The rise in popularity of new financial products often coincides with the rising popularity of stocks. And if one takes off, you’re bound to get more.
One of the first examples of this in the U.S. was investment trusts in the 1920s. Investment trusts are a type of fund that got their start in the U.K. in the 1860s.
The first trust of any significance was created in the U.S. in 1924. One of the main selling points was the benefit of a professional investing your money for you. As the 1920s rolled on, another point emerged on how trusts would be a stabilizing force for the stock market during a decline.
Trusts were not an immediate hit. Only $175 million were in investment trusts in 1927. That all changed within a year. The number jumped to $790 million in 1928. Then it hit $2.25 billion in 1929 and represented 22% of all stock issues. In fact, the number of investment trusts more than doubled from 172 at the start of 1929 to over 400 by the end of August of the same year. And more investment trust securities were offered in September 1929 than in August.
But the love affair investors had with investment trusts was short-lived. Like many investment fads, there are always a few bad apples that spoil the bunch. Of all the investment trusts, one stands out as the most egregious.
Goldman Sachs Trading Corp. (GSTC) launched on December 4, 1928. The initial one million share issue was bought by Goldman, Sachs and Company for $100 million at $100 per share. Goldman, Sachs then sold 90% to the public at $104. Control of the Trading Corporation remained with Goldman, Sachs through a management contract and control of the board of the GSTC.
Two months after GSTC launched, its stock reached $222.50 — double its asset value. Public eagerness to own the stock was not the cause.
The Trading Corporation was buying heavily of its own securities. By March 14 it had bought 560,724 shares of its own stock for a total outlay of $57,021,936. This, in turn, had boomed their value. However, perhaps foreseeing the exiguous character of an investment company which had its investments all in its own common stock, the Trading Corporation stopped buying itself in March. Then it resold part of the stock to William Crapo Durant, who re-resold it to the public as opportunity allowed.
The scheme was so successful that the directors behind GSTC — Walter Sachs, Sidney Weinberg, and Waddill Catchings — looked to replicate it. They announced two new trusts in 1929 — Shenandoah Corp. and Blue Ridge Corp. Though, the setup was unique.
Like nesting dolls, Blue Ridge sat inside Shenandoah. Shenandoah sat inside GSTC. GSTC funded Shenandoah in July 1929, selling 20% of the shares to the public. 25 days later, Shenandoah repeated the process with Blue Ridge, selling 20% of its shares.
Two months later, the stock market crashed.
GSTC stock would end the year down 74% from its 1929 high, trading below its net asset value. Investors, who weren’t put off by the pessimism surrounding trusts, probably thought it was a steal. Little did they know things would get worse.
The stock market recovery in 1930 was short-lived. Investment trusts were hit the hardest in the continued decline. Shenandoah’s stock fell to $3 5/8, 90% below its 1929 high of $39. Blue Ridge faired slightly worse. It fell 91% from a 1929 high of $29 to $2 5/8.
GSTC topped them all.
The rumor mill said that GSTC had a problem of $24 million in short-term debt but its convoluted structure made it impossible to service it.
The leverage in this structure was twofold. Shenandoah and Blue Ridge were each highly leveraged by the convertible preference stock they sold. Shenandoah had outstanding $42.5 million in preference stock at the end of 1929 on a total capitalization of $123 million. Blue Ridge had outstanding $58 million of preference stock at the end of 1929 on a total capitalization of $131 million. The 6% dividend on both issues required a cash outlay of just short of $6 million per year. The system, from Goldman Sachs Trading Corp. to Blue Ridge, was also highly leveraged by the pyramid of control which left, as net income for Shenandoah, what was left over after Blue Ridge paid preference dividends, and as net income for Goldman Sachs Trading Corp. the even smaller amount remaining after Shenandoah paid its preference dividends. There was no way for Shenandoah to escape the impact of a decline in Blue Ridge’s earnings, as Shenandoah had $62.4 million of its $122 million investments at the end of 1929 invested in Blue Ridge Corp. Goldman Sachs Trading Corp. invested approximately $55 million of its $250 million in investments at the end of 1929 in Shenandoah Corp.
The effect of such leverage were exacerbated by problems from the principal investments of Goldman Sachs Trading Corp. and its offspring. American Trust Co. of San Francisco, which constituted almost 50% of Goldman Sachs Trading Corp.’s assets, stopped paying dividends in July 1929, and North American Co., which was a high-quality public utility holding company controlled through Shenandoah Corp. and Blue Ridge Corp., never did pay dividends. Thus, these two supporting columns of the Goldman Sachs Trading Corp. empire provided no cash flow to service either the $6 million in preference dividends of Shenandoah and Blue Ridge, or the approximate $1 million in interest Goldman Sachs Trading Corp. had to pay on its debts.
Leverage presents a dual power to enhance returns or destroy them. Using debt to buy highly volatile assets means you can experience both possibilities in a short amount of time. The directors of GSTC experienced this firsthand.
Unwilling to underperform their peers, the directors of GSTC used debt to increase their portfolio holdings and boost their returns. They did the same with Shenandoah and Blue Ridge. It worked flawlessly up till October 1929.
Using debt to buy overpriced stocks at peak optimism creates a problem for investors and investment trusts. Untimely market declines can lead to forced selling.
This is known as a margin call to investors. Without adequate cash in their accounts, investors are forced to sell holdings to cover the debt requirements. And since margin calls are due to a decline in asset prices, sales result in a loss.
Investment trusts face a similar problem of forced selling. Though, trusts also have the option to raise cash by issuing new shares. But as the directors of GSTC learned, it’s difficult to issue new shares when you need money the most.
The pessimism around the stock market in 1930, and trusts specifically, made issuing new shares impossible. Nobody would buy them. So GSTC was forced to sell off its portfolio at the worst time ever. It began liquidating assets in 1930 to cover its debt. They started with the stuff they could most easily sell.
The first to go was a controlling interest in three insurance companies to Home Life Assurance Co. The second to go was the $7.3 million sale of Manufacturers Trust Co. — another controlling interest — at a $48 million loss. Next was C.F. Childs & Co., a bond trading firm, which they sold back to C.F. Childs, at a discount, of course. They also sold the Guardian Detroit Union Group back to the Group at a discount. In total, losses on the sales amounted to $165 million. But the sales allowed the directors to collect their management fees and pay interest on the debt.
From GSTC’s 1929 high of $121 (after a two-for-one stock split), it sank 97% to $4 3/8. It traded at a 65% discount to its portfolio value. That’s after the sale of all the assets. To put that into perspective, an investor with enough capital and patience could buy the trust outright, slowly liquidate it at reasonable prices, and walk away with at least a 186% profit!
Peak pessimism hit investment trusts in 1931. GSTC’s stock continued to fall, hitting $1 3/4 by June 1932.
Investment trusts began to recover in the second half of 1932 and into 1933. Though, by then GSTC was plagued with other issues.
Shareholder lawsuits sought to oust management and put the trust into receivership. The directors also wanted out. They sold 40% of GSTC to Floyd Odlum in 1932. Shareholders officially removed the directors in April 1933 and changed its name to Pacific Eastern Corp.
Odlum seized control in September 1933 and made a fortune on his purchase.
This post was updated on October 28, 2022; originally published on June 18, 2021.
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