POLI 100K, Railroads and American Politics: Topic 6, The Nature of Railroad Competition

The Perversity of Rate Competition

1. Excess Capacity and Rate Competition
   
   
   1. By 1873 nearly all the railroads had excess capacity. Consequently, prices on competitive through traffic quickly dropped below rates on local non-competitive business. Because of the over capacity, one railroad’s gain was another’s loss so rate wars were severe.
      
      
   2. Railroads with high bonded debt would cut rates to generate cash to pay the interest on their debt thereby forcing the stronger, better capitalized, roads to match freight rates. The weaker road would then go into bankruptcy and, with protection from its creditors, would cut rates further. The problem was that federal judges (bankruptcy, unless the Congress permits the States some flexibility, is a U.S. government concern) were very reluctant to allow the physical liquidation of a railroad’s assets because of the political implications! Once towns had service, they did not want the railroad to disappear! As a practical matter most Railroads were more valuable if they were left intact and running than they were if they were liquidated! In addition, during the 19^th Century there was no federal bankruptcy law that covered corporate enterprises! From 1867-78 there was a law that covered bankruptcy by individuals and merchants, but not corporations! Consequently, the federal courts were forced to innovate.
      
      
      1. Beginning in the early 1870s the federal courts developed a set of rules known as Equity Receivership so that major corporate enterprises could be reorganized. This process has been outlined in detail by Peter Tufano ("Business Failure, Judicial Intervention, and Financial Innovation: Restructuring U. S. Railroads in the Nineteenth Century," Business History Review, 71:1-40.)
         
         
      2. Before the 1850s Railroads were financed mostly with sales of Stock. By the Civil War most Railroads were using bonds and stock. The problem with bonds was that they carried a strict lien on the real property of the railroad in the form of a mortgage. Consequently, the bond holders were almost always senior claimants when the railroad went into bankruptcy because they held a mortgage.
         
         
      3. Equity Receivership proceded as follows: the Court appointed Receivers - usually the exiting management of the bankrupt railroad. The Receivers were allowed to:
         
         
         1. Break leases and contracts
            
            
         2. Withhold interest payments due existing creditors
            
            
         3. Obtain interim financing to keep the Railroad running
            
            
      4. The Court allowed Receivers to issue Receivers' Certificates to raise cash. These allowed the receivers to borrow against the "whole estate" of the railroad and were super-senior borrowings.
         
         
      5. The basic goal of the reorganization was to reduce fixed charges. This was achieved by:
         
         
         1. Exchanging old securities for new securities.
            
            
         2. Assessment - current holders of securities had to invest more capital.
            
            
      6. A key innovation was the setting of Upset Prices by the Court. If an investor decided not to participate in the reorganization then he received a cash payment for his existing securities. The Court set the Upset Values for all the various claims on the defaulted railroad. These prices were usually set LOW in order to "encourage" broad participation in the reorganization and to increase the likelihood of success of the reorganization.
         
         Equity Receivership (Figure 1 in Peter Tufano's Article)
         
         
         
2. Because of this perverse logic of competition the railroads put together various mechanisms to fix rates to prevent the ruinous competition. They tried a number of schemes the most popular of which was freight pooling. Traffic was divided between the competing roads based upon an agreed upon formula and all roads maintained the prevailing freight rate. These arrangements more often than not broke down for obvious reasons.
   
   
3. Another solution was consolidation. This was effectively achieved in the mid to late 1890s by J.P. Morgan and other investment bankers after a devastating wave of railroad bankruptcies in the early 1890s.
   
   John Pierpont Morgan (1837 - 1913)
   
   
   Percent Railroad Mileage in Bankruptcy (Figure 2 in Peter Tufano's Article)