(3) COLLATERAL

36. LOANS ON COLLATERAL

Loans that are contracted for the purpose of investing in fixed capital, or in any way that does not give rise to funds for the payment of the loan at an early maturity, must be classed as investment rather than commercial loans. Such short-time loans may be perfectly safe if the bank is not required to pay on demand, but it is clear that a bank cannot meet demand liabilities with assets whose maturities depend upon the more or less remote incomes to be derived from investments in fixed capital. In a similar way loans granted to individuals for personal consumption or non-commerce, or to be used in speculative enterprises, are unsafe for a commercial bank whose liabilities are demand liabilities. Unless borrowed funds are used in the manufacture or marketing of goods, there is not a reasonable assurance that the loans will be paid at maturity. Accordingly, noncommercial loans are usually made on collateral; that is, the borrower pledges with the bank as security some valuable claim to wealth, such as bonds, stocks, or warehouse receipts. In case, then, that the loan is not paid at maturity, the bank can sell the security thus pledged and thereby keep itself in funds. In the event that the loan is paid, the collateral is returned to the borrower. This sort of loan, when properly safeguarded, is in normal times quite as liquid as commercial-paper loans. The nature and types of collateral may be indicated by reference to a few typical cases.

A bond or brokerage house is a concern which deals in investments or securities, and has nothing to do with the marketing of goods. It would be dangerous for a bank to loan to such a concern without collateral security. But such a house owns blocks of securities, stocks and bonds, which have a definite market value and which can be hypothecated with the bank as security for a loan.

A brewer has his capital invested in the manufacture of products which will be consumed only after an interval of several years, often from four to eight years after they are manufactured. These goods are stored in government bonded warehouses and negotiable receipts are issued by the warehouses to the owners of the goods. These receipts can be used as security for a loan at a bank in the same manner as stocks and bonds.

Spring eggs are placed in cold storage and negotiable receipts are issued by the warehouse. The eggs are covered by fire insurance

and are safeguarded by such means as the cold storage affords. The possibility of wide fluctuations in value render them undesirable security for commercial loans, but the warehouse receipts, with a proper margin, can be safely used as collateral for a loan.

Grain is stored in grain elevators under the supervision of the government. In Illinois, for instance, there is a State Warehouse Commission under whose supervision warehouse receipts are issued certifying that the wheat, corn, or oats is all of a certain grade. These receipts are insured against theft or loss by fire, and they pass current almost as money does. They are, therefore, well adapted to serve as security for loans at a bank, and are among the most common forms of collateral security.

It is not safe for banks to make loans to the full present market value of such securities. They may fluctuate widely in value during the life of the loan and prove inadequate in case of forced sale to cover the amount of the loan. It is necessary, therefore, to require a margin, an excess of valuable securities over the amount of the loan. This excess is, of course, returned to the borrower after the loan has been paid.

The amount of margin required will vary in proportion to the chance of sudden shrinkage in the salable value of the collateral. In the case of the best bonds ten per cent is usually regarded as a safe margin. Twenty per cent is usually required in the case of the best active listed stocks. On less active or more speculative stocks, and in common stock, a much larger margin is necessary for safety. Mixed collateral is obviously better than that of a single class of bonds or stocks. In the case of collateral, marketability is even more important than steadiness of value or ultimate safety. Collateral is not regarded as an investment. It is merely a protection for the investments in the form of loans, hence ready salability is of first importance. It is for this reason that collateral that is regularly quoted and dealt in on the exchanges is much more acceptable than non-listed securities. "The fact that a security is listed on a stock exchange, however, even the New York Stock Exchange, is not in itself evidence to warrant its being accepted as the best of collateral, any more than the fact that a security is not listed should preclude it from acceptance as collateral." Investigation of the conditions surrounding the given security is necessary in either

case.

37. THE CAUSE OF THE DEVELOPMENT OF COLLATERAL LOANS IN THE UNITED STATES'

BY EARLE P. CARMAN

National banks are fundamentally commercial banks. Their operations are restricted by law almost entirely to transactions involving short-term credits, which Congress assumed would consist mainly of commercial credits. The National Bank Act attempted to make such credits feasible by requiring the banks to keep a minimum cash reserve equal to a certain percentage of their deposit liabilities. It was assumed that this cash reserve would enable the banks to meet the unusual and extraordinary demands of depositors, and that their remaining funds could be employed in commercial credits by arranging their loans in such manner that they would mature in rotation, and thus maintain at an average level the funds required to meet the usual and ordinary demands of depositors.

In all countries commercial credits have always been preferred by banks of discount and deposit because of the fact that they automatically provide the means for their own liquidation under ordinary circumstances. In other words, the mere granting of the loan places the borrower in possession of property through the sale of which he will be able to pay the loan at maturity. And banking experience for more than a century has demonstrated that pure commercial loans are the safest of all temporary investments. Commercial loans, however, are usually made for periods of thirty, sixty, or ninety days, while the larger part of commercial bank deposits are payable on demand. Now it is obvious that a bank cannot safely loan for fixed periods of time any large percentage of funds which it may be called upon to pay out instantly unless it has some means of converting such loans into cash before maturity, if necessary.

For a century or more commercial loans in the leading countries of Europe have been instantly convertible into cash by reason of the fact that they could be rediscounted at the central banks of the countries where they originated. This instant convertibility of commercial credits, added to their inherent safety, caused them to be favored with a lower rate of interest than any other short-term credit. Thus in European countries commercial loans, or "discounts," as

I

Adapted from "The Change in Credit Methods Made Necessary by the Federal Reserve Act," Commercial and Financial Chronicle, 1915, pp. 1396-97.

they are called, are made at a rate of interest usually 1 per cent lower than collateral loans, however choice the collateral pledged as security.

In America, however, prior to the passage of the Federal Reserve Act, no means existed for rediscounting commercial paper, and it could only be converted into cash when it matured. The necessity of loaning a large percentage of demand deposits in such manner that they could be instantly converted into cash was no less imperative here than in Europe, and it compelled American bankers to relegate commercial credits to a secondary position and devise a means of making loans which could be converted into cash whenever desired. Consequently, demand loans secured by collateral which could be sold in the open market became the favorite method of investing demand deposits, and clearly the most logical method under the circumstances. This preference for collateral loans encouraged the creation of collateral which could be pledged to secure such loans. This collateral, however, consisting of stocks and bonds, is the product of investment banking and represents fixed or permanent property. The loans made against it, therefore, are in no sense commercial. The stock exchanges furnished constant market quotations for such collateral and provided a means of selling it instantly should the banks desire to do so. Naturally, under such circumstances, collateral loans could be secured with the greatest ease, and this encouraged speculation on the stock exchanges. Whenever this speculation expanded sufficiently to absorb the demand money readily available, the interest rate for such money advanced, and whenever this interest rate rose above the legal rate for commercial paper it naturally drew into the demand, or "call," money market funds which otherwise would have been available for commercial credits.

38. CALL LOANS

Call loans are loans that are terminable at the demand of either the borrower or the bank. If the borrower wishes to repay the loan he has the privilege of doing so without waiting for a maturity date. If the bank wishes to enlarge its cash reserve it may demand immediate payment of its call loans. In practice, "on demand" means subject to call the next day, and call loans always run at least one day. There is a rule, also, that loans cannot be called or paid after 1:00 P.M., unless notice has been given before that hour.

Compare chap. xi, sec. 1.-EDITOR.

The rates on call loans are subject to very wide fluctuations. Ordinarily they are lower than any other rates, ranging from 1 to 2 or 2 per cent, but on a few occasions they have gone beyond 100 per cent. The call rate rose to 127 per cent on October 29, 1896; to 96 per cent on November 2, 1896; to 186 per cent on December 18, 1899; to 75 per cent on May 9, 1901; to 125 per cent on December 28, 1905; in 1906 to 60 per cent on January 2; to 30 per cent on April 5 and 6; to 40 per cent on September 5, and to 45 per cent on Decem

ber 31.

These high rates occur at times when a dearth of loanable funds in New York coincides with both a heavy commercial demand and a great financial demand for credit. A flurry on the stock exchange will often give rise to the most insistent demand for funds for a short time.

High call-loan rates are often pointed to as evidence of a monopolistic control of credit; but as a matter of fact there is a greater profit accruing to the banks when the call rate is only 3 or 4 per cent than when it is 25 or 50 per cent. When money rates reach these high figures many corporations and large individual depositors are tempted to withdraw their funds from the banks in order to make loans to borrowers directly. This depletion of the banks' reserves at a time when money is generally tight more than counterbalances the high returns on the loans they may make on call. Because of this some banks in New York have made it a rule never to loan money on call at more than 6 per cent.

39. COLLATERAL LOANS AND STOCK EXCHANGE

SPECULATION'

BY SERENO S. PRATT

The stock-broker executes orders for his customers on usually 10 per cent margin, but he is obliged to pay for the securities in full upon delivery. It would be manifestly impossible for any broker to do this without borrowing money from the banks. He has extended credit to his customer; he must himself get credit from the banks. For instance, a broker buys 5,000 shares of New York Central at 110, amounting to $550,000. But he executes the order for his customer on a margin of $55,000, so that he must pay the difference of $495,000,

'Adapted from The Work of Wall Street, pp. 267-74, 287, 275-78. (D. Appleton & Co., 1903.)