, often well below, par.14 The markedly higher market-to-par ratios in the Old World might, by analogy with De Long’s conclusion from similar differentials within America, be used to argue that European directors were superior to Americans. What it actually reflects is alternative approaches to balance sheet accounting. In the common law jurisdictions of the USA and of England (where stocks were,
as in continental Europe, then typically above par), good accounting and control of stock
watering depended more on voluntary standard setting than under the continental
commercial codes. Morgan, of course, was most familiar with the London market, where a
high degree of voluntary compliance with accounts publication had been achieved at the
urging of Sir Henry Burdett, secretary of the London Stock Exchange from 1881, even before
the state made external auditing compulsory in 1900.15 It was otherwise in New York. Many
large trusts – like Standard Oil, American Sugar, Singer or Amalgamated Copper - were
“blind pools” that simply did not publish accounts. Some quoted companies that had once
published accounts, like Anaconda and Procter & Gamble, decided in the later 1890s to stop
doing so. The NYSE committee from 1895 followed London and required listed companies to
publish accounts and actually finally de-listed Procter & Gamble in 1903 for repeatedly
failing to comply (they were not re-listed until 1929).16 However – unwilling to lose
commissions on more frequently traded stocks– the NYSE allowed many other firms not
publishing accounts to continue “unlisted” trading until that was abolished in 1910.
11 Neymarck Valeurs Mobilières, 1897, p.21, 1903, pp. 143, 193, 213. 12 Grandy, “New Jersey Corporate Chartermongering.” 13 Moody, Truth, p.492. 14 Lyon, Capitalization, p. 104; Bunting, Rise, pp. 96-7. 15 Duguid, Story, p. 351.The collection of company accounts and annual reports in the
Guildhall Library, London is a monument to his labours. 16 Schisgall, Eyes, p. 51.
The result was that the information available to investors was generally
superior in Europe. In Britain, for example, almost all of the thousands of companies quoted
on the London Stock Exchange were audited by professional accountants by 1900, most
publishing both balance sheets and profit-and-loss accounts.17 Yet 43% of even the largest
100 US industrials did not publish even balance sheets at that time.18 The observer of
Morgan companies could, however, be forgiven for confusion about which country he was in:
all De Long’s Morganized firms appear to have published accounts. Morgan was clearly on
the side of the angels on this one. The way that Morgan drove this improvement in American
accounting quality was not a closely guarded business secret, but was emblazoned on many
of his merger offer documents and annual reports. He did it by importing British
accountants, professionally trained in the basics of merger accounting, valuations and
corporate audit. The annual accounts of many of the Morganized firms listed by De Long
were a mainstay of Price Waterhouse, the English firm that had opened a New York office in
1890, initially for a London financier, but soon helping Morgan’s men with railroads, steel
and harvester enterprises. The New York office had to cable London for reinforcements,
increasing its staff from fifteen to seventy-three in 1901-1903 alone, to cope with merger
investigations and subsequent regular audits of US Steel and others.19
Let us suppose that some NYSE issues were by less scrupulous issuers, who typically created more watered stock than Morgan. For any given level of real assets, the par value of the stocks will, therefore, be lower in the Morgan firms. Suppose, further, that the quality signalling of directors (or whatever else determines performance) is precisely equal in Morgan and non-Morgan firms and that this is reflected in the market value of their stocks: which will, therefore, be the same. The market-to-par ratio will, however, be higher in the Morgan than the non-Morgan firms: as De Long observes, and as also was generally observed in European relative to American firms. Both observations tell us nothing about investment quality signalling and much about varying accounting norms. The measured “informational” advantage of Morgan firms may have been of a rather more basic accounting nature than the quality signalling posited by De Long. There was one business sector in the United States - banking - where public regulation of accounting standards was the equal of, indeed arguably more stringent
17 Fisher, “President’s Address,” p. 1109. 18 Bunting, Rise, pp. 155-56. 19 Jones, Tru and Fair, pp. 75-78, 90-97; DeMond, Price, Waterhouse, pp. 32-36, 58-66.
than, that in Europe.20 Morgan’s men were very active as directors of financial institutions, though De Long excluded all such cases from his sample, for reasons not stated. Morgan banks do, however, provide a natural test of the plausibility of my suggestion that the measured Morgan effect comes from the denominator rather than the numerator of De Long’s metric, since their accounts were prescribed, externally monitored by bank examiners and, in the nature of the business, not as subject to the depredations of Wall Street promoters. In this case, the Morgan effect will be generated by the numerator, not the denominator. Table 1 shows the added value (again, calculated from market-to-book ratios) in the nine banks and trust companies in New York and Philadelphia of which Morgan partners were board members, measured against nine, size-matched, paired banks in the same cities.21 The Morgan banks performed less well than their matched pairs, but the difference is negligible. Comparison with the De Long results for non-banks might suggest the bizarre conclusion that Morgan’s men were better at running Table 1. The Morgan Premium in 1911/12 Morgan Firms Control Group Banks and trust companies. Market-to-book ratio 1.300 1.322 Morgan Premium minus 2% Other companies
20 There was, of course, also some US public prescription in accounting for railroads and
public utilities, but it was not as stringent, uniform and externally monitored, as for
banking. 21 Data from Commercial and Financial Chronicle Bank and Quotation Section, 94, January
1912, pp. 60, 62. The nine Morgan institutions are: Astor Trust, Chemical National, Liberty
National, National Bank of Commerce and New York Trust in New York, and Fourth Street,
Franklin National, Girard Trust and Philadelphia National in Philadelphia. The matched
pairs were the alphabetically nearest bank (or trust company, as appropriate) of identical (or,
failing that, nearest) size in the same source.
Morgan Premium (De Long) +30% Morgan Premium (Ramirez) +14% Source: author’s calculations, De Long, Ramirez. railroads, industrials and public utilities than they were at banking. A more plausible explanation is that his results are an artefact of generally backward American accounting standards versus Morgan’s enlightened approach – an effect which, because of regulation, naturally disappears in the case of banking - rather than the posited out-performance of Morgan non-banking directors. The implication of US accounting standards and propensity to water new stock issues is, then, likely to be precisely the opposite of that suggested by De Long. The measured Morgan effect derives, not from adding market value, but from subtracting balance sheet water. Morgan conservatively decreased the stated book values when issues were first made or reconstructions undertaken, relative to reckless standard Wall Street practice. Morgan certainly deserves credit for encouraging greater honesty in accounting and for promoting the notion – still an outrageous foreign deviation to some businessmen – that stockholders should receive annual accounts and that they should be professionally audited.22 He watered stock only moderately, though he was no doubt wise not to outrage local norms by abandoning the practice completely. None of this constituted “adding value” to the companies by monitoring management after the issue, nor did it require a continuing presence as a signal to investors. Any confirmation of such long-run, value-adding capability has to come from elsewhere. LONG-RUN MONITORING De Long’s second test showed that a sample of ten non-railroad and five
22 When the president of (then largest NYSE-traded) industrial, American Sugar, thundered
to Congressmen that “You cannot wet-nurse people from the cradle to the grave” (Industrial
Commission, Preliminary Report, p. 122), he was not condemning socialized medicine, but
the publication of company accounts. See also Vanderlip, From Farmboy, pp. 208-09.
railroad, Morganized common stocks in varying periods between 1895 and 1913 performed better than the average NYSE common stock return between 1890 and 1914.23 The logic is obscure. For example, the annual return on Baldwin Locomotive (a Morgan IPO of 1911) in its first two years was 22.23%. This is gravely reported to be 14.27% higher than the mere 7.96% that a hypothetical investor could have achieved by travelling back in time twenty-one years (to 1890), investing randomly in an NYSE portfolio, then selling out, not in 1913, but a year later. Apart from the unworthy suspicion that a lucky investor capable of time travel would not have wasted time indulging in the posited Morgan-director-spotting in order to make money, the arbitrary extension of the yardstick to end-1914 (when war and the temporary closure of the NYSE had depressed stocks by 8.5% since end-1913) artificially lowers the bar. A more appropriate yardstick against which to judge the Morgan stewardship of Baldwin Locomotive would surely have been the NYSE portfolio invested over the same 1911-13 period, and pari passu for the other stocks. Alternatively the Baldwin Locomotive observation could be omitted, as relating to too short a period for Morgan directors to have had a significant impact. However, that single omission would slightly change the explicandum, from why Morgan non-rail firms performed 0.045% better than the 7.96% NYSE benchmark, to why they performed 1.424% worse. (De Long diligently reported the large standard errors, but they have been equally diligently ignored). The long-run sample is also contaminated by survivor bias. Morgan’s men sat on more boards than the sample, singled out by the Pujo Committee at the end of the period and further winnowed from 43 to 15 by De Long. Investors attempting to decide where to invest by the method recommended ex ante did not have De Long’s or Pujo’s ex post knowledge. In 1900, Morgan partner Charles Coster died holding 59 directorships, many not included in De Long’s analysis.24 De Long rests his case for presuming this is not an issue on his standard argument: Morgan’s market share was so large that partners would not sully their reputation by cheating investors, whereas small rivals
23 No reason is given for his further truncation of the sample. I have been unable to replicate
any of his reported results from the sources cited. For example, the Cowles Commission
(Common-Stock Indexes) gives a number of alternative measures of NYSE rates of return,
but none of them appears to be his 7.96% p.a. Many of the issues were not in fact IPOs of
common stock and there are a variety of possible exchange rates, implicit prices, curb rates
and first listing prices. The results are sensitive to the choice made. Nonetheless, in what
follows, I assume all his data are correct. 24 Sobel, Big Board, p. 128.
would be tempted by the fast buck. He instances (p. 210) Amalgamated Copper as the kind of investor scam that Morgan partners, following his logic, would avoid. He was evidently unaware of the extent to which the partners failed to understand their strategy: Morgan partner Robert Bacon was on the board of Amalgamated Copper. Morgan also sponsored or co-sponsored hundreds of issues that did not result in a Morgan partner being on the board. Pierpont claimed to the Pujo committee that branding new issues with the firm’s good name - not directorships - was the quality signalling he strove for. Moreover, as de Long points out, International Harvester was a private firm, not quoted in the period from 1902 for which he reports a return (presumably to the family owners): not very useful for investors wishing to act on the Morgan signal! Those who imply that the De Long results show that investors looked to Morgan certification in new issues should therefore be aware that, while the great majority of stocks and bonds that were issued by Morgan to the public are not in his sample, some that were not available are. Indeed, it is surprising that there is much variation between the performance of the Morgan sample and the Cowles NYSE index, since there were rather few securities in the Cowles index (most large American industrials in 1900, for example, were still unlisted or quoted elsewhere) and a high proportion of these were Morgan-influenced in one way or another. The Cowles NYSE index, the comparator which he reports as doing worse, actually includes very many more Morgan issues than his own truncated sample, though it also includes non-Morgan stocks, so some difference might be expected if Morgan firms performed better. However, the obvious source of divergence – given the extreme size differences within the sample - is that De Long’s calculation of returns is equal-weighted, whereas the NYSE index was compiled using a size–weighted method. Data limitations prevent the exact replication of the NYSE weighting, but we can approximate it by using an aggregate 1912 par value weighting for the common stocks in De Long’s sample.25 This reduces the measured rate of return from a simple mean of
25 I assumed the Adams Express no par value shares were standard $100 shares. I have
weighted his reported return figures by the aggregate par values of the firms’ common
stocks in early 1912, reported in the Manual of Statistics and Poor’s Manual. This procedure
will probably introduce some upward bias, relative to the Cowles weighting, to the extent
that, through new stock issues or stock dividends, the more successful firms will likely have
higher nominal stock values toward the end than at the beginning of the period of
10.27% to a size-weighted mean return of 8.09%: only 0.13 percentage points higher than his reported Cowles NYSE average of 7.96%. This implies, on De Long’ own data, and with all the required caveats about low sample size and high standard errors, that an avid follower of Morgan’s men, with an uncanny ability both to buy untraded stocks and to forecast the boards on which Morgan’s men would persist in the future, would do 1.6% better than a random stock picker. If corrected for sample selection bias, this result could easily be reversed. In the light of such multiple faults, there can be no presumption that Morgan directors added value, in De Long’s sense, on the basis of his second test.
That is not to say that Morgan directors were hopeless: George Perkins did an excellent job sorting out family squabbles at International Harvester, as De Long’s case study demonstrates. Nor is it to say that the half dozen leading New York investment banks in this era played no part in certifying the quality of new issues, as investors cautiously learned to value that signal and avoid cowboy promoters. That is exactly what narrative historians tell us happened. A reasonable prediction, if that system worked well, would be that their issues would soon cover most of the market. That, also, is what happened. There would, in these circumstances, not be a large difference between the NYSE index and the issues of any one banker. And - for all we know from De Long’s results - that may also be what happened. LONDON VERSUS NEW YORK More generally, De Long relates the weak performance of London’s securities markets before 1914 to the absence of Morgan’s certifying capabilities there, though he is aware (p. 230) that Morgan operated in London. His argument about what was wrong with London is not entirely clear, but there are two threads. First, he suggests that Morgan’s quality-signalling innovations facilitated more divorce of ownership from control in America than Britain. The reference (p. 229) is Chandler’s, well-known, assertion that personal ownership in the early twentieth century was common in Britain, while professional management control had advanced further in America. Chandler’s S ale and Scope was, of course, just published when De Long appealed to its authority and he could not know that its family capitalism thesis was to be, almost unanimously, rejected by European business historians. On the more precise question at issue, there can be little doubt that, in the first decade of the twentieth century, plutocratic control was the norm in America and Germany, and indeed in many British businesses, but ownership was more commonly divorced from control in the UK
than in the other two countries.26
That leaves De Long’s second point on London’s backwardness (p. 230): its “absence of finance capitalist institutions,” a characterisation that would have produced some mirth in the offices of London’s foreign banks. It might also have puzzled leading European exponents of theories of finance capitalism, like Vladimir Illyich Ulyanov, who lived in exile a mile up the road. From the context, it seems that De Long had in mind a narrower point than Lenin’s: London would have been better off with fewer investment banks or universal banks, which would then have had a stronger incentive to certify quality, which in turn would strengthen their market power, in a virtuous spiral to excellence. The point is that, with many banks, each with a small market share, “the future returns expected from a reputation as an honest broker might … be small, and less than the present benefits of exploiting to the fullest one unsound deal” (p.210) To paraphrase: “Don’t go to London. There are too many banks competing, so they cheat. You are safer in Berlin and New York, where Deutsche Bank and Morgan dominate the market and are therefore trustworthy.” The revealed preferences of international investors, footloose overseas companies (and banks themselves) suggest a mass inability to understand De Long’s logic. Hundreds of American domestic companies and dozens of German ones paid to list in London, but only one British company (Nobel Explosives, which had issued securities there to acquire German assets) paid to list in Berlin and none in New York. Of the major international corporate borrowers, only Russians favoured Paris and Brussels over London. London perhaps had an unfair advantage in attracting listings of Indian, Australian and Canadian companies, but enterprises from Spain, the Transvaal republic, Japan, Mexico and Argentina also preferred London, as did American companies seeking capital overseas. In 1900, it was possible to buy shares in Chicago meatpacking, Milwaukee breweries, America’s largest flour miller and Kodak cameras in London, but not on the NYSE. The largest business corporation in nineteenth century America, the Pennsylvania Railroad, had been paying to list in London (as well as on its native Philadelphia exchange) for decades when, as late as December 1900, it reluctantly agreed to list on the NYSE. In 1901, well over four thousand British and foreign companies were listed in London’s Stock Exchange Official Intelligence, but only about 200 corporations had stocks listed on the NYSE.27 By 1912,
26 Hannah, “Marriage.” Becht and De Long (“Why has there been so little blockholding”) is
also consistent with the view that Chandler exaggerated the divorce of ownership from
control in early twentieth century America. 27 Fisher, “Presidential Address,” p. 1109 for the UK; Commercial and Financial Chronicle
London dealt in the securities of 71 of the world’s largest 100 enterprises by equity capitalization (30 US-headquartered, 28 British-headquartered and 13 headquartered elsewhere), while the NYSE listed 40 of them (all but the Canadian Pacific US-headquartered).28 London’s status as the world’s leading financial centre would have felled lesser men, but De Long is undeterred. His resolution of the puzzle (p. 230) does not lack ingenuity. London’s apparently dominant position, he explains, is deceptive: it results from the failure of London’s financial institutions. British investors, mired in a domestic economy irredeemably blighted by competitive banking, had to seek (presumably better intermediated) offerings overseas. It is not easy to reconcile this analysis with the behaviour of international investors. The flow of capital through London was from all over Europe, not just from Britain, and it is not clear why footloose international investors should choose the conduit of “failed” intermediaries. Moreover, although there was some specialisation of London’s financial institutions, the ones serving domestic and overseas needs extensively overlapped. In a largely passport-less world, in which English corporate law, accountancy and language, as well as the pound sterling, all had international currency, London saw little difference between a Buenos Ayres tramway and a Dublin stout brewery. Barings launched IPOs for both of them. London’s standard reference manual, the Stock Exchange Official Intelligence, urbanely classified companies by business sector, not nationality (the classification that has obsessed most historians). In this cosmopolitan city, overseas and domestic issues were thought of as one business: the same polyglot, globally-minded lawyers, stockbrokers, bankers and accountants serviced both. The most striking contrary evidence supporting De Long’s hypothesis is the success of Morgans - his prime exemplar of “American financial capitalism” - in introducing US securities to the London market, though it is a moot point whether their expertise only flowed from west to east. The Morgan partnership in Old Broad Street was, of course, originally the main business of Pierpont’s father, and for two decades after his death was still known as J S Morgan & Co, though from 1910 re-named Morgan Grenfell.29 Morgans in London had been second only to Barings in floating US
for 1901 (NYSE railroads and “miscellaneous” stocks only). 28 Author’s calculation from Wardley’s global top 100 list (“Top 100”) and data in Stock Exchange Official Intelligence and Commercial and Financial Chronicle Bank and Quotation Section. 29 Carosso, The Morgans, pp. 273, 276.
railroad issues in the classic period of overseas financing of US corporations. Morgan began the 1890s with as large a position in London as New York and some of the US directorships examined by De Long were, in fact, “inheritances” of the earlier US deals of the London partnership!30 Pierpont, by the end of the 1890s, had decisively shifted the balance of the family business to New York, but his self-image was not as an innovator, but rather as the bearer of the sound London practices of an ethical conservative merchant banker, worthy of public credit, to a new venue where it was badly needed: New York.31 He still worked and played in London, where he owned two houses, every spring. His son (and successor in 1913), the even more Anglophile “Jack” Morgan, served his apprenticeship as a partner in London for eight years beginning in 1898. Both Morgans routinely cooperated with British capitalists, for whom their firms had long been a conduit to American wealth-building opportunities: Sir Charles Tennant, for example, was one of the three voting trustees of the Erie Railroad, along with Pierpont.32 When Pierpont thwarted Harriman’s bid for the Northern Pacific in 1901, it was by virtue of Jack’s purchases of the pivotal final shares in London.33
It was, then, not surprising that many Morgan securities were actively traded in London. Of the fifteen Morganized US common stocks investigated in full by De Long, eight - four railroads, plus AT&T, International Harvester, Pullman and US Steel, together accounting for 79% of par values - were also listed on London34 The partners’ signalling skills appear to have had a Viagra moment on transfer to London.
30Chapman, Rise, p.97, Carosso, pp. 12, 77-8, 224, 249, 290, 354, 390. See also p. 18, below. 31 Ibid, p. 294; see also pp. 352, 647. 32 Carosso, pp. 373,376. 33 Carosso,. p. 477. 34 Stock Exchange Official Intelligence 1912. The 4 railroads were the Atchison, Topeka &
Santa Fe, the Erie, the Reading, and the Southern. I have excluded from this list:
International Mercantile Marine (then listed on Liverpool), General Electric (its British
subsidiary, British-Thomson-Houston, had only London-listed debentures, though the US
parent was also noticed in the Stock Exchange O ficial Intelligence, perhaps implying that
GE stock traded over the counter in London), Westinghouse (only the bonds and preference
shares of its British subsidiary, British Westinghouse, were London-listed), the New Haven
railroad ( only its European loan was London-listed) and Baldwin Locomotive (purchased by
Morgan Grenfell as private equity, see Carosso, Morgans, p. 604). I can find no indication of
Adams Express, Philadelphia Rapid Transit or Public Service Corp of New Jersey trading in
any form in the UK.
De Long’s fifteen American stocks did 1.6% better than random NYSE investments, but the eight stocks listed in London achieved a weighted rate of return 10.1% above random NYSE investments.35 This is a more decisive margin, but should – given the problems we have noted – also be taken with a large pinch of salt. De Long’s test did not decisively prove that Morgan’s men were a tiny bit better than a blindfolded New Yorker with a stock list and a pin; and this does not – with certainty - show that the London partners were six times better at stock certification than their American colleagues. Were Morgan’s men the conduit of so much British capital to the USA because of London’s reputation, experience and skills, or because of the appreciation by British investors of the decisive signalling innovations which De Long believes were transforming American capitalism? If the latter, players in the world’s financial centre would presumably be willing – indeed, deeply anxious - to pay for the service. Yet, in the period 1900-1913 the New York partnership averaged net profits (after interest) of $5.9 million a year, while the British house only averaged $0.3 million annually between 1900 and 1909.36 These figures need to be related to the human and capital resources employed. There were in the early twentieth century about 150 employed by Morgan in New York, in addition to partners and associates, and a further 75 at Drexel & Co in Philadelphia, all generating the reported American partnership profits, while the London house employed under 50.37 This is compatible with profits per employee more than four times higher in American investment banking. Returns to capital are more difficult to assess: Carosso oddly refrains from reporting annual capital employed in the American partnership. The average capital in the London partnership accounts for 1900-1909 was $8.7 million, a figure very similar to Pierpont’s father’s core London operation of the 1880s; and this implies an average net, post-interest return in the first decade of the century of only 3.5%. This was about what a conservative, gentlemanly, English banker, leveraging his father’s reputation, could, with an above average share of luck, readily earn, but – American citizenship apart – that is a not inaccurate description of Morgan. There is no obvious sign here that international investors in London were willing to recognise and pay a premium price for whatever Morgan offered. Of course, more could be achieved in cosmopolitan London, for example by a lively German aristocrat, perhaps with an even
35The weighted average return on the 15 New York stocks is 8.09 %, that on the 8 London
ones 8.765%. 36 Carosso, The Morgans, pp. 615-16; Burk, Morgan Grenfell, p. 265. 37 Carosso, The Morgans, pp. 436, 459.
larger share of good luck: Schroders were growing faster than Morgans, with about the same number of employees by 1910. On the same (post-interest) net profit basis, Schroders made an exceptional 12.6% in 1905-1913, but that was at the peak of that partnership’s success.38 Yet New York was different. The reported figure for J. P. Morgan’s partnership interest when he died in 1913 implies a total capital in the US partnership that had then risen to $75.9 million, a sharp increase from the reported 1895 figure at only $7.1-7.3 million.39 Assuming constant annual growth in partnership capital, the rate of profit (in addition to normal interest) on the American partners’ capital would have averaged 13.5% between 1900 and 1913.40
SOURCES OF EXCESS PROFITS Why, then, were Morgan partners so handsomely rewarded in New York? In order to answer that question we have to look at their main source of fees: business corporations. Carosso’s study identifies two sources of high fees, both of which figure prominently in De Long’s sample: the railroad reorganisations (especially in the last decade of the nineteenth century) and the industrial mergers (especially in the first decade of the twentieth). Railroads provoked constant contemporary debate on the “Europe versus America” question: were speeds, comfort and baggage check arrangements better over there or over here? Morgan was, perhaps, more interested in differences in corporate governance and financial structure, as were the European investors with whom he often worked on American railroad reconstructions. These differences were large. European railroads were run by the state, as in Germany, or, where private, as in France and Britain, by stable, professional boards of directors (typically business users, managers and bankers) and the railway professionals that they appointed. As Colleen Dunlavy has emphasised, this was partly underpinned by “democratic” voting rules (one-stockholder one-vote, or reduced voting power with cumulative blocks of stocks), which prevented plutocratic shareholders exercising
r r
38 Roberts, Schroders, pp. 149. Barings and Rothschilds also made good profits but it is
unclear how comparable the accounting base is, see Ferguson, Wo ld’s Banker, p. 809. 39 Ibid, pp. 273, 276, 644, 745 n. 124; Burk, Morgan G enfell. p. 265. 40 These figures may seem surprisingly modest considering the alleged price gouging of the
“money trust.” These figures for “net profit” exclude interest paid to the partners, so are a
measure of economic rent (or monopoly profit in excess of normal capital charges) rather
than total profit on capital.
control.41 In the United States, by contrast, “plutocratic” (i.e the, now normal, one-share one-vote) voting was the corporate norm, there was an active market in corporate control, and, apart from a few roads such as the Pennsylvania, with European-style voting rules, widespread share-ownership and professional management, personal ownership of US railroads by plutocrats with a large, sometimes majority, stockholding was common.42 That control could, however, be precarious, both because others could acquire stock - in the market or from other large holders - to challenge minority control and because American railroads were more heavily leveraged by bonds (and by fixed-interest preferred stocks) than their European equivalents, laying them open to foreclosure by bondholders if payments were missed. This unusually high leverage was partly because their early European investors had wanted to limit the managerial discretion of distant corporations, partly because the equity culture in America was itself extremely underdeveloped, while bonds were well understood by NYSE investors and dominated the market. As in the United States, large European railroad corporations were the core of the quoted corporate economy in the 1890s, but they had a higher proportion of equity capital and they hardly ever (and, in the case of major lines, never) went bankrupt.43 In the USA, in the 1893 crisis, nearly a quarter of all railroad mileage – at a time when railroads completely dominated the NYSE stock and bond list - was in receivership. To European observers, one distinctive characteristic of American financial capitalism was that it was bankrupt. Morgan saw more clearly than anyone how to remedy this, because he understood the weaknesses of American finance and governance practices. 44 His railroad reorganisations have two hallmarks, both tending to propel America closer to European norms. The first was the voting trust. If any large stockholder or director– like William P. Clyde in the Southern reorganisation – refused to put controlling shares in a trust, Morgan simply walked away (seven months later Clyde came begging and Morgan work resumed)45. He wanted to install professional railway managers whom he could trust to use new money to reorganise the road technically and commercially and he wanted to prevent marauding plutocrats gaining control and sabotaging that work
41 Dunlavy, “Corporate Governance.” 42 Hannah, “Marriage.” 43 Hannah, “Global erquity markets.” 44 Carosso, Morgans, pp. 363-69; Campbell, Reorganization. 45 Carosso, Morgans, p. 370.
for short term gain.46 The voting trust, typically for five years initially, but often renewed for longer, essentially gave that stability, by taking the voting rights away from the stockholders and putting them in the hands of Morgan’s men and the other voting trustees. Both Morgan and his partner, Henry Davison, explicitly stated that they saw this as the equivalent of the European norm of what Dunlavy calls “democratic” voting. 47 However, as in Europe, its principal effect was to ensure incumbent (Morgan-appointed) board control, even though the board did not personally own a majority of a road’s stock. At the same time, Morgan’s men undertook a thorough review of the revenue-earning power of the railroad and of its needs for new investment funds to improve that earning power, usually resulting in the second hallmark of the Morgan method: that the proportion of bond capital had to be reduced, while that of equity was increased. Again lower leverage ratios were standard British practice, and the pattern was set by the Atchison, Topeka & Santa Fe, reconstructed in 1892 by the London office. Moving more US roads in that direction required full-time attention (New York partner and railroad specialist, Charles Coster, gave it) as well as some fine judgments among contending interests. Often, stockholders were forced, by the threat of foreclosure, to put in more equity, via direct assessments or heavily discounted issues. In some reconstructions, like the Erie and Southern, it was difficult to make a settlement that gave a realistic chance of raising future capital by stock rather than bonds and leverage remained high. Yet, the confidence in Morgan’s men’s ability to get this difficult balance right, guaranteeing a return to preferred stockholders and – if things went well - perhaps eventually to common stockholders also, was the key to successful re-financing. That they – and others with similar skills - generally got this right is shown by the dramatic improvement in railroad finances in the two decades before World War One. In 1901-10, the overall return on railroad common stocks was 121%, substantially influenced not by the modest dividends, but by capital gains, as confidence they would not again be worthless improved. This was slightly better than the return on industrials
46 One can, of course, debate whether a fluid market in corporate control is better than
entrenching stable management teams in self-perpetuating corporate boards. That was not,
however, a debate that Morgan – or European railway directors – cared to have: they were
Chandlerians to the last man. The debate hardly re-surfaced until takeover bids were
re-invented after World War Two. 47 Pujo, Hearings, pp.1058-60, 1970-72.
and well above the 21% on other utilities.48 In the crisis of 1907-08, less than 5 % of US railroads were in receivership, a dramatic improvement on the 1890s, though still the Wild West to European railwaymen.49
Of course, well-run US railroads, like the Pennsylvania or the New York Central, had no need of de-leveraging and corporate restructuring and the ordinary issue business that the firm conducted for such roads was, accordingly, not especially remunerative. 50 However, the reorganisation skills of Morgan and his team of professional railroad company doctors were at a premium: it is here that the largest profits of the partnership were made in the 1890s. For example, the Reading deal of 1895-1897 netted them $3.4 million in reorganisation and underwriting fees.51 They earned such fees because they were the best in the business. They could not earn such fees in Europe because the problem addressed did not exist there. This was also why, by the turn of the century, Morgan’s market share was higher in New York than London. The railroads were already publicly quoted firms, but Morgan’s major industrial initiatives often involved the flotation of firms that were previously owned by entrepreneurs or their descendants. Even in the case of US Steel, where most of the merged assets except Carnegie Steel had been previously quoted, it was only a few years since Morgan or others had first sponsored their IPOs. This was a relatively new business everywhere but newer in New York than on the main European bourses. It offered rich pickings, since the gap between the profits made by entrepreneurially-owned firms and the expectations of dividend returns of the investing public were so large The price-earnings ratio for NYSE industrial stocks in the first decade of the twentieth century averaged 13 (and the dividend yield was even more generous), while private sales of businesses to new principals sometimes achieved only half that.52 In an IPO, if the decline in profitability from reducing the incentives of personal ownership could be neutralised or limited, by appropriate governance, information and management structures, there was a considerable surplus to be shared between the vendors (whose knowledge of such affairs was, by definition, limited) and practitioners (who knew what the market would bear). This led to some quite extraordinary returns, both in Europe and in America, to some promoters who had
48 Cowles, p. 48. 49 Ramirez, “Did J. P. Morgan’s Men,” p. 675. 50 Carosso, Morgans, pp. 358-61. 51 Ibid., pp. 382-83. 52 Cowles, Common-Stock Indexes, p. 44; Ackrill and Hannah, Barclays, p. 62.
dubious skills, and some who were downright crooked, especially if they exploited their information advantages against vendors. Stories of promoters buying from vendors at a low price and selling to investors at substantially higher prices were then routine. Although competition and publicity limited the potential gain, some of Morgan’s profits from this business were possibly of such windfall kinds.53 The Bureau of Corporations estimated that the fees, net of costs, for the 1901 refinancing of US Steel, and the many IPOs of its constituent corporations that had taken place in the previous five years, totalled $87 million, 7.7% of its market capitalisation.54 The 1901 merger fees alone accounted for the bulk of this sum. On the face of it, the transaction was a very large-scale, but straightforward exchange of shares (no new capital was raised by public subscription), together with a large printing job for $303 million par value US Steel bonds, issued to Andrew Carnegie and his partners for the previously unquoted component in the merger (five Carnegie partners also took part payment in US Steel stock of $189 million par value).55 The main risk arose from the possible unwillingness of existing equity investors in some or all of the merging firms to accept that Carnegie’s bonds should have a massive prior charge. Such high levels of leverage were unusual except for stable railroad stocks, so this could not be taken for granted.56 Morgan risked not only $3 million expenses, but also the underwriting of the equity share of the commitment to Carnegie, if they were obligated to go ahead with that separately. However, the stockholders in the other merging companies would rationally only exchange their shares if they felt that the increased profits (from future monopoly or cost savings) compensated for the increased risk of the new prior charge
53 O’Hagan, Leaves, for the effects of competition. 54 Bureau, Steel Industry, p. 251. 55 The 5% bonds were worth $349 million, on the basis of infrequent trades averaging 115 in
the first year, as the Carnegie partners trickled their bonds to the market. (Bureau, The Steel Industry, pp. 174, 242). 56 In 1899, the top 100 US industrials had, at par, only 8% bonds, 23% preferred and 69%
common (Bunting, Rise, p. 118); the previously quoted merging steel companies also had
only 8% bonds, while US Steel at par had 27% bonds, 36% preferred and 36% common
(Bureau, The Steel Industry, 1, pp. 170, 242). At average first year market prices, the
leverage was even higher: 34% bonds, 42% preferred and only 20% common. It was not
uncommon in London for one third of the capital of an industrial to be in bonds, one third in
preference and one third in ordinary, but half common and half preferred, with occasional
bonds, was the 1900 NYSE industrial norm.
and for the dilution of their existing (perfectly good) equity by the new stock issued to pay the Morgan syndicate’s fee. Since both these effects were large, this was quite a tall order and I doubt whether signalling accurate information about it was uppermost in the minds of the partners. The problem that investors might baulk at the latter dilution was simply resolved by offering the managers of the merging firms an insider deal (via participation in the underwriting syndicate) to induce them to recommend acceptance of the US Steel paper. Their stockholders, in the opaque offer document sent to them early in March 1901, were not informed of the level of fees, nor that their directors were beneficiaries.57 As Morgan later acknowledged, he understood why in London such non-disclosure was criminal. He also knew that in New York it was perfectly legal.58
Morgan proposed this integrated multi-firm merger with strong market power partly for well-known industrial reasons: Carnegie was threatening to integrate forward to tube manufacture, which would trouble Morgan’s National Tube Company. The financial imperatives of the deal have been less noted. Carnegie wanted to retire, but the obvious solution was an IPO for an independent Carnegie Steel. An offering for the world’s biggest (and, probably, most efficient) steel company might attract the investing public, but it would also, at $480 million, have been the world’s largest-ever IPO, and by a large margin. It was far from clear that the New York market had this capacity: the amount of cash raised in 1900-1904 from the general public averaged only $40 million a year from common stock issues and $29 million from preferred; bonds - mainly for the railroads - raised another $521 million annually.59 London could have taken some of the strain, but in 1900-1904 even London was able to direct only $230 million annually to worldwide issues of all private overseas borrowers.60 It becomes evident that an IPO was probably not the answer. The decisive brilliance of the Morgan plan was that it was all-paper and avoided an immediate and large call for cash
57Bureau, Steel Industry, pp. 243-49; Carosso, Morgans, pp. 466-74; Commercial and Financial Chronicle, 72, 9 March 1901, pp. ix-x. The syndicate’s stock entitlement – but not
the insider participation – were disclosed in the accounts for 1902. 58 Pujo, Hearings, p. 1088. He stated it would be desirable to outlaw this behaviour in New
York, but difficult because of competition between stock exchanges, ignoring the point that
in Britain (as in America later) it was legislation, not a stock exchange rule, that achieved
this. 59 Goldsmith, Study, pp. 489, 503, 505. The much higher figures routinely quoted do not
allow for issues below par, exchanges, stock retained by vendors etc. 60 Davis and Huttenback, Mammon, p. 41.
subscriptions. It required the underwriting syndicate only to provide a (more manageable) $25 million of new cash for operations, though they were potentially liable for a further $175 million, in the unlikely event that both preferred and common stock prices fell to zero, so that the Carnegie price guarantee could not be met.61 The world’s “first billion dollar manufacturer” simply merged existing paper, with some questionable adjustment of rights, into one federation.62 It was not so much an IPO, more a highly creative way of sidestepping an IPO that would probably have failed. There is something faintly comic in this situation. When Andrew Carnegie - who owned 55% of Carnegie Steel – assented to the deal, Pierpont, probably correctly, congratulated him on having become the richest man in the world. It is difficult to think of anyone who could more appropriately shoulder equity risk, even in a retirement and philanthropy portfolio. Yet he had no faith in Wall Street, in Morgan, or in the new company (he knew that Federal Steel, the main Morgan component and a virtually identical business to Carnegie Steel in all except size, had been so managed that its rate of return on capital was only half that of his own steel partnership) and he insisted on payment in 5% gold bonds. This was not an issue on which Morgan could rely on European precedent: European business owners usually wanted to retain some of the equity action when going public; and efficient firms acquired inefficient ones, rather than vice-versa. Moreover, no European manufacturer was even one-third the value of Carnegie Steel and the only American industrial that was bigger - Standard Oil – was not listed on the NYSE until 1920.63 This was a unique challenge. US Steel would, therefore, naturally find it difficult to benchmark fees, but its discussion of the matter was no doubt simplified by Morgan partner George Perkins,
61 The amount underwritten was presumably much less than the full issue, because only the
Carnegie partners’ non-bond payment needed to be covered. 62 It was worth $1,133 million (Bureau, The Steel Industry, p. 242), but was not the world’s first billion dollar corporation. The Paris-Lyon-Méditerranée Railway had already exceeded
that in the nineteenth century. 63 Its stock was still owned by the Rockefellers and other founding families, who trickled it
out slowly to the public on the curb over many years A major difference between London and
New York was that in New York stock was gradually released by families in this way (and
also by syndicate members in NYSE listings), rather than measurably subscribed in a public
issue. London’s listing rules, that required that at least two-thirds of an issue be sold to the
public, partly explain why London more closely resembled modern IPO practice and had
lower levels of family ownership.
who chaired its finance committee. Such conflicts of interest may be against all the modern rules of corporate governance (and the Bureau of Corporations and the Pujo Committee were suitably shocked), but in 1901 the rule book was still being written by Morgan. Effectively the only restraint on his profits in this exceptional transaction - in which he was, effectively, both client and banker - was his sense of moral responsibility and the threat of competition. Moral compasses are often erratic when such large sums are involved, but we can analyse potential competition. It certainly existed: in 1899 Carnegie had conditionally sold Carnegie Steel to a promoter for a third of what he later got from Morgan, but the promoter had failed to deliver, forfeiting the $1 million penalty specified in the option contract. There were, of course, other large investment banks undertaking significant corporate finance business, but this penalty would have made them pause for thought. Morgan was already the most respected investment banker, and he would have to share underwriting commissions quite broadly. He had successfully launched Federal Steel, reconstructed leading railroads and rescued New York from the 1895 panic. Perhaps it was now payback time: his reputation was at its height and he had a bold, new idea. In Europe, liquidity for developing large public issues was provided by giant, multi-branch commercial banks with substantial capital and large retail deposits, but America’s banking laws kept all but a few banks small. Morgan’s networking with these few banks and rich individuals gave him access to the short term funding that could be required on a scale that probably no one else in New York could replicate.64 In effect, because of a mixture of retarded equity market development, small commercial banks and an uncharacteristic burst of originality, Morgan was a monopolist for this transaction. The total fee for Morgan & Co and the underwriting syndicate was fixed at $130 million stock at par, half in common, half in preferred. Out of this, $3 million actual cash expenses, and the $25 million cash paid by the syndicate to the corporation, need to be deducted to determine the gross profit of the syndicate. The fee was paid in paper (there was nothing else in which to pay it), so Morgan also had to unload the stock onto the market on behalf of syndicate members. In the first year the stock traded at 31% below par, so the syndicate realised $62.5 million net.65 This was a complex and creative transaction and surely justified more than the few million dollar fees for a large railroad reconstruction of one quarter its size, but twenty or thirty times more? In
o64 Vanderlip, Fr m Farmboy, p. 193 and see n. 6, above.
65Bureau, Steel Industry, p. 38. $12.5 million of this was Morgan’s but it is not clear how
much of the $50 million syndicate profit they also retained
essence, the transaction had three elements. Allocating the total profit among these in the ratio 1:2:3 suggests rates of 42% on the $25 million new cash subscribed, 16% on the further $175 million underwritten and 6% on the $1,133 million value of paper shuffled. To present any part of this transaction as a payment for “information signalling” would require someone with the imagination of Mark Twain (and he was on the other side). I do not know of any significant transaction in any country at any time where such fees have been charged. This was an exceptional transaction and these were exceptional fees. Morgan’s men had done a workmanlike job establishing the new firm. Steel was a good growth industry (capacity was doubled in ten years) and Judge Gary, the president, if unable to match Carnegie as a steelman, excelled at running a large bureaucratic federation with capable managers (building the image of a “good trust” by cultivating price stability, profit sharing and exemplary accounting transparency). The company had curtailed the immediately threatened competitive investments being planned by the merging partners and had more than half the market in many steel products. It was also able to buy some troublesome competitors and massive protective tariffs locked out foreign competition, so it is difficult to believe market power did not play a part in its rising profits, particularly as there were no conceivable economies of scale in steelmaking at a size larger than Carnegie Steel. Wherever the profits came from, they fully covered fixed payments on bonds and preferred and still left something for the common.66 Even so, the latter was no more than averagely successful: on De Long’s data, investors would have done slightly better selling out at US Steel’s birth and investing in the NYSE index. This was, then, a merger which did not turn out too badly for investors, and turned out immensely well for the insider managers and bankers in the syndicate. Given that Tobin’s q approached 2 for US Steel, the puzzling question (to which American economic history has not given a satisfactory answer) is why more new plants were not built to force steel prices down to nearer long-run marginal cost. Maybe the rapidly growing American economy had so many financial needs, for capital
66 The market in 1899-1900 valued the constituent firms’ equity and bonds at $793 million,
17% above their asset value; after the merger they were valued (at average first year prices)
at $1,133 million, 94% above asset value (Bureau, Steel Industry, pp. 20-1, 37, 170). The
difference between the two percentages suggests the capitalized value of expected future
increased monopoly profits and/or management savings around 1901 was $287 million. The
value of the common stock then was $223 million, implying that without these expectations
the common would have been worthless.
widening and deepening, and so little financial capacity, that disequilibrium conditions such as this could persist for a long time. There was a fringe of competitors but their costs were high. The question really boils down to why only US Steel (rather than a fringe firm or a new entrant) built a new, state-of-the-art $70 million multi-plant complex, like that at Gary, Indiana.67 The answer may lie in vertical restraints (ore ownership or predatory pricing threats) or it may be that US capital markets still had only one man who could undertake risky financings at that level: if so, Morgan was a formidable barrier to entry. Whatever the correct answer to this question for the early twentieth century, it soon changed and US Steel accordingly began its long and inexorable relative decline. The world’s largest manufacturer was hardly a trendsetting precedent for the future of US finance and market structure and Redlich’s judicious summary of Morgan’s last decade or so - “profitable rather than economically desirable” - still carries some weight.68 Far more typical of America’s oligopoly future was the electrical industry, with three strong competitors (General Electric, Westinghouse and Western Electric), but - although Morgan had all three as clients - their issue business was sparser and less profitable. The highly leveraged steel merger (at average first-year market prices, there was four times as much capital in bonds and fixed interest preferred as in common stock) was also more like old-style railroad finance or new monopoly utilities than the lower levels of leverage which had been, and later again became, the corporate norm in competitive industries. Morgan’s vision of a capitalism of controlled competition of railroad-like, quasi-monopoly industrials receded. By 1910, a new generation of more competitive and diverse American banks was taking over from the Pierpont generation, exploiting new ideas and opportunities, soon lauding equities over bonds and democratising the limited and unusually plutocratic stockholding population that Morgan knew.69 The New York capital market of the 1920s was wider, deeper and more competitive. Even Morgan’s insider dealing and conflicted roles became disapproved, and, eventually, illegal. LONDON NEMESIS
67 Bureau, Steel, p. 265; Stigler, “Dominant Firm.” 68 Redlich, Molding, p. 384. 69 Ibid., pp. 376, 380-81, 383
The obvious test of whether protection and quasi-monopoly in product markets, and market power and conflicted roles in financial markets, jointly explain some of Morgan’s high profits in American deals is to compare the outcome of his similar activities in Britain, a tariff-free economy with a more competitive financial market, that had developed earlier and had larger corporate banking and securities capacity than New York. Rumours of Morgan merger initiatives multiplied on the other side of the water in the early twentieth century, as Europeans looked with incredulity at the merger into the steel behemoth of Carnegie Steel, itself already six times larger than any European steelmaker.70 Yet no European steel manufacturers before 1914 saw any compelling advantage in being much larger than the Gary plant and many in Britain, France and Germany operated profitably at much smaller scale. The London partners (and the, rather smaller, Morgan Harjes partnership in Paris) could do little merger business, even on a smaller scale, in this, or other industries. In London, they also met livelier competition from boutique finance houses, stockbrokers, accountants, solicitors, foreign banks, sector specialists and company promoters, as well as from bigger players. In 1900, the Rothschild banks - in London, Vienna and Paris - together had $180 million capital, and the family had much more personal wealth in reserve; while the self-made, German-born, British-naturalised partners in Wernher Beit, the specialist London mining finance house, were personally (jointly) worth more than Morgan and they controlled investments worth $359 million.71 Yet, in so far as anyone dominated new issues for ordinary British businesses, it was the City of London Contract Corporation, a boutique collaborating on new issues with Phillips & Drew, the stockbrokers. With perhaps 10% of the market in the 1890s, it offered a cheap and honest service and its solid reputation with the large retail banks meant that, even on its modest capital, it could readily pay vendors and carry assets prior to public issue, when required.72 This, it will be recalled, was, for De Long, precisely London’s problem: too much competition. Yet, nothing in London prevented firms like Morgans - “first class firms whose reputations and profit are dependent on
r e
70 The only steelmakers of remotely similar scale in Europe -Armstrong-Whitworth and
Vickers in the UK and Krupp in Germany - had 1900 capitalisations in the $47-$67 million
range and were all integrated arms manufacturers of the kind that did not then exist in the
USA. These three specialist firms in the European military-industrial complex apart, all the
rest of the world’s steelmakers were smaller than all the main merging firms of US Steel. 71 Ferguson, Wo ld’s Bank r, p. 1039; Chapman, Merchant Enterprise, p. 278. 72 O’Hagan, Leaves.
fair dealing” – attempting to play a role as quality certifiers of new issues and erecting entry barriers if they did it successfully.73 Indeed Morgan and a few other banks had achieved that in London issues for American railways, which was why they first came to prominence in New York. Competition did, however, mean that their certificate had to mean something to command premium fees and that these fees had to be closely related to costs. Hence, fees were generally lower in London than in New York, particularly for the larger issues. Even for small IPOs equivalent to around two million dollars – smaller than the New York partners would normally look at – the British merchant bank, Hambros, charged only 1-2% of the money raised, with 3% optional extra for underwriting.74
One possible Morgan strategy in this more challenging market environment was servicing European capital with strong American interests, such as railroads in the past. Vickers, the British warship builder, was in 1900 interested in buying its smaller, unintegrated US equivalent, Cramp’s Philadelphia shipyard, but Morgan found himself on the other side: helping the American family firm with its liquidity crisis and setting up a voting trust to prevent foreign takeover. Another possibility was rich American entrepreneurs, many of whom then spent part of their spring and summer in London. One such was George Eastman, who floated his photographic enterprise in London as Kodak Limited in 1898 (his Rochester NY factory was a subsidiary of the English company).75 However, Eastman was not impressed by bankers and their fees in New York or London, so he decided to dispense with them, managing Kodak’s IPO himself. His brand name, and the addition of Lord Kelvin (a well-known Glasgow professor of physics) and a few other respected British names to the board, was sufficient to guarantee the success of his do-it-yourself IPO in London. He set up a large temporary clerical operation for processing the paperwork and paid modest fees to a lawyer to approve the details and to a stockbroker to negotiate listing committee approval. Eastman had realised that professors offered cheaper quality certification than merchant bankers and that a sterling issue for the equivalent of just over $3 million was a fairly routine operation. Few people had Eastman’s time (or imagination) to do things this way: the division of business labour really does make sense. When he later moved Kodak’s headquarters to Rochester, Eastman was content with the New York curb for local dealings, but the new Eastman Kodak Inc. dollar stocks were professionally
73 Lavington, English Capital Market, p. 192. 74 Rutterford, “The Merchant Banker,” and see also O’Hagan, Leaves. 75 Brayer, Eastman, pp. 168-86; Stock Exchange Official Int lligence 1901 and 1913.
re-listed in London, cheaply and without fuss (foreign denominations were no problem in London and, since the end of the silver controversy in 1900, international investors no longer considered the dollar risky). The British coal industry (at that time the world’s leading energy exporter) was populated by many family firms, while Pennsylvania anthracite provided a model of consolidation, buttressed by Morgan railroad control. The London house in 1901 merged some Scottish collieries into United Collieries, offering 1million (about $5 million) of its debentures, at a high 10% commission. They later really had to earn it, lending the poorly managed company the interest payments to prevent default, while its two Morgan directors sorted out problems. This appeared to be an industry in which it was difficult to compete with personal owners and the company had no market power: unlike Pennsylvania, Glasgow’s coal transport (by ship and rail) could not be controlled.76 Other issues also paralleled its New York interests: they included Edison & Swan, British Thomson-Houston, Electrical Power Distribution, British Electric Traction and the National Telephone Company. Curiously, their American bankers kept the two British halves of the 1892 General Electric merger apart: it was decades later that GE managers explored a consolidation of the US-inspired electrical manufacturers in Britain.77 Morgans were able to charge 6% for brokerage and underwriting of the National Telephone Company’s 1901 1 million offering of preference shares, but this company
was no British AT&T. British investors knew its franchise was insecure (it was competing with the
Post Office, which eventually took it over) and only 15% of the shares were subscribed, leaving
Morgans barely covering costs on the deal. The London house also spearheaded a takeover of London’s underground railways (built forty years before New York’s and badly needing modernisation), but were beaten to it by Speyer Brothers, an American investment bank also operating in London.78 The partners were doing modest corporate finance deals with modest profits, but they apparently did not have the distinctive capability in the London market that they enjoyed in New York. De Long does not directly address the issue of why Morgan’s supposed magic did not work for Britain, but hints (p. 230) that the firm may have foreseen Britain’s decline, so focused elsewhere. (Having a quarter of the partners - including the next senior partner - in London was hardly a headlong rush for the lifeboats?) More generally, of course, De Long believes that domestic competition was a crushing burden for British finance. (In light of their
76 Economist, 28 June 1902, pp. 1007-08, Carosso, Morgans, p. 497. 77 Jones and Marriott, Anatomy, p. 89; Carosso, Morgans, pp. 271-72, 496. 78 Economist, 1 November 1902, pp. 1674-75.
London profits, one can imagine the Morgan partners agreeing?) A more plausible answer can be found at the bottom of De Long’s performance list: International Mercantile Marine. He (correctly) treats this as an American corporation, but it was Morgan’s flagship British deal, with a higher profile at the time in Europe than US Steel (which neither sold nor invested overseas significantly). Essentially a merger of key British shipping lines, its American-flagged ships accounted for only 15% of its assets.79 The first moves to consolidate the north Atlantic freight and passenger trade – the largest world market for shipping - were made by John Ellerman, an analytical, 36-year old, British boutique financier, involved at the time in breweries, shipping and meatpacking. As chairman of Britain’s Leyland Line, having failed to buy his smaller British rival, Cunard, he bid for Atlantic Transport, a small, Baltimore-based, shipowner. Clarence Griscom was then president of the Philadelphia-based International Navigation Company, which owned some downmarket, loss-making, US-flagged liners on the key New York-Southampton route and made its profits on European-flagged niche routes between Philadelphia, Antwerp and Liverpool. He had interested Morgan in his own plans to create an American champion on the north Atlantic – the United States was only a bit player in international liners - and opposed the idea of a British takeover. Ellerman could hardly believe the reckless prices - 50% above replacement cost – that Morgan was willing to pay for shipping assets. He changed tack and agreed to sell Leyland. Morgan naturally offered Ellerman an insider deal for recommending the offer to shareholders, but Ellerman insisted on full disclosure and the insider price for all shareholders, all in cash not paper. Morgan’s reaction is not recorded, but he paid up, buying the line for his personal account. Wider talks – involving both European and American partners – then took place, with the world’s largest shipbuilder (Harland & Wolff of Belfast, Ireland), the upmarket British line (White Star), smaller British fleets, and the leading, continental owners: Hamburg-based HAPAG, Bremen-based NDL and the Holland-America line (the Compagnie Générale Transatlantique was excluded because it was known that its French
government contract barred foreign ownership). Eventually it was agreed that continental competition would be neutralised by a ten-year, profit-sharing cartel agreement with
e e
79 This account is based on Navin and Sears, “A Study;” Vale, Ame ican Peril; Saliers, “Some
Financial Aspects;” Field, “International Mercantile Marine;” Carosso, Morgans, pp. 481-86,
491-93; Moss and Hume, Shipbuilders pp. 96-174; O’Hagan, L av s, pp. 384-85; Taylor, Ellermans; Huldermann, Ballin, pp. 40-130; Yui and Nakagawa, eds., Business History.
the two German lines, while the new company would have a priority-guaranteed, cost-plus ship supply contract with Harlands, who would (on behalf of the other interests) buy majority control of the Dutch line. The new, American-registered, International Mercantile Marine Company (IMM) was the vehicle for the 1902-03 merger of the core partners. It would be the largest shipping company in the world, with an unprecedented million tons capacity (equalling the entire French merchant marine), providing scheduled service on 32 transatlantic routes, using 127 ships, including most of the world’s fastest and largest liners. It was essentially a merger of the British flagged lines - Leyland, Dominion and White Star - with the small Baltimore and Philadelphia companies Most of the company’s ships would continue to fly the British flag: Morgan partner Sir Clinton Dawkins had smoothed ruffled British feathers by negotiating an agreement that these American assets would be available to the British government in time of war. However, the balance of ownership and control had decisively shifted and – a year after Ellerman’s sale of Leyland – the British-owned liner companies on the north Atlantic were relegated from first to third rank, behind the USA and Germany. Substantial cash payments were required both for the British assets and for all new ships ordered from Belfast. This swallowed almost all the cash proceeds of the $50 million bond issue, underwritten by a Morgan syndicate, nearly 30% being placed in Britain and overseas by the London partners. Perhaps half the preferred stock went initially to British interests, but more than half of the $50 million common and some preferred were the Morgan syndicate’s fee. This was, at par and proportionately to capital, of the same ample proportions as the US Steel fee. Morgan avoided the problem of the competitive London banking market in setting fees, as in the USA, by setting them himself. This was perfectly legal in Britain, but, as the offer document was to go to a British company’s shareholders, only if the fee was disclosed. It was, in May 1902. To the British press this appeared excessive dilution and, since the deal would put the New Jersey company’s paper beyond British shareholder protections, the Economist advised that shareholders should, like Ellerman the previous year, insist on full cash payment and bail out.80 However a third of the key White Star shares were owned by British managers who were inspired by Morgan’s financial power and business vision. They carried the shareholder vote to accept only 25% in cash, taking the rest in IMM stock. The partners recognised that there was a good deal of water in the capitalisation, but most of the upside lay in American hands. No one, for obvious reasons, mentioned
80 Statist, 3 May 1902, p. 893; Economist, 10 May 1902, p. 733.
cheaper finance, but the aim was for increased market power, better fleet scheduling to improve load factors, management savings from applying American methods, and a growing, modernised fleet. The Wall Street Journal expected the new management would raise profits from $6.5 million to $11 million, enabling the company to pay the full preferred 6% dividend and 3% on the common. The disastrous outcome for all except those who took the Morgan dollar and ran is well known and appropriately reflected in De Long’s quantitative evaluation: a rate of return of minus 25% annually on the common between 1902 and 1913. It is no accident that Ellerman - the British financier who initiated the merger process, then yielded to Morgan’s superior firepower, while insisting on payment in cash - is the only contemporary Briton known to have died richer than Pierpont Morgan, who lost at least a million dollars on this deal, while others lost a good deal more.81 Morgan & Co and their underwriting syndicate members could only unload IMM securities on the public at a heavy discount (by January 1904 the common traded on the curb at 95% below par and the preferred at 80% below par). No dividends were paid on any of the stock, except, for a time, to the continuing minority holders of Leyland preference shares (Ellerman, puzzled at how Morgan could pay a dividend, had put his lawyer on the board and left a ring-fenced structure to protect them). IMM’s 4½% bonds also fell below par and by 1906 Morgan had still only been able to dispose of 20-25% of them. Morgan saved face by paying the bond interest in some years when IMM could not, but this charade ended with his death: IMM finally defaulted on its bond interest payments in 1914. The north Atlantic cartel was ineffective in raising prices and was not renewed when it expired in 1912. The German merchant marine edged America’s down to third rank, globally, in the years before the war. Ellerman thought that Morgan had overpaid for the assets, but, by the same metric, he had also overpaid – and by a wider margin - for US Steel. That metric was market-to-book: precisely the measure of De Long’s first test. IMM, however, could not generate the monopoly profits or management savings required to recover from the mistake and its failings were even greater than the financial results indicated. The White Star line had previously ploughed back 85% of its profits into the development of the business (a figure also approached by its rivals, Cunard and HAPAG), but Morgan’s generous capitalisation had been based on the idea of reducing this to 30% by increasing the investor payout. The expected savings did not materialise and profits often fell
81Son of a German immigrant who left $3,000, Sir John Ellerman in 1933 left $179 million,
in real terms the largest ever British fortune.
below those earned by its predecessors, so the doubly reduced investment flow was absorbed by losses in the inefficient partner lines. While British and German companies made 5-6% depreciation allowances, IMM made under 3½%: clearly too little for a line aspiring to upmarket service, especially one whose underinsured Titanic sank on its maiden voyage in 1912. IMM - a takeover of a formerly well-run core firm by apparently weaker management, organised as a holding company, with high leverage and “world-beating” scale – shared all these key characteristics with US Steel. The minimum efficient scale in both industries was similar. The Gary multi-plant complex (at $70 million) may be taken as US Steel’s own estimate of optimal scale and scope: it was vertically integrated and its many fabricating plants, managed by separate federated subsidiaries, produced a wide range of steel products. In the case of shipping, $70 million would buy 14 of the largest state-of-the-art liners at $5 million each, or more likely a mix with smaller ones (not all routes had the heavy traffic and premium passengers of New York-Southampton). A line that size – as many were - could offer frequent scheduled liner service between several ports. There may have been some agglomeration economies available to larger firms like US Steel and IMM that a $70 million firm could not capture (for example, shared marketing, or efficiency gains from owning both a Mesabi ore mine and a Pittsburgh tube extruder), but they are not obviously large. IMM was less vertically integrated, but it seems unlikely that owning Harland’s would have produced cheaper ships than its long-term supply contract. The fact that the White Star and Leyland lines (before IMM took over) and their British rivals on the Atlantic like Furness and Cunard (thereafter) were well managed and financially successful suggests Boyce is right about the effectiveness of British approaches to finance and information asymmetries in this industry.82 Within ten years, the smaller rump of British companies that had been left out of IMM had regained the Blue Riband liner speed record (important to first class passengers and the result of pioneering turbine power) and they again owned most north Atlantic tonnage, with a good part of the premium passenger market and clear dominance in freight. British tramps could easily move in and out of the north Atlantic trade from other markets, responding flexibly to changing profitability. The Irish shipbuilder partner, Harland & Wolff, regretted holding IMM stock, but its cost-plus orders (modernising the fleet but increasing its size by only 10%) preserved its own high profits. Ellerman, though barred by agreement from the North Atlantic for fourteen years, spent his cash
82 Boyce, “64thers.”
pile on building a new shipping line, soon one of the largest in the world and paying investors initial 6% dividends, rising to 7%. Of course, that did not mean that British managers and financiers were incapable of matching Morgan’s delusions of boardroom competence and financial omnipotence. Lord Kylsant did create RMSP - a group as large and dysfunctional as IMM - but that, too, eventually disintegrated. All dysfunctional firms in this industry disappeared; it simply took large ones a little longer. That points to the degree of competition they faced as the difference between the IMM and US Steel cases. Griscom was no Gary, but it is doubtful whether Gary would have been as successful in a competitive industry. IMM had a smaller initial market share (20% on the North Atlantic) and its cartel partners only a little more. Critically, IMM also lacked tariff protection, which was inherently impossible on the high se