The Financial Situation

The Scramble for Internal Bonds

MERRYLE STANLEY RUKEYSER

THE war left us all with a vivid sense of the tumultuous. Nineteen months after the signing of the armistice, many still perpetually fear that large sectors of this world of ours are on the verge of a cataclysm.

There has been, a quickening of the currents in the rivers of contemporary life. Instead of quiet creeks, most folk can now see only dashing waterfalls. After six years of drastic rearrangement of the economic and political facts of the world, observers have acquired the habit of expecting the hitherto impossible. The unusual now seems routine.

Few have been immune from the effects of the virus. The sharpened desire to obtain great rewards is an expression of the new attitude. The plodding man of pre-war days—patient, easily satisfied, undramatic—is indeed scarce to-day. Workers and capitalists, men and women, have equally succumbed to the influence of events. Just as manual toilers hunger for higher pay and shorter hours, so owners of wealth demand an ever larger return on their investment.

"Every one seems to be shooting at a pot of gold in the moon," a senior officer of one of the principal institutions in Wall Street remarked, in commenting on this situation.

Only in the light of this interpretation can the attitude of many Americans toward placing money in foreign securities be understood. The enthusiasm for external dollar bonds of the countries of the Old World has been at a low ebb, whereas there has been a flaming ardour impelling Americans to purchase the more risky internal obligations of the same countries. Since the ending of hostilities, we have been living through a speculative period. The herald of the virtue of pure investments has been shouting to a multitude that would not hear.

European Bonds

EXTERNAL loans floated in the United States are payable in dollars at a fixed date, and the value of the dollar in the foreign exchange market in no way affects the bondholder. On the other hand, the internal bond, which was issued for distribution among home population, is payable, both in respect to interest and principal, in pounds, francs, lire, and marks, as the case may be. The value of an internal European bond held in this country fluctuates each day with the movement of rates of international exchange.

The buyer of an external obligation of a solvent European nation is an investor—a person seeking regularity of income and safety of principal. The purchaser of a European internal bond, however, is really speculating in exchange rates. If five or ten or twenty years hence the franc is worth 19.3 cents instead of 7 cents, the value of French internal bonds in terms of dollars will be nearly trebled. If, on the other hand, when the bond matures, the franc is worth less than 7 cepts, the principal translated into dollars will have shrunk. It is the conviction that the pound, the franc, the lira, and the mark will be worth more in the future than to-day that is driving thousands of Americans to accumulate municipal and national bonds that were originally intended to remain in the possession of Englishmen, Frenchmen, Italians, and Germans.

"The sale in this market of European internal securities, rendered attractive by the prevailing rates of foreign exchange, is reported to be increasing in volume," Pierre Jay, the Federal Reserve Agent in New York recently informed the Federal Reserve Board. "Inquiry among dealers is basis for the estimate that $600,000 to $650,000 a day would amply cover the aggregate. German municipal obligations have been particularly in demand. Canadian bonds payable in Canada or in New York continue to enjoy a good market here."

A Warning to Investors

BUYING the internal obligations of foreign countries and cities—importing the title to European street railways, waterways, and gas works—is a new venture in world finance for Americans. The scramble for internals began only last autumn and purchases have been progressively, though sporadically, expanding in volume. It is likely to continue for a decade, and will probably wax larger unless some catastrophe should come to chill the zeal of those who are pioneering.

Before the war, the United States was a borrowing nation, and now, as creditor of most of the world, it has been finding itself unequipped with knowledge and facilities to play its new international role. The appetite for European internals has been the basis for a mushroom growth of new bond houses in the financial districts of the country.

The feeling that the spur of ignorance was leading many to participate in the new financial activity induced the National City Bank to issue a warning in its journal, The Americas:

"It is doubtful," it says, "whether the average American who purchases a bond of one of the many internal issues understands the profound difference between such a bond and an external security issued, by a European government. There have been several examples of the latter, the Anglo-French loan being the one with which the public is perhaps most familiar. In such a loan, the fact that it is to be sold to investors who are not citizens of the borrowing country is definitely understood, and clauses are inserted for the protection of alien purchasers from the effects of any laws which the borrowing nation may conceivably pass in its dealings with its own citizens.

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"In purchasing most of the internal European securities, such as make up the largest part of the buying movement now in full swing, an American places himself on exactly the same footing as a citizen of France, Great Britain, Italy or whatever country issued the bonds. Should the country in question decide that the quickest means to a sound postwar economy should be through the exaction of a tax on capital amounting to say, 50 per cent, the American could not look to his Government for the protection of his interests, because he would in fact have no interests involved that would be different from a citizen of the nation which ordered the tax levy."

Although charity is supposed to begin at home, in practice the internal obligations of governments are the first to suffer in times of trouble. The financial ministries recognize that to default on external bonds would perhaps irreparably impair the national credit in foreign money marts. In the case of utter financial ruin, it would be necessary to default on both the internal and external loans, but the latter constitute a prior lien and would suffer last. When Russia nearly three years ago set out upon the adventure of re-examining the fundamentals of orthodox economics, her national debt became dishonored. But, whereas by a sudden decision the internals went into immediate default, interest on the externals was paid almost a year longer out of funds on deposit in the United States. Moreover, Lenin has offered to recognize the external bonds under certain conditions, but the internals are worth scarcely more than their weight in paper.

Moreover, in many instances, external bonds are secured by a lien on a particular source of revenue, in addition to being a general charge on the national wealth. For example, the Japanese sterling 4j4's, maturing in 1925, which were selling to yield 12 per cent earlier in the year when sterling was ebbing, constitute a first and second lien on the state income from the tobacco monopoly.

Internal bonds are almost invariably merely general obligations. In the case of external bonds issued by Turkey and some of the South American countries, the foreign creditors were permitted to retain agents in the debtor country either to collect customs or to supervise collections, on which the bonds were a direct lien. This gave the security holders greater assurance that their interests were being taken care of, but it often seemed a humiliating surrender of independence on the part of the borrower.

Internal and External Bonds

SO much for the essential differences between externals and internals, which differ much in the same way as first and second mortgages on the same property. Legally, the disparity between the two types of foreign bond is striking, and the external is unquestionably better safeguarded. However, where a borrowing nation or municipality is solvent, it will in all probability meet both its internal and external obligations, and thei difference is largely a matter of theory. Likewise, where a nation is thoroughly unable or unwilling to pay its debts—as the Republic of Mexico has been since 1913, although it is now working on plans for the resumption of interest—it is likely to default on both categories of loans. The superiority of an external loan over an internal really counts most in borderline cases, where countries, though well intentioned, are unable completely to meet their obligations. Where it is necessary to scale down some, the internals suffer first, because, after all, paying off internal loans to citizens merely means taking the money out of one pocket in the form of taxes and putting it back into another. It is conceivable that some of the less solvent European countries, though still respecting the rights of bondholders in principle, may be unable to liquidate the entire heritage of debt left by the war. In such instances, the externals, from the standpoint of safety, would be infinitely more desirable. The risks connected with the internals are greater, and yet many feel that risks are inherent in the uncertain European situation, and prefer to assume the greater risks in the hope of greater rewards in the event that all turns out well.

Recognizing the desire of many Americans to speculate in the strangely vacillating foreign exchange market, both the British and the Belgian governments in floating loans in this country recently combined some of the advantages of an internal and external bond into one security. Though both the new United Kingdom and Belgian bonds are external, dollar obligations, the holder has an opportunity to profit if exchange rates move in favor of London and Antwerp. The principle was carried further in the Belgian issue, which came later, and brought the loan to complete success at a time when the investment market seemed especially unpromising.

A Loan to Europe

A YEAR ago Mr. Henry P. Davison, Mr. Frank A. Vanderlip and other fashioners of financial changes in this country hoped American investors would lend billions of dollars to suffering Europe through the purchase of external bonds. The floating of huge issues now seems unlikely, because of the limited demand for new external bonds, and other means of achieving similar ends are being sought.

What the Europeans need is dollars —dollars with which to buy foodstuffs and raw materials. If an Italian wants to get dollars by exchanging lire, his native currency, for them, he will have to give four times as many lire as in pre-war times. It would therefore be much more advantageous for him to borrow the dollars and to pay them off at some future time when he hopes lire will buy more dollars than at present.

From the standpoint of the European, it makes little difference whether the American purchases an internal or an external bond, for in either case dollars are obtained in New York. In the matter of an external loan, a definite amount is fixed. Perhaps it is $250,000,000. If the investing public fails to subscribe to the full amount, the operation is stamped a failure. The credit of the unsuccessful borrower has been hurt. The American bankers who advanced the money to the foreign government have been unable to reimburse themselves through the sale of the bonds to the public, and will be disinclined to finance that country in the future.

In the case of internal bonds, there is no formal underwriting—that is, taking of a specified block by a group of bankers, who expect to retail the bonds to the public. Bond dealers import only as many internals as there is a market for. They purchase them on the London, Paris, Rome and Berlin stock exchanges in accordance with the retail demand in this country, just as the lace importer brings over delicate fabrics. Thus there is no concentrated selling campaign, as in the case of externals, but a continuous, all the year round, sale.

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French Certificates for Americans

RECOGNIZING in the distribution of internals in this country a medium for meeting some, at least, of the French needs, certain bankers, in cooperation with the French Government, have been carrying on negotiations for the purpose of putting this new type of bond on a more formal basis. At present an American purchaser of a foreign internal security has to wait many weeks before it is purchased abroad, shipped across the high seas, and delivered to him. It is now purposed to obviate such delay by getting an American trust company to issue American certificates against French internal bonds which will be physically deposited to its credit in Paris. If this plan is adopted, the American purchaser will get an engraved certificate that he can read, instead of a French bond designed for Frenchmen. Thus counterfeits will be made less easy, and the barrier of unfamiliarty which has been halting the purchase of securities from faraway places will be removed.

The European governments, yearning for credit from the United States, no matter in what form it comes, have during the present year been taking subscriptions in this country for their new internal loans.

Including the bonds of the 1920 loan, of which 85,000,000 francs were sold in the United States, perhaps more French internals have been purchased here than those of any other country. In recent months, however, there has been a rush for German securities, which banking authorities regard as exceedingly speculative. Enslaved by the memory that the mark was once worth 23.9 cents, many Americans cannot help believing that German currency—though it no longer is backed by an adequate gold cover—is a real bargain, when the mark has been quoted as low as 1.04 cents.

Assuming that one is going to speculate in marks, it is better to hold internal bonds, particularly those of the old cities, than the currency itself. Even within Germany, this view obtains, and a movement known as the "flight from the mark" has been going on. Residents of the former realm of the Kaiser distrust the value of the mark, and prefer to own securities. They fear that the Government, borne down by reparation payments and by the evil effects of a watered currency, will cut down the mark by calling a 1000 mark bill perhaps 600 marks.

Speculating On Germany

WHAT would happen to a 1000 mark municipal bond in the event that marks were scaled down is problemati cal, but some speculators assume that the bonds will fare better than the currency. It is not exdusively the gullible amateur who is speculating in mark securities. Not a few well informed persons, recognizing that they are virtu ally gambling, have been laying aside money for this speculation in the future of Germany. The most reasonable are writing off the money placed in mark securities as a loss, and are not antici pating pleasant surprises for at least a decade. But some are hoping that when their infants become adults German se curities, measured in terms of dollars, will be far more valuable than to-day.

The holder of German securities are speculating on the ability of the country to emerge from chaos and also on the contingency that the rights of private property will be continuously respected.

Speculative investments in foreign in ternal securities are not without their allurements. The pound sterling be tween February and April rose 75 cents to the pound, and the holders of British internals profited to that extent. The prevailing opinion is that of all the securities of former European belliger ents the British are the safest, and the Belgian possibly next. France is mak ing progress, and in proportion as she recognizes that too much reliance can not be placed on large reparation pay ments from Germany her credit will improve.

Buying internal bonds is part of the experience of a creditor nation, and the war has left the United States the most important creditor. If the importing of bonds is to persist, it is essential that an open market in these securities be established, so that the American investor can sell as well as buy.