Companies in the United States are peculiarly reliant on capital markets to obtain debt financing. Whereas large firms elsewhere often turn to banks for loans, even mid-sized companies in America find it easier to float bonds. Many cite the relative lack of large ‘universal banks’ in the United States, at least up until the recent past, as the reason for this difference. However, it isn’t clear if this is a cause or effect of the unique characteristics of American finance. As always, history offers many potential answers though. Indeed, the dynamism of the American corporate bond market and its relatively markets-oriented banking sector goes back over a century and it may owe a lot to the nation’s railroads.
In the early-to-mid 19th century, on the eve of the railway boom, the United States lacked the financial infrastructure to finance any substantial capital-intensive projects. Most of the nation’s banks were small state-chartered lenders, a far cry from the large national banks of today or those already in existence at the time in Europe. These small banks focused principally on offering farm mortgages, a sensible and in-demand product in the still overwhelmingly agrarian economy. By contrast, they were too small to make large loans for infrastructure and industry.
Though the 1790s and early 1800s did see a proliferation of banking firms established to serve urban mercantile communities, these were in some ways even less fit for serving the nascent railroad industry than the mortgage banks. These urban firms were primarily focused on offering short-term credit to merchants and not the long-term financing that extensive projects like laying down railway track required.
Perhaps the only exception, the only firm large enough to serve the needs of railway entrepreneurs, was the Second Bank of the United States. That bank, headquartered in Philadelphia, was chartered and co-owned by the American federal government. It had a considerable equity capital of $35 million; however, it was less focused on direct lending to railroads than marketing their securities to other investors as a middleman. At any rate, the bank lost its congressional charter in 1836 and closed five years later, still early in the railway boom.
The first commercially successful railways were opened in Britain in the 1820s and owed a lot to the locomotive designs of George Stephenson, an English engineer. It took little time for the concept to transport itself across the Atlantic. Just two years after the first railroad to use steam locomotives opened in the north of England, the first American railway company, the Baltimore and Ohio Railroad, was founded. However, this railroad would be horse powered for its first few years in operation and at its opening had just 13 miles of track. Within a couple years though, the country was building 130 miles of track per year.
Of course, this pace was still lethargic compared to the rate of construction that would occur after the Civil War, in which many years saw over five thousand miles of track completed. However, even the capital required for these smaller projects was too much for the banking system of the country to handle. Easing matters somewhat, many cities and states provided support to the railroad industry, particularly to those building east-west lines as regions vied to be the best connected with the nation’s rapidly populating western frontiers. To these ends, states issued municipal bonds with state guarantees to provide financing to private railroads, a model that had already been used in the earlier canal building frenzy.
Though entrepreneurs behind north-south lines often benefited from land grants as well, they were generally forced to resort to finding private capital. These land grants were not insignificant though, contributing in-kind up to perhaps 5% of American railway investment between 1850 and 1880. This may also understate the true contribution of land grants to financing the country’s rail network because many railroads borrowed against the land granted to them, enabling them to raise even more money. Though north-south routes were judged to be of less strategic importance for the states, they could be more profitable, connecting established cities and already discovered resources.
However, the issue of finding sufficient capital was still troublesome. Turning to banks was not an option due to the lack of banks large enough to supply the requisite credit and the long-term financing required, to say nothing of the high-risk nature of the industry. Though seemingly a natural monopoly, the railroad business was not necessarily a safe one thanks to the large fixed costs and potential for mutually destructive ‘rate wars’ with competing railroads. It didn’t help matters that much of the investment was very speculative, track was often installed on a ‘build it and they will come’ basis.
Riskier investments in theory should be best financed with equity capital but that too had its issues. Selling stock in large public offerings was difficult due to the information asymmetries involved in 19th century investing. By contrast, the face value and creditor protections of a fixed income security provided some extra safety and ultimately proved the best bet for raising large amounts of capital in mid-19th century America. Thus, a common model employed by railway promoters consisted of raising equity capital locally, where the entrepreneur could rely on personal connections, but raise debt capital from a broader and more dispersed pool of largely anonymous investors.
That said, in its early days, the American capital markets were not much more helpful than the banks in raising the money required to fund the massive desire for railway investment. Railway promoters thus turned to Europe for backers. Indeed, many of the earliest American railway bonds were denominated in pounds sterling and payable in London as well as in various American cities. Domestic railway companies went so far as to establish London offices to cultivate relations with the City’s merchant banks and local investors. While the dependence on foreign investors by American railroads diminished over time, railway securities continued to account for up to half of all foreign investment in the US into the early 20th century.
Critical to the development of the American bond market was the fact that in 1837 this flow of investment from Britain to America came to a halt. Over the previous few years, capital inflows from Europe led to a surge in American bank lending and capital investment. In Britain, there was growing concern about the credit quality of American debtors and the capital outflows which were reducing the Bank of England’s reserves. In response, the Bank restricted credit, especially to firms with substantial American exposure, and increased its bank rate to 5% from 4%. The change led to a contraction in credit that triggered a recession back in America.
The Panic of 1837 certainly reduced foreign investors’ confidence in American railroad bonds and caused many operators to seek state support. The Panic also helped contribute to the failure of the Second Bank of the United States and other firms that placed American bonds in London. The long-term result was that, going forward, it would be the domestic American bond market that would have to absorb the need for railway capital. Decades later, the likes of John Pierpont Morgan used this market to place railway bonds with investors. However, by the 1870s, the decade Mr. Morgan’s firm was founded, the American bond market was far more firmly established than it was in the 1830s.
The existence of the American corporate bond market, and the reason American companies have for over a century relied more on capital markets for financing than firms elsewhere, owes a lot to the financial innovation of railway bonds. For example, the most common form of railroad bonds in 19th century America were not plain vanilla ‘straight’ bonds, but long-term convertible mortgage bonds. A typical convertible mortgage bond issued by an American railway company in the 1850s paid a 7% interest rate, was secured by a mortgage on the company’s property, and was convertible into stock at the owner’s option. Surprisingly, bonds of a century or longer in term were not unknown. Previously, only governments borrowed for periods anywhere as long as these.
However, as unique as the mortgage bonds were, there were still other innovative flavors of railroad bonds. Among them were ‘land income bonds’ which were backed by the income railroads generated from land sales. Other varieties included bonds that were the joint obligation of two or more railroads or the joint obligation of a railroad and an industrial company. There were also ‘participating bonds’ that received some stock-like capital appreciation on top of their interest income. These innovative bond issues helped domestic capital markets more easily swallow the vast amount of debt issuance desired by American companies, especially railway companies.
Today, the American corporate bond market is responsible for absorbing a much larger share of company indebtedness than is the norm in other countries. In Europe for example, about 80% of corporate indebtedness is in the form of bank lending, with just 20% coming from the bond market. In the US, the ratio is closer to the inverse. Historical studies show that this has been the case for well over a century, with America’s greater reliance on capital markets for raising debt capital dating to the railway boom of the mid-19th century. The financial innovation of that era may explain why this became so.
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1. Chandler, Alfred D. “Patterns of American Railroad Finance, 1830–50.” Business History Review, vol. 28, no. 3, 1954, pp. 248–263.
2. Eichengreen, Barry. “Financing Infrastructure In Developing Countries: Lessons From The Railway Age.” The World Bank Research Observer, vol. 10, no. 1, 1995, pp. 75–91.
3. Gordon, Jeffrey N., and Kathryn Judge. “The Origins of a Capital Market Union in the United States.” European Corporate Governance Institute: Law Working Paper N. 395/2018, Apr. 2018.
4. Mundy, Floyd W. “Railroad Bonds as an Investment Security.” The Annals of the American Academy of Political and Social Science, vol. 30, Sept. 1907, pp. 120–143.
5. Williams, Geoffrey Fain. “‘Lending Money to People across the Water’: The British Joint Stock Banking Acts of 1826 and 1833, and the Panic of 1837.” 2016.