This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
The use of marketable stocks and bonds as collateral for short-time loans has already been noticed in the chapter preceding. The issue of long-term obligations based on similar security is, however, comparatively a modern invention. There is a fundamental distinction between the two.
Short-term obligations are ordinarily secured by stocks and bonds which are active and which the borrower holds temporarily for resale. Long-term bonds should never be secured except by stocks and bonds that it is intended to hold permanently. Ordinarily these securities, posted as collateral, are those of subsidiary corporations or of other corporations in which the borrowing company expects to maintain a permanent interest. Sometimes nearly all the stocks and bonds of subsidiary companies, held in the treasury of the parent company, are collected and posted in one lot. This is the case, for instance, with the Missouri Pacific $10,000,000 issue of collateral trust bonds which is secured by the deposit of first mortgage bonds of subsidiary companies. Twenty of these companies are represented, one of which is operating a road only two miles long.
It is a somewhat curious fact that a collateral trust issue will generally sell at a much better price than will the stocks and bonds which are posted as collateral. The reason is to be found not only in the fact that the parent company is adding its quota of credit to the credit standing of its various subsidiaries, but also in the fact that the collateral trust issue is comparatively large and therefore commands more attention and a better market. Inasmuch as the amount and quality of the collateral posted is seldom examined with much care by investors, there is always a chance, unless the banking syndicate which sells the issue is very careful, that the collateral will eventually be found of less value than was originally supposed. The general public, in fact, has no method, ordinarily, of securing genuine information as to the status and prospects of subsidiary companies whose securities are posted. It must regretfully be admitted that the collateral trust device has sometimes been used to obtain credit for corporations that were not worthy of credit.
A collateral trust bond issue is the favorite method of financing the purchase by one corporation of the securities of another corporation. The purchase may be made in the first place with temporary bank loans, which in their turn are repaid as soon as the collateral trust bonds can be sold to the investing public. It was in this way, for instance, that the Northern Pacific and Great Northern financed their purchase of stock of the Chicago, Burlington and Ouincy Railroad Company. The collateral trust bond issue based upon this stock is highly regarded. In the same way the Atlantic Coast Line took care of the purchase of Louisville and Nashville stock, and the Union Pacific of the purchase of Southern Pacific, of Baltimore and Ohio and of New York Central stock.
While the collateral trust bond issue is used most extensively by railroad corporations, it is common also among public utility holding companies and is used to a less extent by industrial combinations. The customary rule is to make the collateral trust bond issue about 80% of the appraised market value of the securities posted as collateral. This is the same percentage that is commonly regarded as proper among banks in granting short-term collateral loans. However, there are some exceptions. For example, the Queens-boro Corporation, which deals in New York City real estate, has outstanding an issue of first gold 4's, secured by a deposit of mortgages on New York City real estate to an amount at least equal to the bond issue.