Mitchell may have been planted in the spectators’ row, but his policies were clearly still on trial. Pecora was now ready to challenge the claim to which Mitchell and Baker had so tenaciously clung in their first week of testimony, the claim that the affiliate only “manufactured” securities that were “safe and proper” for investors. And to test that claim, Pecora chose his example carefully. He picked an offering that was synonymous at the time with worthless securities. He picked Peruvian bonds, which he regarded as a “spectacular” example of National City’s “disregard of elementary fair play to investors.”4
Spectacular it may have been, but the testimony on Monday proved to be anticlimactic, not only because of the high-profile resignations but because Pecora was treading on familiar ground. A year earlier, the Senate Finance Committee held hearings on foreign bond sales, and the picture that emerged was not pretty. In fact, Hiram Johnson, chairman of the committee, called it “grotesque and tragic.” American investment banks sold billions of foreign bonds in the 1920s, quickly turning the United States into the world’s largest creditor nation. The vast majority of those bonds plummeted in value with the onset of the Depression. Some of the worst were the Peruvian bonds, which, after a revolutionary coup in Peru in August 1930 and a subsequent default, were currently selling for pennies on the dollar.
The Finance Committee investigation was, however, sparked by more than poor performance. Senator Johnson wanted to explore the government’s role in those bond sales, which every administration since Harding had been urging investment bankers to make. One of the biggest boosters of foreign investment was Harding’s commerce secretary, Herbert Hoover. Under his direction, the Commerce Department conducted an extensive program to educate Americans about the value, as well as the pitfalls, of investing in foreign securities. He urged bankers to sponsor safe and productive loans that would “bless both the borrower and the lender.”
While Hoover didn’t want foreign loans to come directly from the United States Treasury, he wanted the government to do more than simply provide educational announcements. Hoover, the man who thought regulating the New York Stock Exchange was probably unconstitutional, wanted the government to adopt strict guidelines on what loans could and could not be made. The business-friendly administration balked at that heavy-handed approach. As a compromise, the State Department began to informally sign off on foreign loans before they were made. It wasn’t technically approving the bonds, but investment banks made sure to heavily play up the government’s involvement as they tried to sell them. The practice led many customers to believe that the government was vouching for the safety of those bonds, when in fact it wasn’t. The State Department wouldn’t object to a loan, one official admitted, even if it “was absolutely rotten.”5
Given all the federal encouragement, Mitchell, not surprisingly, told the Finance Committee that City Bank thought it was the firm’s patriotic duty to participate in these foreign loans. “Many of us,” he said, “found a real inspiration in the fact that in the issuance of this large volume of foreign loans we were playing a part in the development of American trade and industry. That is our first motive always.” Those high-minded sentiments notwithstanding, underwriting foreign bonds during the halcyon 1920s was one of the biggest drivers of National City’s growth. In fact, participating in foreign loans not only enhanced a firm’s prestige, it earned the bank unusually fat fees and commissions. Both factors prompted investment banks to fight tooth and nail to win this lucrative business. Foreign governments were not, in many cases, begging for loans; instead they “were actually besieged by those bankers until they accepted loans.” With its far-flung foreign branches, City Bank was in a unique position to capture a good deal of this business, eventually participating in about one-third of all foreign bond offerings. Other investment banks were hardly ready to throw in the towel. One firm paid the son of the president of Peru over $400,000 for his help in winning the right to sell some of the country’s bonds. The investment banks politely called the payments “commissions” and said that they were “quite customary” for South American loans.6
Thomas Lamont, the J.P. Morgan managing partner, didn’t mention City Bank by name, but it was quite clear who he meant when in the late 1920s he rebuked “American banks and firms competing on an almost violent scale” to sell foreign bonds. American investors, he warned, needed to be more circumspect about these bonds. It was an easy thing for Lamont to say; after all Morgan was the most prestigious investment banking firm in the world and could afford to be exceedingly picky in whom it chose to underwrite. City Bank was fighting for what was left, and with the large overhead from its retail sales staff, it was important to keep the pipeline full of new offerings. Lamont’s warning, however, was not the only one; others warned average investors away from all foreign offerings, which as a class they considered simply too risky. Despite the warnings, National City went right on selling them and its customers went right on buying them. The company told investors not to worry. As its advertising repeatedly emphasized, the company “buys and offers to investors only such securities as it can recommend after thorough investigation.”7
If that was the case, how had the bonds failed so spectacularly? Senator Johnson thought it was a massive fraud. The bankers knew or should have known, he claimed, that the securities were worthless and that they were bound to default. The bankers, of course, argued otherwise. No one could possibly expect investment bankers to be prescient. Even the most diligent investigation might prove to be inadequate in hindsight, particularly where there had been a worldwide economic catastrophe like the Great Depression, which might cause even the safest issuers to default. The bankers had a point. To show the kind of fraudulent conspiracy Johnson charged would require more than showing that a bond turned out to be a bad investment. Johnson would have to show that the investment banks were in possession of information before they sponsored the offerings from which they could determine the bonds were bound to fail. That hypothesis seemed far-fetched, massively overestimating both Wall Street’s cupidity and its foresight. With Baker, the now former president of National City, back in the witness chair, Pecora seemed bent on demonstrating that the fraud existed.
As he did the week before, Pecora eased into the subject, asking Baker about how the executives of the affiliate evaluated proposed securities offerings. The procedure was the same for foreign bond offerings as for any corporate security. The vice president in charge of a particular field made “an intensive study of economic and political conditions” in which he “tried to determine every important factor connected with that proposed loan.” The affiliate would not offer the securities unless the executives unanimously agreed to do so. In the abstract, the process sounded quite rigorous.
Pecora’s investigators had carefully pored over these bond offerings, and all morning, he now read into the record a series of the affiliate’s internal memoranda. They all seemed to reach precisely the same conclusion—it would be foolhardy to lend the affiliate’s good reputation to any Peruvian bond offerings. In the five years before the offering, the affiliate’s own South American experts reported that the Peruvian government’s finances were “positively distressing.” The “government treasury,” one report noted, “was flat on its back and gasping for breath.” It was unclear “how the government can continue functioning on the basis of its present income.” The president of the country was, despite the early reports of bribes, thought to be honest, but he was surrounded by “rascals.”
At first, those assessments led National City to decline to participate in any Peruvian bond offerings. The history of Peruvian credit was too shaky; it had “been careless in the fulfillment of contractual obligations” and had defaulted on loans in the past. The political situation was too uncertain. All in all, the “moral risk was not satisfactory.” Was there anything, Pecora asked, in these reports that made Peru sound like a good candidate for a bond offering?
“It was not particularly enthusia
stic, certainly,” Baker granted.8
After an improvement in the Peruvian economy, however, National City suddenly decided to offer the country’s bonds to its customers, for which the affiliate earned a nice underwriting spread. Was this the fraud Senator Johnson alleged? Pecora wanted it to be and the press thought that “investors seemed destined to take tremendous losses.” Didn’t the company know these securities were bound to fail? Hadn’t they said that Peruvian bonds represented an adverse moral risk?
In truth the fraud didn’t seem to be there. People have a remarkable capacity for self-delusion, particularly when those delusions are congruent with their own financial interest. It seemed that the analysts at the company had deluded themselves about the safety and security of Peruvian bonds. With an ever rising market, the lure of fat underwriting commissions, and Mitchell’s constant hectoring to keep the pipeline full of new issues, executives at the affiliate were willing to believe that short-term improvements swamped long-term dangers. They were willing, despite Peru’s long history of political instability and debt defaults, to believe that this time things were different. “[A]s the great bull market grew greater and greater,” Pecora wrote, “as the careless ‘New Era’ psychology grew more and more pervasive, National City suddenly found nebulous reasons to justify a complete change of attitude.”9
It was a point that Victor Schoepperle, one of the company’s youthful South American experts, would make quite explicitly when he took the stand that afternoon. Just as he had with Baker, Pecora ran Schoepperle through the litany of adverse information in the affiliate’s files. Subsequent events, Schoepperle conceded, showed that his earlier assessment that the company should not participate in Peruvian loans was right. He tried, nonetheless, to excuse the optimism that led him to recommend participation as a by-product of those heady days in the late 1920s. “I thought,” he said, “like a great many others, that I was in a new era, and I made an honest mistake in judgment.” When Pecora pointed out that Schoepperle had seen just as many cons as pros, the banker’s only response was that it “was an optimistic era in which optimistic interpretations were put on any situation where the pros were about equal to the cons.” And, he might have added, where there was a chance to earn some underwriting fees.10
In early 1927, National City participated in its first offering of $15 million of Peruvian bonds, which it very quickly sold. If there was any hesitancy in the buying public, the company’s salesmen quickly assuaged it. “Gracious alive,” one salesman told a hesitating customer, “we don’t lose money for people—we make money for them.” Accompanying the offering was a brief prospectus describing the bonds, and Pecora turned from the company’s internal documents to what it actually told investors. He was laying the groundwork for the securities legislation that would be offered in the new Congress. His questions fit precisely with Roosevelt’s campaign promises to require increased publicity before securities could be marketed to the public.11
“Do you find any mention in [the prospectus] whatsoever,” he asked Baker, “of the bad credit record of Peru which is embodied in the information I have read into the record from your files?”
“No; I do not see anything.”
“No statement or information,” Pecora reiterated, “was given to the American investing public . . . concerning the bad debt record of Peru and its being a bad moral and political risk?”
“No, sir,” Baker demurely responded.
The company’s ads painted a radically different picture. “When you buy a bond recommended by The National City Company,” one touted, “you may be sure that all the essential facts which justify the Company’s own confidence in that investment are readily available to you.” Pecora wanted to know whether Baker knew any reason why this information wasn’t conveyed to investors. Baker had no answer. “Do you think it was fair,” Pecora then asked, “to the investing public to withhold from it knowledge which the participating bankers had of this issue when they offered it to the public?” Baker seemed to think that, regardless of what the ads said, the affiliate’s decision to offer the bonds was all that customers really needed to know.
“You think it was fair to the public to withhold the information which you had or your company had,” Pecora asked, “merely because somebody in your company reached the conclusion that the loan would be a sound loan?”
For Baker that was indeed enough: “I think it was fair to present the facts as they existed.”
“The facts as they existed included this bad-debt record, did they not?”
Baker quibbled: “I am speaking about the facts that were then currently existing.”
“You mean you think it was fair to present a conclusion based upon facts which could not have been more than a year old as against a bad-debt record for many, many years prior thereto?”
Baker finally conceded that “it would have been better if the whole story perhaps were included.” Even he now seemed to realize that the affiliate couldn’t offer bonds and simply tell investors, “Trust us. If they are good enough for us to offer, they are good enough for you to buy.”12
The ease of that first sale, Pecora argued, only whetted the company’s appetite for more fees (it ultimately netted about $100 million in today’s dollars). Here was a ready way to satisfy Mitchell’s constant demands that the company manufacture more securities to help cover the costs of its vast retail network. National City kept right on offering Peruvian bonds in 1927 and 1928, even though one of its own South American experts continued to conclude that he had “no great faith in any material betterment of Peru’s economic condition in the near future.” The political situation, he wrote, was “equally uncertain,” with “revolution” a distinct possibility. Would the public have purchased these bonds, Pecora asked, if that information had been included in the bond prospectus? “I doubt if they would,” Baker replied.
The company, Pecora showed, didn’t even take responsibility for the limited information it did choose to provide investors, and here too Pecora seemed to be laying the basis for the securities legislation that Roosevelt would propose when he took office. Each of the National City Company’s prospectuses had for years carried the same disclaimer: “The above statements are based on information received partly by cable from official and other sources. While not guaranteed, we believe them to be reliable, but they are in no event to be construed as representations by us.” National City, it seemed, was perfectly happy to collect the fees, but it didn’t think it should be on the hook for anything it told or failed to tell investors.13
Throughout the day’s testimony, Baker was no more cooperative than he had been the previous week. In fact, his public humiliation seemed to make him worse. At one point, Pecora asked the former president about the meaning of a statement issued by an industry group to which he belonged, the Investment Bankers Association, and by his response, it appeared that Baker was denying any ability to comprehend the English language. The professor who wrote the report said he was not at liberty to express his own personal opinions because he was acting as a representative of the IBA. Pecora then asked Baker whether he agreed “with the implications of this statement.”
“Well,” Baker hesitantly replied, “that depends upon what they are.”
Pecora was so surprised at this response that he gave Baker another chance: “Suppose you read them again and see what meaning you attach to them.”
“I read it,” Baker insisted, “and I told you I don’t know what he means.”
The two men went back and forth in that manner for some time until an exasperated Pecora finally asked a question that he thought Baker could answer: “And those words are meaningless to you?”
“Well, they are meaningless if you ask me to interpret what was in his mind when he wrote it. I cannot do that.”
“Do you think the English used there is so involved that the author did not make himself clear?”
Baker claimed that he didn’t know what Pecora was asking him, leading the now t
horoughly frustrated lawyer to reply: “I am trying to find out if you attach any meaning at all to that sentence, or if those words are merely a meaningless jumble to you.”
“Well,” Baker responded, “they do not seem to particularly convey anything to me. I don’t know what they mean.” Now in his second week facing Pecora, Baker—a man who had once commanded an army of salesmen, a vast, international securities-selling network—was so afraid of this little lawyer from New York he could hardly speak.14
The day was filled not only with an inability to grasp the English language, but also with the same kind of casual prejudice that was being directed at Pecora. One of the company’s analyses posited that a factor “that will long retard the economic importance of Peru” was its native population of “Indians, two-thirds of whom reside east of the Andes, and a majority [of whom] consume almost no manufactured products.” Pecora wanted to know whether, when National City began to offer the country’s bonds, the Indian population had changed. To general laughter, Schoepperle remarked, “I imagine it had increased.”
“I hope no personal consideration enters into that?” Pecora joked.
The Hellhound of Wall Street Page 28