Other People's Money, and How the Bankers Use It

by Louis Dembitz Brandeis

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Good-will—the possession by a dealer of numerous and valuable regular customers—is always an important element in merchandising. But in the business of selling bonds and stocks, it is of exceptional value, for the very reason that the small investor relies so largely upon the banker’s judgment. This confidential relation of the banker to customers—and the knowledge of the customers’ private affairs acquired incidentally—is often a determining factor in the marketing of securities. With the advent of Big Business such good-will possessed by the older banking houses, preëminently J. P. Morgan & Co. and their Philadelphia House called Drexel & Co., by Lee, Higginson & Co. and Kidder, Peabody, & Co. of Boston, and by Kuhn, Loeb & Co. of New York, became of enhanced importance. The volume of new security issues was greatly increased by huge railroad consolidations, the development of the holding companies, and particularly by the formation of industrial trusts. The rapidly accumulating savings of our people sought investment. The field of operations for the dealer in securities was thus much enlarged. And, as the securities were new and untried, the services of the investment banker were in great demand, and his powers and profits increased accordingly.

CONTROLLING THE SECURITY MAKERS

But this enlargement of their legitimate field of operations did not satisfy investment bankers. They were not content merely to deal in securities. They desired to manufacture them also. They became promoters, or allied themselves with promoters. Thus it was that J. P. Morgan & Company formed the Steel Trust, the Harvester Trust and the Shipping Trust. And, adding the duties of undertaker to those of midwife, the investment bankers became, in times of corporate disaster, members of security-holders’ “Protective Committees”; then they participated as “Reorganization Managers” in the reincarnation of the unsuccessful corporations and ultimately became directors. It was in this way that the Morgan associates acquired their hold upon the Southern Railway, the Northern Pacific, the Reading, the Erie, the Père Marquette, the Chicago and Great Western, and the Cincinnati, Hamilton & Dayton. Often they insured the continuance of such control by the device of the voting trust; but even where no voting trust was created, a secure hold was acquired upon reorganization. It was in this way also that Kuhn, Loeb & Co. became potent in the Union Pacific and in the Baltimore & Ohio.

But the banker’s participation in the management of corporations was not limited to cases of promotion or reorganization. An urgent or extensive need of new money was considered a sufficient reason for the banker’s entering a board of directors. Often without even such excuse the investment banker has secured a place upon the Board of Directors, through his powerful influence or the control of his customers’ proxies. Such seems to have been the fatal entrance of Mr. Morgan into the management of the then prosperous New York, New Haven & Hartford Railroad, in 1892. When once a banker has entered the Board—whatever may have been the occasion—his grip proves tenacious and his influence usually supreme; for he controls the supply of new money.

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The investment banker is naturally on the lookout for good bargains in bonds and stocks. Like other merchants, he wants to buy his merchandise cheap. But when he becomes director of a corporation, he occupies a position which prevents the transaction by which he acquires its corporate securities from being properly called a bargain. Can there be real bargaining where the same man is on both sides of a trade? The investment banker, through his controlling influence on the Board of Directors, decides that the corporation shall issue and sell the securities, decides the price at which it shall sell them, and decides that it shall sell the securities to himself. The fact that there are other directors besides the banker on the Board does not, in practice, prevent this being the result. The banker, who holds the purse-strings, becomes usually the dominant spirit. Through voting-trusteeships, exclusive financial agencies, membership on executive or finance committees, or by mere directorships, J. P. Morgan & Co., and their associates, held such financial power in at least thirty-two transportation systems, public utility corporations and industrial companies—companies with an aggregate capitalization of $17,273,000,000. Mainly for corporations so controlled, J. P. Morgan & Co. procured the public marketing in ten years of security issues aggregating $1,950,000,000. This huge sum does not include any issues marketed privately, nor any issues, however marketed, of intra-state corporations. Kuhn, Loeb & Co. and a few other investment bankers exercise similar control over many other corporations.

CONTROLLING SECURITY BUYERS

Such control of railroads, public service and industrial corporations assures to the investment bankers an ample supply of securities at attractive prices; and merchandise well bought is half sold. But these bond and stock merchants are not disposed to take even a slight risk as to their ability to market their goods. They saw that if they could control the security-buyers, as well as the security-makers, investment banking would, indeed, be “a happy hunting ground”; and they have made it so.

The numerous small investors cannot, in the strict sense, be controlled; but their dependence upon the banker insures their being duly influenced. A large part, however, of all bonds issued and of many stocks are bought by the prominent corporate investors; and most prominent among these are the life insurance companies, the trust companies, and the banks. The purchase of a security by these institutions not only relieves the banker of the merchandise, but recommends it strongly to the small investor, who believes that these institutions are wisely managed. These controlled corporate investors are not only large customers, but may be particularly accommodating ones. Individual investors are moody. They buy only when they want to do so. They are sometimes inconveniently reluctant. Corporate investors, if controlled, may be made to buy when the bankers need a market. It was natural that the investment bankers proceeded to get control of the great life insurance companies, as well as of the trust companies and the banks.