§3. Limitations on Loans

The necessity of having to offer collateral will affect not only the rate which a man has to pay, but the amount he can borrow. It will limit therefore the extent to which Edition: current; Page: [211] he can modify his income stream by this means. Consequently it will not be possible, as assumed in the first two approximations, for a man to modify his income stream at will; its possible modification will be limited by the fear of the borrower that he may not be able to repay and the greater fear of the lender that he may not be repaid—because the borrower's credit may not prove good. In consequence of this limitation upon his borrowing power, the borrower may not succeed in modifying his income stream sufficiently to bring his rate of preference for present over future income down to agreement with the rate or rates of interest ruling in the market; and for like reasons he may not succeed in bringing the rate of return over cost into conformity with any rate of interest.

One feature of these limitations on borrowing may here be noted. The ability and willingness to borrow depend not only on the amount of capital which the would-be borrower possesses, but also on the form in which that capital happens to exist. Some securities are readily accepted as collateral, and accepted as collateral at a high percentage of their market value, whereas others will pass with difficulty and only at a low percentage of that value. The drift, especially during the last generation, toward the corporate form of business has had a striking effect in increasing the power and readiness to borrow. Whereas formerly many businesses were conducted as partnerships and on a small scale, numerous stocks and bonds have now been substituted for the old rights of partnership and other less negotiable forms of security. Similarly the small local companies, the stock of which was held almost exclusively by one family or group of friends, have been merged into large nationally known companies, the securities Edition: current; Page: [212] of which are widely marketable. This increase in size of business units, although it tends to decrease their number, has resulted in a rapid growth of the number of securities listed on the stock exchanges. The possessors of these securities have far wider opportunities to make use of collateral, and the tendency to borrow has received a decided impulse.

Where, on the other hand, the security needed is not available in the convenient form of engraved certificates, there is often considerable difficulty in negotiating a loan. A poor man may see what he believes to be an investment opportunity to make millions by exploiting an invention of his own, and he may be right. This option would have a much higher present value than the one he actually chooses, if only he could borrow the money needed to exploit it. But, being poor and hence without adequate collateral or other guarantees, he cannot get the loan. His choice of income stream, therefore, although the maximum open to him, is quite different from what it would be if he had that collateral or guarantee. If he goes into the enterprise at all he must choose a stopping point far short of what he would choose were he a large capitalist. This means that his marginal rate of return over cost will be higher than the market rate of interest, just as his rate of impatience will be higher than the market rate of interest. The last $100 he ventures to put in may promise a yield of 25 per cent as compared with a rate of interest of 5 per cent. Yet he does not go further into debt because he cannot. Supposing a definite limit of possible debt, all he can do toward further investing must be out of his own income, obtained by abstinence. But this possibility is also limited. He cannot cut his income down to zero, or he Edition: current; Page: [213] would starve. He can however cut it "to the quick", stopping at the point where his impatience has risen to meet the rate of return over cost which in turn will tend to fall with each additional dollar invested.

The story is told of the inventor of rubber making a last desperate—and, fortunately, successful—sacrifice in his experiments in which he resorted to burning up his furniture because he could not get funds with which to buy fuel.

Many such cases exist—cases of limitation on loans—which prevent a person's degree of impatience and his rate of return over cost from reaching the level of the rate of interest. But there is another part of the picture. The poor man who cannot borrow enough to exploit his invention can often find substitutes for loans and lenders. He may associate himself with others in a joint stock company and get the required capital partly from loans, by selling bonds secured by mortgage, partly by selling debentures on a higher interest basis, partly by selling preferred stock on a still higher basis, and partly by selling common stock. That is, the risks are recognized and pooled. One result may be to bring both his estimated rate of return over cost and his rate of impatience more nearly into harmony with these various rates of interest when due account has been taken of the various risks involved.