Commercial paper

Preface

MAW parts of our financial system of the United States arc now arousing more discussion as to their adaptability for our great needs than they have for years. It is to point out the condition, the tendencies and the importance of one great factor in this system. Commercial Paper, its strength and its defect-, that the following pages are written.

The book is primarily written for the officers of our nation's twenty thousand hanks, to aid them in selecting the best of such paper; but all merchants and manufacturers who borrow money, 1 believe, also will find this hook very helpful.

I especially wish Here to state that practically all the work of preparing this book has been done by my associate, Mi-. Ralph May, who, in addition t<> knowing the theory involved, is connected with one of the largest commercial paper firms in Boston and thoroughly understands the practical Bide of the Commercial Paper business. Therefore T«» Mi*. May belongs the credit of this work, my name appearing firsl -imply owing to bis courtesy to me.

Roger \Y. Babson.

Wellesley Sills, Mass.

Chapter I Lending And Borrowing

THE money in a community is enhanced to the holders if it can be made to increase. In any community with a proper monetary system, money and the substitutes for it which are broadly classed as money, practically correspond to the wealth or well being of the community. If we take money as representing the wealth <>f a district, which is not strictly a true representation, as we shall see, but which is sufficiently so tV>r our purpose; and capital, as that part of the money used in the attempt to increase any given supply of money, Ave have the basis of business, and the first factors to notice in an instigation into what constitutes an effective system for the increasing of any given supply of alth. Most men have a desire to progress in whatever they have undertaken. A- most of us are dependent for our happiness to a huge extent <>n money, most of us are engaged in turning our money into as effective a form of capital as is 3sible. Provided gain in money to the holders [ginal capita] is not at the cost of the good die whole community, thia advance is ant-

ly to he attempted and rvcry method for giving individual ho! money opportunity to turn

it ita] i- to 1>" discovered ami

Money is Unevenly Distributed.

In every community money is unevenly distributed among the individual holders. Some men are born rich, some acquire riches and some have riches thrust upon them. The shrewdness, ability, or opportunity of some over others have always caused a difference in the distribution of money. With this in mind it is easy to see how certain men are better able than others to make money earn more money. It is also easy to perceive that oftentimes it is not the men with opportunity who have the money to turn into capitalistic form.

Interest is Divided Between Borrowers and Lenders.

If it is well to attempt to turn to capital account any given supply of money in a community or nation, any thing or things which can bring this about are needed servants of the community. Lending and borrowing, if according to true economic principles, are such, and their use is to be aided by all possible means. Lending and borrowing serve a double economic purpose. Lending, if the lender has not as satisfactory a chance to increase his money as capital as the borrower has, insures to him an enhanced value of his money. Borrowing, if the borrowing is warranted, insures to the borrower a certain amount of money wealth. Interest is something like economic rent. No money will be lent which the

I lender feels will not show an actual compensation in return for the time and ability spenl over looking up the security of a loan, plus the amount the lender could make his capital return if he

■hied it himself. On the other hand, no borrower will borrow unless he feels that his borrowing will bring him a return sufficient to compensate him for the time and ability he spends in wielding the capital lent him. The return in borrowed capita] over and above the sum equivalent to these two compensations we may call middle ground interest. Properly, the borrower and the lender should each receive one-half of any middle ground interest there may be, but the actual apportioning of this part of the gain on capital is ruled by the relation or apparent positions of lender and borrower.

Commercial Loans Carry Pure Interest Only.

The price of money, at any one time, like the price of anything else, is ruled by demand and supply. Therefore, if a single borrower is oppos< d by several lenders, his -bare in the middle ground interest is properly more than one-half, and vice versa. Bui fused into this is the knowledge of the lender of the borrower's desire to borrow, or the borrower of the lender's desire to lend. Fused into this also is what the borrower can make the lender think his need to lend is, or," on the oibcr hand, what the lender can make the borrower think his need to borrow is. Actually, the apportioning of any middle ground interest is dependent on what appears to be the demand and the supply rather than what really is the demand for and the supply of money. We are speaking now of ordinary business loans in which no more than on ordinary business risk is involved. The interest in such loans, may be called pure interest, whether it takes the form of discount in commercial paper or interest in collateral loans, bonds or other form of investment. When there is an evident element of risk in a loan over and above that always apparent in business loans, the apportioning of middle ground interest is directly dependent on the risk involved; for such interest takes the form of a bet or insurance.

Insurance of Commercial Loans Should be Possible.

Insurance companies have served a very useful purpose for the world in accepting individual risks because of the strength of many. Health, the value of real estate and of shipping have all been allowed to retain constant values through insurance. As yet such chance for the retention of the face values of commercial loans of money has not been afforded to any marked degree by insurance companies or other financial agents, and in such loans there is a great field which must surely soon be opened. Doubtless within a comparatively few years an enormous amount of insurance will be

LENDING WD BORROWING 11

taken in one form or another on loans bearing unusual risk. There is no more reason why loans for ventures of unusual risk should not be insured than that destructablereal estate or shipping and the like, which would be largely the product of these l<»an-. should be insured. Up to a certain point, very considerably beyond that now admitted, borrowers should be able to get credit, and this they undoubtedly will be able to receive before long. At the present time the only method <>f writing such insurance or semi-insurance is through lenders which are largely banks or other forms of fiduciary agents. It is obviously the duty <»f Mich lenders to avoid unnecessary risks and to confine themselves as much as is possible to the gaining of interest in pure form. Kisks, however, must sometimes be taken. As President lladley of Yale says: ".Risk is an incident to progress." We should hardly be far advanced in our increase of wealth if we had avoided Risk altogether. Some method of insuring risks in lending should come to the front; but it should be distinct from the methods of raising money lor ordinary business loans. Any student of the increase of money wealth or of any of its factors must studiously avoid confusing the interest dependent on ordinary business transactions in which there is no reason to suppose there is more risk involved than i in the average business trans

action and those transactions in which there is admittedly more risk.

All Lenders Should Study Business Conditions.

It is, of course, apparent that knowledge of conditions is the great factor in the deciding to which class loans belong. What may be pure interest to one man may be interest in the shape of insurance or a gamble to others. For this reason it is most important that all lenders should be as thoroughly conversant with the fundamental condition of the nation as a whole as well as with the conditions of borrowers. With bankers too much stress cannot be laid on their acquaintance with general business conditions, the basic factors in their business world and the general forecast of future business events. To gain the right to compete with the ignorant and to enter a small group from a large one, often enables a lender to secure from the law of demand and supply what is pure interest at a considerable advance over the average of pure interest return in that particular market. Where lending is a business in itself nothing but constant study of the many changing business conditions will enable the lender to compete at such advantage with his fellows. It is most advisable that every aid in this direction shall be made use of.

Loans are to be Classified.

In dealing with the particular subject undertaken, we have to consider primarily those lend-

LENDING AXD BORROWING 13

ings and borrowings in which there is no more than an ordinary risk. Commercial paper, as we shall Bee, is by its very nature opposed to any usage except for ordinary mercantile transactions in which no more than the average risk in such dealings is involved and in which any interest acqruing is interest in pure form. There are various forms of borrowing, both for loans involving exceptional risk and for those which do not; but as interest in the form of insurance is a study by itself and without our especial field we must here (•online ourselves to the ordinary business loans or those in which money seeks to turn itself into capital and at the same time to avoid channels in which its gain may not readily be classed as pure interest. Loans dependent on such capital may he divided into the following classes: —

1. The borrowing directly from one thoroughly conversant with the condition of the borrower.

(a) Loans between individuals, with or without security, in which the lender has an intimate acquaintance with the borrower.

Loans between groups of individuals or between a borrower and a bank where the lenders have such intimate knowledge.

_. The borrowing through one or moye distanl channels from lenders only moderately conversant with the condition of the borrower.

Lou- time loans, with or without security.

(b) Slort time loans, with or without security.

These classifications may, of course, be themselves many times subdivided ; but for a short inquiry into lending and borrowing and for our especial purpose they will suffice.

Classes 1 and 2.

In Class 1, that of loans in which there should be protection through knowledge against any exceptional element of risk, we have to place broadly such loans as the careful investor would at once feel fairly certain of as being paid at maturity. ~No one can be sure of absolute security in the world of lending and borrowing; but there are many loans, some apparently better than others because of known resources back of them, yet all of which seem from the first likely to be convertible into cash at their expiration. These are to be grouped under Class 1. To Class 2 belong such forms of loans as those which, because of lack of knowledge of conditions or for other reasons, need and receive additional "checks" or security to prove their soundness over and above the safeguards which a lender having intimate knowledge of the borrower would demand.

The Place of Commercial Paper.

Commercial paper, which is our subject, is a form of loan, with or without security, suited only for a short time transaction in ordinary mercantile business, and always' provided that the laws relating to the issuance of commercial paper are kept, this, or any form of loan at all closely allied to it, finds its place distinctly in Class 1 or 2 of our classification of loans. It will appear that if any commercial paper ever by its history proves itself to have belonged or to belong outside of the employment of capital in which the accruing interest cannot be classed as pure interest, it is because the laws governing its issuance have been disregarded. Loans to packing houses on short time, or to some large dry goods house or to a mill (if properly issued,) are examples of commercial paper. These loans are made to firms conducting a well known business and for well known needs. They distinctly belong with loans the interest on which is pure interest, as there is no exceptional risk involved in the loan. Stock subscriptions, underwritings and loans for unusual commercial I-' n if for a short time only, cannot be dj and belong to a field outside our slated divisions.

Collateral Loans.

In our first division of loans, that is, of loans in which there appears to be no especial element of risk and in which the lender lias an intimate acquaintance with the condition of the borrower. have to deal first with leans which show their value in their form, such as lean- secured by salable collateral, and second with unsecured Loans

3Uch ;.- Usually OCCUr between banks and their individual customers. There are other lean- which fall into this class but the foregoing are the most prominent. Collateral loans form a very considerable portion of bank investments throughout the world and are among the safest. In this country loans on approved collateral with a ready salable value and a margin are considered as among the most desirable investments to be had. Even the necessity for allowing borrowers against collateral to make exchanges against this collateral does not change their relative position as compared with unsecured loans. Abroad, commercial bills, if in acceptable form, bring lower rates than collateral loans do ; but abroad, commercial paper is on a different basis from what it is with us. Collateral loans to be worthy of the name must be secured by collateral for which a market is known and the collateral should be put in at prices which can be readily obtained in that market. Securities quoted daily on some large stock exchange, and generally accepted as being quoted at a fairly constant valuation, should be the most acceptable form of collateral.

A Margin Should be Guaranteed on Collateral Loans.

A margin in value of collateral over the face value of the note should be given, the amount of margin varying with the chance for sudden shrinkage in the salable value of the collateral. A guarantee should be given in the note that this margin will be maintained during the life of the

I loan or the loan will become due and payable. In the case of the besl bonds ten per cent is usually taken as a conservative margin to be required to be maintained when active, listed bonds are given as collateral against borrowings. In the case of the best active listed stocks twenty per cent is customarily demanded as a conservative margin. On stocks other than the best or in the case of loans jured by stocks which are all of one kind or very similar, a grekter margin than twenty per cent is often required to be maintained, here again the margin being dependent on the history of the prices at which the stock has sold and the chance for its depreciation at the moment. Loans secured by one class of stock or bonds are obviously not as satisfactory as loans secured by mixed collateral.

Collateral Loans Form Our Best Test of the Money Market.

Collateral loans with us test the value of money for the moment better than any other form of

lurity. Call loans, which banks put out from day to day and which they depend on first to replenish their reserves if a need comes, all arc secured by quick, usually the quickest, collateral. Call money, as it ia known, and money lent or three or four month- time againsl the same Borl

collateral, which, by the way, is usually sixty-five per cenl railroad stocks and thirty-five per * industrial stocks, arc as uear money as any loans can well be. Interest or discount accruing on these loans is absolutely pure interest and represents without any foreign factors exactly what money is worth for the time the loan is made. From call loans secured by stock exchange collateral, sixty-five per cent railroad, thirty-five per cent industrial, and properly margined or secured by similar collateral that has an immediate salable value, it is but a step to loans secured by like collateral for six months, a year, or even longer. The longer loans are of the same order as the shorter ones though they make use of money held for rather different purposes than the money which goes into short time collateral loans. The goodness of the longer time collateral loans is, too, somewhat more difficult to estimate than is that of the short ones, for it is hard to foresee just what level of prices for securities will rule from six to twelve or more months ahead. The margin requirement partially obviates this difficulty so far as the security for the loan is concerned ; but the late maturity prevents the lender from using the money for the purchase of securities if prices decline greatly before the loan matures.

Weaker Collateral Loans Should be Especially Well Margined.

Often certain notes creep in among collateral loans on which the collateral, though apparently in good repute and fairly salable, is dependent on the efficiency of the promisor for its salable value.

LENDING AND BORROWING ID

Borrowings by bond and stock houses carrying large blocks of securities which obviously require

very extensive work to sell, which have not a broad market and which are offered chiefly by the bond or stock house in question are examples of such

loans. These loans, though not necessarily faulty, should be protected to a fuller extent than the

other collateral loans already referred to. If such notes are taken, the promisor should be known to have especial strength and a considerably larger margin than on loans secured by more salable collateral should be called for. Twenty to thirty per cent is not too much to ask for on notes secured by bonds carried in this way, and thirty to fifty per cent on stock. Moreover, great care should be taken that the securities given as collateral are put in at what is really a fair valuation. Too often the collateral is valued at the "asking price" instead of ar the "bid price."

The Best Collateral is Listed Collateral.

I he fact that a security is listed on a stock exchange, even the New York Stock Exchange, is DOt in itself evidence to wan-ant its being accepted as the bgst of collateral, any more than the fact that a security is no1 listed should preclude it from acceptance as collateral. The best collator, is that listed <>n some large stock exchange, because it can he more readily quoted there than in the private market ; and, to he satisfactory, collateral must no1 only he listed, but quoted and quoted regularly through bona fide sales and purchases, at least several a day. The amount of such sales and purchases over some time should also be taken into consideration in lending against the security in question.

The Relation Between Banks and Their Customers Should be Very Close.

In the case of unsecured loans between banks, individuals or groups of individuals and their customers for money, a more difficult problem presents itself than that which appears in loans secured by collateral. Banks doing a general banking business largely cater to those persons engaged in business who will keep a fairly large deposit all the time with a bank for the sake of being able to call on the bank for a loan, usually considerably larger than the deposit, at certain times during the year, the amount to be loaned and the length and other terms of the loan to be governed by the amount of the deposit and the condition of the bank. Such so-called "borrowing accounts" form the basis of the deposits in most of our national banks and in many of our trust companies and state banks in this country. Loans based on them fall distinctly in the class of borrowing in which there is or should be a most thorough personal knowledge of the condition of the borrower on the part of the lender. Borrowing accounts with banks exist either to effect the major part of

LK\niX(i AND BORROWING 21

the financing of a business or to effect a final and absolute resource in time of need. It is obvious

that in either case the bank should know exactly where it stands in regard to its customer, a knowledge which necessarily includes thorough information in regard to the business done and the business needs of the customer. As safety of its own deposits should be primarily its first care; a hank cannot for a moment afford to offer itself to till a wide breach, such as a borrowing account often offers, unless it knows that it stands on firm ground. A nig depositor using his deposit as a borrowing account should recognize this fuel absolutely ^ and should regard his loans with the bank as that with his best friendj being trilling to show his condition at all times and also being willing to he guided so fur as his financing is concerned largely by his bank's ad rice. The financial experience of the officers of a bank is necessarily so much wider than that of men engaged in mercantile affairs alone that if the bank officers are students of fundamental business conditions their advice should be taken as the best obtainable. Respect, too, should ho shown a bank by a customer in the case of a friend if the demands on the hank appeal- to he such as to preclude a loan as asked t'<»r mi account of other demands OD the bank'- resources. Such occurrences as this where a h»an i- asked for in all fairness should not occur often. If it due- other borrowing accounts should he opened in other banks; hut occasionally such a condition will arise and when it does the bank deserves friendly consideration.

Banks Should Not Pay Interest on Borrowing Accounts.

Two facts are very important in a consideration of borrowing accounts. The first is that a borrowing account should not give a customer of a bank a right to demand a loan larger than four or five times the amount of his average deposit, a loan which should not be for more than ten months of the year ; and which at least once each year should be paid in full. The second is that banks having borrowing accounts should not pay interest on those deposits made by borrowers which call on the bank to any considerable extent for loans. There is too much competition between banks on a basis of a war of interest. Such a struggle is injurious to the best interests of banking and to the usefulness of banks to their customers, as it hampers them greatly. For borrowing accounts banks perform enough service as it is, and this should be sufficient.

Large Borrowers Need Resources Other Than Their Own Banks.

Bank accounts carrying the right to borrow at the bank, at certain times, or so called borrowing accounts, include the right to the depositor to call on the bank to protect short overdrafts, or to i discount short or longer time notes or commercial paper. The chief use of such accounts is, however, limited to the righl of the depositor to the discounting of shorj time loans or commercial paper. .It is this that tonus the basis of the lending to customers on the pari of mercantile banks, a lending which, as has been shown, should be dependent on an intimate acquaintance between borrower and lender. As will be readily seen, however, no man or group of men engaged in extensive business operations can fairly expect to obtain, or as a matter of fact can by law obtain, all the money they need to borrow for their business from their bank or banks. Such men, too, like to keep their opportunities to borrow from their own banks open so that in case of need they may fall hark on them. The consideration of the borrowings that these men make use of, therefore, leads us to the consideration of Division i ; in our classification of loans — those loans made through one or more distant channels and from lenders who <-an ho only moderately conversanl personally with the condition of the borrower. Such loans arc from the point of view of the borrower, hardly dif- M the loans made with friends or with hi- own hank-. To lenders under this class, howir, the difference is very great. A general knowledge of the condition.- of the borrower is impossible, with the resull that either certain spefeguard jailed for to surround

loans of this class or i1 must be stipulated that loans shall take a certain form, the safety of which is fairly apparent.

Many Large Borrowers Can Best Finance

Themselves Through Well Secured

Bonds.

Many businesses need to borrow money for a long period. Such businesses do not care to tie up their ability to borrow from their own banks or friends for good and all, so they make use of the general investing public or the general investing banks. This is done primarily through the medium of bonds, and customarily these bonds are secured by mortgage. There are a great many people with available wealth wishing to turn it into capital without accepting much risk themselves, and who cannot or do not care to place their funds in local loans. To such the offers to borrow on the part of large businesses, the good standing of which is generally accepted, offers which come for small sums and all of which are secured by a share in fixed assets, the stability of which is vouched for, form attractive inducements to many to turn this available wealth of theirs into capital. To the borrower such forms of loans are little less advantageous than ordinary notes. They must be paid just the same; and whether the fixed assets are mortgaged or not does not affect the general business clone. To the lender, however, there is certain knowledge that there is something to fall back on in case the earnings of the company fail.

To those who lend this makes all the difference in the world. Lenders believe, of course, in the g neral successful operations of the company, luit really base their loan on fundamental assets. For this - o borrowers who make use of distant capital, which ran be only moderately aversant with the actual condition of the borrower, should not fail to appreciate the point of view of such lenders and be ready to secure their bonds in every reasonable way. They will have far better success in their borrowings it they do this.

Long Time Bonds Should be Especially Well Secured

L riders of this -tamp should demand ample margin of safety in security on long term Loans. Conditions chj og 30 rapidly, 1 S] 1 eially in a new country like this, that the longer a loan is made for the better should the loan be protected. That the country is constantly advancing in inherent

alth and that a business now successful should _ >w with it. i> imt a sufficient answer to this

tement. Very long term bonds, say for anything <»vcr twenty-five years, should be especially well protected, and if possible some method for partially, at least, repaying the total borrowi should he introduced into the tonus of the bond Sinking Is [lent insl itutions

the lender, and rarely hinder the operations of the borrower. The Bale of refunding is a perfectly proper means of raising money on the part of a borrower to repay loans, but a possible lender sometimes questions how much refunding a borrower may be able to do fifty or a hundred years from the time the loan is made. The introduction of sinking fund requirements in the terms under which long time bonds are issued, will aid the selling of those bonds enormously. An even better scheme of finance over sinking fund requirements is to have an issue of bonds mature serially. This over a term of years tvorks better for both borrower and lender.

Debenture Bonds May Also be Satisfactory.

Some large borrowers in excellent standing may, after covering their fixed assets with mortgages, still wish more money and issue debenture or nonmortgage bonds. These may or may not be good ; but investment in them should not be made till after a very careful study of the earnings, assets and general reputation of the borrower has been made. Debenture bonds such as those of the Boston and Albany Railroad Company, which has no mortgage on its property, are, of course, as long as the bonded debt is considerably less than the fixed assets of the company, just as good in themselves as mortgage bonds ; but it should be remembered that mortgages may be placed on such property unless a promise has been given in the debentures that they shall not be so placed. Such bonds, therefore, are not as satisfactory as mortgage bonds, though in the case of debenture borrowings, such :i> those of the Boston and Albany, Lenders may expect that a history of good standing as to credit will be maintained, and thai even if a mortgage were executed it would hardly be so placed as to imperil the holders of debenture bonds.