The Machinery of Wall Street: Why it Exists, how it Works and what it ...

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Contents

I Why Do We Need a Wall Street? ... 7

II The Banks — Bank Statement — Gearing

House — Sub-Treasury 21

CHAPTER I Why Do We Need a Wall Street?

TO most people the machinery of Wall Street seems intricate and mysterious. There is probably no part of the business activities of the country that is so much misunderstood.

The popular idea of Wall Street, picked up from miscellaneous sources, such as newspaper headlines, cartoons, magazine stories and moving pictures, seems to embrace a hodge-podge of corpulent, side-whiskered bankers surrounded by champagne bottles, haggard speculators bending feverishly over stock tickers, habitually risking their last dollar and generally losing it, Mephisto-like manipulators always determined to ruin each other or be ruined in the attempt, and child-like young gamblers whose touching confidence in human nature leads them to risk their widowed mothers' patrimonies in a single throw on any "tip" which may be offered them.

To the man who is earning his livelihood day by day in the clock-like, well-ordered, efficient business life of the Street, these popular ideas seem so absurd that he thinks they must be msrthical. It is only when he leaves his habitual haunts and mingles with the people on the farms, in the stores and in the factories that he awakes with a start to the monumental ignorance of the public in general about the things that seem to him nothing but daily business routine.

But while the details of the machinery of Wall Street are complicated, just as are the details of the steel industry or boot and shoe manufacturing or any other specialized department of modern life, its main features and purposes are comparatively simple and very interesting.

Why a Wall Street?

Why do we need a Wall Street? For it must be that we do need it or we should not have it. Nothing could call it into existence except a demand of some sort for the services rendered.

To start at the beginning, it is, as all the economists tell us, division of labor that permits and to a great extent causes the advance of civilization. So long as each individual grows for himself or makes for himself everything that he needs, he is a slow and clumsy producer. He has to do everything on such a small scale that he can make use of no machinery and only of the simplest tools. He has little chance to rise above the standard of living of a savage.

With the division of labor comes a g^eat gain in production^ and the gain is constantly increasing through the use of more and better machinery, which only the division of labor permits.

But division of labor means that each man, or each group of men, makes a different product- — Whence these various products must in some way be exchanged before they can be put to use where they are needed. At first the man who has too many potatoes exchanges some of them with his neighbor, who has too much corn, and so on. But this is a slow and awkward process, and the next step is for all the people who have any exchanging to do to meet together at some agreed place, and do

It all at once — in other words, a market is established.

So long as transportation is slow and crude, each community has to have its own little market; but the larger the market the more conveniently the process of exchanging can be carried on, and now that railroads, mails, telegraph and telephone bind whole nations together, it is possible to have sectional, national or even world markets.

There is another thing besides transportation that permits the exchanging process to be centralized for a large area, and that is the intricate network of credit that binds the modern community together. The Dakota farmer, for example, can, by establishing a credit at Chicago, sell his wheat there by telegraph — to be delivered at some future date — and at the same time the New York or Liverpool merchant can buy at Chicago in the same way.

And as the use of credit develops, the credit itself comes to be something to be bought and sold for a certain rate of interest, so that a central market for credit is also needed — the money market, in current phraseology.

Next, large-scale production requires the corporation — because one man would not ordinarily have money enough to finance large-scale production, so that it is necessary for many persons to club together and put up the money. Each member of such a club gets a certificate showing his share — as the English logically say — in the ownership of the corporation, and these shares or stocks have to be bought, sold and exchanged somewhere in a central market.

'Thus in a perfectly natural and obvious way, to meet the necessities of the modern industrial organization, the money market and the stock exchange arise — or in common parlance, Wall Street.

Wall Street a Money Market

In the Wall Street district we find the central exchange or market for money, capital, securities, several important commodities, and foreign exchange. AH these things may be and constantly are exchanged elsewhere also, but Wall Street affords the principal market for them in this country.

The term "igoney market" is used to cover not only the exchange of actual cash, in goldi silver or currency, but also bank checks (which are merely substitutes for money, made pos* sible by established credit) and short term loans, which involve the payment of money at an early date. Thus call loans — the payment of which may be demanded at any time — or loans for three or six months and occasionally one year, are included in the money market.

If these short term loans arise out of commercial transactions they appear in the form of nptss given by those engaged in various lines of business and are called commercial paper. If the loans are based on mortgages, bonds or stocks as security, they are called collateral loans. *^

C apita l, on the other hand, as used in Wall Street phraseology, refers to funds which are invested in a more permanent way ; that is, in some productive enterprise, whether through the medium of securities issued by a corporation, or directly, as in the case of a partnership or individual business. .

It will be seen that the distinction between ''money"-^in the sense of bank deposits, commercial paper, or ihort term loans — and capital, is not very sharply drawn. We deposit our "naoney" in the bank; the bank loans it to somebody else as "money"; but a surplus of unloaned deposits in the banks represents a sort of potential capital, because a part of such a surplus is pretty sure to be invested in business enterprises of various kinds. Hence an accumulation of bank deposits if often referred to as "liquid capital," because it is capital in a preliminary form, ready to flow into any business enterprise that its owner may select.

Wall Street carries on the process of exchanging securities in a variety of ways, ;to suit the convenience of the people who have the work to do. If a stock or bond is being constantly bought and sold in considerable quantities it is more convenient for the brokers who do the work to get together around a post on the floor of the Stock Exchange. If for any reason the Exchange has not admitted a certain security to its list, but there is nevertheless a good deal of trading in it, the brokers who teuidle it gather in the street outside, forming the Ctirb market.

Still other securities are bought and sold only occasionally. These are generally classified as "unlisted." Certain brokers specialize in one or more of these inactive securities, being always ready to buy at one price or to sell at a somewhat higher price. Other brokers know who the specialists in diflferent securi-

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— ties are, so that the market for a security is more or less centralized around the specialist.

In this way there arises an "unlisted market," in which brokers get toegther by telephone or telegraph, instead of gathering in the Stock Exchange or on the Curb.

Sjrmbols of Capital

All these stocks, bonds and mortgages represent capital. They are not capital in themselves because the capital they represent has long ago been paid in and has gone its way into the business of the company which issued the securities, where it can be found in the form of factories, warehouses, land, materials, steel rails, cars and locomotives, bank deposits of the company to be drawn upon as needed, or what not. The stocks and bonds are merely certificates of ownership or of capital loaned.

New capital is, of course, constantly piling up, as a result of the profits and savings of the people, and as constantly flowing out into new business enterprises or the enlargement of old ones, generally through the medium of securities of some sort.

Few even among well-informed persons have any adequate idea of the rapidity with which new capital accumulates in this country. The graphics herewith show the approximate increase of wealth in the United States as estimated by the Census Bureau. In 1916 our wealth is growing at the rate of at least - eight per cent, yearly, probably nine per cent., possibly ten per cent.— or say $20,000,000,000 a year.

A part of this increase represents the growth in the appraised value of land, which is a monopoly value, because the land is but little more productive than it was last year; but probably' $12,000,000,000 a year is produced wealth which actually goes toward making the people richer. A lai^e part of this wealth is spent for immediate use and enjoyment, but even after that has been deducted there remains a tremendous surplus which is carried forward as new capital every year. For the distribution of this capital into business enter* prise Wall Street is the important central agency.

Investment of Savings

In this way Wall Street affords the principal opportunity for the profitable investment of savings. Savings of a business man are more likely to be called profits, and the savings of a corporation are known as surplus, but the three amount to the same thing.

Savings are sometimes invested directly in securities, but more often indirectly. The wage-earner puts his money in the savings bank and the bank buys bonds with it. The business man allows his profits, perhaps, to accumulate in his checking account at his local bank, but that bank will make profitable use of them in some way — ^and to earn a profit they must be invested somewhere. The corporation's surplus may go into a New York trust company, which perhaps loans them to a broker on collateral security, while the broker in turn lends the money to a customer who uses it as part payment for stocks. So in one way or another a very large part of the country's savings pass through Wall Street on their way into productive enterprises.

Since commodities, such as wheat, hay or cotton, are not as easily transported as securities or creditj Wall Street situated at one end of a country 3,000 miles wide, naturally does not hold the same dominating position in the commodity markets as it does in security markets. There are three important commodity exchanges in New York City, dealing in cotton, coffee and grain. The Produce Exchange, is only one of a dozen or so of various sizes in different parts of the country — ^the largest of which is, of course, the Chicago Board of Trade. The Cotton Exchange shares business in that staple with New Orleans.

These exchanges deal in their respective commodities for future delivery as well as on a cash basis. If cotton could not be bought or sold on the exchange unless the cotton was actually on hand to be delivered at once, the usefulness of the exchange would be nearly nullified. Now, any one who has or expects to have cotton in any part of the world can buy or sell it at New York for delivery as far ahead as may be necessary. That brings buyers and sellers on different continents almost as near together as though they were in the same room.

Necessity for Central Market

The necessity for a central market in foreign exchange arises from our foreign trade. If A has sold $10,000 worth of cotton to England while B has bought $10,000 worth of pocketknives, there is obviously no sense in A's sending $10,000 in gold across the ocean only to have it sent back again to B. Stripped of all technicalities, the foreign exchange market simply enables B to pay the $10,000 to A, thus closing up both transactions. This could only be done through some sort of central market, as otherwise A and B would never get in touch with each other.

The principal reason why we need a,JSJalL St£«et, then, is to bting together buyers and sellers, borrowers and lenders, from all over the word. Capital flows through Wall Street into varied industries just as the heart distributes the blood to the different parts of the body. It is like the big central exchange of a telephone system. From it the wires run to all the people who want to do business in the things with which Wall Street deals. The man who has a few shares of stock to sell or a few thousand dollars to loan is indirectly put in touch with the whole world for a market.

It is a splendid piece of machinery, probably the most valuable to the country of any mechanism or organization the mind of man has devised. It will be well worth our while to examine its parts more in detail.

CHAPTER II The Banks — ^Bank Statement — Clearing House — Sub-Treasury

THE modern bank grew up out of the ancient business of money-changing, or exchanging the money of one country for that of another. That business was always unpopular because the money-changer did not appear to be doing any real work for the profits he made out of the exchange, and because the money-changers often drove unfair bargains with those who were at their mercy.

The Middle Ages did not recognize the legitimacy of interest on borrowed money. It was looked upon as extortion, the economic function of capital being altogether too abstract a conception for the people to assimilate — and that is still true of many untrained minds in every country.

Most of the diatribes against the "Money

Power," the "sharks of Wall Street," and so

on, are really the off-spring of this ancient

prejudice. It is, perhaps, an evidence of the

natural selfishness of mankind that the moneylender has always been hated by the borrower, with or .without cause; but the advent of the corporation has done much to remove this prejudice by taking the personal element out of

business.

The first bank worthy of the name is supposed to have been established in Venice in 1157. The word bank signified a "pile" or "mass" of funds. The early Italian banks were chiefly for the handling of government obligations. The next step was for the bank to undertake the care of money for individuals and firms, and at a later date for corporations. Money so deposited is always subject to the order of the depositor, either on demand or at a certain date, or after a specified notice.

Interest may or may not be paid on these deposits, according to the agreement; but to pay the cost of handling the money, and the interest, if any, the bank is allowed to lend the deposits out at interest, always keeping in hand a certain amount of cash to meet the current demands of depositors. In this simple way we arrive at the main items of the modern "bank statement" — deposits, loans and reserves.

Trust Companies are chartered under State laws, and are authorized to do a general banking business, but cannot issue currency, that power being reserved for banks having the National charter. Trust Companies may also undertake almost any kind of trust as their name indicates, and engage in nearly every kind of legitimate business. They are of recent development. The first one was established in New York in 1822, and as late as 1871 there were none in Boston.

Trust Companies at first confined themselves to handling funds left in trust, but as they were not so closely restricted by law as the banks they graduj^lly found themselves able to pay a higher rate of interest on deposits, and hence did more and more a general banking business. In New York they are now almost equal to the banks in importance.

The Bank Statement

All banks — except private bankers-tissue public statements of their condition from time to time. The U. S. Controller of the' Currency calls for such statements from all National Banks about once in two months. The exact date is not fixed until after it is past, to prevent the banks from making special preparations for the statement.

The banks of several of the big Eastern cities issue statements weekly, for the convenience of the public. Far .the most important of these weekly statements is that of the banks and trust companies which are included in the New York Clearing House. It is given out on Saturday, and is printed or summarized in the leading newspapers throughout the country.

Although at first glance the Bank Statement appears rather formidable, its main features are simple enough. Each institution give its capital; its net profits; the total of its loan, discounts and investments; the amounts of various kinds of money it has on hand; the amount of cash it has on deposit in other banking institutions which, under the law, may be counted as a part of its reserves ; its own "net deposits" — that is, the total of the funds that have been placed in its care; and, in the case of a National Bank, its outstanding "circulation," or the total of the currency which it has itself issued.

The figures given out for each of the above items represent the average for all the days of the week covered by the statement. The average is used to prevent any temptation to "window-dressing," or trying to make an especially good showing for the particular day of the report.

The several items are then totaled in three groups — ^banks which are members of the Federal Reserve system ; State Banks not members of Federal Reserve; and Trust Companies not members of Federal Reserve. Finally, the three groups are combined to give the total of each item for the entire Clearing House.

A supplementary statement is also issued showing the totals for each of the three groups on the day the statement is issued. This is called the "Actual Condition," and is in most general use for judging money conditions, since it gives the latest available information.

As the provisions of the new Federal Reserve law in regard to reserves are somewhat complicated, a special statement is added showing the "Reserve Position," both average and actual.

With such complete weekly statements of the condition of each bank, manipulation of the accounts becomes impossible, and the statement of the New York Clearing House is perhaps the most important weekly financial showing in the world. Its only possible rival would be the statement of the Bank of England, and since that does not cover other London banking institutions it is necessarily less comprehensive. Certainly no other table of figures will show the trained observer so much about financial and economic conditions in the United States.

Surplus Reserves

The figures most closely watched by Wall Street are the Surplus Reserve and the relation between "Net Demand Deposits" and "Loans, Discounts, Investments, etc." The reserve consists of two parts— cash in vault, and reserve in the hands of other depositaries as permitted by the law — and this total reserve must equal of exceed a specified percentage of each bank's own deposits. If for any temporary reason a bank's reserve falls below this percentage of deposits, the reserve must be restored to the legal requirement at the earliest possible moment, and State and Government officials will see that this is done.

When, on the other hand, the reserve exceeds the legal requirement, as it nearly always does, a "surplus" reserve arises, and the amount of this surplus shows the relative strength of the bank's cash position. Hence this item is carefully watched as an index to the supply of money available for loans. Since a great many securities are always being carried by their owners partly on money borrowed from the banks, the amount of this surplus reserve has a more or less direct relation to the stock market.

The relation between deposits and loans is not so generally understood as the surplus reserve. These show not so much the condition of the banks as the condition of the business men who are their patrons. When the banks' customers are depositing more money than they are borrowing, they are mainfestly prospering. When they are borrowing more than they are depositing it is evident that they are not so prosperous, and when this condition continues for a long time a danger point may be reached where some business men have

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i A difficulty in meeting their loans and may even have to fail.

Under normal conditions the total loans of Clearing House institutions are somewhat greater than deposits, because a bank may lend not only the money that other people deposit in it but also its own money — ^that is, its capital and its surplus of net profits. Hence if deposits exceed loans, a very strong position is shown; but when the loans begin to show a large excess over deposits the situation will bear watching.

The Clearing House

The "clearing" of numerous transactions between two or more persons by offsetting one debt against another and so simplifying the payments to be made, is a custom so old that its beginnings can hardly be traced. In Roman law it was called compensatio. The principle was used throughout the Middle Ages and it is rather surprising that the New York Bank Clearing House was not organized until 1853.

It is a slow process for each bank to collect checks from all the other banks separately, involving a great waste and duplication of time and labor. This is avoided by establishing — ^to quote from the Pennsylvania Supreme Court — "a place where all the representatives of the banks in a given city meet, and under the supervision of a competent committee or officer selected by the associated banks, settle their accounts with each other and make or receive payment for balances and so 'clear' the transactions for the day for which the settlement is made."

Every hkajikis, in essence, a merchant of credit, constantly buying credit from its depositors and selling credit to its borrowers; and credit which is vouched for by established banking institutions is practically a uniform commodity. Since Wall Street is a sort of central market for this credit, serving the whole country, there are a vast number of credit transactions which may be offset against each other without cash payments. New York City bank clearings for 1915 were $110,563,374,000, which was 59 per cent, of the total for the whole United States. Moreover, the ten largest New York banking institutions clear more checks than all the rest of the Clearing House combined, so that the handling of the country's credit is pretty well centralized.

Whether or not there arfe dangers arising from this extreme centralization, it is exceedingly convenient and efficient. Each institution sends two clerks to the Clearing House every day, one to present checks to other banks and one to receive checks from them. The process usually takes only a few minutes. Seven of the biggest institutions clear their mutual exchanges by themselves an hour earlier, in order to accelerate the final clearing.

Payments amount to about four per cent, of the total clearings, as a rule. They are sometimes made in cash and sometimes in Clearing House certificates representing deposits of cash by member banks in the Clearing House vaults.

The Clearing House also serves the purpose of bringing all the banks together into a central organization for other objects besides the simple process of clearing checks. Banks which are entirely solvent, but have become involved in temporary difficulties, are often assited by the Clearing House and thus $aved from suspension ; and, in times of panic. Clearing House loan certificates have several times been issued to take the place of money. In 1907 this practice spread all over the country, and was undoubtedly the means of preventing a general crash. In future the notes issued by the Federal Reserve banks will obviate the necessity of Clearing House loan certificates.

The Sub-Treasury

Of the nine Sub-Treasuries which act as branches of the Treasury Department at Washington in receiving money and paying Government bills, the one in the Wall Street district handles about two-thirds of the total business.

The relations of the Sub-Treasury with the banks are necessarily close. The assistant treasurer, who has charge of it, is a member of the Clearing House, and in times of stress he is in frequent consultation with leading bankers and co-operates with them in handling the situation.

The Sub-Treasuries were established in 1846 because the Government had lost considerable money through the failure of depositary banks

OF WAI-L STREET 33

in which it had been kept. From then until the establishment of the National Bank system in 1864 the Government kept entirely free from the banks, and even after that most of the Government's balances were held at the various Sub-Treasuries.

In times of prosperity the Government receipts were naturally large and consequently the Sub-Treasury withdrew a great deal of money from the market just when it was most needed. In recent years, therefore, it became necessary for the Secretary of the Treasury to deposit Government money in the banks at times to prevent stringency in the money market.

Now that the twelve Federal Reserve Banks are in operation the Sub-Treasuries are beginning to look like an unnecessary duplication of Government facilities, since the banks could without difficulty perform all the work.

CHAPTER III The Money and Credit Markets

THE word "money" is used in Wall Street and in commercial circles generally to mean two entirely separate and distinct things. This is unfortunate, since it causes a great deal of confusion in the minds not only of students and novices, but even in quarters where a better knowledge might naturally be expected. It is therefore necessary to get these two meanings thoroughly in mind before considering the workings of the money market. ' The first meaning of money is cash or currency — ^gold, silver and paper money of all kinds. This is the money we carry in our pockets, or which is deposited in the Sub- Treasury, or imported and exported, or shipped back and forth between the country banks and those located in the big financial centers. The second meaning of m oney is short-term credit, such as call loans, time loans, commercial paper, checks, bank deposits, etc. For example, when a man says he has money in his purse he refers to the first meaning of the word, but when he speaks of his money in the bank he means something very different— his credit ballance at the bank.

This double use of the word grew up because a credit balance at the bank could be instantly turned into money at any tune. When the savings bank depositor takes a hundred dollars of cash around to his bank and deposits it, he knows that he can draw that cash out again whenever he wants it, and very naturally he speaks of his "money" in the bank; but the bank does not hold all its depositors' money in the form of cash. If it did it could not pay any interest, since to earn interest it must loan the money out in some way. The batik simply credits its patron with the amount of his deposit, and what he really has in the bank is a credit balance.

Thus the "money market" is really a credit market, for jiardly any one ever borrows or lends the actual cash. Nearly all the transactions in the money market are in bank checks, which merely serve to transfer bank credits from one person to another. Even loans on the notes of business firms — commercial paper — ^which may run for six months or a year or even longer, are included in the general term "money market."

How the Money Rate is Fixed.

Since credit can be transferred anywhere in the United States by the simple process of mailing a check, or even by telegraph if necessary, the whole country is practically included in the "money market." A merchant in Kansas City wants to borrow $10,000 for the purpose of increasing his stock of goods. He goes to his bank and if his credit standing is good the bank lends him the money. This perhaps leads, the Kansas City bank to withdraw $10,- 000 which it was carrying on deposit in a Chicago bank, and may again lead the Chicago bank to draw an equal amount from its New York correspondent bank or trust company.