Spot a Debtor by His Skull: A History of Credit Analysis
06.04.21
Imagine you are a creditor. A man approaches you about a business loan. He has no proof of cash flow, shows confusion at the term “EBITDA,” and takes great personal offense when you request an income statement. All he can offer you is his name, age, marital status, and a shining letter of recommendation written by his coerced neighbor.
In the absence of traditional financial statements, which of the following is most indicative of creditworthiness?
- The shape of his skull.
- His choice in partner.
- His choice in haircut.
- What street he located his business on.
(Answer: all of the above).
This was the state of affairs faced by 19th century creditors. Insurance companies and railroads were the first financial pioneers to publicize ~reliable~ income statements and balance sheets, yet they remained an anomaly well into the 20th century. Without the specter of taxes or auditing, keeping detailed financial reports (other than for internal use) seemed ludicrous, and handing them to a potential creditor was the best way to admit you were a fraud without saying you were a fraud.
How then did one identify a credit flight risk? In this article, we discuss the history of credit risk analysis, from its earliest days of homespun character assessments and small-town spies, to its latest manifestation as the legalistic quagmire we know and love today.
Spot a Debtor By His Skull
As late as 1900, the U.S. Bureau of the Census found that the majority of businesses could not calculate their own assets and liabilities, much less determine profitability (or lack thereof). “Unfortunately, many a small merchant does not keep books in any real sense,” complained one credit manual. “You will find in his store a couple of spindles, on one of which he puts the bills as they come in, while on the other he puts the bills as he pays them. He may also have a blotter in which he records the sales he makes on credit.”
Trade credit exceeded the volume of bank loans as the single largest source of business capital well into the late 20th century, yet few merchant creditors had much certainty about a business’s liquidity. Without basic capital worth estimates, much less detailed financial statements, nineteenth-century creditors relied on more personal measures of risk assessment. These included letters of recommendation, word-of-mouth information, detailed character assessments, and good old-fashioned physiognomy — an ancient pseudoscience revived in the Victorian era that claimed to predict valuable information based on the shape of a person’s face and skull. (Large jaws, handle-shaped ears, and “hard, shifty eyes” were all considered signs of criminality).
Some large New York wholesalers filled up to thirty ledger pages worth of transactions every day, forcing on-the-spot risk assessments. A man’s testimony, physical appearance, and signature were sometimes all that a creditor had to go off of. “The main source of information,” recommended one treatise on business in 1853, “is to see the man and hear his statements. This, like other means of information, will sometimes fail, but generally the appearance and manners of a man will show his character… In nine cases out of ten the first impression will be found to be correct.”
For more distant borrowers, a creditor might reach out to locals in an attempt to assess “honesty, punctuality, thrift, sobriety, energy, and focus.” A wife and children were a positive sign (free labor!) and were routinely enlisted to help preserve the reputation of a firm. “We care not how much money a man may make,” reported the Illinois Daily Journal, “if his wife does not second his endeavors, he is just as sure of dying poor as if he had kept a grocery and trusted everybody.”
The Invention of Credit Reports
It took an unconventional personality to establish the first major national credit agency. The idea of credit reports was so culturally unpopular it would have been akin to Apple suggesting a publicized “dating rating” (and charging for it, at that!). Nonetheless, Lewis Tappan — a strident Calvinist known for giving out Bibles, reporting gaming houses, and raiding New York brothels to “pluck fallen women from roaring lions who seek to devour them” — rose to the occasion.
Tappan’s contemporaries found him so grating that even his biographer, Bertram Wyatt-Brown, was reluctant to dole out praise. “It must be sadly admitted,” writes Wyatt-Brown, that he “scored all too well on the familiar checklist of the Yankee do-gooder’s grave defects: moral arrogance, obstinacy, cliquish conformity, provincial bigotry, and abrasive manners.” Still, during his adventures as a New York wholesaler and abolitionist, Tappan picked up a wide array of national contacts that he later tapped as subscribers for the Mercantile Agency, the first major national credit agency. Founded in 1841, it would evolve into Dun & Bradstreet, the largest credit rating agency in the world.
Its earliest years didn’t spell immediate promise. Tappan explicitly founded the agency to “check knavery and purif[y] the mercantile air,” an idea few took to warmly. The press condemned the venture as a “system of espionage,” and the editor of the New York Herald referred to Tappan as the man who kept “an office for looking after everybody’s business but his own.” Thanks to his prominent reputation as an abolitionist, Southern states were particularly hostile. One Louisiana newspaper predicted that “no home will be secure” and “no privacy will be sacred from these harpian visitors.”
Indeed, the correspondents enlisted by the Mercantile Agency — sheriffs, merchants, postmasters, bank cashiers, and, most popularly, small town lawyers such as Abraham Lincoln — were necessarily invasive. Most small businesses mixed business costs and family expenses, making a borrower’s personal spending habits fair game.
Despite its ethical dilemmas, Tappan’s business model prevailed for one simple reason: cost savings. It was cheaper to subscribe to a credit rating agency than to employ your own local spies. The growth of railroads continued to fling trade routes far beyond the scope of local information networks, and by 1851, the Mercantile Agency had enlisted over 2,000 national correspondents.
Accounting Comes of Age
Credit reports remained largely qualitative until the birth of corporate taxes and regulations demanded more standardized accounting procedures. In the early 1900s, creditors first began using negative pledge covenants and tied them to basic performance ratios (the leverage ratio was not introduced until 1981). Public accountants, however, remained a rare breed, forced to work in the dead of night or on Sundays, because their mere presence was enough to invite accusations of fraud.
Financial statements began to improve in 1909, when Congress first passed the franchise tax — basically an income tax — on corporations. This tax could only be collected if each company knew its own revenues and expenses. In 1917, Congress levied another tax on business to fund World War I, which required the amount of capital invested and capital charges incurred. Still, prior to the 1930s, no corporations were required to have their financial statements audited (though quite a few — United States Steel, General Motors, Eastman Kodak, etc. — voluntarily produced audits).
The merger movement to form giant megacompanies in the post-1900 period continued to drive incremental changes in accounting, but it was not until the infamous McKesson & Robbins scandal of 1938 that the profession was truly called to action. “Like a torrent of cold water,” wrote the Journal of Accountancy, “the wave of publicity raised by the McKesson & Robbins case has shocked the accountancy profession into breathlessness. Accustomed to relative obscurity in the public prints, accountants have been startled to find their procedures, their principles, and their professional standards the subject of sensational and generally unsympathetic headlines.”
McKesson & Robbins was a well-known pharmaceuticals company managed by a quartet of criminally minded brothers who inflated its receivables and merchandise inventory by $19 million. Price Waterhouse & Co. had audited and approved their financial statements without confirming receivables or inventory (this was not required at the time). The company’s president, “Doctor” F. Donald Coster, had awarded himself a PhD and somehow buried two previous felony convictions, one for a cheese fraud in 1909 and the other for a human hair fraud in 1913. For years, PWC — one of the most respected accounting firms in the nation — failed to notice that “… there were not enough Himalayan musk deer in the world to fill the orders placed…” or “…that the amount of procaine or iodoform supposedly stored in Canadian warehouses would supply the entire United States for years…” or that merchandise was moved “…from South America to Australia and China … by truck.”
Horrified by the sudden limelight, CPAs immediately bolstered auditing requirements and resolved to make annual reports less of a guessing game by providing fixed standards of minimum financial disclosure.
It’s Better to Pay Interest than Taxes
By the 1960s, segment reporting became more relevant for multinationals, and top corporate executives faced increasing pressure to improve earnings performance. The single-most important metric for public firms was earnings per share (EPS), followed by net income. But that all changed when John Malone, an engineering prodigy and “Cable Cowboy,” took the helm at Tele-Communications Inc. in 1973.
Few individuals did more for the use of leverage than John Malone. Inspired by his mentor Bob Magness, who followed the mantra, “it’s better to pay interest than taxes,” Malone disavowed the earnings his peers were so enamored with in favor of levered cash-flow growth. Recalling his earliest meetings as CEO, Malone said, “I used to go to shareholder meetings and someone would ask about earnings, and I’d say, ‘I think you’re in the wrong meeting.’ That’s the wrong metric. In fact, in the cable industry, if you start generating earnings that means you’ve stopped growing and the government is now participating in what otherwise should be your growth metric.”
Malone created EBITDA as a natural metric to complement his business strategy: the strategic use of leverage to lower costs, maximize cash flows, and pursue unrivaled scale. “Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction,” wrote William Thorndike, in his study of Malone. “These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows.”
Other cable operators soon turned to an emphasis on cash flow, and EBITDA became an indispensable part of a creditor’s arsenal. Throughout his tenure as CEO, Malone consistently targeted a ratio of 5x debt to EBITDA. When asked about his intensely analytical approach, he responded, “They haven’t repealed the laws of arithmetic … yet anyway.”
Our Fellow Men Remain Inscrutable
We have come a long way since the days of enlisting small-town country lawyers or scrutinizing faces for traces of the devil. Each financial upheaval invites new regulation and refinement, as we have seen with banks and the latest installment of Basel III standards. Today, many complain that credit analysis has become too legalistic, and that the average credit agreement is “jam-packed with legal jargon that often bears little resemblance to the English language.” Some hope that blockchain — the new panacea for all social evils — may reduce information costs and improve transparency, but it has yet to prove itself on a large scale.
Until a person’s skull truly reveals the contents of their character, the issue of credit risk will remain a perennial problem that the lessons of history can make more quantifiable, if no less costly. “Experience is a good teacher,” observed one popular Victorian writer, “but she sends in terrific bills.”
About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at inquiries@colbeck.com.