|The Collapse of Penn Central
In June 1970, the failure of Penn Central represented the largest bankruptcy in America. And in the retelling of this story, you may notice an interesting parallel or two regarding our current economic environment.
This is a tale about the railroads and mismanagement in the 1960s. But to set the stage, going back to the late 1800s, recall that the railroads were the first national business, frequently dominating the geographic regions through which they passed. Everyone was beholden to them; the farmers had to accept their terms, the coal mines, travelers, and on and on.
Meanwhile, as the railroads became some of the giants of American commerce, the Pennsylvania and New York Central were two of the major players. Pennsylvania had no real competition in the Pittsburgh market, and the New York Central was the dominant force from New York to Chicago.
But many of the railroads had gone through very difficult stretches, with the chief cause being the regulatory climate overseen by the Interstate Commerce Commission (ICC). The ICC established rates and as the costs soared for the railroads (the cost of maintaining track and the burgeoning salaries for workers, for example), an investment in one of these companies wasn't as lucrative as it had once been. [Echoes of today's California?]
By November 1957, the Pennsylvania and New York Central announced that they were contemplating a merger. The industry was losing both freight and passenger traffic to the new superhighways as well as the airline industry. But financially, Penn and NYC were in decent financial condition. Unfortunately, talks were put on hold the following January when the CEO of NYC committed suicide.
A few years went by and in the early 1960s, Stuart Saunders became the CEO of Penn while Alfred Perlman held the reins at NYC. The two began to hold discussions again on a merger, while at the same time Saunders was launching a massive acquisition and diversification campaign. But to paraphrase Cornelius Vanderbilt (and market historian Charles Geisst), building a monopoly requires that you extend your empire into areas you understand, not those you don't.
Saunders razed Pennsylvania Station in New York and created the new Madison Square Garden, along with two office towers. [In return for the property, Penn retained a quarter interest in the complex.] And then Saunders went after the Great Southwest Corp. (whose prime property was Six Flags over Texas), Arvida (a Florida land company), a mobile home company, and Executive Jet Aviation (from which Saunders sought to start a major charter service), along with others. Finally, Pennsylvania sold the Long Island Railroad to New York State for $65 million.
It's pretty clear that the shift was away from railroads. So why would Saunders seek to merge with New York Central? Simply to gain additional publicity and borrowing power.
By 1965, the merger of the two creating Penn Central was approved by the ICC; however, it wasn't until January 15, 1968 that the move was formally approved by the U.S. Supreme Court. Saunders became chairman / CEO, Perlman was president / COO. And lurking in the weeds was a shady character, David Bevan, who ran the books.
The new Penn Central was a mess. Chairman Saunders was clearly more interested in his non-railroad activities and, anyway, the railroad operations were steeply in the red.
Pennsylvania politician Milton Shapp (who would later become governor) once said of Saunders:
"I've been to several parties with him where he had a few drinks, and he was always talking about Litton Industries and how Litton and other conglomerates had cash coming in and were putting it to good use
He said he wanted to keep the money for real estate investments instead of putting it in the f------ railroad. That's what he said." [Source: Robert Sobel]
Yes, part of the problem was that this was the era of the conglomerates; Litton, LTV, Gulf & Western, ITT
to name a few. But PC was acquiring companies that reportedly never really made money. The investment landscape of the time, however, allowed PC's share price to rise and the acquisition binge continued, as well as the accumulation of massive amounts of debt.
And economist Henry Kaufman says of this period in the late 1960s, "I watched with growing alarm as sources of corporate borrowers - in an effort to circumvent regulatory lending constraints - piled into the commercial market as issuers. The trend continued, and culminated in the collapse of the Penn Central Railroad."
The U.S. financial system was flailing badly. It was a period of rising inflation, Vietnam (with ever increasing military spending) and a tight Federal Reserve. The banks began to feel a squeeze, while corporations issued massive amounts of commercial paper through their holding companies.
[Today, the energy problems in California and the potential bankruptcy of two major utilities are causing a crunch in the commercial paper market itself. Banks are afraid to lend to certain risks, even if for very short periods of time.]
Kaufman blamed regulators for the atmosphere in the 60s, many of whom were simply out of touch with evolving technologies and markets.
Back at Penn Central, the Penn and New York Central cultures were clashing badly. There was confusion among the crews and PC had problems with the unions, even though it was forced to guarantee employment to all existing workers as a condition for the merger.
The end result was that some trains were misplaced for days, while corporations like Eastman Kodak saw their piggyback vans miss connections; in the case of St. Louis, three quarters of the time. So it was no surprise when the freight business began to go elsewhere, like to the trucking companies. Major industrial customers such as Allied Chemical abandoned PC.
All the while, David Bevan was playing with the corporate books. Penn Central's subsidiaries were stripped of their treasuries in order to prop up PC's own earnings. For example, New York Central Transport, a trucking subsidiary, had profits of only $4.2 million and yet paid $14.5 million in dividends to the parent. Despite this kind of maneuvering, the dividend on Penn Central common was slashed from $2.40 to $1.80 in 1969. Chairman Saunders vowed to hike it back up, soon. [It was later learned, however, that insiders at PC were unloading their company stock and bonds while all of this was going on.]
At this point, Saunders, recognizing the coming disaster, thought he could pull a fast one. He proposed a new Penn Central Co., a holding company that was to be formed through the acquisition of Penn Central Transportation, on a one-to-one share basis, as a way of recognizing a new company. This way if the Transportation Company went into bankruptcy, Penn Central might survive.
[To digress just a bit, at this time Henry Kaufman saw a huge problem on the horizon. Commercial paper borrowing had climbed from $10 billion in mid-1965, to $32 billion by the end of 1969 (and it would further increase to $40 billion by May 1970).]
So in early 1970, PC's Transportation Co. had $100 million due to mature in a matter of months, and, not having the cash, CFO David Bevan thought he could float some bonds. Well, the market was not too fired up about buying more PC paper and, while the company waited, they had to report a first quarter loss from railroad operations of some $102 million. Now no one wanted to touch the bonds and the offering had to be withdrawn.
Penn Central had one last chance, its lead bank First National City. Well, couple the commercial paper environment described above with PC's balance sheet and you can see why the bank would say no.
It was now May and news stories had been floating around describing Penn Central's problems for weeks. Just two years earlier, in 1968, PC stock was trading at $86. On May 11 it hit $18, then traded at $15 the next day.
The company had one last shot at staving off bankruptcy, a government bailout. Bernard "Bunny" Lasker, Chairman of the New York Stock Exchange, went to President Nixon to see if a package could be put together. Penn Central wasn't the only railroad having problems, of course, and an agreement was reached for $750 million in aid, of which $300 million would go to PC. Saunders, Perlman, and Bevan were dismissed.
On Sunday, June 21, Penn Central declared bankruptcy. And, as it turned out, Congress failed to approve the aid. The federal government thus had to step in to preserve needed rail service. The result? Conrail for freight service, Amtrak for the passengers. And you all know how that has turned out.
Henry Kaufman, "On Money and Markets"
Charles Geisst, "Monopolies in America"
Robert Sobel, "When Giants Stumble"
Floyd Norris and Christine Bockelmann, "The New York Times
Century of Business"