Bagehot

by James Grant

  “What! £40,000 and 10 percent interest?” I screamed rather than asked.19

  This seeker of funds, Stefanos Xenos, the founder, chief executive, and owner of the Greek and Oriental Steam Navigation Company, was in no position to negotiate, though quibble he did. After some chaffering, he agreed to settle for a “bonus” of £30,000 and a 5 percent rate of interest.20

  There was a final demand: Edwards told Xenos that he needed a little something for himself. Xenos, flabbergasted, asked if he was not in Overend Gurney’s employ and, if so, whether the £30,000 “bonus” he had reluctantly agreed to pay was not enough? Edwards replied that he had “spoken to them about it, and that they had told him he must look to me for remuneration. He added that he would be satisfied with £500 a year.” At least, Xenos reflected, the demand for an annuity, rather than a single payment, suggested some confidence in the solvency of himself and of Overend Gurney.21

  As to Overend Gurney, there were recurring doubts. As early as February 1861, rumors had made the City rounds that this supposed Rock of Gibraltar was crumbling. In reply to an anxious correspondent, the governor of the Bank of England, Bonamy Dobree, deflected them. Yes, he acknowledged, Overend Gurney was said to have incurred heavy losses of as much as £400,000, and was engaged in a most “reckless” business with lock-up securities. Still, profits remained considerable, and “the capital is ample enough to meet any contingency. The uncertain mode in which the business is conducted is the subject of general censure.”22

  It had meanwhile dawned on Xenos that Edwards was not in the least curious about how he would repay his debt:

  He had advised the house to advance me the sum of £80,000, without even going himself or sending some competent person to inspect the steamers, a mortgage on which was to be the security for the amount lent. I was amazed at the facility with which this gigantic transaction was completed in the short space of eight-and-forty hours. Mr. Edwards, to whose name, as the nominee of Messrs. Overend, Gurney and Co., the steamers were to be mortgaged, did not even ask me, till several months after, for the policies of insurance on them; and it was a week after I had all the money that I signed the bills of mortgage. In fact, I received nearly all this large sum of money without having given any security in return.23

  When not so constructively engaged, the new partners organized an attack on the Bank of England—or rather, by their lights, a counterattack, as the Bank had provoked them in 1858 by withdrawing their on-demand accommodation privileges. No more could Overend Gurney, or any other bill broker, raise cash at the Bank by presenting the accustomed collateral at a time of the broker’s own choosing. The brokers might borrow only at the end of a calendar quarter, when the bunching of dividend payments ordinarily pressured the money market. The Bank so acted to induce the brokers, Overend Gurney in particular, to hold reserves against times of trouble. Overend Gurney, which had sought and received massive accommodation in the 1857 blow, preferred the old way of doing things, but the Bank, concerned that it was now underwriting recklessness, refused to reconsider. It did not sweeten relations between the two institutions when, at the end of March 1860, the bill discount rate popped up—an unusual decision, as the Bank was in the habit of holding its rate steady at quarter-end.

  To Overend Gurney, the move was a declaration of war on the bill market in general and on itself, the preeminent bill broker, in particular. It was therefore necessary to organize a reprisal. In league with other discount houses, the Overend Gurney partners arranged for the sudden withdrawal of £1.4 million in Bank of England notes from the Bank’s own vaults. Lombard Street, caught unawares, feared that the monetary exodus was a sign of trouble with the currency, or with the Bank. Overend Gurney—or someone pretending to act for Overend Gurney—followed up this probing action with an unsigned letter to the governor of the Bank threatening a still more damaging demonstration the next time.

  But when the incident was brought to Parliament, the Bank stood firm, and Overend Gurney backed down, apologizing.

  OVEREND, GURNEY AND CO. seemed almost to comprise two hermetically sealed divisions, one crooked and loss-making, the other upstanding and profitable. In 1864, Robert Birkbeck, a junior partner in the honest wing of the business, confronted Edwards about the mounting losses in the corrupt subsidiary. Edwards thereupon resigned, though not empty-handed. Having signed a five-year employment contract in 1863, he carried off a douceur of £20,000. There was nothing sentimental about this going-away gift. Edwards, as Chapman later acknowledged, “had become possessed of sufficient knowledge to have forced us to put up our shutters within 24 hours.”24

  By 1865, the great Overend Gurney firm was insolvent. Its assets footed to some £15 million, of which about £4 million’s worth was impaired, doubtful, or desperate. The partners judged that, among these nonperforming loans and investments, £1 million’s worth was eventually salvageable. Against an indicated loss of £3 million stood £1 million in partners’ capital. The partners’ personal estates were said to be more than adequate to cover the remaining troubled £2 million. Cash on hand totaled £120,000.

  Confronting these facts, the sadder and wiser partners faced a momentous decision: wind up the business, or persevere. If the latter, they might carry on as they were, a private company, or become a public one. To quit would of course be devastating; quite apart from considerations of family and social standing, the old business had never ceased to be profitable. Over the ten years leading up to 1864, it had produced average gross earnings of £227,000 per year, before bad debts and income tax. For the first six of those ten years—before the full onset of the Edwards plague—the actual distribution of profits averaged £185,000 a year, net of write-offs on “ascertained” bad debts.

  The partners resolved to continue, though not as the ancient, still estimable, private partnership of yore, but rather as the limited-liability joint-stock company of modern times. The firm was going public. There would be a pronounced reduction in social status, but the public, though it brought no luster, would contribute money, and with that money the chance to begin the business anew, sans Edwards. They would issue a prospectus and sell shares to any and all, and with the proceeds of the sale, the new Overend Gurney would purchase and recapitalize the old one. Four new directors would be recruited to join three of the old partners on the board of the new firm, lending their imprimatur to the still luminous Overend Gurney name.

  In confidential communication with the prospective board members, the partners laid their cards on the table. They wanted to put their blunders behind them, and provided an overview of ten years’ operating results and a description of the crippling “extraneous” business into which they had “unadvisedly entered.” As later came out in court, the legacy partners provided the incoming directors with “the fullest disclosure of the state of the concern.”

  As far as the public was concerned, more was withheld than disclosed. The prospectus, only five paragraphs long, contained neither current financial information nor financial history. It enumerated no risk factors, and conspicuously failed to mention the £4 million deficiency. There was only one, indirect reference to the Edwards era: the firm would be sold with “the vendors guaranteeing the company against any loss on the assets and liabilities transferred.” The meaning of “any” was left to the reader’s imagination, as was the size of the pool of private wealth from which the partners of Overend Gurney could draw to make good their contingent liability.

  Thus enlightened, the public was invited to purchase 100,000 shares at £50 each, of which £15 would be paid, with the remaining £35 callable in a future time of trouble.† “The directors,” the document went on to say, “will give their zealous attention to the cultivation of business of a first-class character only, it being their conviction that they will thus most effectually promote the prosperity of the company and the permanent interests of the shareholders.” Any in search of further detail—“the company’s memorandum and articles of association, as well as the deed of c
ovenant in relation to the transfer of the business”—were invited to visit the offices of the company’s solicitors. “Such terms,” stated the document, “in the opinion of the directors, cannot fail to insure a highly remunerative return to the shareholders.”

  When all was said and done, the new Overend Gurney took in £1.25 million.‡ The prospectus did hint that there was a deficiency on the balance sheet, but it hardly mattered; only thirty or forty curious people turned up at the solicitors’ offices to examine the fine print. Complacent investors subscribed for more than twice as many shares as were offered for sale.25

  Editorial reception of the IPO ranged from respectful to rapturous. The Times contented itself with a reference to the wealth and honor of the selling partners and to the acumen of the incoming directors (“it may be inferred that in that respect due judgment has been exercised”). The Bankers’ Magazine treated the Overend Gurney conversion as the culminating triumph of the doctrine of limited liability. Once upon a time, it had been taken for granted that “public confidence could only be secured by establishments whose every shareholder stood in peril of the ruin,” but with the transformation of Overend Gurney into a public company that fear was finally put to rest. Were the investors getting a fair valuation? Like The Times, Bankers’ Magazine was content to accept the judgment of “the eminent gentlemen who constitute the new blood of the board.” All would win by this transaction:

  The members of the firm, if they lose something in position, gain a good deal in pocket, and something also in ease of mind by the division of their responsibility, especially in times of financial difficulty. To depositors and discounters it is unquestionably an advantage to have the unpaid capital of a number of shareholders, as a practically inexhaustible reserve, to fall back upon. And to the political economist it is a source of gratification to see the mass of small capitalists admitted to a participation in the profits which result from great commercial undertakings.

  Yes, the magazine’s editors admitted, there were “errors, failures and frauds,” but human imperfection could not efface the vast net benefit of public ownership of profitable enterprise. The sun was setting on the age in which the rich got richer and the poor got poorer.

  The Money Market Review, the Economist’s would-be rival, weighed in at the extreme side of rapture, seeming to pull its forelock to the third generation of Gurney bankers (“riper and richer in years as in wealth”), celebrating the triumph of the system of limited liability, credulously repeating a story about the partnership’s historically unblemished credit experience, and concluding with a word of advice to its readers: “Upon the whole, we must say we know of few commercial undertakings of recent date which may be more strongly commended to the investing public.”

  Few were better qualified to pass judgment on this seminal transaction than the editor of the Economist. Bagehot and Stuckey’s Banking Company had grown up together. Since his fumbling start with columns of figures that refused to add up, the assets of the firm had expanded to £3 million from £2.5 million, and the annual remuneration of the proprietors—Walter Bagehot among them—from £7 to £12 a share. Bagehot knew what a successful financial institution looked like.

  Indeed, Stuckey’s seemed crisis-proof. It sailed regally through the Panic of 1857, the American Civil War, and the occasional poor West Country harvest. And the 7 percent interest rates of 1864—the year of the “cotton famine,” so devastating to the Lancashire textile industry—had served only to afford management wider opportunities for the profitable deployment of borrowed funds. In January 1865, the directors were able to report that “the commercial disasters which have reduced the profits of many banks have not visited either Somersetshire or Bristol, the result of the half year’s operations are very satisfactory.” There was a 10 percent bonus for long-serving clerks, but no such emolument for the stockholders, as “it would be inexpedient, out of temporary and extraordinary profits, still further to increase a dividend which has been augmented so rapidly to so high an amount.” Instead, the directors voted to carry forward £11,000 in earnings in order to fortify a balance sheet for which the partners of Overend Gurney would have given their eye teeth, and, still deeming their position insufficiently strong, the board presently resolved to raise more capital. What we today call a “culture of risk management” was something that Bagehot might have absorbed around the Langport dinner table.

  Bagehot was, of course, more than a banker, even more than a bank director; it was in his capacity of thinker, editor, and essayist that the members of the Political Economy Club tapped him for membership in May 1864. John Stuart Mill, the economist John E. Cairnes, Lord Overstone, William E. Gladstone, and the parliamentarian Robert Lowe were among the company that so honored him. Founded in 1821 by the likes of Thomas Tooke, David Ricardo, James Mill, and the Rev. Thomas Robert Malthus, the club gathered for discussion on the first Friday of the month, December to July (January omitted). Friday was the night that the Economist went to press, but Bagehot did not hang back on that account. He led his first discussion at the March 3, 1865 meeting with a question that suggested he had been talking to Goschen, himself a newly elected member: “Are there circumstances which should induce us to think that the average rate of interest in this country has a tendency to rise as compared with the rate (say) ten years back?”

  What, then, did this more-than-journalist have to say about Overend Gurney?

  To write about finance in a useful way is to take an unconventional view of the future (there’s not much demand for what everybody already knows). It is good to write well about dry subjects—a pleasing style would suffice to support a financial paper if only the readers read for pleasure, but then and now, they mainly read for profit.

  Since the future does not exist, the useful financial writer must try to imagine it. So imagining, he or she enters into the non-factual field of speculation. Speculation can be highly lucrative, though it is rarely so for the mid-level journalistic employee. The journalistic proprietor is in a very different position. For him, speculative success pays the tangible dividend of a growing readership. Bagehot, who earned a share of the Economist’s profits and who was married to a stock-holding member of the founder’s family, was a proprietor in fact if not in name; his financial interest in correct prognostication was direct and immediate.

  The new Overend Gurney was three days old when the July 15 edition of the Economist hit the stands; Bagehot, unsigned as usual, reviewed the financing. He began with a remark on the wondrously changing times: “among those who are guided by their notions and their conduct rather by present facts than by past facts, the step which Messrs. Overend have taken is generally approved of.”

  Cast in the passive voice, the sentence committed the paper to no editorial judgment. Bagehot seemed to have his doubts about something. He quotes “a well known case” in which one of the Chapman brothers admitted to having lent “certain parties money upon ‘some shells,’” a confession that had set tongues wagging. “All the country bankers in England began to ask, ‘Is our money put out in shells or not’?” Overend Gurney had not done much of this unorthodox business, Bagehot asserted, but exactly how much would now come to light: “Now we shall know this. It will be incumbent on the new company to publish such an account as will tell the shareholders and the public the principal points of its business.” The Economist wasn’t the only curious party, he continued: “we have heard many people with real money say that they should like to know the proportion between the pure bill-broking business of Messrs. Overend, and the extra and accessory business which their large superfluous means had led them also to undertake.”

  The possibility that this “extra and accessory business” was large and rotten enough to threaten the solvency of the firm was a risk Bagehot seemed not to consider. As to the management of the new enterprise, he gave it a backhanded vote of confidence:

  We will not say anything unfavorable of any one, but we only speak the admitted conclusions of Lombar
d street when we say that the continuing partners—the practical managers, as we apprehend, of all the detail of the new concern—are men with whom everyone would delight to do business. The name of Mr. John Henry Gurney is a guarantee of solid wealth, and that of the other continuing partners for sound and careful management, when they are left to themselves and can act without disturbance as they like.

  Bagehot was similarly ambivalent about the valuation of the new Overend, Gurney & Co. Lombard Street thought that the price was reasonable, “but we have no means of really judging—we have not seen, and the public has not seen, the interior.” The law required no such disclosure, nor did Bagehot propose that the law be revised to demand it. Public investors must trust in the new directors.

  The Economist then struck a bullish note: “Therefore, we entirely approve of the step which this great firm have taken, and sincerely hope that it will be the means of handing down to posterity the historical name of ‘Overend.’ It is not without value to have hereditary names in the money market as well as in politics. They are incentives to preservative caution.”

  Bagehot went on like a man who has something to say but can’t quite come out with it. He entered some cautionary observations about the legal nature of the old partners’ guarantees, noted that risks are inherent in the very nature of a discount company, and speculated about the nature and size of Overend Gurney’s deposits. Then, finally, he said this:

  Anyhow, Overend’s must have much money left with them; and doubtless all of it will remain under the new firm as under the old. The house is not weakened but strengthened by what has occurred. As to the management, there ought to be, and must be, great traditional knowledge and skill in a concern which has been so very profitable so very long, and where such vast sums have gradually been made.