No business is risk free. It is remarkable how even monopolies, whether of a natural sort or those granted by law, are susceptible to challenge. The British East India Company possessed one of the most remarkable monopolies in history and even it struggled to make money for certain long periods in its history. Railroads were different though; in America, they were once immensely profitable and natural monopolies. Still, even they were exposed to tremendous risks and these could be magnified by the capital-intensive nature of their business. Technological and economic changes, together with questionable management decisions, particularly with regard to financial policy, brought about the end of one major American railroad, Penn Central.

Railroad Industry

            The railroad industry in the United States took a turn for the worse after 1960 or so and so too did investments in railroads. Railroad securities were once considered conservative investment choices but now railroads were struggling. This was particularly true in the Northeast. The railroads were hit by a myriad of negative developments manifesting simultaneously. Firstly, the profitability of passenger service was declining. Airlines would have taken some business but railroads also competed with the interstate highway system and ubiquitous automobiles. There was a regional dimension here because the system of highways was denser in the Northeast than elsewhere.

            Secondly, more inter-city freight was being moved by truck. This was particularly problematic for railways in the Northeast where distances between cities was shorter and therefore more conducive to truck transport. Third, the American economy was also expanding more quickly in the South and West, regions with less railway track mileage, whereas the Northeast was growing more slowly but had what by 1970 needed to be considered an overbuilt network. Many routes were served by duplicative lines. Fourth, the structure of the economy was changing. Industry was moving out of the Northeast for other regions and the American economy overall was shifting away from producing goods and towards services. These don’t need to be delivered by rail.

            So, the railway business was deteriorating. The combined earnings of the nation’s Class I railroads, the largest railroads, would fall to $226 million in 1971, half of levels from 1960 and only a quarter of 1929 levels. Normally, businesses would adjust to these changes by restructuring or at least shifting their focus and pricing. However, railroads were prohibited by the government from abandoning unwanted track. The Interstate Commerce Commission, which regulated railroads, resisted not only the shedding of unprofitable branch lines but also price increases. Despite this, railroads’ labor costs were also increasing. In the late 1960s and 1970, all this was compounded by a weakening economy.

Merger

            A response the railways could resort to was combination and the 1960s saw a wave of railroad mergers. Norfolk & Western bought the Virginian in 1959, kickstarting a wave of this activity. Whether by the merger activity, or more likely the strong economy in the middle of the decade, the profit margins of eastern railroads were improving in the mid-1960s, rising from an average of 4.1% in 1963 to 12.2% in 1966. Demand for railway transport was rising for a moment; industry-wide revenue ton miles, a metric of railway volumes, rose 27% between the late 1950s average and 1966. In fact, in these favorable conditions, eastern railroads had seemingly returned to the levels of performance experienced by railroads elsewhere in the country, though they would suffer worse in the coming recession.

Penn Central Logo

            Pennsylvania Railroad and New York Central Railroad had discussed a merger in the late 1950s but it did not proceed then. Discussions began again in 1961. Like other eastern railroads, their performance was improving; the net profit margins of the companies that would become Penn Central had improved from 3.2% in 1963 to 6.3% in 1966. Their merger was finally approved in 1968. However, to secure approval, the combined Penn Central was forced by the Interstate Commerce Commission to take on the operations of the bankrupt New York, New Haven & Hartford Railroad.

Difficulties

             The merger had unsatisfactory results. To start, different computer systems made integrating the systems difficult. Efforts to introduce efficiencies by consolidating interchange operations often resulted in cars being misrouted or lost. Other carriers had to update routing information on their end to reflect the changes Penn Central had made and this was often the source of shortfalls.

             Further, agreements with labor unions essentially prohibited the company from cutting its workforce. Rising labor costs and pressure on revenues as the economy turned resulted in less capital investment and what investments would be made had to be financed at high borrowing costs. The quality and speed of Penn Central’s service declined, causing a loss of customers and putting more pressure on revenues. The company’s pre-tax profit margins fell from an already poor but not horrendous 6.3% in 1966 to negative 5.4% in 1969. By contrast, an investment grade railway company would normally run a positive profit margin of 11-12%.

             The company’s discretionary financial practices were also questionable. Problems remained but so too did the company’s dividend payment to investors. Dividends were paid in 1968 and 1969 despite losses in the railway division. This was unsustainable but management believed that paying the dividend would distract investors from the company’s woes.

             Penn Central was also diversifying into areas like pipelines, real estate, amusement parks, and an airline. The development of the new Madison Square Garden in New York was just one example of this diversification. Early on after the merger, these activities did seem to earn the company profits that more than made up for losses in the railway business. Investors were banking on a new Penn Central where these divisions would be the primary source of value creation. Unfortunately, these activities typically required high operating and financial leverage, meaning that a slight turn in fortunes could have a big effect of profits. Borrowing was fundamental to this approach and Penn Central’s debt grew.

Debts

            Investors took at least a little notice in the company’s problems. In the mid-to-late 1960s, the yields on Pennsylvania Railroad general mortgage 4.25% bonds due 1984 were rising steadily, from 4.91% in 1965 to 7.13% in 1968. In this period, market yields were generally rising so most of the increase is not attributable to Penn Central’s creditworthiness. Still, the increase in yields was still a little more than experienced by AA rated utility bonds, which rose from 4.49% to 6.15% over the same period, or about 0.5% less. Yields rose as bond prices fell, indicating reduced interest in the securities, at least compared to others in the market. In any case, Penn Central was borrowing still more in 1969 and much of this through short-term commercial paper.

            In 1970, Penn Central had $200 million in debt coming due by year-end. Losses were rising and the likelihood of securing a successful refinancing of this debt diminished as the problems at Penn Central were becoming more well known. Some investors were selling off their holdings of Penn Central securities. Facing an unenthusiastic market, Penn Central sought assistance from the government and the Federal Reserve.

Bankruptcy

            Sadly for the firm, efforts to receive a government-guaranteed loan failed and Penn Central filed for bankruptcy on June 21, 1970. The news caught many investors off guard. A once conservative investment in railroad securities now brought headaches to creditors. At least when it came to making needed changes to the management of the company’s assets, bankruptcy could open up new opportunities. Penn Central’s bankruptcy trustees planned the abandonment of one-fourth of the company’s track, or 5,000 miles, reductions in the workforce, even on a per-train basis, among some other measures designed to support revenues.

            Indeed, bankruptcy was perhaps the best venue for a restructuring available here. Several railroads in the Northeast made use of bankruptcy protections in the early 1970s. These included the Central of New Jersey, the Boston & Maine, the Reading, the Erie‐Lackawanna, the Lehigh Valley, the Lehigh and Hudson River, and the New Hope and Ivyland.

            Besides problems with the railroads, the failure of Penn Central also brought to light the reliance of many nonfinancial companies on commercial paper, a form of very short-term borrowing, typically for terms of less than 30 days. This financing could be withdrawn by creditors fairly quickly but the size of the commercial paper markets in the U.S. had grown from $5 billion in 1960 to $40 billion by 1970.

            Fear spread in the wake of Penn Central’s failure, threatening other companies reliant on this form of borrowing. This prompted intervention by the Federal Reserve. The measures they enacted included encouraging banks to borrow money from its discount window to support lending to corporations shut out of the commercial paper markets and removing an interest-rate ceiling on certain certificates of deposits, allowing banks to raise more funds. Both avenues for raising more funds were put to use by the banking system.

Conclusions

            There was plenty of blame to go around. A U.S. Senate Commerce Committee report concluded government support in running railroads in the Northeast might be necessary. It did blame the management of Penn Central but acknowledged that problems extended beyond Penn Central specifically. It claimed that the industry was structured poorly and regulators’ decision-making, or reluctance, accelerated the railroads’ decline. An SEC report found the merger of two already-struggling firms without major restructuring meant “the drift into bankruptcy was inevitable. The only question was the timing”.

Lesson

             Railroads may be natural monopolies and in the United States, they used to be immensely profitable ones at that. However, even the most established, entrenched businesses immune from much direct competition are vulnerable to technological changes or adverse developments in the macroeconomy. Regulated industries are also susceptible to the whims, or the intransigence, of regulators. Thus, in corporate finance at least, there are no risk-free borrowers. The railroads were once considered safe investments and they could issue even very long-term bonds at fairly low costs. The failure of Penn Central exposed the latent risks and changed investors’ perceptions of the industry forever.

More from the Tontine Coffee-House

           Read about the role of the bond markets in developing American railroads, the construction of the Union Pacific and the Canadian Pacific Railway specifically, and the perpetual bonds of Canadian Pacific Railway which remain outstanding after a century. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts. 

Further Reading

1.      Jordak, Jerry W. “Penn Central: Fifty Years Later.” Railfan & Railroad, Feb. 2018.

2.      Murray, Roger F. “The Penn Central Debacle: Lessons for Financial Analysis.” The Journal of Finance, vol. 26, no. 2, May 1971, pp. 327–332.

3.      Nygaard, Kaleb B. “1970 Commercial Paper Market Liquidity Crisis (U.S. Historical).” Journal of Financial Crises, vol. 2, no. 3, 2020, pp. 101–115.

4.      Shabecoff, Philip. Collapse of Penn Central Reflects Ills of Railroads, The New York Times, 11 Feb. 1973.

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