2. A Historical Study on the Evolution of Risk Assessment and Credit
2.6. Credit Information on Corporations and Securities in the Second Half of the
the Assessment of Risk based on Specialized Publications and Statistics.
In modern times it is possible to assess the creditworthiness of individuals as well as businesses through scoring models based on an analysis of payment histories as well as financial and accounting data. These models are used on a proprietary basis by profit- seeking providers of credit information such as Callcredit and Experian in the United Kingdom; Dun & Bradstreet, or Fair, Isaac and Company in the United States; and Equifax, operating in both countries. The informational input, from which an assessment on the creditworthiness is derived, is acquired by these agencies through lenders willing to share their payment records with them. In this way, business debtors can access the credit assessments on any potential business or new customer that allows them to make a lending decision based on the likelihood of timely payment. The scoring models are most useful to businesses that receive large numbers of applications as they have the potential to identify different levels of risk through fine gradations and ultimately make prudent and adequate decisions based upon their desired degree of risk. However, scoring models are a relatively recent development in credit information analysis; in the first half of the nineteenth century, it was very difficult to obtain reliable credit information on individuals as well as businesses. Individual payment histories were not available and the accuracy of financial information was very doubtful given the lack of regulated practice. Furthermore, many times creditors would not ask for these sources of information directly because of the possibility that the new customer take offense and go to another house more willing to provide credit without requiring this kind of information. Not surprisingly, adverse selection was a constant problem, which was compounded by the high degree of competition in both the United States and the United Kingdom.
Similarly, investors willing to buy debt from an enterprise in the form of securities had to make assessments of its creditworthiness and were therefore confronted with the problem of the quality of the available information. In fact, one of the main obstacles to the development of public securities markets in both the United States and the United Kingdom in the nineteenth century was the information asymmetry between the corporations offering debt securities and the investors in possession of the resources to buy them. The history of the development of public securities markets is also the history of the methods used in order to acquire information on the creditworthiness of corporations
and thus overcome the existing information asymmetries. In order to have a better understanding of the evolution of credit information in the nineteenth century it is very important to present a brief historical context that includes the nature of the trading of debt as well as the associated informational issues. The first organized (although informal) form of trade in securities markets took place in the trade of government issues, and after 1720 it became the primary activity of the coffee shops in the City of London41. It was during the eighteenth century that securities markets grew considerably in size and importance in Europe and the United States. Stock exchanges emerged as increasingly organized markets for the trade of securities, which continued to be mostly dominated by government issues in both sides of the Atlantic.
In Europe, governments used debt to finance military conflicts and in the United States, to finance their war of independence as well as the Civil War. According to Niall Ferguson, Britain was the first country in Europe capable of generating enough balance of payments surpluses “to allow sustained capital export42” and by 1815 the British Empire’s foundations were based on an increasing amount of international lending. At the time, sovereigns were already conscious of the fact that they needed to gain and maintain the confidence of investors if they wanted their issues to be successful. Therefore, with some exceptions, they refrained from cancelling their obligations unilaterally or failing to make interest payments when they were due. The creditworthiness of sovereign borrowers was thus based more on the “belief” of investors on the trustworthy or safe nature of government debt than on the analysis of information collected on the state of the country’s finances or other kind of credit assessments. For instance, since 1749, date when the British government consolidated its debt into one single issue, known as consols, these could be easily bought and sold in the securities market, as investors were more and more attracted to them because of the timely payments of principal and interest from the British government through time (past payment history). As suggested by Michie (2006) “with the British government consistently honouring its debts and interest payments, investors were attracted to transferable securities whose value was directly or indirectly dependent on government payments.43”
Besides this easily observable measure of the creditworthiness of sovereign borrowers, there was also the perception, from the investors’ side, that governments with
41 The informal trade in sovereign debt was formalized as early as 1802 with the establishment of the London Stock Exchange.
42 Ferguson (1998) p. 680.
43 P. 43.
representative forms of government were more likely to honour their obligations than absolutist ones. This observation was first brought by Ferguson (1998) and used by Sylla (2001) in order to explain how the bond market provided an incentive two centuries ago, for governments to become responsible and representative, and concludes that “As more countries in Europe and around the world, adopted constitutions and representative forms of government during the nineteenth century, the international bond market grew in scale and scope. But it was for the most part a market in sovereign debt”. In Ferguson’s words,
“a constitutional monarchy was seen in London as a better credit-risk than a neo-absolutist regime”44. The securities market of the eighteenth century and the first decades of the nineteenth century was indeed dominated by government debt and there was little progress made in the use of the bond markets by joint-stock companies to obtain funds. First of all, the securities market was almost exclusively used in order to fund wars or projects that required an initially vast amount of capital, like railways, canals or public utilities. Second, it seems that the safety and liquidity that characterised government issues was enough to satisfy demand from investors through long-term transferable securities. Third, most of joint-stock firms did not require large initial amounts of capital; they could be financed through traditional bank loans or even pools of funds stemming from the firm’s associates or family members. Fourth, investment in joint-stock companies was perceived as more risky due to the unproved nature of the enterprise in question and the lack of information regarding the prospects of profit and therefore the creditworthiness of the borrower.
In the United States, before the war of Independence, the majority of securities traded were short-term bonds issued by individual states whereas businesses did not yet use transferable shares or bonds issues in order to obtain the funds they needed. Those Americans with excess of capital looking for remunerative investments used to buy securities in London, where securities markets were better organized and therefore safer to invest in. Clearly, a domestic securities market started to develop more rapidly in the 1780s with the war for independence through increased state borrowing. But even if the volume of issued securities by governments and firms increased considerably in this period, the organization of the market remained very precarious and most brokers entered the business as a part-time activity rather than a full-time profession with the degree of specialization achieved in the United Kingdom. One example of this is the fact that even after the war of independence, the United States government issued debt in Amsterdam to acquire the funds needed to finance war-related costs instead of using domestic markets.
44 Ferguson (1998) in Sylla (2001), p. 6.
In the nineteenth century, especially in the second half, both the development and use of the concept of limited liability and the very large amounts of capital needed to build railroads and canals considerably stimulated the trade of securities of business corporations in the United Kingdom and the United States. However, the financing needs of the latter were the largest because of the geographic scale. Prior to the middle of the century, railroad corporations were relatively small in size and were therefore capable of fulfilling their financial needs through banks credit and stock issues. From the 1850s, however, railroad corporations rapidly expanded in size covering unsettled and undeveloped territories, which required large amounts of capital that could not be provided anymore by traditional sources of finance such as bank loans. Additionally, the scale of capital required for railroads (for the Western railroads in particular) exceeded by far the wealth of private individuals. Only pubic debt issues were judged as capable of fulfilling the vast funding needs of the firms operating on a national scale, but as the railroads corporations covered now very distant cities and towns, investors very rarely knew, or possessed information on the firm allowing them to assess their creditworthiness.
In the case of these new forms of corporation, where the also largest London merchant bankers invested considerable amounts (especially in the finance of North American trade and the marketing of American bonds since the 1800’s45) accounting and financial information was very hard to obtain. As Henry Varnum Poor points out in the preface to his History of the Canals and Railroads of North America, even as late as 186046, the state of the information on railroad and canal corporations can be generalized to most of the corporate sector regardless of the industry: “There is not in this country as in most others, a central point at which the more important companies are either domiciled, or at which all are required to present annual statements of their affairs, for the reason that they derive their existence and powers from the legislatures of the several States. In a few States only, is such duty imposed. Where it is, it is often neglected, no penalty being suffered thereby. It is not uncommon for leading companies to publish no reports whatever. Some make them unwillingly, with no design to convey information upon the subject to which they relate. Reports that are full and explicit are accessible only to a small number of parties interested. Fewer still have the means of comparing results for consecutive years, without which it is impossible to form a correct opinion as to the manner in which a work has been conducted, or of its present or prospective value…47” This description of corporate
45 For a discussion on the amounts and sources of foreign capital in the nineteenth century in the United States, see Davies and Cull (1994), p. 10-49, and on British foreign investments, Edelstein (1982).
46 Date when the first edition of the History of the Railroads and Canals of the United States of America appeared.
47 Poor (1970), preface.
reporting says much about its general state until the end of nineteenth-century America and provides an explanation of the reasons for the poor quality of information on creditworthiness and the search for new and more effective methods of acquiring it in order to make informed investments.
In this context, it is worth noting that railroads were the first regulated enterprises, but it was not until 1887 that the Interstate Commerce Commission (ICC) promulgated formal and uniform accounting standards in the United States. Given that railroad corporations were the first to apply accounting standards, it is evident that manufacturing corporations took even longer to develop the practice of disclosure of accounting information, and that the content of their reports was neither reliable nor complete throughout the nineteenth century, which impacted considerably the ways in which creditors (investors) acquired credit information. As early as 1869, the New York Stock Exchange tried to regulate disclosure of financial information (in order to reduce information asymmetries and enhance its reputation for quality) for all the companies traded there through the adoption of an official policy requiring annual financial reports.
Nevertheless, this rule was rarely respected “to the extent that in 1885 the Unlisted Department was created for firms providing no information.48” This department disappeared in 1910, but it was not until 1926 that almost every company listed in the New York Stock Exchange disclosed audited annual financial reports. In the United Kingdom the standards of public disclosure required to enterprises were more developed: the Companies Act of 1844 required directors of corporations to make up a complete balance sheet, which in turn had to be approved by auditors, one of whom (at least) was usually elected by the shareholders. And as discussed by Barron Baskin, “the Italians may have invented double entry bookkeeping, but it was the British who invented modern financial reporting.” Moreover, financial collapses such as the one suffered by the Bank of Glasgow in 1878 propelled regulation through compulsory edicts49.
With regard to this very issue, the existing asymmetries in the development of the disclosure of financial information in the second half of the nineteenth century between the United Sates and the United Kingdom, Davis and Gallman (2001) bring to our attention that “the Board of Governors of the New York Stock Exchange recognized that savers were concerned about the problem of asymmetric information, and that if the Exchange were to flourish, it must provide signals of quality and reputation. They adopted
48 Barron Baskin (1988), p. 228. See also Michie (1987), p. 206-208.
49 Barron Baskin (1988), p. 228.
appropriate signalling policies. In England, such concerns had been largely alleviated among a substantial class of saver by the 1870s, although they may still have affected the typical investors’ choice of securities. Not only was the number of savers who were willing to invest in paper assets increasing and the scope of their portfolios broadening, but the British investor had also become more venturesome…50” This difference in the level of dissemination of financial information between the two countries provides a partial but powerful explanation to the faster development of American reporting methods of gaining credit information as well as the emergence of credit rating agencies such as Standard and Poor’s, Moody’s and Fitch, in the United Sates only.
It is within this context that one can find one of the first and most fundamental methods of gaining information on railroad and industrial corporations creditworthiness in the late nineteenth-century America: through the specialized business and financial press.
The United States was characterised by a rapidly growing demand for business and trade information at the time; there were therefore many periodicals published in order to satisfy this demand. These publications providing business information can be roughly divided into four types: the industrial, the commercial, the agricultural, and the scientific journals.
However, industrial railroad journals received particular attention from the investors’
community given the rapid expansion of railroads corporations and their vast capital requirements. As discussed, investors needed a reliable source of information on the creditworthiness of corporations issuing debt in the form of bonds and its importance was compounded by the lack of knowledge of firms given the considerable geographical scale of their operations, so these publications proved to be very useful in carrying successfully that the task of dissemination. During the 1850s four periodicals provided a good deal of information on railroads: Hunt’s Merchants’ Magazine, United States Economist, Bankers’
Magazine and The American Railroad Journal.
In the beginning these publications included technical engineering information and statistics, and only gradually information relevant to businessmen interested in the business and commercial aspects of the industry was included. Railroad journalism in Europe, and especially in the United Kingdom, had already more sophisticated means of exchanging information on the technical side as well as on the business and financial aspect of railroads. In the United Kingdom, the engineering societies, the Institution of Civil Engineers and the Society of Mechanical Engineers were highly effective channels of communication for technical matters regarding the railroad industry, and the Railway
50 P. 154.
Magazine, founded in 1843, “concerned itself primarily with defending the railroads from the attacks of canal and turnpike operators, property owners and conservative-minded persons throughout the Kingdom.51” And the British periodical Railway Times, a successful publication founded as early as 1837, provided financial information only, and was widely consulted by investors buying railway bonds. Moreover, by the mid-1840s, when railroad construction reached its peak, a half dozen railroad journals were being published in the United Kingdom. In the United States, “the editor of the American Railroad Journal52, watching the success of the British financial papers, decided that his paper should follow suit… He told his readers that the time had come for the publication of a weekly paper concerned with the management and financial affairs of American railroads.53” However, the idea revealed itself premature, as the business of investing on railroad debt was yet to expand in the subsequent decades.
It was not until 1849, when Henry Varnum Poor became the editor54 of The American Railroad Journal, that the paper gradually started to appeal to the American investors’ community and successfully became a widely consulted financial tool that included systematic information on the property of railroads, their assets and liabilities, and earnings. And as reported by Richard Sylla, “after the American Civil War, Poor and his son started a firm to publish Poor’s Manual of the Railroads of the United States, an annual volume that first appeared in 1868, ” which reported financial and operating statistics covering several years for most of the major American railroads55. By the turn of the century, another American businessman, John Moody, who is credit with being the founder of the bond rating business, focused also on railroads as well as industrial corporations in general and published in 1900 the Manual of Industrial Statistics which provided information on stocks and bonds of financial institutions, government bonds, manufacturing, mining, utilities, and food companies. This publication did not contain credit ratings yet but had a considerable success because of the information asymmetries characterising the market at the time. Given the already mature state of railroad companies, the continental scale of the industry and the lack of useful information on railroad firms by the end of the nineteenth century, John Moody reports in his autobiography, “A high percentage of corporation securities had to be bought on faith rather than knowledge… Somebody, sooner or later
51 Chandler (1956), p. 40.
52 Founded in 1832.
53 Chandler (1956), p. 40.
54 Henry Varnum Poor’s editorship of The American Railroad Journal lasted from 1849 to 1962.
55 Sylla (2001), p. 9.
will bring out an industrial statistical manual, and when it comes it will be a gold mine. Why not do it myself?56”