20 April 2009

Atlantic Monthly January 1930 "The Break in the Credit Chain"

The Break in the Credit Chain

Three paragraphs in an agreement too often signed without thought have played a devastating role in recent stock-market history. They relate to customer’s borrowings from his stockbroker, pleasantly referred to as ‘debit balances.’

The sum total of these debit balances furnished the flimsy scaffolding upon which stock quotations were lifted so far above rational investment values they could only fall on any change in speculative sentiment. And it is on account of them, and the lack of real it behind them, that the fall in stock prices, once commenced, was precipitate and could not be stopped until thousands of financial tragedies had occurred—tragedies affecting the life prospects of hundreds of thousands of individuals. These loans by brokers to their customers, made without regard to the customers’ credit rating and without pretense of credit investigation, form the weakest link in our credit structure.

On the stage, the Mortgage on the Old Homestead played a familiar part in the melodramas and tragedies of a former day. In the tragedies of real life to-day, the mortgage has been replaced by the much more highly efficient debit balance—efficient in its power to wipe out a man’s financial standing without affording him recourse to any of the protections and safeguards against hasty action which are thrown about the borrower on mortgage.

Moreover, formalities of law, evidenced by documents and red seals, have firmly planted in our minds the idea that the condition of being a mortgagor is not one to be entered into lightly. It is understood by a majority who mortgage their homes that interest and payments to reduce the principal of the mortgage must be calculated ahead and made a part of the family budget, along with life insurance, clothing, groceries, meat, fish, and music lessons. A mortgage is solemnly contracted and plans for its repayment out of income are made in family council, for it is understood that if the mortgage is not paid the home is in jeopardy.

Likewise, when a man wishes to borrow from a bank, although the lending of money is the bank’s largest source of profit, he will not find himself urged to borrow. In the well-conducted bank he will meet a counselor who will investigate the whole question of whether the loan is advisable, and if so, within what limits it should be kept, in order that it may be as happy a transaction in its termination as in its inception. In other words, the man’s credit is appraised and a loan is made proportionate to his credit standing.

Banks rarely, if ever, make loans to people with whose affairs they are not reasonably familiar. And even in the case of a well-known customer, if the loan exceeds what would normally be expected to satisfy the ordinary requirements of his business, the bank will call for a special investigation, perhaps an engineer’s or an auditor’s report, before making advances. And further, when a loan is made the bank will insist that a direct promise to pay a definite sum of money be signed by the borrower, so there can be no question in the borrower’s mind with regard to the amount and terms of his debt. This again is a sober business transaction, soberly entered into.

Not so with the debit balance and the agreement concerning it which is signed when an account is opened with a stock brokerage firm. A new customer enters the brokerage office with $25,000. He may or may not be known to a member of the firm. Perhaps he knows a ‘customers’ man’ who is eager to report a new customer and to swell his record of commissions earned for the firm. The customers’ man is delighted to see some real money. No question is raised even as to whether or not the money actually belongs to the customer. It may belong to his wife, his child, or, in a few unfortunate cases, to the bank where he is employed—situations that would come to light under credit investigation. But to the customers’ man it is too often sufficient that the money is present and that it is the material out of which margins are made.

The discussion proceeds at once as to what may be a ‘good buy.’ In ordinary times, this may involve discussion of earning ratios and dividend records, but in the last year or so generalities and golden future prospects have been substituted, because the earning ratios did not account for the current quotations. The customer’s own enthusiasm to participate in some of the ‘easy money’ which his friends have made and the youthful assurance of the customers’ man are enough to result in an order involving $50,000 or perhaps $75,000, of which from $25,000 to $50,000 must be borrowed by the customer. Is he asked to sign a note for $25,000 or $50,000, with a promise to repay it? Hardly, for in many cases the full realization of what he is doing would bring him part way back to his senses, and he would be unwilling to sign such a definite obligation. Commission business would suffer. Instead, ‘as a matter of mere form,’ the standard agreement relating to debit balances is presented for his signature.

Many who have suffered a tragic change of prospect as the result of having incurred a debit balance at their brokers’ may not even now remember just what it was that they signed that put them in such jeopardy. So it is well to print below the three paragraphs in the standard form of the agreement which has brought so much trouble upon so many people. No lawyers were present when this agreement was signed, no red seals attached; no drama had forewarned them of the seriousness of their act, when they affixed their names; nor had any disagreeable questions been raised as to their capacity to protect themselves against the full force of the third paragraph, in case of need. The three fatal paragraphs run in part as follows:

AGREEMENT OF........... Richard Roe

X, Y, Z & Company

In consideration of X, Y, Z & Company consenting to act as my brokers, and to carry for me securities on a debit balance, giving me credit service and/or affording me facilities for the transacting of business in securities, I hereby agree with them, as follows:

FIRST: [unimportant]

SECOND: I agree that X, Y, Z & Company may at any time, without prior notice to me, pledge any securities deposited by me with them, or purchased by them for me, or any part or portion of such securities, for the debit balance due thereon, or may pledge any or all of my said securities with other securities in a loan or loans for an amount greater than the debit balance due on my said securities…

THIRD: X, Y, Z & Company may, at any time, if my indebtedness or my obligations are not secured to their satisfaction, without notice or demand, sell at public or private sale, without advertising the securities or any portion thereof that they hold in my account…

How many have signed this agreement to their own and their family’s irreparable harm?

The debt they incur, represented by an ever-growing debit balance on their brokers’ books, has rarely any relation to their power to repay it. The hope of extricating themselves from debt, if in fact they fully realize that they are in debt, is founded upon the hope of selling the securities in their account upon a constantly rising stock market.

A stock market rising constantly at a rate greater than the steady growth of the country’s investable surplus is without precedent and presupposes an endless chain of optimists forever ready to incur greater and greater debit balances at their respective brokers’. It further presupposes an inexhaustible reservoir of credit available to the broker. It presupposes, in fact, a combination of circumstances which is obviously absurd.

It is now evident that a serious thing has happened in the lives of a large number of individuals through a dangerously unguarded use of credit. If it had happened to a relatively small proportion of the community, it might not call for more than passing thought. But it has happened to a substantial portion of the community, and its effects will be felt eventually by almost all who do business in this country and by many abroad. The normal flow of credit has been broken. The effectiveness of thousands of members of the community has been impaired.

Our civilization is based largely upon credit. Credit has become, in its various forms, the circulating medium of the country. It is the commodity in which banks deal. Through hundreds of years, banks have developed an experience enabling them in some measure to control the volume and to safeguard the quality of credit in use at any one time; to prevent it from being squandered and rendered valueless. They have learned that credit, to be a valid form of purchasing power, must be based on one of two things, either (1) upon the competence, character, and earning power of the borrower, or (2) upon documents representing genuinely self-liquidating transactions.

By self-liquidating transactions, we mean transactions which involve goods, services, or, in fact, securities which are in transit toward the ultimate consumer, user, or investor who will be able to pay for them in full without incurring a new debt.

The term ‘banker’ in its best sense implies a man who, through long training and experience in the affairs of men, has developed some degree of wisdom enabling him to form sound judgments with respect to the competence, character, and earning power of those to whom his bank is to extend credit, and to recognize the type of transaction which, under the conditions prevailing at the time a loan is made, will be genuinely self-liquidating. The community depends upon the fraternity of bankers to see to it that the credit of the community is not squandered, that it is sound in character and can be depended upon. And this is the function of the innumerable bankers who deal directly with the borrowing public. No Federal Reserve or other system can be devised to protect the quality of credit if the bankers throughout the country do not apply sound judgment in the making of each loan.

Broadly speaking, bankers have accepted this responsibility, but only as they have dealt directly with the final borrower. In the case of loans which they have made to brokers, secured by Stock Exchange collateral, they may have used some discretion in selecting the brokers to whom they were willing to loan. But the amount of the loan has been based almost entirely upon quotations on the Stock Exchange for the securities pledged. The final appraisal of the ultimate source of credit, namely, the power of the ultimate borrower to repay the loan, has been delegated in this class of transaction to the stockbroker. And it may be fairly said that hardly a brokerage office, if any, maintains a credit department.

Here we find a serious break in the credit chain; serious because of the enormous volume of brokers’ credit which is put in circulation, running to a peak, as it did in September 1929, of over eight and a half billion dollars. This is the amount reported by the New York Stock Exchange as having been borrowed by its members alone. It does not include loans made by banks or others to brokers not members of the New York Stock Exchange. But without further addition or estimate it is a staggering volume of credit to be allowed to grow under an established practice which provides no adequate deterrent to its reckless use, no systematic investigation of the ultimate borrower’s capacity to discharge his part of the total debt, and, in too many cases, no clear intimation to the ultimate borrower of the amount of his loan or of the serious nature of the obligation to pay which he has incurred.

The financial fallacy which underlies the creation of such a volume of loans and the manner in which they are created is evident to all who have made a study of the major influences which contribute to the creation of stock prices. There can be no doubt in the minds of those who have made such a study that the general level of stock quotations above a normal valuation is itself chiefly dependent upon the volume of brokers’ loans. Certainly it becomes almost wholly dependent upon this factor when stock prices have risen to a point where they are obviously far above any possible current investment values represented by the stocks.

How unwise it is to base a substantial portion of the nation’s credit upon the general level of stock prices, when those prices themselves are a function of the volume of the credit so granted, without introducing the credit standing of the ultimate borrower as a safeguard.

Out of the nation’s income, a certain part is available for investment in securities, and there is evidence to show that this amount increases from year to year in an orderly fashion along with the growth of industry and the consequent need of industry for additional capital. On this basis, new investment capital to buy outright the securities offered by corporations in providing for their growing corporate needs is available without the introduction of any abnormally large amount of credit. Some credit, indeed, is needed, as it is in any business involving distribution. But no gigantic credit burden would ever be created if the effort were only to coordinate the capital needs of corporations with the growing investing power of the community.

The greater part of stockbrokers’ loans to customers (in the form of debit balances) are made in the speculative hope that it will be possible for the customer to sell some of his securities to investors or to other speculators at a price higher than he paid for them. The hope is frequently justified in the early stages of a rising market, as more and more speculative buyers on credit are drawn in and the volume of loans to customers increases, while the general price level of stocks rises. Thus the appetite of the earlier speculators who have bought and sold out to later speculators is whetted by the profits they make, and they again enter, making larger commitments at a higher level. During the course of the process, some considerable volume of stock is distributed to bona fide investors; but to the extent that the investor pays more than what may be regarded as the normal investment value for these stocks, the investing power of the country is depleted more rapidly than it can be replaced. Consequently, toward the end of a long rise, both in brokers’ loans and in stock prices, there are few investors left capable of buying stocks outright and removing securities from the market. Only those are left as possible purchasers who must create new debt if they are to buy at all.

The sum total, then, of the debt against stocks is no longer self-liquidating, and the amount of debt owed by each individual borrower bears no relation to his competence, character, and earning power. The quality of a great volume of credit is then found to bear no relation to sound banking standards. It is based solely upon fictitious stock quotations, themselves the result of the abnormal volume of debt created. The credit structure breaks at its weakest link, and thousands who suddenly find that they are in debt beyond their means to repay are sold out.

It is all very well to say that the customers were foolish. As we suggested earlier, if only a small part of the population were affected, the matter might be passed over lightly. But when a system prevails which caters to the folly of too large a proportion of a population, a proportion so large that the destruction of its purchasing power is of concern to every business in the land, then it deserves serious attention.

Particularly is this true if stock quotations are to be used, not only as a basis of credit, but also as a basis upon which major financial transactions are undertaken. It will be well for the banking community, who are vitally interested in the maintenance of stable credit, thoroughly to investigate how valid stock quotations are, either as a basis of credit or as a basis for major intercorporate transactions. If they do this they will soon find that, under the present indiscriminate method of extending credit to brokers’ customers, such quotations are without validity, and the principal reason that they are without validity is that the credit upon which they finally rest has never been really appraised. It has not been based either (1) upon the competence, character, and earning power of the ultimate borrower, or (2) upon documents representing genuinely self-liquidating transactions.

The collapse of the stock market in 1907 was attributed in large part to an inelastic currency and banking system, which resulted in an inadequate volume of credit and a shortage of actual cash. The lesson learned inspired the formation of the Federal Reserve System, which cured these particular weaknesses.

The fall in stock prices in 1920 and 1921 was attributed largely to the inflated inventories which had been accumulated during 1919, accompanied by a spectacular rise in commodity prices. Attention then was focused upon the use of credit in its relation to commodity prices and inventories. From this episode, business has learned a lesson, and in 1928 and 1929, as stock prices reached ever higher levels, great comfort was taken in the fact that corporate inventories were low, and that therefore there could be no danger in the situation.

Let us not forget the lessons learned from these two former experiences. But let us face the fact that, while in 1929 we had apparently no inflation in commodity prices, no accumulation of inventories, and, through the operation of the Federal Reserve System, abundant credit and currency, yet a fall in stock prices has occurred, exceeding in rapidity anything we have previously experienced. Let us focus our attention upon one of the causes, perhaps the principal cause of this unprecedented break: namely, a weak link in our credit structure—the fact that no proper credit investigations are made when stockbrokers make loans to their customers by means of the debit balance. These debit balances, to be a valid part of the security price structure which they support, should bear some relation to the borrower’s power to repay the debt, whether or not stock quotations move in the direction he hopes they will. Let us find the means of applying to this form of credit standards which have been tested through centuries of banking practice.


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