Money to build through the wilderness
Financing a pioneer railway in the past - types
of securities used - Canadian Northern Railway finances and pitfalls
Notice:
This section is intended to present "edutainment" which may
help explain pioneer railways' unique needs for capital, and the
processes used for financing major railway projects in Canadian history
... mixed in with a few of today's capital markets processes for contrast.
Please note that I am not licensed to provide advice about securities
- but those using the legal title "Investment Advisor" are.
... And while I'm doing a typically paranoid website legal disclaimer
:
Neither am I licensed to provide advice about how to build a transcontinental
railway through the wilderness in Canada ...
so don't blame me if your
track sinks into the muskeg!
How a company's finances work, and how capital markets
function are interesting subjects once you get into them ... really!
Even before the first Canadian stock exchanges in the 1870s,
Canadians were already handing over their hard-earned money and receiving
ornate engraved certificates in exchange.
Today, an investor's portfolio generally exists only as
an electronic record ... on a remote computer, with securities
segregated for that investor - but registered in the name of a securities
firm ("in street name").
Investors can download all of their portfolio records as computer
files, never using paper at all.
Detail from a stock certificate
Even more than most other enterprises,
a wilderness railway required the world's most important commodity.
Characteristically, it is mobile, sensitive,
and scarce ...
Capital is the savings of individuals, corporations and
governments. It is money surplus to their current needs.
So individuals, corporations and governments
can be suppliers of capital.
A railway in the building stage is a huge
user of capital . It needs to buy or
build a lot of things before it can earn money ... land, buildings,
bridges, locomotives, rolling stock. There is no way a Canadian
wilderness railway can get started without a large infusion of capital
from a number of sources. Early in Canada's history there just wasn't enough
spare money in the whole country, so capital had to be obtained from foreign
countries such a Britain and the United States.
To standardize the transfer of capital,
and to define the risks an investor was taking, securities (e.g.
stocks and bonds) were invented.
Like a simple paper driver's licence, the real power of securities
is in the legal rights and obligations they represent.
Although the definitions were less clear back in the 1800s, three
classic types of securities are :
- Bonds
- Debentures (or "debs")
- Stocks ("shares" or "equities")
Bonds: A user of capital is lent
money and issues a standard certificate to the investor to "securitize"
the loan. The certificate shows how much annual interest
will be paid and when the company will return the borrowed
money to the bond holder. The bond holders' rights are secured by
claims on the assets of the corporation - through a legal agreement
governing each particular issue of bonds which a corporation may
issue.
... If the company does not
follow the agreement, it has "defaulted" ... and the suppliers
of capital (the bond holders) may seize the assets to which
they are legally entitled (e.g. for a railway : track or buildings
or rolling stock or land).
Note: After they are
first issued by the railway from its treasury in
exchange for money ... all of the securities discussed
can usually be resold by one investor to another investor
through a stock or bond market. They are said to be " marketable
".
The securities of big Canadian railways (e.g. the CPR) were
generally listed (approved) for trading between investors at
London, New York, Montreal and Toronto.
The floor of the New York Stock Exchange in
the 1950s
Debentures : ... are almost the
same as bonds - they are also issued for a loan to the company.
However in this case, the securities are
not secured against assets . The interest paid may be
higher because there is nothing to seize - "more risk" means that
"more reward" is expected.
Marketable bonds of a government are really debentures
- because holders of government bonds would not be allowed to seize
government assets ... like a museum, an army base, or the legislative
buildings. Besides ... in theory a government can keep raising everyone's
taxes forever to pay off the debt ... seriously! ...
that's why "sovereign debt" usually has a higher "rating" than "corporate
debt". The flip side of the government's legislative access to the quick
cash it needs means it generally borrows at cheaper rates than the corporations
within the same country.
Looking at the example of the Canadian Northern Railway in
1916
Here are some of the securities from the building
of the transcontinental Canadian Northern Railway (last spike
January 1915) and its subsidiary companies. The list is from April
1916. You can see the interest rates of the debentures and the maturity
dates : 1934-1962. Notice that the Canadian government guaranteed the
bonds listed (against default by the railway).
Because suppliers of capital were really ... sort of ... lending to the
Government of Canada (as guarantor), the railway was able to borrow at
lower interest rates than a typically risky wilderness railway. So
more investors were interested in the Canadian Northern because
the risk was decreased, and borrowing cost the railway less
. The government had a clear policy of encouraging the building of the railway.
In the case of the Canadian Northern, all
the common stock was owned by its builders and the common
stock was never traded on public stock exchanges - only debt securities
with annual interest payments were issued to governments, institutions
and individuals.
Expressed another way : two men got hundreds of millions
of dollars to build a railway which they alone controlled.
Too much detail if you care:
I think "Deb. Stock" above would be called "convertible debentures"
today ... At a predetermined date or period (or perhaps under given
conditions) in the future, debt holders may exchange their debentures
for a predetermined amount of common stock - which represents partial
ownership of the company. The advantage? : unless the company
goes bankrupt, investors will first get regular interest payments ... Meanwhile
the company's stock may "skyrocket". The predetermined
exchange ratio from debentures to stock may result in an large profit at
the time of conversion.
For example:
- If an investor bought a $100 deb
with a 1:5 exchange ratio when the exchange-traded stock was worth
$10, they would prefer the interest-paying $100 debenture ... to swapping
it for 5 x $10 = $50 of common stock.
- If, on the other hand, between 1916
and 1934 CNoR stock went up like a rocket to be worth $80 - using the
same 1:5 exchange ratio, then the $100 debenture could be exchanged
for 5 x $80 = $400 of common stock. Wow! (This
didn't happen.)
Here is a statement from the legislation which indicates
that the government will guarantee a new tranche of debt
securities which may be issued after 1914:
When the railway's financial picture worsens and a debenture
investor wants to get out:
Let's say that many years ago a railway had
made a legal promise to redeem a 4% debenture (remember, no assets
to seize), in one year from "today", for $100, but an investor
thinks things look really bad for the railway. And in this case, the railway
has no government guarantor.
How can the "concerned investor" unload the deb to avoid
what they see as an unacceptable risk of losing all their money ....
if the railway goes bankrupt during the next 12 months ?
Generally, the market uses factors like this
to value marketable debt securities (bonds and debentures) :
- Interest payments due. (e.g. $4 during the next 12 months)
- Face value and maturity date. (e.g. $100 to be received in 12
months)
- What an expert bond rating company thinks of the company and
its "report card rating" for that deb (AAA to D)
- ... and then the market considers everything above in the context
of the "time value of money".
Time value: would a person rather
have $100 NOW ... or in a year from now ?
At 2% inflation, $100 is intuitively
worth only $98 a year from now. And what if the promiser gets hit
by a bus??
So the market will look at the factors 1 to
3 above, then plug the payment schedules and dollar values into
a financial calculator to determine factor number 4 ... "time value of
money" ... to figure out what single price to pay today
for all the various money payments coming in over time from the concerned
investor's "about-to-go-bankrupt" railway debenture. Logically, this
is called the "present value".
The Bond Market speaks:
"OK, let's see ... The Trans-Wilderness Railway
Company ... 4% Deb ... maturing in one year ...
Hmm ... the market thinks it wants a 14% annual
return for that risky railway ... so ... we, the market,
offer you $90 for your $100 deb."
So the "confident bond investor" who BUYS from the "concerned
investor" through the market at $90 gets:
... > 4% from the railway as the
scheduled interest payment of $4. ($4/$90 = 4.4%)
... 10% for the specific risk of the Trans-Wilderness Railway Company
possibly going bankrupt and defaulting on its deb.
... and therefore Mr.Confident must believe
that the railway will survive and give him $100 at the end of the
year when the debenture is scheduled to be redeemed.
So ... all together ... Pay : $90 ... Receive over
12 months : $4 interest & $100 from
railway's redemption.
$104 actually represents a 15.5% return !!
... did we mention the fees charged by the securities firms who act
as professional intermediaries in the market for the concerned seller and
the confident buyer?
This is not exactly how it works ! ... but
in rough and round numbers you can maybe visualize that marketable debt
securities sell at a discount (or a premium) to their face value, depending
on many different factors.
As well, securities transactions must go through securities professionals
who often act in the legal role as "agent" of the investor.
Question: OK ... how do you value a 7.5% convertible debenture
, with an exchange privilege in 18 years , on which a semi-annual interest
payment has just been made , when the pioneer railway's stock is currently
valued at $14 with an exchange ratio of 1:4 , and annual inflation
is not projected to be above 5% for the next 20 years ?
Answer today: See a licensed Investment Advisor (and watch
their computer do it) or take the Canadian Securities Course.
Above: Look at those shiny shoes! Brainy bond traders in New
York in the 1950s. It is said that "you can lose more money faster
in [ marketable ] bonds than in stocks". Perhaps it
is for this reason that the bond market "always gets it right".
That is, if you look at the interest rates paid for government and corporate
bonds maturing in the future, it is said to paint a more accurate
picture of the future economy than the stock market.
Pioneer Railway Stocks
Stocks: A stock represents
ownership and therefore some control (if you own just
one share)... or complete control (if you own all the voting shares).
If and when they are declared, cash dividends may
be paid. No dividends may be paid unless bond and deb holders
have first received their promised money (interest & scheduled
redemptions) - that's part of their legal agreement.
In terms of company operations, if an important issue is before
the pioneer railway company, shareholders generally have a
right to vote and the debt holders generally don't.
What is the stock worth?
This was probably more subject to emotion and
external stock market forces than the debt securities' valuation.
Consider what happens if the pioneer railway goes bankrupt :
- The bond holders can seize "their" listed assets
- most of the hard railway property.
- The debenture holders are legally owed their interest
payments and the face value of their debs - if there are assets left
to cover those legal promises. Better call the lawyers in!
- As an owner, you should feel good ! You probably
still own the glorious name "Trans-Wilderness Railway Company"
and you have the stock certificate as a souvenir !
- However, the debt holders have just seized all the things
that enabled the company to operate and earn money.
- If they choose to operate - not sell off - the railway assets,
probably the last thing they want to do is name their "new" railway
after a bankrupt company which has been all over the newspapers!
On the other hand ... take the CPR ... it did
not go bankrupt because it was able to get capital as needed, wring
operating income from its services, and service its debts. Generally over
the decades its stock price continued to climb.
But how would an individual investor ever have known whether
to hold on to CPR stock or sell it in 1884 or 1885 - during the grim and
desperate months before the Last Spike?
Canadian Northern Railway common stock was privately held,
until ...
In the case of the Canadian Northern Railway,
before its last spike in January 1915, World War One (started August
1914) made it difficult for the railway to raise new money to immediately
satisfy demands for interest payments and other amounts due.
It just couldn't pay its bills on time.
Instead of investing in the CNoR, British and American
investors - who had the Big Money - were investing in war industries
and/or lending to the governments at war. There are much bigger profit
margins in stamping out tin helmets or making artillery shells - which are
in high demand at "The Front" - than in waiting for some distant Canadian
branchlines to make a profit hauling grain !
Capital is mobile, sensitive, and scarce - especially during a war.
Shortly after the Canadian Northern's last spike,
action was taken to fix its financial crisis by the Canadian
government because a large portion of the debt securities were
guaranteed by the Canadian government. The government
clearly had "believed" in the railway and its builders for a period
of time ... but things weren't working out well politically ... the
war wasn't expected ... and, well, governments change.
In the end, the two builders were required to
give up their control - their private holdings of all the railway's
common stock - and completely leave the transcontinental railway
company they had built. For the risk and work of planning and building
the railway, and meeting all the challenges that came up during its
20 year history, they were paid $10,800,000 for their stock by the Canadian
government.
This is a lot of money.
However, this was just about enough to pay
off the pledges of their personal property which had been made to
"pay the bills" to keep the railway out of bankruptcy.
The railway had about $400 million dollars of debt.
But it was generally a well-built railway across the country
through the northern prairies.
It provided an competitive alternative to the CPR "monopoly" for farmers
and other shippers.
The Canadian government assumed ownership of the
transcontinental CNoR and it became a significant part of the
future Canadian National Railways. Today much of the route exists
as part of the exchange-traded Canadian National Railway.
A lost art - security certificates
Here is a cancelled and worthless railway share certificate.
It is my understanding that the Cuba Railroad Company was
the railway which W.C. Van Horne built. Van Horne is famous as the General
Manager of the CPR while it was being created. After he left the CPR,
he just couldn't stop building railways. Someone made the mistake of telling
him it was "impossible" to build through the challenging terrain in the
eastern half of Cuba, so he took the project on as one of his retirement
hobbies.
If you wanted something done, you told Van Horne it was impossible.
When certificates were used (abridged):
- When an individual purchased a security, their name would be
registered on the company's books and a share certificate would be
issued in their name and delivered to them.
- When they sold the security, the certificate would be returned
to the company to be cancelled and the investor's name would be taken
off the company's list of owners. Someone saved the one above after it was
cancelled.
Today, an investor's securities are usually registered
in the name of their securities firm.
Following strict rules, securities firms keep track of which investor
owns what. Investors still have all the traditional rights of ownership
like voting. Because stocks are registered in the name of various securities
firms, stocks can be bought and sold between them - without
notifying the original stock issuer that a particular person has
just purchased 10 shares of the Cuba Railroad Company. This makes
ownership changes much quicker to process.
Transactions today: Via the internet, investors send orders to their
securities firm ... and the firm's computer makes the purchase at the
computerized stock market. No more hand signals from telephone clerks,
open outcry bidding, or discarded paper on a hardwood trading floor,
Today, at the end of each trading day, millions of shares
of a single company, representing the net total of all the individual
orders placed, simply shift within the records kept for the big securities
firms, i.e. within computers.
This has made transactions faster and ultimately cheaper.
Handling securities certificates before
computerization.
We're the Government, how can we help
you?
To finance a wilderness railway,
capital comes from various sources,
flowing through financial markets,
using financial instruments,
which represent the specific legal rights and obligations
of the suppliers and users of capital.
... or perhaps the government will just go into debt
to give the wilderness railway money ...
Railways in the 1800s take Canadians from canoes, boats, and horse
or ox-drawn wagons .. to complex industrial systems, and organized armies
of specialized employees, which support gargantuan steel machines, thundering
down networks of permanent steel guideways which are thousands of miles
long.
Governments love to support this kind of progress because
railways would obviously bring prosperity and growth.
... And popularity for the governments who supported them !
After government approval of a route, specific amounts were paid for
each mile completed, and for each bridge built to government standards
using steel or iron, and masonry.
Land grants were given. The CPR was masterful in freezing out land
speculators and ensuring that CPR sales of the often fertile farmland
brought the best results to the company. Next, the railway had on-line
revenues as it carried in supplies, and carried out agricultural products.
The CPR also had a number of favourable legislative provisions to protect
it from competition, and ensure its financial survival during its first
decades of life in the late 1800s and early 1900s.
Another railway running through wilderness, if given land grants in
the bush, hoped that forest or mineral wealth would contribute to the company's
revenues ... eventually. The railway or independent entrepreneurs would
have to define and exploit the natural resource.
A non-CPR railway, getting established in the early 1900s in an unsettled
area of the Prairies, had to wait for the settlers to get homesteads built
... and prairie sod a'busted ... and local grain elevators built ... before
they saw dime one of agricultural traffic.
The transcontinental Canadian Northern Railway started
life as a set of viable prairie branchlines. It was quite appropriate
to "vertically integrate" operations by constructing terminal elevators
like this at the Lake Superior lakehead.
However, "suppliers of capital", including the governments got distracted
by the War to End All Wars,
and the CNoR still had to make its minimum Visa payments on this puppy.
Besides cash from selling off government land grants,
and cash from selling government guaranteed bonds, the government
cash paid for each completed mile of track was probably
addictive for the railway builders. The easiest and quickest lines to build
were on the prairies. Cash, cash, cash.
Until the lands opened up by the railways matured economically, getting
as much cash from hauling things was going to be problem.
So the highly addictive government building grants helped keep the locomotives
in coal ... at least for a while.
After World War One - the 16,000 km, 20 year old Canadian Northern system
- and the 7000 km Grand Trunk Pacific/Grand Trunk system which started
small over 60 years earlier - slumped into bankruptcy under Canadian government
management, as part of the newly established Canadian National
Railways.
For many decades to come, the Canadian Parliament would vote the annual
allocation to support this railway system's deficit. A well-planned and
well-managed system might have lessened the financial load on Canadians.
However, after overbuilding, it was politically impossible for decades
for any federal government to prune the marginal lines - and sever the
communities they served - from the national network.
In hindsight, it probably was possible to
have too much progress.
A Grand Trunk Pacific track derrick in action. Human
labour was needed to place the ties and spike down the rails.
However, unlike Van Horne's CPR navvies three decades earlier, the unskilled
work of lugging the rails and ties forward from supply cars was done by
the derrick's steam powered mechanisms. More track was laid faster with less
human labour.
On to the Pacific Terminal at Prince Rupert !
Thence to Oblivion !
