The Great War Loan Conversion

In 1917, to finance the cost of World War I, the British government floated a huge bond issue, the Five Percent War Loan. It was scheduled for repayment thirty years later, in 1947, although it could also be prepaid on three months’ notice any time after June 1, 1929.

By 1932, thanks to the Depression, government revenues were low. Just the interest on this single bond issue–of which over £2 billion was outstanding–absorbed 40 percent of all the money collected from income tax. The bonds could not be paid off in cash, so the government decided to persuade the bond- holders to accept something else instead.

In late 1931 there was a run on the pound, which slid down from $5 to the $3.25-$3.45 area. Starting the following summer, the Bank of England injected immense amounts of liquidity into the banking system. As a result, interest rates, which reflect the supply of money in relation to the demand for loans, fell to 5 percent in February, 2-1/2 percent in May, and finally 2 percent in June. As yields dropped, investors rushed to nail down the highest returns they could, so the prices of existing bonds soared. Government 2-1/2 percent bonds jumped 10 percent in a week, to 72. The Five Percent War Loan bonds could not rise over 100, though, since the government had the right to pay them off at that price at any time. To increase the impact of this move the government closed off the issue of any new securities, meaning that the market’s increased buying power could only be directed to existing issues.

In late June 1932 Chancellor of the Exchequer Neville Chamberlain announced a conversion offer for the entire Five Percent War Loan into a new issue, bearing interest at only 3-1/2 percent, and without any specific maturity. The chancellor exhorted War Loan holders in moving terms to convert to the new issue as a matter of patriotic duty. In case of wavering it was also announced that those who did not refuse the offer would be deemed to have accepted it. And indeed, with the bank rate down at 2 percent thanks to heavy manipulation of the money supply, the 3-1/2 percent coupon looked highly attractive. Since there was no specific maturity date, the owner was also protected forever in his enjoyment of this fine return.

The government created a War Loan Conversion Publicity Bureau, which set off a prodigious barrage of patriotic propaganda to convince the citizenry to accept the deal-like our War Bond appeals in World War II. Every day the Publicity Bureau published a list of institutions that had done their duty.

On July 5 Chancellor Chamberlain called in the heads of the major banks and urged them to give a good example. All agreed except Midland Bank, whose chairman, Reginald McKenna, had himself been Liberal Chancellor of the Exchequer in 1915-1916 and understood Chamberlain’s game. The next day McKenna was summoned to the Bank of England, whose governor, Montagu Norman, put him under heavy pressure to convert. McKenna replied that it would not be in the interest of his shareholders. He was correct, but his temerity probably cost him a peerage. Eventually Midland was persuaded to convert £5 million of the £30 million that it held. The Bank of England itself then agreed to buyout the other £25 million and convert it on its own. So the Publicity Bureau was able to announce–deceptively–that all the clearing banks had converted their holdings.

The hoopla and fanfare surrounding the conversion were intended to bedazzle the small holder. The propaganda was almost too successful. Mounted policemen had to be called out to control the crowds lining up to present their old certificates. Some large holders, however, could see what was happening. John Maynard Keynes, for instance, styled the operation “a bit of a bluff which a fortunate conjunction of circumstances is enabling us to put over on ourselves.”

Anyway, thanks to the pressure, the calls to patriotic duty, and the bluff, 92 percent of the holders converted into the new 3-1/2 percent bonds, which by the terms of their issue need never–and doubtless never will–be paid off. Since then, under more usual money market conditions, interest rates have risen and risen and the 3-1/2 percent bonds have declined and declined.

So at the end of the day what happened to the 98 percent of War Loan holders who accepted the conversion?

The calculation is fairly complicated, but in real terms they lost about 99 percent of their money.

Excerpted from Famous Financial Fiascos, 1995