XVI Commercial Paper Houses as Intermediaries Between Borrowers and Banks

CHAPTER XVI COMMERCIAL PAPER HOUSES AS INTERMEDIARIES BETWEEN BORROWERS AND BANKS In an earlier chapter attention was directed to the rise and development of our commercial paper or note brokerage houses as important institutions in our recent financial evolution. It will be our purpose in the present chapter to examine the work and results, merits and defects of the note brokerage system with special reference to the present and immediate past. Characteristic Features It will be well at the outset to familiarize ourselves with the outstanding features of a typical commercial paper house. Most note brokerage or commercial paper houses represent the partnership, as distinguished from the corporate, form of organization. The corporate form, which has enjoyed such vogue in the realms of transportation, insurance, manufacturing and banking, has not found favor among the dealers in commercial paper. The prevalence of the partnership among commercial paper houses is attributable in large part to the fact that most note brokerage concerns are members of one or more stock exchanges, the rules of which do not permit members being incorporated. Moreover, the partnership form of organization is not subject to objectionable interference by the state 260 COMMERCIAL PAPER HOUSES 261 and has the advantage of direct and centralized control. The unlimited liability feature of the ordinary partnership is no disadvantage inasmuch as our note brokers, unlike the English bill brokers, do not endorse or guarantee, except in rare instances, the paper bought and sold.

Because our paper houses buy paper outright a large capital is necessary. When large transactions are involved the capital of the broker may be inadequate and resort had to borrowing from the banks, in which case the possession of a comfortable capital is essential. A large supply of capital is invaluable during a crisis when conditions render difficult both the sale of paper and borrowing from banks. The ideal broker has selling facilities and saleterritory developed in keeping with his capital and bank connections. Otherwise the borrower could not lean heavily on the fair weather promises of the dealer to take care of paper irrespective of monetary and trade conditions. The resourcefulness of the broker is as important as his resources and bank connections. Young, vigorous, alert brokers with relatively small cash capital may have cultivated a widely distributed clientele and, keeping in touch with the entire field, may be more able to sell paper under adverse conditions than brokerage concerns with large bank balances and superior borrowing connections.

When the demand for paper in the East becomes inactive, these far-seeing brokers, feeling the pulse of the market from the home office in New York, Boston or Philadelphia, put forth redoubled effort in distant but cultivated territory where money is more 262 BANK CREDIT abundant.1 Even when money is plethoric in localities near at home they direct their salesmen where paper is less likely to sell, in distant cities and towns, against the time when the near-by market may be wholly or partly closed. As a matter of necessity, the typical successful note brokerage house has a high rate of turnover. As the profit hovers around a rate of only one-fourth of one per cent, or $2.50 per thousand, the turnover must be very rapid to produce a satisfactory return on the capital investment. It is believed in good circles that the note brokerage business is one that enjoys an extraordinarily good return.

The Paper The kinds of paper handled by the note broker, which are almost as various as those taken over the counters of banks lending directly to their customers, include single name paper, double name trade paper, double name when the endorser is a director of the borrowing corporation, collateral notes, trade and bank acceptances. Unsecured single name paper, one note broker estimates, constitutes approximately half of the total handled by brokers. Some brokers prefer to handle single name paper because of ease in securing renewals. Brokers watch maturities and replace maturing paper whenever possible. In the event of renewal single name paper obviates the necessity of securing endorsements. 1 Cf. William Post, The Loan and Credit Department, Bulletin, American Institute of Bank Clerks, Vol. Ill, p. 137.

COMMERCIAL PAPER HOUSES 263 Double name trade paper, i. e., promissory notes given in settlement for goods purchased, and endorsed by the seller, makes up a very small percentage of brokers' paper, five per cent being a broker's estimate. Non-trade paper bearing endorsement constitutes, perhaps, 30 or 40 per cent of the total bought and sold. Notes of many of the big textile mills are endorsed or guaranteed by the commission houses,—many of which have an extraordinarily high financial standing,— through which they sell. Where corporation officers assume a personal liability through endorsement of a corporation's notes, it not only shows the officers' confidence in the stability and success of the concern but also gives them a direct interest to see that the notes are paid. It is regarded as sound practice to give preference to the paper of concerns whose independent ability to pay seems unquestionable. If endorsements are supplied in addition, it is so much the better.

Only a small proportion of the total, probably not more than 10 per cent, is collateral loans, which, often held by savings banks, are frequently renewed. The buyer of collateral paper may or may not depend upon the note broker to keep the value of collateral in satisfactory relation to the face of the paper. If the demand for additional collateral is not complied with the notes mature automatically. Trade and bank acceptances are new creations in our financial polity and constitute a small but growing proportion of the total volume of paper passing through the brokerage channels. Bank acceptances, which are highly liquid, command a very low rate in comparison 264 BANK CREDIT with the obligations of mercantile or manufacturing concerns. Paper is made in amounts running from $2,500 to very large sums. A variety of denomination enables the broker to meet the demands of different customers.

Small denominations like $2,500 or $5,000 are frequently employed because there are many small banks that have very limited funds to invest in outside paper and larger banks with large sums available for buying paper prefer to invest only small amounts in the obligations of one concern. A given block of paper is, accordingly, generally split up into notes of small denominations. As to time, most brokerage paper extends from two to eight months. The time element generally depends upon the needs of the borrower and the condition of the money market. Loans to finance quick transactions or short-season goods should have early maturities. If the money-market gives promise of lower rates the maturity will be. shortened and renewal made as a means of saving" interest. If a rise in the money market is foreseen the maturity will be lengthened. The Volume of Note Brokerage Business The writer has found only a few estimates of the volume of business carried on by the note brokers acting as intermediaries between borrowers and banks.

As early as 1906 it was estimated in banking circles that upwards of $500,000,000 of commercial paper was sold in the course of a year by the note brokers of New York City.1 Two years later it was estimated that the 1 Samuel S. Conover, The Credit Man in a Bank, Banking Law Journal, Vol. XXIII, No. 4, April, 1906, p. 311.

COMMERCIAL PAPER HOUSES 265 annual volume of such paper sold by note brokers through the country was $2,000,000,000.2 No authoritative figures are obtainable. Ten Days' Option An appreciable part of the large volume of paper handled by the brokers is sold on a ten days' option. If the purchasing bank's investigation of the maker of the paper results favorably the paper is retained; if unfavorably, returned. At the time the paper is delivered to the bank a cashier's check is given in payment for the proceeds, i. e., the face of the note less the discount to maturity. Should notes be returned by the bank as unsatisfactory, reimbursement is made by the check of the broker, allowance being made to the bank for the time it has carried the instruments. The Broker's Profit The note broker of a generation ago performed a different function than does the broker today. Then he was a broker in a strict sense: he took paper only after he had placed it, and handled it for a commission.

Today, as has been increasingly the case for about twentyfive years, the broker is a dealer: he usually buys the paper outright and takes the financial risk of placing it later. Note brokerage houses in buying paper outright do so at a rate of discount per annum at which they expect to sell the paper, and also charge the maker a flat commission of ¾ per cent (more or less) of the face value. The broker, guaranteeing, as 2 William A. Law, Cooperation in Commercial Credits, Proceedings, Pennsylvania Bankers' Association, 1908, p. 43.

266 BANK CREDIT he does, the genuineness of the signature without endorsing the paper, may make more or less than his commission. If the market rate rises after he has purchased a given block of paper, he may lose even more than the one-fourth per cent commission. If the market rate falls, he stands to gain in proportion. The profit of the broker, which is commonly but somewhat erroneously referred to as a commission, was formerly a flat sum of $2.50 per thousand dollars. The broker's remuneration, nominally a commission, but often more or less than the commission, varies with changes in money rates, as we have stated, and according to the bargaining power of the broker as he deals under dynamic conditions with borrowers on the one hand and with lending banks on the other. The commission of the paper dealer being without respect to the length of time the note has to run, makers of paper perceived that an advantage would be gained, brokers' commissions in the aggregate would be reduced, through lengthening the maturity of notes. If a given amount of 90 day paper were sold through a broker four times a year, four commissions would have to be paid. Accordingly, borrowers came to make their paper of longer and longer usance. The longer the paper had to run the smaller was the commission, expressed in terms of a percentage per annum of the principal. The borrower, or maker of paper, always and properly regards the commission as a part of the interest paid. That is to say, lengthening the time paper had to run reduced the per annum cost of the services rendered by the paper dealer, thereby enhancing the power of the paper dealer to compete successCOMMERCIAL PAPER HOUSES 267 fully with banks lending directly. It may make for clarity to point out that one-fourth of one per cent commission on a sixty day loan is equivalent to a rate of interest of one and onehalf per cent per annum.

The same rate of commission on paper running six months would be equal to onehalf of one per cent per annum. Long maturities ease the work of the commercial paper house and entail lowered aggregate costs to their borrowing customers. Lowered costs make the paper house a relatively attractive agency to borrowers in securing needed funds and the longer paper has to run the wider becomes the possible disparity or spread between brokers' rates and bank rates. This fact, which has been pointed to as one of the "secrets" of the business, is undeniably responsible for the lengthening of the average time of loans,—a circumstance that tends to affect adversely the flexibility of the bankers' loan maturities.1 Advantages of the Note Brokerage System to Borrowers The basic reason for the rise and growth of the note broker is that borrowers found it advantageous to float then-paper beyond local limits, which frequently confined their borrowing activities as to both volume and rate. During the last forty years there has been a pronounced increase in the size of the business unit, which has not infrequently found its borrowing demands in excess of the legal lending power of the local bank. The restriction imposed by the National Bank *Jos. T. Talbert, Commercial Paper, Proceedings, Nineteenth Annual Convention, Minnesota Bankers' Association, 1908, pp. 44, 45.

268 BANK CREDIT Act on loans to any single borrowing concern to onetenth of the capital and surplus of the bank—a provision that has its rough counterpart in many of our state banking statutes—necessitated resort to more than one bank. But it was inconvenient and unpleasant to keep a balance in each of several banks. The desire to break away from these arrangements prompted negotiation with the note broker whose market included hundreds of banks in a score of states. Local borrowers were impelled to resort to credit facilities outside their communities also because the wider market commonly afforded lower rates than those obtainable at home. The facilities of the note broker enable the borrower to tap the capital supply where there is a plethora and where, therefore, the rate rules low. The local rate in St. Louis may at a given time be relatively high, in which case St. Louis merchants and manufacturers may be put in touch with lending banks in Boston or other centers where at the time, at least, rates are lower. While there is a tendency toward equalization of rates among the money centers, that tendency never works itself out completely. Nevertheless, in the process of approximate equalization of intersectional rates the borrower securing his funds through the note broker gains a very appreciable advantage in rate. Some of our heaviest borrowers like John Wanamaker and Armour and Company, normally seek little or no accomodation at their local banks but sell their paper in the open market. Having attained a position where they are not dependent directly on the banks, they prefer to be governed by money conditions in the leading centers, COMMERCIAL PAPER HOUSES 269 rather tha¤ be subject to credit influences within narrowly circumscribed areas. The fact that such borrowers sell their paper does not imply that they are compelled to seek credit away from home but, instead, that they have attained the enviable position of being able to sell their paper in those markets that offer the lowest rates of discount.

There is still another way in which selling paper through a broker saves interest. A concern borrowing from a bank is expected, and often required, to maintain a balance of approximately 20 per cent of the credit limit allowed. What the bank borrower loses in interest on the idle deposit balance must be included when interest is reckoned on the loan. It makes little difference in cost whether a concern borrows at 6 per cent and maintains no balance or borrows at 5 per cent and maintains a 20 per cent balance. In other words, the broker would save the borrower interest even if the bank quoted the same rate. The commission of the broker amounting to ¾ per cent partially, but only partially, offsets the economy afforded by the note brokerage system. It would be easy, however, to exaggerate the saving in interest traceable to the fact that the concern selling through a note brokerage house is not required to maintain a substantial deposit balance. Whether a company borrows directly or through brokers, a balance of some magnitude is normally on deposit for safekeeping and in order to facilitate the payment of obligations. A good sized balance is conducive also to friendly relations with the local bank, which may be needed in an emergency, when the open market may fail.

270 BANK CREDIT Besides securing funds at a lower rate and tapping a greatly enlarged number of capital sources, the concern borrowing through note brokers strengthens its borrowing position at home. If paper stands the investigation of alert credit men in buying banks and their correspondent institutions—to say nothing of the increasingly thorough investigation carried out by the credit departments of the note brokerage houses— and lives in the market, the local banker's good opinion of the borrower is strengthened and confirmed. Disadvantages to the Borrower To offset these numerous advantages there are two clearly distinguishable drawbacks. The first is that the concern selling paper through a note brokerage house thereby becomes almost certainly the subject of very numerous inquiries. Banks that have bought the paper on option desiring information that is not contained in the statement or that the broker cannot or does not supply, communicate directly with the borrowing house. Whether inquiries relate to pledged accounts receivable, life insurance, contingent liability, financial worth of endorsers, sales, bad debts charged off, profits, dividends, depreciation, bank accounts and lines of credit or to other more or less important matters, considerable work and trouble may be occasioned.

The second disadvantage is of a questionable nature: the note brokerage system is conducive to overtrading and overexpansion on the part of the borrower. As this disadvantage may easily be avoided by the borrower, we shall treat it later as a weakness of the note COMMERCIAL PAPER HOUSES 271 brokerage system, passing now to a consideration of the advantages of broker's paper to buying banks. Advantages of the Note Brokerage System to Banks The broker is frequently of invaluable assistance to the banks. Bankers with surplus funds not only welcome the broker with his rich assortment of offerings but even seek him out, buying his paper at a lower rate of discount than they would be willing to quote to their depositors. Looked at from this angle the brokerage house is indeed an economical agency for placing the idle funds of banks in the hands of those who can use them advantageously. But for the broker in their midst, banks in the larger cities would have to send capable and highly paid solicitors over the country in search of borrowers. Country banks having only occasional and small amounts of idle funds might find an outlet costly and unsatisfactory.

Surplus funds might be invested in bonds, but such investment is likely to shrink in principal at just the time the banker wants most to realize on its sale, i. e., in a period of stringency and high money rates. Bonds lack the automatic liquidation of well chosen commercial paper and appeal less strongly to conservative bankers desiring liquidity of assets than does broker's paper. The purchase of broker's paper has several additional advantages. Not the least of these is the avoidance of peculiarly unliquid loans that almost certainly result when the banker, in order to put out idle funds, eagerly offers money to his local merchant, jobber, or manufacturer,—to discount bills and "to keep their indebtedness all at home." In such cases the borrowers, after 272 BANK CREDIT some thought as to whether they can use the additional funds to advantage, usually decide that they can save some small discounts or expand their business a little.

The money under those circumstances goes out and the banker later discovers that he has made a long time loan.1 By dealing with a note broker unliquid loans of this character may be happily avoided. The way in which the Hartford, Connecticut, banks coped with the situation arising out of the San Francisco earthquake and fire illustrates nicely the value of well selected commercial paper as a quick bank asset. Hartford insurance companies paid fire losses of more than $15,000,000, all of which found its way out of the city. The heavy withdrawals, however, were offset by the maturity and payment to the banks of outside commercial paper.2 Within recent years one of the oldest and most conservative trust companies in New York, by carrying bills purchased equal to approximately 50 per cent of its deposits and by having about two hundred and fifty thousand dollars of the paper bought mature during each business day during certain months of the year enjoyed the advantage of a degree of liquidity in its assets that enabled the institution to meet easily extraordinary demands whenever they occurred.3 1 Charles R. Hannan, Uniform Statement Blanks, Proceedings, Thirteenth Annual Meeting, Iowa Bankers' Association, 1899, p. 89.

* J. Harold Schmidt, Commercial Paper, Bulletin of the American Institute of Banking, Vol. IX, December, 1907, p. 532. 8 J. Herbert Case, The Desirability of Commercial Paper as a Bank Investment, Proceedings, Ninth Annual Convention, New Jersey Bankers' Association, 1912, p. 32.

COMMERCIAL PAPER HOUSES 273 Even local loans made in the regular course of business are usually slow, often being renewed and in times of stringency are likely to be increased rather than liquidated. One banker has asserted that "the only certainty about local loans is that in time of stress they will increase rather than be paid down. The credit of a local borrower is too narrowly known and there is no market for his note. If perchance it is [eligible for discount] . . . at the Federal Reserve bank and you rediscount it, it is you and not the maker who will worry about caring for it at ... maturity. These defects are . . . inherent in local loans. To a considerable degree in the average bank they are a fixed asset." l To call a local loan when the borrower is not ready to pay may cause inconvenience or distress and tends to alienate business. It may be reported that the bank is "hard up." About renewing broker's paper there is neither concern nor obligation and a refusal to buy is never a reflection on a bank's condition.

From the standpoint of any given bank commercial paper bought from brokers is liquid, but from the standpoint of the whole system it is not quite so liquid as it first appears, being simply shifted to a great extent from bank to bank and renewed. The notes of large concerns having nation-wide credit move from bank to bank, but in many instances they remain relatively constant in volume.2 In a very important 1F. W. Crane, Commercial Paper Purchased from Brokers', Proceedings, ThirtySixth Annual Convention, Illinois Bankers' Association, 1916, pp. 131, 132. s A. E. Adams, As to the Efficiency of our Present System, Proceedings, Twenty Fourth Annual Convention, Ohio Bankers' Association, 1914, p. 46.

274 BANK CREDIT sense such notes are not liquid, but from the standpoint of individual banks they are highly so. Another advantage of buying broker's paper is that it enables the banker to inject variety into his loans. The danger of holding a relatively large amount of any one class of loans, a danger particularly present in the case of many country banks, may be avoided by well made purchases of paper from brokers' lists. A bank in a timber country is enabled to place in its note case paper other than loggers' or milimen's notes; in a stock section, other than stock raisers' obligations; in an agricultural section variety may be built up on the basis of farmers' notes. Should deposits run down from a depression in the industry common to the section it is "a strong anchor to the windward" to have a part of the bank's funds invested in quarters not affected by the depression at home.1 If adverse conditions prevail in certain lines of business it is possible gradually to curtail the volume of paper originating in those lines, and to increase at the same time the holdings of paper in lines good beyond question. This is particularly true in connection with certain trades that are more than commonly sensitive and hazardous, such as jewelry, furs, pianos, and luxuries generally. Whether times are good or bad loans made to staple lines, like groceries, staple dry goods, hardware, boots and shoes, are subject to little variation or loss.2 1 A. L. Mills, Doubtful Banking, Proceedings, Oregon State Bankers' Association, 1907, p. 43.

* Cf. Samuel S. Conover, The Credit Man in a Bank, Banking Law Journal, Vol. XXIII, April, 1906, p. 311.

COMMERCIAL PAPER HOUSES 275 Bankers buying commercial paper axe able also to obtain maturities that satisfy their prospective requirements. If a banker knows that he will probably suffer a withdrawal of deposits or meet new demands for loans at the expiration of three months, he can buy the required amount of paper haying just the desired maturity, keeping his funds fully employed but available at the time needed. In discounting the notes of customers the banker feels obliged to meet their needs, although the maturities may not fit the requirements of the bank. The assortments of the paper dealers are so large and so varied as to maturity—as well as to denomination—that the banker may pick and choose. Broker's paper is also very attractive to those numerous bankers who dislike to rediscount their own customers' notes. Broker's paper is of easy and inoffensive convertibility into cash through the rediscount process. Moreover, if the banker desires to borrow on his own note, broker's paper is almost certain to be more acceptable as collateral to the lending institution than customer's paper would be.

It may be pointed out as a further advantage of buying broker's paper that losses are lighter thereon than on local loans, even though the banker has the advantage of knowing the loan record of his customers and the benefit of personal acquaintance. The heavier losses on local paper may be explained on various grounds. In the first place it is the practice everywhere to extend credit more liberally to customers who maintain deposit balances than would be granted through the purchase of their paper on its merits in the open market. Danger to the banker lurks in his too ready 276 BANK CREDIT recognition of his obligation to take care of the borrowing needs of his depositors. Long years of square dealing and personal acquaintance establish a confidence which would not be warranted by a close scrutiny of neglected credit factors. In the next place a special plea based upon emergency or mishap may cause the banker to extend credit against his own inclination and judgment. A third reason for the relatively heavy losses on local loans may lie in the operations of the note brokers themselves, who enable the borrower to pay off his obligations to the local bank by means of simply shifting his loans to other banks for a while.1 Losses on broker's paper are seldom disastrous to the holding bank, unless an utter lack of discretion has been shown in the amount of one name purchased. It is the local loan that is likely to get the banker in beyond his depth. Such losses as do occur on broker's paper are fairly certain to be more or less evenly distributed in time as well as relatively slight in amount.

Another advantage to the banker of patronizing the commercial paper houses that seems worth noting is that the study of the credit factors underlying broker's paper constitutes a schooling that is valuable when applied to the study of local risks. The analysis of the more complex conditions of distant borrowers affords both background and guiding principles for a more intelligent scrutiny of risks right at home. The intelligent buying of broker's paper makes for sounder local loans. `Jos. T. Talbert, Commercial Credits, Proceedings, Fifteenth Annual Convention, New York State Bankers' Association, 1908, pp. 83, 84.

COMMERCIAL PAPER HOUSES 277 Disadvantages to the Bank What does the banker have to pay for these numerous advantages? In the first place he pays the difference between the relatively low and variable rate obtained from investment in broker's paper and the relatively high and stable yield on "straight" paper. Just what that difference is it is impossible to say with exactness, but the experience of a prominent, and perchance a typical, bank in Illinois will throw some light on the question. A record extending over twelve years prior to 1916 showed an average discount rate on broker's paper of 4.88 per cent. An officer of the same institution states that the average return from direct loans during the same period was approximately 5.5 per cent. But the loss in earnings between 4.88 per cent and 5.5 per cent is more apparent than real, for had it not been for the ready availability of the broker's paper as a secondary reserve a larger cash reserve would have been maintained. (This consideration is offset in varying degress in individual cases by the fact that dir>ïct loans almost invariably result in an increase in deposits for the lending bank.) The convertibility of broker's paper is only one step removed through the process of rediscount from cash itself. Indeed, commercial paper stood the test of the panic of 1907 more creditably than did demand loans backed by the best collateral security.

Weaknesses of the System The most serious disadvantage or penalties of buying paper from the note brokers do not relate, however, to specific transactions. The operation of the note 278 BANK CREDIT brokerage system as an institution results at times in a loose but powerful regulative control over the activity of our banks, both in particular and in the aggregate, that is both far-reaching and objectionable. During periods of both easy and tight money the influence of the note brokerage houses on the lending activities of the banks is pronounced. During times of easy money the brokers come forward as rivals of the banks; during periods of stringency they tend to withdraw to a high retreat, leaving the banks to care for the needs—-swollen needs—of customers returning from the broker's to the banker's fold. It has already been said that banks with surplus funds seek out the broker, at least give his representative a cordial welcome and, because of a surplus of funds, buy from the broker paper of concerns not among the banks' customers at a rate below that which the banks quote to their local borrowers. Now a corollary is that somewhere another bank is losing a borrowing customer. A Chicago bank, let us say, having idle funds, buys the note of a Grand Rapids concern. A Grand Rapids bank, just having lost a borrowing customer, tends to have money lying idle and, seeking a natural outlet for its excessive funds through the purchase of paper from a broker, invests in the obligations of a New York concern, a concern that commercial paper dealers have succeeded in divorcing from a New York bank. The New York bank in turn tends to have idle cash available for investment in broker's paper. The process continues and spreads. The result is that the note broker, especially with easy money prevailing, comes to the front as a COMMERCIAL PAPER HOUSES 279 distributor of bank credit, an active competitor of the banks. Individual bankers purchase the notes offered by the broker, even if the rates of discount are below those quoted to their regular customers, in an endeavor to prevent a break in local rates; but brokers' low bids reach the banks' borrowing customers and the rates on loans made directly by the banks also decline.

Competition among banks and brokers assumes a cutthroat character and rates tend to become unduly depressed during periods of easy money. At such times when money is plentiful the broker may send out scores of telegrams to both those concerns whose accounts he handles and to those whose accounts he is soliciting, offering funds at the rate prevailing in the lowest money market in the country, plus his commission.1 Note brokers frequently resort to underbidding in order to take accounts from competitors or to be able to offer especially choice names that may be used to assist in the sale of less attractive ones. A broker thus threatened with the danger of losing an account naturally meets the bid and may "go one better." Demoralization of rates results. The situation is analogous to the competition afforded conservative bankers by their ambitious neighbors who attempt to attract business by the offer of high rates of interest on deposits, free collections, and more liberal credit extension. Among note brokers, however, the offenders are protected in a measure against the consequences 1 Thomas P. Beal, Jr., Effect of Increased Operations of Note Brokers upon the Earnings of Commercial Banks, Proceedings, Fortysecond Annual Convention, American Bankers' Association, 1916, p. 500.

280 BANK CREDIT of their action. If rates fall, their low bids are justified; if they rise the margin of commission is likely to be adequate to protect them against loss.1 It should not be overlooked that progressively lower money rates result in advancing profits for the broker. If he buys paper today at a discount of 5 per cent and, harboring hopes of a fancy profit, counts on selling the same paper at 4¾ per cent, and the rate in the paper buying market drops to 4½ per cent before the sale is made, the broker's profit, aside from the commission, will be doubled. The broker is, therefore, always under an inducement, in so far as he is able, to depress the rate of discount, which means to increase the price at which the stream of paper passing through his hands is sold. The relation between falling discount rates and brokers' profits explains what is said to have happened repeatedly; namely, when one or two large banking institutions having a superabundance of reserve and great eagerness to get it out have bought paper at rates slightly below those current, their action has been instantly communicated by brokers to every note-buying market in the country and advantage taken of it in order to break the rate in other centers. It is plain that during periods of easy money banks with surplus funds are placed, through the instrumentality of the note broker, at the mercy of the banker who, "in a moment of weakness" is willing to buy a block of paper at a rate below the market.2 lJos. T. Talbert, Commercial Credits, Proceedings, Nineteenth Annual Convention, Minnesota Bankers' Association, 1908, p. 46.

2 Ralph Van Vechten, Proceedings, Fortysecond Annual Convention American Bankers' Association, 1916. p. 506.

COMMERCIAL PAPER HOUSES 281 While the note brokerage system is to be credited with a strong tendency toward equalizing discount rates territorially, it must be charged with accentuating differences in rates in point of time. The possible spread between the rates of Newark and Kansas City at any given time has been narrowed; the difference between the low rates of a period of easy money and the high rates prevailing when brisk trade and industry all but outrun the volume of the circulating media has tended to become widened. An outstanding feature of the expansion of the work of the note broker, particularly in times of easy money, is the anomalous situation of bankers in being called upon to testify as to the credit of their customers whose business may be about to pass into a paper dealer's hands. A Grand Rapids banker long ago voiced poignantly the irony of conditions in which the banks, keenly pressed by their rivals the note brokers, become the agents, reluctantly, for establishing a market for and selling brokers' notes.

I have recently talked with a Chicago banker who believes in the plan of buying paper from brokers. He says that the majority of his loans are made in that way, and I presume the same plan is f ollowed¾y many other metropolitan bankers. Getting a little insight into that method, from that standpoint, it is a queer sensation that creeps over the bank cashier as he opens the mail in the morning and reads one letter after another inquiring about the standing, reputation, character, and responsibility,—of whom? The best customers he has got; the very men that he depends upon to maintain his business, and by whom, perhaps, he has stood in those times of testing that you speak about, in the years 282 BANK CREDIT gone by, and by whom he expects to stand in the years to come, when those times come—and come they will. What kind of an answer is he to dictate to his stenographer to write back to the banker in Chicago or New York about that customer? Give him a good bill of credit, put him in good credit in his local town? Why yes, he is entitled to it. But what does it mean? What is that inquiry for? You know.

We have learned what that inquiry means.1 The unfavorable influence of the paper dealers upon the interests of the banks through their weaning away many of the banks' best borrowing customers reaches its culmination during a period of stringency or, more rarely, crisis. As a stringency comes on bankers gradually convert their paper holdings into cash, and the brokers find them unresponsive and disinclined to further buying. Borrowing merchants and manufacturers finding the brokers unable to dispose of their paper are compelled to fall back upon their old time bank connections which may have been kept open for emergency at the insistence of the brokers themselves! Bankers then as a matter of local patriotism and out of consideration, perhaps, for hundreds of men employed by the borrower, extend credit2 as freely as the conditions of the time permit. 1 James R. Wylie, Proceedings, Thirteenth Annual Convention, Michigan Bankers' Association, 1901, pp. 36, 37.

2 What becomes of the proceeds of such loans is an interesting and pertinent question. It has been urged that the money goes "straight into the reserve of the foreign bank." (James R. Wylie, op. cit., p. 37.) That contention, however, overlooks the possibility of counter currents of funds which might hold in check and even more than offset the tendency of the reserve of the lending bank to diminish. To the extent that the loan policy of the lending, t. e.f COMMERCIAL PAPER HOUSES 283 The note brokerage business has so facilitated borrowing in the open market in normal times that credit is frequently granted too liberally; too liberally as to both rate and amount. The significance of abnormally low rates in this connection is that they go hand in hand with a serious danger that borrowers will be induced by this lowered element of cost to expand their operations beyond the point of safety. The difference in rates paid by borrowers in times of easy money and those paid in periods of tight money is widened with the consequence that borrowers find adjustment to stringent monetary conditions, coupled with sagging prices for their wares, so much the more difficult. That many houses have borrowed more money through brokers than their limited capital would warrant is scarcely open to debate.

There is a very serious danger that the man with inadequate capital of his own will regard borrowed money as permanent working capital, extend his busilocal, bank is more liberal than that of "foreign banks" the tendency will be for the lending institution to lose its cash. To the extent also that the territory tributary to the lending bank is a debtor section and creditor sections served by "foreign banks" are able to enforce collections during a period of tight money, the local bank will tend to lose its cash in favor of the banks serving the creditor sections. If we reverse the conditions, however, we get reverse results. Whether the proceeds of a loan the like of which we are considering go into the reserve of a "foreign bank," then, depends altogether on such conditions as the lending policies of the banks concerned, relative collectible intersectional indebtedness, even international exchange transactions, and perhaps other independent factors. However, any given bank that expands its loans and discounts will tend to lose reserve to other banks, unless at the same time the other banks are adding correspondingly to their outstanding commitments.

284 BANK CREDIT ness beyond prudent and safe limits, and, when disturbances occur in the business world, be unable to meet his obligations for borrowed funds. The broker, in contradistinction to the banker, ordinarily owns for only a short time the paper which he sells and has accordingly less incentive to keep the volume of paper sold for a client strictly within safe limits. Besides, the remuneration of the broker, as already stated, varies directly with the volume of his sales, which in turn are not anchored to and limited by the requirement of a cash reserve. When the banker, commonly conservative by nature and training, would offer discouragement from expanding a business upon the proceeds of paper maturing in four to six months, the note broker, mindful of his own interest, frequently takes the contrary course. This would be true if borrowers confined the sale of their paper to a single brokerage house. It is more noticeably true where the maker of paper employs two or more brokerage houses in addition, it may be, to borrowing directly from banks.

From what has been said it is plain that the note broker has greatly increased the difficulties of the banker in holding borrowers in restraint, in preventing overtrading and excessive indebtedness. It has happened, also, that the proceeds of notes have been absorbed by the losses of an obsolescent and unprofitable business—until a check on the further issue of paper has been imposed by a restricted money market. The banker who buys brokers' paper can no longer, as was possible before the advent of the middleman, test his borrower's solvency and ability to pay by insisting on a seasonal "clean up." Such a "clean up" may COMMERCIAL PAPER HOUSES 285 now be only apparent owing to the wide and continuous market for paper which makes it possible for a borrower to take up his notes through the sale of fresh obligations in other quarters. The paper dealers, in other words, tend to promote reliance of the borrower upon the commercial banker for permanent or semi-permanent capital. How this tendency works out practically may be seen in connection with one or two extreme but instructive cases.

Several years ago a St. Louis concern failed owing banks $805,000, of which only $50,000 was borrowed directly. The remainder, $755,000, was sold from one end of the country to the other by note brokers, largely to country banks. Not a note was placed with St. Louis banks and the concern owed the trade,—an important source of credit information,—next to nothing. A more recent as well as more noteworthy illustration is furnished by the borrowing operations of the H. B. Claflin Company of New York, which failed in 1914. This concern, which was one of the largest wholesale dry goods houses in the world, had affiliated with it a manufacturing concern and twenty or more retail stores. The retail stores bought of the wholesale house on open account, until the accounts reached certain amounts when notes would be given in payment of the accounts. These notes the H. B. Claflin Company would endorse and steadily offer for discount over a wide area, generally through note brokers. As to the amount of endorsed paper outstanding at any time, brokers, fearful of losing the lucrative business, were reluctant to inquire and bankers only guessed. The 286 BANK CREDIT key to the explanation of the willingness of bankers to buy paper offered under such uncertain conditions was the personal esteem in which Mr. H. B. Claflin, the head of the concern, was held. One of the foremost citizens of the metropolis, of unquestioned integrity and business capacity, he had cultivated a personal acquaintance with prominent bankers over extensive territory.

It was known that "everybody" held Claflin paper and it developed at the time of the failure that the "Claflin receivables or endorsements" were diffused among 2000 to 3000 banks.1 "If everybody wants the paper," the bankers seem to have reasoned, "it must be good." The very knowledge that everyone else is carrying the paper of a given house that a banker thinks well of is a source of satisfaction to him. If failure should occur others would share his disappointment. In June, 1914, with tight money prevailing, the concern was unable to market more paper through its brokers and asked for temporary additional assistance from its bankers. The bankers interested cooperated in making an examination of the offairs of the company, uncovering direct indebtedness of $9,000,000 and contingent liabilities of almost $32,000,000, representing the endorsed notes of the retail stores, the condition of which was a depressing revelation to the bankers concerned. Quick assets amounted to approximately $12,000,000. In spite of having long paid five or six per cent dividends the concern had been insolvent for several years. The note brokerage system 1 Trust Companies, July, 1914, Vol. XVIII, p. 6.

COMMERCIAL PAPER HOUSES 287 had prolonged the life of the company at the expense of the banks. Correctives One method of eliminating the disastrous competition that the note brokers generate would consist in banks withholding credit information sought by other institutions for use in passing judgment upon broker's paper. A bank in Philadelphia in considering the purchase of broker's paper issued by one of the customers of a Baltimore bank very naturally makes inquiry of the credit department of the Baltimore bank as to the character, financial standing, etc., of the firm or corporation the purchase of whose note is under consideration. If the Baltimore banker, and other bankers similarly, were to withhold the information sought it would be like throwing sand in the bearings of the otherwise smoothly running note brokerage machinery. Such a procedure, resorted to as a corrective of the over-weening tendency of note brokers, especially in times of monetary ease, is incompatible, however, with the present cordial relations among bankers, might curtail unquestionably fair and legitimate note brokerage activity, and would probably interfere seriously with the exchange of credit information desired in connection with the determination of the quality of non-brokerage paper.1 Another corrective of the unfavorable influence of the paper dealers which results in semi-demoralization of interest rates and overexpansion of operations 1 Proceedings, Fortysecond Annual Convention, American Bankers' Association, 1916, pp. 506, 507, 508.

288 BANK CREDIT on the part of borrowers in periods of cheap money, merits serious consideration. Let the banker, it is urged, educate his customer to appreciate the personal character of their mutual relations and the value of the willingness of the banker to be of the greatest service in case of need. Even more important than this, it is essential to drive into the minds of borrowers the difference between paper that is given to a broker and that which is discounted at a bank. Paper discounted at a bank may be renewed at maturity if the borrower's deposits have been satisfactory and his credit is still good, even though reserves are low; paper sold through a broker may be renewed and it may not. It depends on whether the broker is able to market the renewal paper or is strong enough to carry it. Borrowers should be reminded tactfully that, by forcing their banks to lend to them at rates quoted on "commercial" paper, they are actually obtaining from the bank an insurance against times of trouble without paying for it.1 Still another remedy for the feverish and disturbing activity of note brokers at times when the existence of surplus loanable funds delivers the bankers into their hands is greater carefulness and watchfulness in the selection of paper by the banks. The banker should be so insistent with reference to requiring statements of condition in all cases where paper is offered for sale, so closely vigilant of the moral standing and so persistent 1 Cf. Thomas P. Beal, Jr., Effect of Increased Operations of Note Brokers upon the Earnings of Commercial Banks, Proceedings, FortySecond Annual Convention, American Bankers' Association, 1916, p. 504.

COMMERCIAL PAPER HOUSES 289 in checking up borrowings as to "shut and bar the door" against unsafe and overexpanded makers of paper. Many of the most serious disappointments bankers have had with brokerage paper have resulted from the purchase of notes whose makers failed to submit audited statements through their brokers to buyers. Certain failures occurring in 1913, have been investigated carefully by a prominent Chicago banker1 whose findings are pertinent and instructive. The year 1913 was marked by a protracted period of stringent money and a gradual retirement of paper issued through commercial paper houses. The liquidation of the paper, which caused much inconvenience and heavy business mortality, placed a heavy strain on the commercial paper houses and was effected only after the banks took on lines of credit from their customers out of all proportion to their previous agreements, preventing thereby what might have been serious disaster. As it was, there were numerous failures of houses unable to secure accommodation at their banks sufficient to relieve their over-extended condition.

Note brokers and bankers were in a large measure responsible for the over-extension that led to failure. The ease with which flotations of paper could be made through note brokers, without proper restrictions being thrown around the issuance of statements, was responsible for many of the largest failures. Insistence by note brokers and bankers upon carefully audited statements would have obviated most 1 Ralph Van Vechten, Proceedings, Thirty-ninth Annual Convention, American Bankers' Association, 1913, pp. 518, 519.

290 BANK CREDIT of the trouble. Fifteen failures out of twenty one were due to over-extended credit. Two were caused by dry rot, poor business and poor management. One case was the result of labor troubles combined with poor business. One was due to internal dissensions. In another, the working capital had long been employed by the largest stockholder in private operations. One failure was the result of flood conditions in the Ohio Valley. In the entire list there was only one case of an audited statement, and the failure of that company was the result of an unforeseen disaster. Only one name in the entire list would have been purchased if the note brokers or buying banks had insisted upon the purchase of only those notes whose makers submitted audited statements. Inasmuch as bankers frequently give preference to the paper of those houses whose accounts are audited and certified to by independent accountants, it seems reasonable to expect that the present tendency of bankers to insist more and more upon audited statements from makers of paper will continue.

In addition to the insistence of bankers and note brokers upon audits by chartered accountants of recognized character and ability there should be a friendly and intelligent cooperation between note brokers and the bankers who carry the accounts of concerns floating paper in the open market. Frequent comparisons could be made and over-extension prevented. The same desirable end would be favored by close cooperation among national, state and clearing house examining authorities with reference to lines of credit having an extensive market.

COMMERCIAL PAPER HOUSES 291 The registration of commercial paper as a method of preventing its over-issue was widely discussed a few years ago, after the panic of 1907, and was hailed as a great forward movement advantageous to both borrowers and lenders, saving time in the inquiry of buying banks and resulting, it was contended, in a favorable rate to the borrower because of the full and definite knowledge obtainable with reference to the amount of paper outstanding.1 The details of registering commercial paper are simple. Registration requires a resolution of the board of directors of a concern about to have its paper registered, affirming that all notes signed or endorsed by the company and all drafts and bills of exchange accepted in the name of the company in order to be valid must be registered by a trust company and the registration noted on the paper itself over the signature of an officer of the trust company. The trust company is authorized and directed to keep a record of all registrations, including amounts, maturities, and any other detail necessary to identify the paper. The trust company is also instructed to furnish any bank, banker or trust company, upon request, a statement of the amount of unmatured registered paper.

In principle, the registration of commercial paper is similar to the registering of corporate stocks and bonds. Wide publicity which was given the registration of the short-time obligations of the International Paper Company with the Bankers Trust Company of New lOwen Shepperd, Commercial Paper Registration, Trust Companies, Vol. 12, No. 3, March, 1911, pp. 178-182; also ibid., p. 271, and New York Bankers' Magazine, Vol. 82, May, 1911, p. 572.

292 BANK CREDIT York, February 1, 1911, and the announcement of facilities for registration by other prominent financial institutions has made little impression upon our great borrowing concerns and the movement has made no substantial progress, receiving meager support, even positive opposition, from borrowers and note brokers. The note broker, sensible of having served as a repository of information relating to his clients' affairs in the past and having no liking for red tape, refused to give the movement his support. The borrower objected to registration because it might disclose to competitors his lack of capital, his volume of business or other facts that might be detrimental to him. The advantages of registration to the bank buying commercial paper are so pronounced that it is hoped the movement will not fail. Forged or spurious paper could scarcely pass undetected through the registering trust company, where signatures of the officials of the issuing corporation would be on file. The issue of unauthorized paper would also be forestalled. The amount of paper outstanding would always tally with the amount on the signed statement. Overexpansion would be rendered difficult and flagrant over-issue of paper, such as occurred in connection with the Claflin failure, scarcely possible.

If the obstacles in the way of formal registration should prove insuperable, a closer cooperation between note brokers and banks might result in a greatly modified form of registration that would be simple, effective, and acceptable to all concerned. If concerns issuing paper would make statements to their respective bankers and to banks where the notes are payable COMMERCIAL PAPER HOUSES 298 of the amounts and maturities of paper outstanding at the time of issue, instead of a short time in advance of maturity, as is now customary, the objections to registration that it would permit of too much publicity and involve objectionable red tape would be, in large measure, overcome. The borrower's own bank would always be in possession of the amount of paper outstanding and where there were two or more payer banks an exchange of information would be just as easy as it is today between banks that have accounts and lines of credit in common. The adoption of the recommendation would encourage makers of commercial paper who do not maintain accounts in banks located in the large cities to establish banking connections in the important centers, thus fortifying themselves by providing additional bank accommodation against emergency or need. If they preferred, they could arrange through their home banks to have their paper made payable to the latter's city correspondent, with the understanding that the city correspondent would keep the local bank informed of the volume of paper outstanding at all times.1 Change has come so fast in our lending methods during the last decade that it is perhaps not too much to expect that proper safeguards will be thrown around the commercial paper passing through the hands of dealers, and particularly in so far as the problem relates to placing prospective buyers of paper in a position readily to find out the amount of paper outstanding in any given case.

In brief, the reëstablishment of a cooperative spirit 'Ralph Van Vechten, Proceedings Thirty Ninth Annual Convention, American Bankers' Association, 1913, pp. 520, 521.

294 BANK CREDIT and friendly personal relations between banks and their borrowers, combined with more searching and exacting methods of investigation by the banks, and close cooperation between note brokers and banks, would tend to curb overexpansion and to stabilize interest rates by keeping the operations of the note brokers within bounds. The result would be a slightly higher interest rate when rates were low and a lower rate when rates were high. Meanwhile the business of the note brokerage houses would not be wiped out. Like the rates on paper passing over their counters the volume of their business would itself be more stable and uniform.