Credit And Discredit

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My files bulge of late with stories that tell unedifying tales of cupidity and stupidity in world and national credit markets. There is the S & L scandal—the story of how hundreds of savings and loan institutions failed through unsound investments, while supposed regulators looked the other way. The bill for their “bailout” climbs toward some new megabuck horizon, it seems, every time there is a fresh disclosure. Some of the stricken banks held quantities of the infamous “junk bonds,” that is, risky securities backed mainly by the expectations of their issuers, rather than by solid assets.

And passing to the international scene, there are Third World nations such as Mexico and Brazil looking for debt relief as they struggle (and fail) to meet interest payments on money borrowed for development purposes. Their banker-creditors answer that before any loans can be renewed, the delinquents must stop squandering money on inefficient state-run enterprises and popular social programs.

There are common denominators to all these stories. In a time of economic change and growth, some avid borrowers will bend common sense and law out of shape. Some eager lenders will take foolish risks. And some politicians will do their best to avoid interfering with the process. It is rather sobering—and very familiar to anyone who knows the history of banking and borrowing in the United States between, say roughly, 1830 and 1855.

The great leitmotif of this period was growth. The population was doubling every twenty years, new states were entering the union—and the crying need of the hour was for capital to build a transportation and marketing network. It was a climate made for speculation.

States had the power to charter banks, and they did so—especially in the new, development-hungry West—with a liberality that S & L operators would look upon enviously. There were 329 chartered banks in the entire nation in 1829. Six years later there were 704, and in 1840 the number was 901. But the available banking capital was not growing nearly as fast as the available banks or the volume of their loans. The new institutions issued their own colorfully printed bank notes, but the only universally recognized hard currency to back them was specie—gold and silver coin. And there was very little specie behind these paper millions.

True, each state had inspectors who were supposed to ensure that there were adequate reserves in the vaults. But the officials who chose the inspectors were elected by voters who wanted easy credit, so nobody looked too closely. In Michigan, for instance, bank examiners were readily bamboozled by boxes of specie shifted from one locale to another in advance of their arrival. As a contemporary put it, “Gold and silver flew about the country with the celerity of magic.” One treasure chest was found to have a top layer of precious metal over a substratum of nails and glass. A legislative committee appointed to study why, in Indiana, fifty-one banks out of ninety-four created between 1852 and 1855 failed, reported that many had no funds, no deposits, and no directors, and one opened its doors only twice a week. One etymology for the term wildcat bank , used to describe such institutions, suggests that it was because they were located “out where the wildcats are.”

Growth-hungry state legislatures not only could charter such banks to put “money” into the hands of promoters, but they could get the states directly into the banking game as guarantors or part owners. In Mississippi, for example, a banking corporation was chartered whose stock was bought by the original subscribers for only 10 percent cash down. And that 10 percent was returned to them as soon as the state itself deposited five million dollars’ worth of its own bonds as the working assets. In short, they “enjoyed the special privilege of bank ownership without contributing anything themselves.” They could share in the profits, borrow to buy land, use the land as collateral for more loans, and continue this bootstrapping in a way that makes dealing in junk bonds look positively respectable by comparison. Until, somewhere down the line, some spoilsport asked for payment in cash. When that evil day came the state, too, would be in trouble. What then?

By 1838 the total indebtedness of all states was about $172 million, very substantial money for the time. About a third of it represented investments in banks; the rest consisted of debts contracted to build turnpikes, canals, and railroads. Without these cherished “internal improvements,” there was no hope of growth for young states. But with them, it was believed, the economy would become so robust that repayment would be no problem. The shining example was New York’s Erie Canal, completed in 1825. Before the last mile was completed, the tolls collected already exceeded the interest payments on the construction bonds.

So Pennsylvania began work in 1826 on a system of canals to link Philadelphia with Pittsburgh and the Ohio River trade. Maryland followed with liberal subscriptions to canal and railroad projects. Out west Ohio, Indiana, Illinois, and Michigan set afoot projects designed to connect the Atlantic Coast, the Great Lakes, and the Ohio-Mississippi river basin in one grand national market. The more elaborate the schemes, the better their chance of approval by state legislators thinking of their home districts. Every hamlet should be in direct touch with buyers of crops and sellers of goods. Illinois issued $8 million in bonds in 1837 to pay for no fewer than seven railroads and for the improvement of navigation on five rivers.