The most unique financial arrangements are usually the product of new or desperate circumstances. Why else would one need to deviate from the norms with which market participants are already acquainted? The American Civil War had a lasting effect on the American economy and on American finance. However, one of the most curious financial innovations of the war period was introduced in Europe, the cotton bond, also known as the Erlanger loan. It was a novel bond offering for a sovereign issuer, an issuance of bonds convertible into a commodity.
Confederate Public Finance
The fiscal condition of the secessionist Confederacy was never good. An aversion to high taxes deprived the breakaway state of much-needed revenue. However, even if taxes were kept at high rates, it hardly would have helped matters. Cotton, the commodity that drove the local economy, was stuck in the Southern interior and unable to be exported overseas amidst a blockade of its ports by the Union navy. Thus, the breakaway government in Richmond resorted to flooding the economy with locally issued bonds. One of these was raised in 1861 to the tune of $15 million; another the following year ran up $100 million in debt.
Alongside the liberal issuance of bonds was a persistent over-emission of currency. While new printing of paper money was a feature of wartime finance in both the North and the South, it was far more pronounced in the South. Regular issuances of Confederate dollars helped finance their armies. The money’s steady devaluation and wartime shortages triggered inflation and a widening disparity between the value of the paper dollars and gold coins. In early 1863, on the eve of the Erlanger loan, it took $5 in paper dollars to purchase $1 by face value in gold coins. That premium would only grow far larger with time.
Emile Erlanger & Company
It was in these unconventional circumstances that a foreign loan was arranged for the Confederacy in 1863. The two men most immediately responsible for effectuating the loan were John Slidell, a former Louisiana Senator and then a Confederate diplomat in Paris, and Frédéric Émile d’Erlanger. A year and a half earlier, Slidell had been one of the diplomats at the center of the Trent Affair, when he was captured by the Union navy while aboard a British vessel, an act that tested British restraint and American reversal. Slidell was eventually released and made it to Europe in early-1862.
At the time, d’Erlanger was a well-connected German banker who proposed floating a bond offering to Slidell while the latter was in Paris. As it happens, d’Erlanger went on to marry Slidell’s daughter, Marguerite Mathilde Slidell, the following year. In the winter of 1862-63, many in Europe believed the prospects for Confederate victory to be good. With the possibility of a successful offering high, Slidell and d’Erlanger secured Confederate authorization for a £3 million ($14.5 million) loan in January 1863. From there, it took little time to arrange the offering and a prospectus was published on March 19th. D’Erlanger’s firm Emile Erlanger & Company was to manage the offering.
Bonds and Cotton
The bond offering for the belligerent nation was, as would be anticipated, hardly borrower-friendly. Investors were to be paid a 7% coupon in pounds sterling and the Confederacy was to amortize the bond over its twenty-year term in forty equal semi-annual payments. Further, it was not to receive the net proceeds from issuance all at once but over the course of the year since investors’ subscriptions were payable in installments over 7 months. However, these were the terms set out by Emile Erlanger & Company for what was to be the Confederacy’s only foreign loan. That said, European investors were already familiar with Confederate paper as some domestic bonds were also traded across the ocean in Europe.
Perhaps the most interesting feature of the bonds was not any of those terms already described, since they were standard for speculative bond issues in the 19th century, but rather the convertible aspect of the bonds. The Erlanger loan, as the issue was called, was redeemable in cotton within six months after the conclusion of the war at a rate of eight bales, each roughly 500 pounds, per £100 in face value of the notes. This equated to a conversion price of just six pence per pound of cotton, an extraordinary discount when prices in Liverpool, Britain’s cotton textile center, were as high as twenty-four pence at the time.
In terms of the American dollar this was twelve cents per pound of cotton. Compare this to prices of well over $1 at their peak during the Civil War. The novel feature allowed the South to monetize cotton stuck on its side of the Atlantic, cotton which could not be safely exported in large quantities amidst a Union blockade, but which could serve as collateral for a loan. In Europe, where prices for the commodity surged amidst the scarce supply, the feature added value to investors. This convertibility even caused the Erlanger loan to be known simply as the ‘Cotton Loan’ in Britain.
Emile Erlanger & Company stood to make a fortune from the cotton bonds’ issuance. The bank purchased the issue at 77% of face value and, along with its syndication partners, sold it at 90% to investors across Europe. The bond was syndicated in London, Liverpool, Paris, Amsterdam, and Frankfurt. The hefty spread was not the only source of the bank’s profit on the offering for it also collected a 5% commission for each note sold and a further 1% for handling the sinking fund which required that 2.5% of the loan amount be set aside twice a year to gradually retire the debt. In all, Erlanger would make over £500,000 off the £3 million transaction.
Erlanger itself was to syndicate the bonds destined for the markets in Paris and Frankfurt. Sales in London and Amsterdam were handled by the firm J.H. Schröder & Co. and in Liverpool they were doled out by Fraser, Trenholm, and Co. The former firm was the ancestor to today’s asset management company Schroders while the latter bank, though based in Liverpool, was run by George Trenholm, the Confederacy’s future Secretary of the Treasury. Fraser, Trenholm, and Co.’s inclusion may have been an act of reciprocity since it was George Trenholm who helped arrange John Slidell’s troubled secret transport to Europe in 1861.
In the end, the offering was a success. The issuance was more than five times oversubscribed with orders of £16 million against the £3 million size. Prices for the bonds traded a premium over the first few days on the secondary market. So popular was the cotton loan that even several British Members of Parliament were said to have invested, a potential conflict of interest as the decision to intervene on the side of the Confederacy was an open question in British foreign affairs. Remarkably, one alleged investor was none other than the future Prime Minister William Gladstone, then the Chancellor of the Exchequer under the government of Lord Palmerston.
Repurchases and Performance
Over the subsequent two years, prices for the bonds in Europe tracked the course of the war in America. Records of prices from the more developed sovereign debt markets in Europe, specifically that of London and Amsterdam, show the ups and downs of victory and defeat. Almost immediately, the bonds struggled. Prices fell below 90% of face value in their first month on the market but purchases by Confederate agents in Europe, like Erlanger, supported prices as did occasional military victories by the South.
Nonetheless, the notes fell again below the offering price of 90% in May 1863. This came about despite frantic buying by the bonds’ issuer. By mid-May, it is said that over half of the issued bonds had been repurchased by the Confederate government through its agents. It may seem strange that the rebellious republic would be so concerned with the prices for its debt in Europe, especially while the economic and military situation at home was so dire. Wouldn’t that money be better spent on weapons or economic necessities?
However, the structure of the cotton bonds’ sale necessitated such a move. Recall that investor subscriptions were payable in installments. In theory, if prices collapsed before the first couple payments were made, investors may have been inclined to accept their losses and abandon the bonds. This would have deprived the Confederacy of the full proceeds. As a result, the price needed to be supported so that subscribers would not abandon the bonds and stop paying their installments. Only once they had paid for much of the issuance could the Confederate government back away and let the market take its course. Thereafter, it could always resell the bonds it acquired, albeit likely at a loss.
This is exactly what occurred. The Confederacy set aside roughly £1.5 million, half the issuance amount, to be used to repurchase bonds and most of this was later resold at prices as low as 40% of face value, recouping some money. The combined effect of Erlanger’s fees and losses sustained in the repurchases of notes meant that in the end, perhaps as little as just over £1.4 million, or $6.8 million, was raised from sales of the cotton bonds.
Repurchases did support the price long enough to prevent abandonment though and the bonds’ value was still hovering around the issuance price of 90% through the spring of 1863. From there, market prices fell with Southern defeats and rose with the occasional Southern victory or increased prospects for foreign intervention or an armistice. Prices plummeted in July following the twin Confederate defeats at Vicksburg and Gettysburg; they fell to around £64 per £100 of face value that summer.
However, prices recovered all the way back to 84% of face value in 1864 on hopes for General McClellan’s victory in the Presidential elections that year. That said, McClellan lost but not before another Southern defeat, the fall of Atlanta in September 1864, caused prices to plummet once again. Still, the bonds’ prices in Europe held up better than the falling value of Confederate paper money in America. Whereas they started 1863 at a 5-to-1 rate against gold, the paper bills were now at 15-to-1 against the equivalent face value of gold coins.
In the face of an unstable domestic coinage and limited access to hard-currency, the cotton-backed Erlanger bonds served as a money the Confederacy could use in external trade. Confederate purchasing agents in Europe used the cotton bonds repurchased by the government as currency in trade, exchanging them for arms and ships produced in Britain.
Some of these ships acquired in Britain were put to use in blockade running and not long before its eventual defeat, the Confederate States had been planning a new £15 million loan. However, with its credit damaged in Europe, the Confederacy could no longer monetize its cotton holdings at home by issuing cotton-backed bonds abroad. Instead, to finance the war, the South increasingly came to rely on smuggling exports of cotton around the Union navy vessels patrolling off the shore of its port cities. With prospects for victory evaporating and new issuance of money abounding, the Confederate dollar had fallen to 60-to-1 against gold by early 1865. That said, even then, just a few months before the South’s surrender, their cotton bonds were still trading hands at prices as high as 57% of face value.
After the Confederate general Robert E. Lee surrendered to the Union Army’s Ulysses S. Grant at Appomattox in April 1865, the end had come for the cotton bonds. Prices fell below £10; though they continued to trade on hopes of a partial redemption. It was not to be. However, with respect to their foreign bonds at least, the Confederacy was a compliant borrower. Until their surrender they had made every principal and interest payment on the cotton bonds even though they had already defaulted on other domestic debt issues. Those payments were all bondholders would ever see from the cotton loan. Investors’ bonds were never redeemed in money or the cotton reserved for them in America, the latter of which was confiscated by the Union government after the war.
Financing nations at war is a perilous endeavor, especially for wars with consequences as existential as those facing the Confederate States of America during the American Civil War. The cotton bonds were certainly an interesting security but they ultimately failed their investors and, to a certain extent, the Confederacy, which saw only a fraction of the proceeds. Indeed, perhaps the only people who did well thanks to the bonds were the bankers who arranged the offering and sold the instruments to eager investors. Counterintuitively, it is usually the most desperate borrowers, short on alternative sources of capital, who pay the largest fees.
More from the Tontine Coffee-House
Read about other ultra-speculative government bonds, including those issued by Greece in its early decades as an independent country, those of newly independent ex-Spanish colonies, and those of a fictitious nation that didn’t even exist.
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