BOND ISSUES

Graphically indicated the change was as follows:

Comparing the total interest with the total bond issue, we find the average rate to have decreased from 5.5 per cent to 4.9 per cent by the reorganizations prior to 1893, and from 5.1 per cent to 4.3 per cent by the reorganizations of 1893–8. Of some significance is a comparison of the rates prior to the reorganizations before 1893 with those subsequent to the reorganizations of 1893–8. The total interest payable on the issues at the later date was $38,291,319. If the same proportions of bonds had been issued at the same rates of interest as before the reorganizations prior to 1893, this interest would have amounted to $48,552,688. The total interest payable on the issues before the reorganizations prior to 1893 was $35,658,192. If the same proportions of bonds had been then outstanding at the same rates as after the reorganizations of 1893–8 the interest charge would have been $27,941,807. Thus in the first case there would have been a saving of $10,261,369 annually, and in the second case one of $8,279,775. This computation is inexact because it fails to take account of the normal reduction of interest rates due to improved credit and to increased prosperity from causes other than reorganization; but it is included here because, in the first place, a large part of the reduction was due to actual reorganization; and in the second place, because much of the improved credit is attributable indirectly to reductions of charges and other reorganization features.

It should be noticed that the new bond issues not only bore lower rates of interest, but were of greater volume and of longer term than the issues which they replaced. The greater volume is reflected in the considerable reduction in the number of issues at the same time that the total amount of bonds outstanding decreased slightly or increased. Thus the reorganizations before 1893 increased the amount of bond issues from $645,605,522 to $788,629,515, and decreased their number from 128 to 98; while the reorganizations of 1893–8 decreased the amount of bonds from $919,836,832 to $881,574,002, and decreased the number of issues from 189 to 90, or in far greater proportion.714 The matter may be viewed in another way. Just before the beginning of the later reorganizations the predominant rate of interest for the roads concerned was 6 per cent. The number of issues at 6 per cent outstanding was 85 and the average amount per issue was $3,540,302. The predominant rate just after those reorganizations was 4 per cent. The number of issues at 4 per cent outstanding was 16, and the average amount per issue was $32,544,319. In other words, the process was to replace numerous small issues which bore high rates of interest, by a few comprehensive issues at lower rates; thus simplifying the financial situation, as well as lightening the burdens which the roads had to bear.

The lengthening of the terms for which the various mortgages were to run is equally apparent. Before its reorganization in 1897 the Union Pacific had no mortgage issued for more than 40 years. The first mortgage of 1897 ran for 50 years. The Reading in 1895 had four mortgages, all issued during the reorganization of 1888, with terms of 70 years. All its other mortgages were for shorter periods. In 1897 it put forth a grand divisional mortgage with a term of 100 years. The Erie in 1894 had two mortgages of 91 years each and one of 84 years, issued during the financial scandals of 1869, but no other of over $1,000,000 which ran for more than 43 years. Both its prior lien and its general mortgage bonds now outstanding are to mature 101 years from date of issue. The Atchison in 1889 could boast of only one mortgage with a term of 51 years. Its reorganization at that time gave it two of 100 years. The Northern Pacific issued one 100-year mortgage in the course of its troubles in 1889, and two mortgages for 101 and 150 years respectively in its reorganization of 1896. The reason for long terms has been the wish to make new mortgages attractive. Reorganization mortgages, as has just been said, tend to be large mortgages, at a lessened rate of interest. They are also blanket mortgages with an inferior lien. Some inducement besides the compulsion of necessity is useful in securing the assent of old bondholders to the proposed exchanges of these bonds for outstanding securities. The long-term bond protects the holder against the probable steady fall in the rate of interest on capital. It promises him advantage in the future in return for surrender in the present.

The reduction in charges by the substitution, for mortgage bonds with fixed interest, of securities upon which payment of interest is optional, has been as important as the reduction in the rates of interest just described. Such securities may be either income bonds or stock. The income bond has a lien upon railroad property similar in kind to the lien of an ordinary mortgage. Upon default in the payment of its principal it can exercise foreclosure rights. But it has no claim on earnings except in a right to receive dividends out of net earnings before any dividend shall be paid upon the stock. Stock certificates control the company by their right to vote,715 but are entitled to its profits only after expenses of every kind have been met. When divided into preferred and common shares the former receive preference in dividends and sometimes in voting power. Among the reorganizations described in the text three made use of income bonds before 1893 and one after 1893. The amounts of the issues and the percentages of incomes to total capitalization before and after the reorganizations were as follows:

Income Bonds

The East Tennessee reorganization of 1886 did away with income bonds, as did that of the Atchison in 1892. It will be noted that these bonds were more used before 1893, owing probably to the fact that the name of bond was considered to increase the salability of a security on the market. Securityholders hesitated to accept stock, but received bonds without too great a protest. The extent to which railroads catered to this preference is seen in the case of the Reading deferred income bonds, on which payment of interest was deferred to a 6 per cent dividend upon the common stock. From certain points of view, however, the income bond is inferior to preferred stock. For instance, preferred stock almost always has voting power, while income bonds usually have none. And although the income bondholder is sometimes protected from the insertion of new claims upon earnings between his bond and the underlying property, provisions in preferred stock certificates may afford an equal guarantee. In consequence, the use of income bonds has declined as a more accurate knowledge of their limitations has become widespread, and the Atchison adjustment 4s represent the sole use of this security in our reorganizations from 1893–8.

The exchange of preferred stock, with or without new bonds, for old bonds which have borne a fixed interest rate represents the best current practice. Six of the seven principal railways reorganized from 1893–8 retired old bonds with fixed interest by new bonds and preferred stock or by preferred stock alone. Take for illustration the case of the Erie, which exchanged new general lien bonds and preferred stock for old second consolidated bonds; of the Northern Pacific, which exchanged new prior or general lien bonds and preferred stock for its second and third mortgages; of the Union Pacific, which gave 4 per cent bonds and preferred stock for its old first mortgage 6s; exchanges which are but typical of a widely extended use. Even the Reading, which alone refused so to lighten the claims upon its earnings, employed preferred stock in retirement of old first, second, and third income bonds.

These issues were all protected from future introduction of new bonds between them and their property. The preferred stock certificates of the Atchison in 1897 contain the following words: “No mortgage, other than its general and its adjustment mortgage, executed in December, 1895, shall be executed by the company, nor shall the amount of the preferred stock be increased unless the execution of such mortgage and such increase of preferred stock shall have received the consent of the holders of a majority of the whole amount of the preferred stock which shall at the time be outstanding, given at a meeting of the stockholders called for that purpose, and the consent of the holders of a majority of such part of the common stock as shall be represented at that meeting.” Similar restrictions were imposed by the Southern in 1893, by the Erie in 1895, by the Northern Pacific in 1896, by the Reading in 1896, and by the Baltimore & Ohio in 1898; or in other words by all the large corporations except the Union Pacific, whose failures in the nineties we have described.

As for the years before 1893, in them the use of preferred stock was known, if not so widely resorted to. The East Tennessee in 1886 offered new consols and preferred stock for old consols, divisional and debenture bonds. In 1881 securityholders of the Reading proposed, and in 1886 nearly secured, the adoption of plans which comprised extensive issues of preferred stock in exchange or in partial exchange for old mortgages. The influence of English capital, however, and the liking for the name of bond to which we have referred seems to have prevented large employment of the device. Where either preferred stock or income bonds were used protection was afforded. When, in 1875, all the outstanding bonds of the Northern Pacific were replaced by stock, provision was made for an issue of first mortgage bonds to an average of $25,000 per mile of road completed; but no other bonds were to be issued except on a vote of at least three-fourths of the preferred stock at a meeting specially held in reference thereto on thirty days’ notice. In the Reading reorganization of 1886 a clause provided that in calculating the net earnings from which dividends on income bonds should be paid there should be deducted from gross profits operating expenses, taxes and existing rentals, guarantees and interest charges, but not fixed charges of the same sort subsequently created. And in the case of the Atchison in 1889 the provision that no bonds could be inserted between the incomes and the general mortgage 4s was so absolute as to prove an almost complete bar to new issues.

It is this use of preferred stock and income bonds which makes it possible to realize the last and highly important rule which the engineers of exchanges have in mind. Only by the combined use of securities upon which payment of interest is optional with securities upon which payment is obligatory can the claims which their corporations are forced to meet be reduced, while at the same time former bondholders are given the chance to share in future prosperity. Such a result is deliberately sought. “The general theory of adjustment of disturbed bonds,” said the Richmond Terminal reorganization plan of May, 1893, “has been to substitute for them the new 5 per cent bonds to such an extent as is warranted by the earnings and situation of the properties covered by the present mortgages, and the new preferred stock for the remainder of the principal.” This purpose receives, moreover, a natural development. Justice does not demand that old bondholders be given the unlimited chance at future surpluses which old stockholders should enjoy. Their former holdings could expect but a fixed amount, and the maximum to be paid on their new bonds and preferred stock is therefore rightly restricted. But fair play dictates that they be given opportunity to receive the same income as before. If they must surrender 6 per cent bonds in exchange for 4 per cent bonds it is equitable to allow to them as well 50 per cent of their original holdings in new 4 per cent preferred stock. The corporation thus announces its intention of saving them unharmed if it can possibly do so, while it insists that its solvency be not dependent on the success of its attempt. This idea has been realized in a number of cases with approximate exactness. The old third mortgage 6 per cent bonds of the Northern Pacific in 1896 received 118½ per cent in new 3 per cents, 50 per cent in 4 per cent preferred stock, and 3 per cent in cash,—which together could yield nearly the same as the old mortgage. The holders of Chicago Division 5s of the Baltimore & Ohio in 1898 surrendered an annual income of $50 for a chance to receive $50.30; the Union Pacific first mortgage 6s in 1898 obtained precisely 100 per cent in new 4 per cent bonds and 50 per cent in new 4 per cent stock. It would be too much to expect that such exactness should generally obtain. The variations in security between issues, the well-founded desire to distinguish and not at the same time to swell unduly the amount of new stock put forth lead to fluctuations both above and below the point of equivalence of return. The important fact to remember is in short this: that the use of bonds with a fixed rate of interest, together with bonds or stock upon which payment of interest is optional, provides that compromise between the interests of the old bondholders and the interests of the corporation which alone can afford justice to both sides and can allow the reorganization to proceed.

The matter of rentals may now be considered. “The extent of the reduction in rentals from reorganization,” says one authority,716 “is seen where the reduction of this item of fixed charges for the entire country is considered. The net reduction in lease rentals from 1892 to 1898 was $24,527,000, and of this sum $17,768,000 appears in the South and West where the failures where most numerous and extensive. The reductions of rentals are most conspicuous in the Northwest and Pacific coast railroads. It is true that a part of this decrease in rentals is to be ascribed to the steady movement in the direction of consolidation which is constantly converting lease into purchase; but coming so close together, the difference between the figures of 1892 and those of 1898 is sufficiently marked to warrant the conclusion that most of the reduction is due to the numerous reorganizations which intervened.”

This conclusion is at first sight borne out by the following tables, which show the decreases or increases in absolute rentals and interest for thirteen reorganizations, of which six fall within the period covered by the quotation:

FIXED CHARGES

It appears that while the decrease in rentals was of little importance in the six reorganizations before 1893, it was of great importance in the reorganizations from 1893 to 1898. Whereas absolute interest charges were reduced by none of the later reorganizations by over 40 per cent, four of the railroads cut rentals by over 60 per cent, and two others might have shown a similar result if a satisfactory division between interest and rentals could have been made. Unfortunately, both these statistics and Meade’s statement are open to criticism for the reason which Meade recognized but to which he did not give sufficient weight. The relative amounts of interest and of rental paid by a railroad at any time represent the method by which its system is held together. If a parent company raises money by the sale of bonds, and purchases its branches outright, or buys a majority of their shares, its interest charges will be large and its rentals small; if it leases these same lines its interest payments will be small and its rentals large. A steady movement in the direction of consolidation doubtless existed before 1893, but this movement was certainly accelerated by, and made a prominent feature of many of the reorganizations of the following five years. Thus the Northern Pacific in 1893 reported a total length of line of 5431.92 miles; of which leased lines and lines operated under contract constituted 1912.92. In 1898, after reorganization and surrender of the Wisconsin Central, it reported 4524.45 miles owned and operated, of which 2430.42 consisted of main line, and 2030.82 of branch lines owned. The Erie in 1893 reported 551.12 miles leased and 598.51 operated for 32 per cent out of a total of 1970.32.718 Four years later it either owned outright or held a majority of the stock of 1806.92 miles out of a total of 2162.81. The Baltimore & Ohio operated 26.5 per cent of its mileage in 1897 under lease or contract, but had reduced this by 1899 to .5 per cent. The Southern Railway proportion was 38.1 per cent in 1892 and 28.4 per cent in 1895. A reduction in rentals through reorganization has occurred, but a reduction due nevertheless largely to consolidation of systems, rather than to revision of rental contracts.

It was partly because of the difficulty of exact statement on the subject that a discussion of rentals was postponed till the matter of interest should have been considered. It now appears that the reduction in interest payments which was so prominent took place in spite of a reduction in rentals. If, for instance, the annual interest charges fell $10,261,369 in the course of all reorganizations, and if in later years the interest figures represented charges which at earlier date appeared as rentals, then the real reduction in interest was greater than the figures show. It is true that consolidation is not responsible for all of that decline in rentals which has occurred. It is as open to a reorganizing railroad to continue old leases at easier terms as it is to absorb the leased roads into its system; and much of this has been done. The East Tennessee, Virginia & Georgia, for instance, leased the Memphis & Charleston in 1877 for a yearly payment of $297,750; while the Southern Railway Security Company a few years before had agreed to pay $318,763.50 annually for the same property. And it is a fact that both consolidation and direct agreement have been the occasion of considerable reductions in the payments for the control of subsidiary lines. There is no reason why leased lines which have not earned their rentals should not suffer as much as portions of the main system which have not earned interest on their bonds. On the whole, then, rentals have decreased, both by means of direct negotiation and through an absorption of leased roads into the main system accomplished by exchange of new securities for old. The significance of precise figures must not be exaggerated. The losses which have occurred have been distributed according to the same principles which have already been detailed.

It is now clear that creditors, stockholders, and syndicate in practically all successful reorganizations agree that cash must be raised, fixed charges reduced, and the losses distributed according to the seniority of existing claims; and that of all methods the comprehensive exchange of new securities for old is best suited to accomplish at least the last two of these necessities. To give a comprehensive view of the operations the capitalization after reorganization of the roads which have been studied may be compared with the capitalization before. It will then be possible to see at a glance the consequences of the great variety of exchanges. The following table gives the percentages which the stock and bonds of these companies bear before and after reorganization to the total capitalization before.

CAPITALIZATION

The most striking fact is that every reorganization but one has occasioned an increase in total capitalization.720 The increase varies from 1.3 per cent for the Atchison in 1892 to 88.3 per cent for the Baltimore & Ohio in 1898; and the average increase is 32 per cent for the later period and 14.4 per cent for the earlier. This reflects the exchange of new securities on which a lower rate of interest is payable with securities on which all payments are optional, for old securities which claim a high annual return. It is the result of the attempt to reduce the demands upon reorganized corporations without materially reducing the sums which old securityholders may in times of prosperity receive. It reflects also, however, the sale of securities for ready cash, or the exchange of these for assessments, as well as the investment of minor sums in the improvement of the roads. A closer examination of the table shows that the increase comes chiefly in bonds before 1893 and in stock after that date. The average increase in bonds of the seven reorganizations before 1893 was 11.4 per cent and of common stock .9 per cent; whereas bonds decreased between the reorganizations of 1893–8 from 65.8 per cent to 59.1 per cent of the previous capitalization, although common stock increased 9.2 per cent and there was introduced a great volume of preferred stock which is scarcely found at all before. The less radical nature of the early reorganizations and the use of income bonds instead of preferred stock as a security with optional interest are here apparent. In brief, the statement of capitalization before and after reorganization summarizes and confirms the conclusions which we have reached. A few fundamental principles have underlain the complicated details of the exchanges of new securities for old. These principles appear when the reorganizations are examined one by one, and they show not less clearly when all the reorganizations are taken in two general groups.

Another question now naturally arises. If an increased capitalization has been obtained without an increase in charges, owing to the lowering of the rates of bond interest and to the liberal use of stocks or income bonds, what has been the effect on the market value of the securities concerned? Is the aggregate value of the new securities less or greater than the aggregate value of the securities which they have replaced? It has been seen that taken as a whole less annual payments can be claimed from the railroads as of right. Has this fact decreased aggregate quotations, or has the larger volume of securities and the chance for dividends over and above the minimum interest, raised such quotations higher than they were before? The following tables compare the quotations of securities disturbed by the various reorganizations one year before the failure of their railroads, with the quotations one year after reorganization of the new securities issued to exchange for them. A third column is inserted to show the effects of years of prosperity upon quotations subsequent to reorganization.

It thus appears that the increased volume of securities of the reorganizations of 1893–8 sold for a less aggregate price than did the smaller volume which it replaced. Whereas the disturbed securities of the seven roads in question, multiplied by their quotations one year before reorganization, give a product of $654,394,232, the new bonds and stock given for the disturbed securities, multiplied by their quotations one year after reorganization, give a product of $548,027,663.721 This is not true for three of the four reorganizations before 1893, and it is not true for the reorganizations of the Baltimore & Ohio and of the Union Pacific in the later period. Individual causes account for most of the difference. The Reading reorganization of 1886–8 took place so soon after the previous failure that our method makes it necessary to take the quotations of securities “before reorganization” only five days after the railroad has left receivers’ hands. These figures are therefore unduly depressed. The Atchison reorganization of 1892 was voluntary, and was not caused by financial difficulties. The reorganizations of the Union Pacific and of the Reading in 1897 and 1898 respectively occurred later than most of the other reorganizations and benefited from the sharp increase in stock and bond quotations which began in 1897. For the seven reorganizations of 1893–8, to repeat, the aggregate market value of old securities before reorganization was greater than the market value after reorganization of the new securities given in exchange for them. The smallest changes took place in the senior securities. In the case of the Northern Pacific the aggregate value of the three prior mortgages disturbed increased from $85,498,685 one year before failure to $86,158,702 one year after foreclosure; while the consolidated or blanket mortgage of the company decreased from $36,032,360 to $29,235,111. In the case of the Reading the value of the general mortgage 4s increased from $37,160,977 to $37,383,503, while the first, second, and third income bonds decreased from $32,353,497 to $22,784,700. The reason was not generally a smaller increase in volume, but the fact that new bonds of fairly stable value were given for the better sorts of old securities, while old junior mortgages were apt to receive new income bonds or preferred stock, of which the value varied within wide limits.

The wide difference in the nature of the securities of the different roads forbids any attempt at precise classification. The following divisions may, however, be made: Three of the reorganizations from 1893–8 retired branch-line bonds for which quotations are obtainable, with a resultant increase in value for the issues of $3,256,127, or 14.2 per cent. Five of the reorganizations dealt with what may be classed as general mortgage bonds, and the value of the new securities given was to the value of the old as $182,160,406 to $196,186,382, or a decrease of 7.1 per cent. Three of the reorganizations retired junior bonds other than income. The value of the old securities was $47,874,648 and that of the new $22,272,174, or a decrease of 53.6 per cent. Four of the reorganizations retired income bonds. The value of the old securities was $40,913,662, the value of the new was $28,177,721, and the decrease was 31.1 per cent. Three of the reorganizations retired old preferred stock, and reduced the aggregate market value from $36,509,662 to $13,825,138, or 62.1 per cent. Finally, the common stock decreased 21.3 per cent from an aggregate value of $125,160,409 to one of $98,316,060. Stated in tabular form the result is as follows:

This makes more definite the conclusion which has been outlined in general terms before. The burden of the reorganizations from 1893–8 fell on the junior securities and stockholders. The holders of prior lien bonds actually had more value than before one year only after reorganization had taken place; the general mortgage bondholders had nearly recouped their losses; while the former position of the other creditors and of the stockholders was far from being regained.

It may be objected that the decreases in market quotations were due to a general decline in prices of securities and not to reorganizations of the roads in question. This objection, however, cannot hold. It is true that a general decline began in the United States in February, 1893, and continued through 1894, reaching its lowest point in August, 1893, and, after that, in March, 1895; and that this decline was due to general conditions of panic and depression. In 1895, however, a revival took place, and, proceeding with uncertain steps through 1896, became obvious and important in 1897 and 1898. The average date of failure from 1893–8 of the seven roads described in the text was October 1, 1893, and the average date of reorganization was September 1, 1896. Since the market price figures quoted are taken one year before failure and one year after reorganization, conditions in October, 1892, should be compared with those in September, 1897. The following diagram traces the movements of twenty-six important railroad common stocks between those dates. Quotations for none of the seven railroads in question are included.722