XII Secured Loans

CHAPTER XII SECURED LOANS The principal kinds of secured loans made by our banks are those collateralled by stocks or bonds, those secured by warehouse receipts, and those backed by mortgages. The volume of our secured bank loans in comparison with those represented by paper unsupported by valuables pledged as security was brought out in a previous chapter. It will be in place now to present some of the aspects of the three classes of loans mentioned. The problems of the banker in connection with secured loans, particularly those secured by stocks and bonds are, by contrast with the exhaustive investigation and analysis carried out as a preliminary to lending on unsecured paper, comparatively simple. His main concern is to see that the security taken has ample value. The important question that confronts the banker bears upon the value of the stocks or bonds offered as collateral. New York bankers in making loans to brokers pay relatively little attention to the character or normal value of the collateral, but rely chiefly upon its value in the market. If there is an active market for a stock —New York, New Haven and Hartford, for example, which is now selling around 30—banks accept it as collateral almost as readily as a stock like Union Pacific, which is selling near 130 Elsewhere, in a 224 SECURED LOANS 225 place like Baltimore, for instance, and among the country banks, the collateral value of a security is gauged by what the banker considers its "intrinsic"

value. New York bankers are chiefly concerned with the resiliency of the market,—whether suddenly throwing large blocks of the given security on the market would leave it in a depressed state.1 Bankers outside of the metropolis are more deeply interested in the wholesome character of security offered as collateral. The common stock of a prosperous Denver enterprise might be highly regarded as collateral by local bankers, but unacceptable to Wall Street banks. On the other hand, the first mortgage bonds of a great railway system which was in the hands of a receiver, but for the securities of which a broad and active market existed on the New York Stock Exchange, might readily be taken as collateral by the New York banker and looked askance at by the banker in Denver. It is a sound practice for bankers making collateral loans to insist upon full security because of the treatment accorded the collateral loan in the bankruptcy courts and the legal technicalities and delays incident to realizing on this variety of loan in many states.2 The margin required ought always of course to be sufficient to throw the burden of value fluctuation on the shoulders of the borrower.

Because of the absence of value fluctuation life in1 John M. Nelson, Securities and Investments, Bulletin, American Institute of Banking, Vol. II, p. 477. s Edgar H. Sensenich, Some Well Founded Principles of Banking, Proceedings, TwentyFirst Convention, California Bankers' Association, 1915, p. 141.

226 BANK CREDIT surance policies are superior to stocks and bonds as security for loans. Such policies, it has long been recognized, are worth as collateral security whatever their cash surrender value may be, and they are freely accepted by banks as good collateral on satisfactory assignment. The surrender value is commonly stated in plain terms in the body of the policy.1 Life insurence policies are a liquid security even in times of severe monetary stringency.2 Warehouse Loans Of the vast streams of produce, merchandise, and manufactured wares of the country a certain proportion representing the surplus of the time finds its way into warehouses and cold storage establishments, where it rests until demand starts it again on its way to consumers. The banking practice of assisting merchants and traders to carry large stocks of grain and other goods when represented by warehouse receipts or bills of lading probably originated with the Corn Exchange Bank of New York.3 Mr. Dunham, the first president of that institution, whose familiarity with the grain trade led to the introduction of lending on warehouse receipts, used to say that such staples as wheat and cotton, wool and pork, coffee and lard were as good as gold and that he was 1 William T. Gage, Life Insurance as Collateral, Proceedings, Twenty-seventh Annual Convention, Michigan Bankers' Association, 1913, p. 128.

2 William Livingston, Proceedings, Twenty-Seventh Annual Convention, Michigan Bankers' Association, 1913, pp. 132, 133. 3 Albert M. Read, Warehouse Receipts as Bankable Paper, Bulletin, American Institute of Bank Clerks, Vol. V, p. 5.

SECURED LOANS 227 willing to lend gold on the pledge of these commodities as security. Preference for these staples as security has generally given way so that at present and for many years past warehouse loans have been made in less desirable lines of trade, where the solidity of the borrower has offset the disadvantage of his collateral. Grain in elevators, whiskey and tobacco in the general revenue bonded stores, silks and tea in the customs bonded warehouses, cotton in the ginneries, eggs, butter and apples in cold storage, citrus fruits, raisins, nuts, vegetables, fish, furs, wool, cloth, clothing, carpets, rugs and rubber tires,—these suggest the extraordinary expansion of the list of commodities now pledged as security for bank loans. Several factors influence the safety of loans on warehouse receipts; the most important being the character and responsibility of the warehouseman, the financial responsibility of the borrower and the value of the goods represented by the receipts. Although the warehouseman can not be held legally responsible for contents of cases, as to either quality or quantity, nor for ownership of goods in the borrower, he is required by law to exercise ordinary care, i. e., that degree of care which men of prudence exert under similar circumstances with regard to their own property, in the safekeeping of goods called for by receipts issued. He may be held responsible also for the fraudulent issue of receipts, as in the case of the issue of two or more receipts for the same goods as well as in the case of making any statement calculated to deceive. If to the solidity and responsibility of the warehouseman and the borrower and a determination of the quantity, 228 BANK GREDIT quality and value of the goods by a trustworthy expert, we add carefulness and watchfulness as to changing values and markets, insurance, duties, etc., we have in mind by far the most weighty considerations affecting the safety of this growing class of loans.1 The commodity stored, the warehouseman, and the borrower himself,—in all three the banker, then, has an interest. Through experience bankers have become unwilling to loan on commodities stored, irrespective of the character and credit worth of the borrower and of the warehouseman. If the banker furnishes funds to enable producers or manufacturers or merchants to put their products or goods in warehouse he may thereby become essentially the purchaser of merchandise otherwise unsalable. If a full knowledge of the goods is not in the possession of the banker they may deteriorate or become unsalable seasonally.2 Many commodities, including cotton, are subject, however, to little or no deterioration. Under reasonably good storage conditions baled cotton will keep unimpaired ten years or longer. Instances have been known where, after being stored in a farmer's barn fifteen years, it brought the current market price.3 Grain receipts are used extensively as collateral for loans to finance the stocks of grain carried in elevators ` Ibid., p.7.

2 F. L. Lipma¤, Rediscounts under the Federal Reserve Act, Proceedings, Twentieth Annual Convention, California Bankers' Association, 1914, pp. 85, 86. 8 Charles J. Haden, A Plea for the Cotton Fields, Proceedings, Thirty-second Annual Convention, American Bankers' Association, St. Louis, 1906, p. 128.

SECURED LOANS 229 during the movement of the crop. When the receipts are pledged as collateral the borrower is expected to maintain the value of the security at ten per cent above the face of the loan. Rigid inspection, weighing, and storing practices have caused the receipts to be regarded as thoroughly sound collateral. Cotton Loans As soon as cotton has been picked and ginned it becomes highly acceptable as security and the banker may advance money to buyers to enable them to carry on their business. According to the usual method of lending to the cotton buyer or broker the banker requiries a cash deposit or other acceptable security at the beginning of the season adequate to protect the bank against loss from market fluctuation. The bank, retaining a safe margin as protection against loss from a sudden decline in the market price, advances a stipulated sum against each bale. The buyer, of course, has to sell as the season advances, or else, if an extensive operator, he would consume his margin in purchasing new cotton. The customary margin required is $5 per bale when cotton is selling at six cents per pound or below; $10 when selling at seven, eight, or nine cents; $15 when selling from ten to twelve cents, the same changing proportion obtaining as the price goes higher.1 In making the majority of these loans on cotton the banks take over order büls of lading, endorsed by the shipper and generally covering shipments to buyers in care of a compress or warehouse that receives, com1R. H. Thompson, Cotton Loans, Bulletin, American Institute of Bank Clerks, August 1,1905, p. 261.

230 BANK CREDIT presses and stores for future delivery to spinners or for export. The compress, upon getting possession of the cotton, issues warehouse receipts in the name of the consignee in individual lots, marked and numbered to correspond to the tags and marks on each bale of cotton. The receipts are then given to the bankers in lieu of the bill of lading surrendered. The system of using receipts in one bale lots enables the banks always to claim the exact bales on which advances have been made, should the lending institution be compelled to take possession of the cotton pledged as security. This system of receipts based on one-bale lots also affords protection against the substitution of one grade for another and reduces the possibility of forged receipts.1 Crop Loans Loans on growing crops may safely be made as a rule only when the crops are nearing maturity. Loans made solely on crops are very insecure, owing to the likelihood of failure. Bankers often advance the cotton grower funds with which to begin his crop, taking a chattel mortgage and usually including in the mortgage all other chattels that are a part and parcel of the farm. This additional security is demanded because the crop may be struck by drouth, flood, or other disaster unforeseen.

The banker can confer benefit on the "ground skinner " and exclusive cotton or wheat grower and at the same time increase the safety of his own interests by insisting that a considerable proportion, one half, SECURED LOANS 231 let us say, of all loans made by the bank be invested in other lines of farming. The man with cattle and a silo, some hogs and brood mares, need not be feared when borrowing to put out cotton, wheat or other crop.1 Loans to farmers on cotton as sole security should not exceed 60 or 65 per cent of the value of the cotton. This percentage is a protection to both the banker and the farmer against the loan being called when the price is fluctuating. The farmer who has to borrow in excess of 60 per cent is hardly in a position to hold the cotton, and the sale of the product is his proper course.2 Real Estate Mortgage Security Urban Real Estate It is natural to think that losses should seldom if ever occur in connection with real estate loans. When they do occur the lending banker is himself frequently puzzled as to the cause. The scene for losses on real estate loans is usually set in "boom" times, when valuations tend to be too high and surroundings improperly judged. The maker of a real estate loan will reduce his losses by taking as a valuation, neither the price which the owner would be willing to pay nor the price at which it could probably be sold by the mortgagee under foreclosure on time, but the price at which it could be sold by the mortgagee under foreclosure for 1 Cf. A. W. Wilson, The Bank and the Wheat Crop, Proceedings, Twenty-Ninth Annual Convention, Kansas Bankers' Association, 1916, pp. 103, 104.

2 Report of the Committee on Negotiable Cotton Warehouse Receipts, Proceedings, TwentyFirst Annual Convention, Mississippi Bankers' Association, 1909, p. 70.

232 BANK CREDIT cash. Allowance should be made for interest during the time required for the process of foreclosure, cost of foreclosure, and depreciation, which may be serious during the time of foreclosure. Vacant properties held for speculative purposes are most dangerous, and more than half the forced value should never be loaned on such security. Care should not be spared in making a loan on a costly property in a poor neighborhood; a moderately good property in a desirable neighborhood is much better security.1 Farm Land as Security With reference to farm land as security, many factors have to be considered. A tendency or disposition of the "young blood" to stay on the farms, a degree of thrift in the community sufficient to insure ownership, clannishness of farmers round about and their desire to be in the neighborhood of their relatives, absence of large speculative holdings near by, good and permanent markets, the character of the soil, climate and population to continue successfully along the lines of the existing system of agriculture and the adaptability or power successfully to change, should change in crops or methods occur,—all these are elements in the problem of determining the value of farm land as security for a loan.

One of these elements or factors requires amplification, viz., a degree of thrift sufficient to secure 1R. W. Smylie, Doubtful Debts; Earnings and Competition, Proceedings, Twelfth Annual Convention, Michigan Bankers' Association, 1900, pp. 53, 54.

SECURED LOANS 233 ownership, and its corollary, the condition of indebtedness of the community. In the event of adversity, such as crop failure, a community lacking in thrift and accumulated wealth in forms other than equity in land not only fails to pay interest but, in the absence of ready cash to pay the defaults, and to take the land from the delinquents, witnesses the forcing of land on the market when there are few or no purchasers. A marked fall in prices results inevitably. Lands subject to heavy ditch or other taxes may be difficult and burdensome to hold during a lean period, but widespread individual incumbrance, uncommon in thrifty communities, is an even more unfavorable condition.1 The immediate neighborhood of a piece of land must also be carefully considered. As is true of urban property, a good piece of farm land in a poor locality is handicapped by its surroundings. On the other hand, a poor piece of pasture surrounded by good farms will not likely lack a purchaser, and, aa security, is more desirable than if adjacent to land of the same character, for reasons that are plain.

How difficult it is satisfactorily to appraise land values is shown by one or two instances where differences in evaluation were very wide. In one case an appraiser recommended, reluctantly, a loan of $18,000 on a certain tract. Soon thereafter the owner succeeded in borrowing $40,000 on the security of the same land. In another instance, which occurred accidentally and unknown to the appraisers concerned, 1E. L. Johnson, The Correct Estimate of Land Values as a Basis for Real Estate Loans, Proceedings, Eleventh Annual Meeting, Iowa Bankers' Association, 1897, pp. 91, 92.

234 BANK CREDIT two appraisers employed by the same lending company, and both experienced men, appraised the same farm and were so far apart in their valuations that the difference was greater than either the margin or the equity on the basis of what the owner himself would have regarded as a fair loan.1 Appraisers differ, and farm values as represented by appraisals are a very uncertain quantity. It may be stated as a general principle that loans made on high-priced land are safer than those secured by low-priced tracts. This is true for several reasons. In the first place, a very appreciable community value exists in nearly all the high-priced land regions, and the rate of "turnover" on high-priced land is greater than that on cheap land. Then, cheap land deteriorates more rapidly with the same degree of misuse than does high-priced land. Hence there is a stronger tendency to abandon the cheaper land. Again, land values seem to fluctuate, particularly decline, not on a percentage basis but on a flat dollar per acre basis,2 placing a great handicap on the cheap land. There is much less likelihood of land now worth $100 per acre falling to a value of $50 per acre than there is of land worth $25 per acre falling to $12.50,—which is another way of saying that the percentage margin of safety should be higher in the case of low grade land pledged as security than in the case of high grade land used for the same purpose, in order that the degree of safety in the two instances may be equal.

1 D. H. Deane, Factors Affecting Appraisals in Determining Land Value, Trust Companies, Vol. XXV, No. 5, November, 1917, p. 462. 2 Idem, op. cit., pp. 462, 463.