Pn 35 3 nd a ‘Commercial Paper - A Text Book for Merchants, Bankers and Investors By Roger W. Babson }/] /) and Ralph May bimaia r h ? > > > 23 29” 2:7 a > ‘a 2 > ” > 2, 4 3373 50, > ’, a8 eens WTI Published by Babson’s Statistical Organization (Incorporated) Executive Offices: Wellesley Hills Massachusetts Largest organization of its kind in the United States Wo a) ae ’ AL $ £ / oJ EIA AAA nd L A AVL CLT Copyright 1912 7 by ROGER W. BABSON er ec TABLE OF CONTENTS. Refane: ok. a. Ea wh 5 CHAPTER I. Lending and Borrowing .............. 7 : CHAPTER TL The Form of Commercial Paper . ....... 31 CHAPTER 111. The Selection of Commercial Paper . . . .. 82 CHAPTER 1V. The Analysis of a Financial Statement an Report . LL 110 Banking CHAPTER VI. The Bediscounting of Commercial Paper 195 CHAPTER VII. How Interest Rates May be Forecasted .. 226 228802 PREFACE ANY parts of our financial system of the M United States are 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 defects, that the following pages are written. The book is primarily written for the officers of our nation’s twenty thousand banks, to aid them in selecting the best of such paper; but all mer- chants and manufacturers who borrow money, I believe, also will find this book very helpful. I especially wish here to state that practically all the work of preparing this book has been done by my associate, Mr. Ralph May, who, in addition to knowing the theory involved, is connected with one of the largest commercial paper firms in Boston and thoroughly understands the practical side of the Commercial Paper business. There- fore to Mr. May belongs the credit of this work, my name appearing first simply owing to his courtesy to me. Rocer W. Basson. Wellesley Hills, Mass. CHAPTER 1 LENDING AND BORROWING. HE money in a community is enhanced to the holders if it can be made to in- crease. 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 com- munity. If we take money as representing the ‘wealth of a district, which is not strictly a true representation, as we shall see, but which is suf- ficiently so for our purpose; and capital, as that part of the money used in the attempt to increase any given supply of money, we have the basis of business, and the first factors to notice in an in- ~ vestigation into what constitutes an effective sys- tem for the increasing of any given supply of wealth. Most men have a desire to progress in whatever they have undertaken. As most of us are dependent for our happiness to a large extent on money, most of us are engaged in turning our money into as effective a form of capital as is possible. Provided gain in money to the holders of the original capital is not at the cost of the good of the whole community, this advance is constant- ly to be attempted and every method for giving individual holders of money opportunity to turn it into effective capital is to be discovered and fostered. Pe ¥ ° € Py oo G.7e « . c < © COMMERCIAL PAPER Money is Unevenly Distributed. In every community money is unevenly distrib- uted 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 eco- nomic principles, are such, and their use is to be aided by all possible means. Lending and bor- rowing serve a double economic purpose. Lend- ing, 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 war- ranted, insures to the borrower a certain amount of money wealth. Interest is something like eco- nomic rent. No money will be lent which the LENDING AND BORROWING 9 lender feels will not show an actual compensation in return for the time and ability spent over look- ing up the security of a loan, plus the amount the lender could make his capital return if he wielded it himself. On the other hand, no bor- rower will borrow unless he feels that his borrow- ing 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 capital 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 bor- rower. 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 opposed by several lenders, his share in the middle ground interest is properly more than one-half, and vice versa. But fused into this is the knowledge of the lender of the borrower's desire to borrow, or of 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 other hand, what the lender can make the borrower 10 COMMERCIAL PAPER think his need to borrow is. Actually, the appor- tioning 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 ordi- nary business loans in which no more than on ordi- nary 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 insur- ance. 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 AND 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 destructable real estate or shipping and the like, which would be largely the product of these loans, should be insured. Up to a certain point, very considerably beyond that now admit- ted, 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 of writing such insurance or semi-insurance is through lenders which are largely banks or other forms of fiduciary agents. It is obviously the duty of such lenders to avoid unnecessary risks and to confine themselves as much as is possible to the gaining of interest in pure form. Risks, however, must sometimes be taken. As President Hadley 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 for ordinary business loans. Any student of the in- crease of money wealth or of any of its factors must studiously avoid confusing the interest de- pendent on ordinary business transactions in which there is no reason to suppose there is more risk involved than exists in the aver age business trans- action and those transactions in which there is admittedly more risk. 12 COMMERCIAL PAPER 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 in- terest 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 condi- tion 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 1s 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 com- pete 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 under- taken, we have to consider primarily those lend- LENDING AND BORROWING 13 ings and borrowings in which there is no more than an ordinary risk. Commercial paper, as we shall see, 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 ac- cruing is interest in pure form. There are various forms of borrowing, both for loans involving ex- ceptional 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 confine 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 be 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 with- out security, in which the lender has an intimate acquaintance with the borrower. (b) Loans between groups of individuals or between a borrower and a bank where the lenders have such intimate knowledge. 2. The borrowing through one or more distant channels from lenders only moderately conversant with the condition of the borrower. (a) Long time loans, with or without security. (b) Short time loans, with or without security. 14 COMMERCIAL PAPER These classifications may, of course, be them- selves many times subdivided; but for a short in- quiry 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 ex- ceptional 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 convert- ible 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 re- lating to" the issuance of commercial paper are LENDING AND BORROWING 15 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 in- terest cannot be classed as pure interest, it is be- cause 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 ventures, even if for a short time only, cannot be so classified, and belong to a field outside our stated 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 has an intimate acquaintance with the condition of the borrower, we have to deal first with loans which show their value in their form, such as loans secured by salable collateral, and second with unsecured loans such as usually occur between banks and their in- dividual customers. There are other loans which 16 COMMERCIAL PAPER fall into this class but the foregoing are the most prominent. Collateral loans form a very consider- able 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 valua- tion, should be the most acceptable form of col- lateral. 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 shrink- age 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 LENDING AND BORROWING 17 loan or the loan will become due and payable. In the case of the best bonds ten per cent is usually taken as a conservative margin to be required to be jmaintained when active listed bonds are given as collateral against borrowings. In the case of the best active listed stocks twenty per cent is cus- tomarily demanded as a conservative margin. On stocks other than the best or in the case of loans secured by stocks which are all of one kind or very similar, a greater 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. Toans se- cured by one class of stock or bonds are obviously not as satisfactory as loans secured by mixed col- lateral. 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 security. Call loans, which banks put out from day to day and which they depend on first to re- plenish their reserves if a need comes, all are secured by quick, usually the quickest, collateral. Call money, as it is known, and money lent or three or four months time against the same sort of collateral, which, by the way, is usually sixty- five per cent railroad stocks and thirty-five per cent industrial stocks, are as near money as any 18 COMMERCIAL PAPER 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 col- lateral, 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 col- lateral 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 good- ness 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 Kspecially 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 19 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 col- lateral 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 at the “bid price.” The Best Collateral is Listed Collateral. The fact that a security is listed on a stock exchange, even the New York Stock Exchange, is not in itself evidence to warrant its being accepted as the best of collateral, any more than the fact that a security is not listed should preclude it from acceptance as collateral. The best collat- “eral, however, is that listed on some large stock exchange, because it can be more readily quoted there than in the private market; and, to be satis- factory, collateral must not only be listed, but 20 COMMERCIAL PAPER 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. 3 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 bank- ing 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 consider- ably 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 na- tional 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 per- sonal knowledge of the condition of the borrower on the part of the lender. Borrowing accounts with Lanks exist either to effect the major part of LENDING 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 knowl- edge which necessarily includes thorough informa- tion in regard to the business done and the busi- ness needs of the customer. As safety of its own deposits should be primarily its first care, a bank cannot for a moment afford to offer itself to fill a wide breach, such as a borrowing account often offers, unless it knows that it stands on firm ground. Any depositor using his deposit as a borrowing account should recognize this fact ab- solutely, and should regard hus loans with the bank as that with his best friend, being willing to show hus condition at all times and also being willing to be guided so far as his financing is concerned largely by his bank's advice. The financial ex- perience of the officers of a bank is necessarily so much wider than that of men engaged in mercan- tile affairs alone that if the bank officers are stu- dents of fundamental business. conditions their advice should be taken as the best obtainable. Respect, too, should be shown a bank by a customer as in the case of a friend if the demands on the bank appear to be such as to preclude a loan as asked for on account of other demands on the bank’s resources. Such occurrences as this where a loan is asked for in all fairness should not occur often. If it does other borrowing accounts should be opened in other banks; but occasionally such a COMMERCIAL PAPER 89) Oo 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 borrow- ing 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 LENDING AND BORROWING 23 discount short or longer time notes or commer- cial paper. The chief use of such accounts is, however, limited to the right of the depositor to the discounting of short time loans or commercial paper. It is this that forms the basis of the lend- ing to customers on the part 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 ex- tensive 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 back on them. The consideration of the borrow- ings that these men make use of, therefore, leads us to the consideration of Division 2 in our classi- fication of loans—those loans made through one or more distant channels and from lenders who can be only moderately conversant personally with the condition of the borrower. Such loans are, from the point of view of the borrower, hardly dif- ferent from the loans made with friends or with his own banks. To lenders under this class, how- ever, the difference is very great. A general knowledge of the conditions of the borrower is impossible, with the result that either certain spe- cial safeguards have to be called for to surround loans of this class or it must be stipulated that 24 COMMERCIAL PAPER 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 invest- ing 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 them- selves, 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 done. To the lender, however, there is certain knowledge that there is something to fall back on in case the earnings of the company fail. LENDING AND BORROWING 25 To those who lend this makes all the difference in the world. Lenders believe, of course, in the general successful operations of the company, but really base their loan on fundamental assets. For this reason borrowers who make use of distant sources of capital, which can be only moderately conversant with the actual condition of the bor- rower, 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 if they do this. Long Time Bonds Should be Especially Well Secured. Lenders of this stamp should demand ample margin of safety in security on long term loans. Conditions change so rapidly, especially 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 wealth and that a business now successful should grow with it, is not a sufficient answer to this statement. Very long term bonds, say for any- thing over twenty-five years, should be especially well protected, and if possible some method for partially, at least, repaying the total borrowing should be introduced into the terms of the bond issue. Sinking funds are excellent institutions for the lender, and rarely hinder the operations of the borrower. The sale of refunding issues is a 26 COMMERCIAL PAPER 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 vears from the time the loan is made. The in- troduction 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 works 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 non- mortgage 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 them- selves as mortgage bonds; but it should be remem- bered 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 LENDING AND BORROWING 27 bonds, therefore, are not as satisfactory as mort- gage bonds, though in the case of debenture horrow- ings, such as those of the Boston and Albany, lenders may expect that a history of good standing as to credit will be maintained, and that even if a mortgage were executed it would hardly be so placed as to imperil the holders of debenture bonds. Short Term Notes are Also Often Proper Mediums of Finance. What is true of long term borrowings through distant sources, is largely true of borrowings for a shorter time. A belief in the convertibility of the loan and its actual convertibility must be present if a loan is worthy of the name. Often a company can issue bonds but does not wish to sell them at the moment, either because of an inappropriate money market or for other sound reasons. A company often in such an instance issues the bonds and instead of selling them places them as security, usually with a margin, against six months, one, two, three, or more year notes. Such borrowings usually are of considerable value to the borrower, who in consequence pays a rate of interest which is always attractive on the money market in which they arise. If the terms are satisfactory, these loans should be very attractive to lenders, as it keeps their capital fairly liquid and ready to take advantage of opportunities for exceptional investment, as they occur. Stock of controlled, or partially controlled companies, is 28 COMMERCIAL PAPER occasionally placed as collateral on such notes instead of or with bonds. The value of such col- lateral is dependent on the worth of the companies represented by the stock and although stock is not as a rule as desirable for security as bonds, loans like these, secured by stock in part or whole, as, for example, certain notes of the “Bell” Telephone Companies, may be very good investments. Short Term Railroad Debenture Notes May Also be Satisfactory. - Many railroads, when the investment market is not to their liking, issue short term debenture notes. Though business conditions change rapidly, they can hardly change so much that steam rail- roads in good standing can in a few years fail to protect such debenture notes. Railroads have wide credit, if they have it at all, and are consequently better able to issue and to protect debenture notes with safety to the lenders than are industrial corporations serving a local district, and apt to keep their business as secret as possible. Deben- ture borrowing of railroads and like corporations on comparatively short time are a satisfactory form of finance provided the borrower is in good stand- ing and has wide credit, not otherwise. Commercial Paper is a Medium of Finance For the Purchase of Merchandise Only. General businesses need to borrow money for short periods of time to a considerably larger LENDING AND BORROWING 29 extent than public service corporations. They find a call for merchandise and a chance to buy it for less than they can sell it. To fill all orders they can get they need more money than they have with which to buy this merchandise. Such borrowing as this, to buy merchandise or something similar which is to be turned into cash, presumably at a profit, and within a short time, is called borrowing through commercial paper. Commercial paper is the name given the medium for such borrowing and is not properly applied to any other form of borrowing. It fills a field of its own and requires separate analysis and study. It is different from the borrowing of railroads and public service corporations, even for an equivalent time. It is different from the borrowing of an individual on the most salable of security and with ample margin. It is a method of finance all its own, just as mortgage bonds are in their particular field. It is a very important factor in the finan- cial system of any country, for as business is the attempt to turn available wealth into capital and as most business must have to do with the purchase and sale of merchandise, so commercial paper must play a most important part, if not the most impor- tant part, in financing the business needs of a community or nation. Commercial paper is one of the biggest aids that we can make use of in economic progress, that is, in the acquisition of true wealth. Commercial paper is entirely as proper an economic medium for borrowing and 30 COMMERCIAL PAPER » lending in its own particular field as are other forms of security in theirs, and when properly used to do the work for which it is intended, and no more, it is exactly as safe. In fact, for the student of fundamental conditions, who at times needs to have his money in liquid form awaiting a forced readjustment or panic, good commercial paper is often the very best investment procurable. We Have to Deal Here Chiefly With Commercial Paper. The purpose of this treatise is to deal chiefly with Commercial Paper, its different aspects, its purpose, and what should be its required form to make it an available agent for its needs. We have already seen that it appears among the borrowing from lenders thoroughly conversant with the condi- tion of the borrower. It necessarily plays a larger part in the borrowings from the many at a distance who cannot well be so conversant. It is chiefly as a medium for such borrowings that it is to be considered, but its similarity is great in both instances, and its function and form in both cases can be considered as the same and studied together. CHAPTER 11 THE FORM OF COMMERCIAL PAPER HE first axiom in the borrowing of money by note or bond, where risk is not ad- mitted, is that borrowers shall prepare in their borrowing for payment of the loan at matu- rity. A borrower who cannot meet his obligations 1s not the sort of borrower lenders wish to meet, and even if his assets are sufficient to pay his debts, their liquidation takes time and causes trouble and expense for the lender. A note which is paid after it is due is not wholly bad; but it is not in accordance with good business and it is not the sort desired by lenders, especially bankers who specialize in lending and have to figure most closely on each of their investments. Any study of loans which will show such lenders how to avoid taking loans which will not be paid till they are overdue will be rated nearly as high as that which will tell them how to avoid worth- less or semi-worthless investments. Notes which have to be extended for a considerable time are to be classed with notes which are paid a com- paratively short while after they mature, for it _is the changing of tactics on the part of busy “men which non-payment of obligations at maturity necessitates that is the principal disadvantage such obligations carry with them. 32 COMMERCIAL PAPER Refunding of Commercial Paper May or May Not be Permissable. Tt follows, as we have partially seen, that those who borrow through commercial paper as a medium of finance should use the amount of money borrowed in those interests only which will presumably arrive at maturity within the life of the notes given for the amount in question. A firm borrowing $200,000 or $2,000,000 to buy merchandise by an issue of mercantile bills, notes or commercial paper—the terms are synonymous —which is able to sell only $175,000 or $1,750,000 + worth of merchandise within the life of the notes and yet which is able easily to discount another issue of notes before the first lot are due, is in a safe position; but, the firm is good really not because it can do this but because its credit is acknowledged, because lenders are sure that if forced it could liquidate its unsold merchandise. Refunding of commercial paper is common enough, just as refunding is in the case of bonds, for busi- ness operations often take longer than the expected time and because it would often injure general business, as lenders recognize, to force a firm to clean up an issue of commercial paper before the merchandise into which the proceeds of this paper have gone has been properly placed. But such refunding should never be at the expense of the original lenders. If such lenders wish their money at the expiration of their notes, the money THE FORM OF COMMERCIAL PAPER 33 should be forthcoming. If the borrowers have not sold over $175,000 or $1,750,000 of their mer- chandise and can sell more notes for $25,000 or $125,000 to lenders who really want them, well and good ; but if they cannot, they should liquidate even at a loss and make up the loss from other sources. If a Lender on Commercial Paper Wants his Money at Maturity He Should Always Get It. By every moral and economic law, apart from legal regulations, the forcing of renewals on holders of commercial paper, even in part, is wrong and disgraceful. Such renewals are being forced on many lenders today. In the Panic of 1907, they were of common occurrence, although forced renewals of commercial paper then occurred not wholly because. of the faulty method of use of the proceeds from the paper, but largely for deeper, though no less disgraceful reasons. The Panic of 1907 brought to light, however, as do the forced renewals of paper in normal times to a less degree, the weak understanding of the use of commercial paper as a medium in finance or an utter disregard for its precepts. Finance is very much like medicine. There are certain funda- mental laws of health in finance which must be recognized and regarded and any disregard of them should be frowned on, as is the man who needlessly ruins his health or the health of others. 34 COMMERCIAL, PAPER Healthy conduct in finance is, however, far more important than it is in the care of one’s body, for in finance any disregard of the laws of health injures not oneself so much as others. The bor- rower who makes use of commercial paper as a medium of finance and who goes beyond its scope and does not reasonably protect it, is a criminal at economic if not at common or statutory law, and should be so decried. In this country we have so much work to do and there is so great a chance for profit that we have become lax in our regard for proper financial methods. If a borrower on commercial paper cannot pay his notes when due because of what is really misappropriation of funds, we get the matter settled as cheaply as possible, say “hard luck” to him, and very often lend him more money. This is a new country and as in all new countries matters often jump in unexpected ways, for they have no great fly- wheel of custom and proportion to steady them. Occasionally, kind treatment towards the maker of overdue notes is fitting; but it is not usually so and certainly it is not what should be expected, as often seems to be the case now, by the borrower. The Proceeds of Commercial Paper Should go into Merchandise Only. The use of commercial paper as a medium of finance is by its nature confined to the raising of money with which to buy stock in some regular business or to avoid selling that stock temporarily. THE FORM OF COMMERCIAL PAPER 35 In this country much commercial paper is sold in order to raise money to buy machinery or other fixed assets. These are no less valuable, perhaps, than the merchandise is, but there 1s absolutely no hope of converting them wnto cash within the life of the notes, and notes issued for this purpose are mot properly commercial paper. In the American method of issuing commercial paper it is difficult to separate the chaff from the grain and we have no way of telling whether or not the particular dollars we lend by buying com- mercial paper go into merchandise or labor con- nected with the preparation of merchandise, which is the same thing, or fixed assets such as machin- ery, which is not the same thing at all. A com- pany may need to buy $100,000 worth of merchan- dise, which it can and does sell for $110,000, and put out $150,000 worth of notes, the $50,000 over and above the $100,000 needed for the merchan- dise going towards the purchase of land or machin- ery. If the notes are made on six months’ time and the merchandise is sold at a profit of $10,000 in this time, only $40,000 will have to be refunded. This the company can probably easily refund and keep on refunding till enough profit has been made to pay the notes off. As it turns out, the extra $50,000 notes are safe enough investments. They are flying under entirely false colors, however, when they are thrown in with pure commercial paper, and they should not properly be used for financing the purchase of the land or machinery. 36 COMMERCIAL PAPER It is good luck rather than anything else if they are taken care of at maturity. Commercial Paper Should Not be Used to Finance Fixed Assets. Such spurious notes as these, as we shall see, would not be tolerated in England or the other older countries. It will be argued that if the company is making $10,000 every six months, is in good standing, and so can refund its constantly _decreasing amount of spurious commercial paper, there is no proper reason why it should not raise money in this way rather than put in more capital which is needed elsewhere. There is no reason why the company should not issue such notes and refund them ; but only provided some arrangement is made beforehand for the refunding in case the something arises which will make the general investing public refuse to take more notes. From the first axiom of borrowing in business, that bor- rowers shall prepare in their borrowing for the payment of the loan at maturity, to thrust a lot of notes on borrowers who can be only moderately well acquainted with the condition of the borrower, when at first sight it is apparent that if necessity arise the proeeeds of such borrowing cannot be converted into cash to protect the notes, makes the thrusting of these notes on the public absolutely unjustifiable. If the notes are made to mature serially over a term of months, or if arrangements THE FORM OF COMMERCIAL PAPER 37 are made with the company’s own banks to protect notes which cannot be renewed when renewals are needed, the case is different. Too often, however, such preparation is not made. As a Rule Commercial Paper Cannot Carry Collateral. Inasmuch as the proceeds of commercial paper are to go to the purchase of merchandise, it follows that from the nature of merchandise it cannot well be given as collateral. Commercial Paper is, therefore, usually an ordinary promisory note without collateral. As merchandise must be sold within the life of the note and as stock in trade must usually be exhibited and be in shape for immediate delivery to be sold to the best advan- tage, it would be injurious not only to the bor- rower but to the lender to require it as collateral. - The credit of the borrower should be such as to make the lender ready to trust that he will buy merchandise and merchandise only with the money borrowed, or the form of commercial paper should be such as to show that merchandise is brought to insure financing through commercial paper. No one should expect dry goods or heavy imple- ments to be turned over to the lender; but occa- sionally a case arises where collateral in the shape of warehouse receipts or similar securities can be given as collateral, and where such cases exist exceptions often occur to the rule that commercial 38 COMMERCIAL PAPER paper shall not be directly secured. In the in- stance of the financing of the purchase of merchan- dise where there is an exceptional chance for fraud on the part of the borrower, it may even be necessary that some such collateral be given. The Boston News Bureau of February 16th, 1911, says, under the caption of “London Banking Com- ment on Cotton Bills:” “American bankers were much interested in reading this year’s annual report of Sir Edwin Holden, chairman of London City & Midland Bank, because of his prominence in the negotia- tions which occurred in 1910 in connection with cotton bills of lading. The London City & Midland Bank had an unfortunate experience with forged and bogus bills of lading on cotton and was generally credited with authorship of the demand upon American bankers that they fully guarantee cotton bills of lading forwarded as the basis of bills of exchange. The report says in part: ‘The business as conducted on old lines placed European bankers and brokers at the mercy of any fraudulent seller of cotton who was allowed to reimburse himself by drawing bills of lading which might be forged. No system has yet been evolved which can be adopted with satisfaction to everybody concerned. Some additional security has been given by what is called a validation certificate, but still the railroads will be responsible for their bills of lading only in cases in which THE FORM OF COMMERCIAL PAPER 39 their officers have received the cotton when the bills of lading and validation certificates are issued by them. If the railway officers issue bills of lading and validation certificates without having received the cotton, the risk will still lie on the European bankers and brokers unless the law intervenes.”” The instance of cotton is exceptional, but the case of financing the carrying of grain until sold is often somewhat similar. Similar, too, is the financing of the carrying of pig iron or of such merchandise as aging wines or whiskey. As a matter of fact, much of the commercial paper carrying warehouse receipts is paper on which no direct call for collateral is given. In many instances, in the case of financing merchandise, purchases in which warehouse receipts, bills of lading or the like for the merchandise exist, and lend themselves readily as collateral, the bor- rower, to show his good faith, of his own free will, puts them up as security, making exchanges of collateral as need arises. Where collateral can be readily given, especially when in the form of United States bonded warehouse receipts, such should be given, as it may encourage lenders to lend or to take the paper on which it is collateral at a lower rate; but, as in the case of a man on trial who does not testify in his own defence, it should not necessarily injure credit if collateral on commercial paper is not given, provided the lender treats all borrowers alike. 40 COMMERCIAL PAPER No Commercial Paper Should Run for More Than a Year. Commercial paper is a term occasionally broadened to include all borrowings, preparation for the payment of which may be made within a short time. As we have seen, commercial paper should not properly include any borrowings which are not made for the purchase of or to carry stock in trade. The time commercial paper shall run, that is, the difference in time between its sale and its maturity, is a somewhat more complex question. From a study of general business we may take a year as the longest time that commercial paper may be allowed to run. Only the very strongest borrowers, however,—those who by the nature of their business and a past history of successful operation show especial strength—should be al- lowed by lenders to make their commercial paper for as long a term as a year. The best mills, such as successful cotton mills, whose paper is endorsed by selling houses in the best of repute, are examples of such businesses. Occasionally because of at- tractive rates bankers who see by their study of fundamental business conditions that rates will probably decline, lend strong mercantile companies or firms for so long a period as a year, and do so with authority, not because it will take so long a period as a year to sell the goods bought, but because the lender is sure that when the first lot of merchandise is sold the proceeds will be used THE FORM OF COMMERCIAL PAPER 41 to buy more merchandise, the result being the same as if the lender had renewed once or more an original borrowing. Conversely, borrowers who study fundamental conditions are justified in borrowing year money when statistics show clearly that rates will advance. The practice of allowing credit through commercial paper on mer- chandise which will undoubtedly be sold long before the paper matures is, however, a dangerous practice, especially for those who are mot fully familiar with fundamental business conditions and all changes which occur from week to week. For such it is better for both the lender and the bor- rower to start anew with each individual trans- action. Most Commercial Paper Should Mature in From Ninety Days to Six Months. Most commercial paper should mature within six months, much within four months, much within ninety days. With any proper operation of commercial paper as a medium of finance, the time the paper has to run will decrease with sixty to ninety days as its limit. Foreign countries, older communities than this, rarely have com- mercial bills for six months’ time. Six months should be taken in general as the maximum time commercial paper shall be allowed to run, the varying maturities allowed being governed by the convertibility of the merchandise back of them, and the foresight of the principals involved. Pack- 42 COMMERCIAL PAPER ing house paper, which is presumably secured by merchandise which has as ready a sale as almost anything, is especially safe and may be taken with safety for the full time, if the makers desire a six months’ maturity. Commission merchants, such as those dealing in cotton cloth and selling for mills, or houses selling groceries and like goods, for which there is a constant demand, should also, if they wish, be allowed six months’ time. Paper used to Finance Specialties Should Run a Short Time Only. Paper of manufacturers, say of a special form of shoe, the value of which is quick to change with fashion and the sale of which ought to be arranged for practically before the paper to cover the mer- chandise is put out, should not be made for over five months. Care should be taken, too, that a firm manufacturing a specialty does not renew its paper except under exceptional circumstances. Such renewals, if in any quantity, should be taken as a danger sign at once. Makers of heavy ma- chinery may or may not be given credit for so long as six months with safety. Usually, in the case of such borrowers, most of the machinery made is contracted for. If a customer is not ready to fill his contract immediately and yet is good, it is perfectly proper that the manufacturer should be given credit to carry his merchandise; but care should be taken that such credit is based THE FORM OF COMMERCIAL PAPER 43 on a firm basis. The trade accounts of the man- ufacturers of heavy machinery and the like, who make their paper regularly for the longest possible period, should be examined with especial care. Banks are Chiefly Responsible for the Form of Commercial Paper. Borrowers through paper cannot afford to waste time over very small denominations. As the turn- over is necessarily fast for them, they must be able to borrow what they want quickly, and like- wise they cannot at maturity worry over a large number of small notes. If they cannot get their money in bulk from one place, they will go where they can so get it. Hence comparatively few notes are made in smaller denominations than $2,500 and most in at least $5,000 denomination. As the number of available individual investors who have money in this bulk to lend for not over six months is small, and as also it is chiefly the banks who heretofore have best been able to pass on the worth of commercial paper, it is the banks who now do principally the discounting of such paper. Hence it is the willingness or unwilling- ness of banks to accept commercial paper in certain forms that is responsible for those forms. Banks Should Demand Their Rights More Firmly. If commercial paper does not seem to be in proper form for proper finance; if, for instance, 44 COMMERCIAL PAPER it is in the form of a six months’ renewal of a note which it appears should have been retired for good and all at maturity, the bank asked to pur- chase it, even if it wants to make a loan, should not take it without much deliberation. It is absolutely the duty of the purchaser of commercial paper, for others as for himself, to inquire care- fully into the causes of a new note of the company in question being offered at that particular time. Unless absolute assurance of legitimate need is given, the note should be declined and, if possible, the matter made public. Occasionally a three or four months’ note with proper explanation may be accepted where a six months’ note may not. Endorsements, When Available, ‘Should be Given. If banks feel that a certain company is con- trolled by very wealthy men, though weak in itself, they should insist on the endoretionts of the men interested. Banks, it is the writers’ belief, are not nearly enough insistent for their rights. There is much competition in this country between banks, too much so for the best banking, and risks are taken for fear that if they are not taken the chance for profit will go at once to another. Tt is a duty that all bankers, large and small, should recognize, and especially in regard to ermal paper, that they should hold out absolutely for what they perceive is the most proper form for their é THE _ FORM OF COMMERCIAL PAPER 45 investments. This does not mean that they should demand ultra safety, but simply a proper con- servatism. Such action, even if individual, and far more powerful if concerted, will soon put an ‘end to much of the loose financing of today, will protect the banks and will, by exploiting a sound basis of finance, greatly strengthen the chance for a successful business on the part of the bor- rower. It is to be noticed especially that methods which are called for by lenders usually are those to which borrowers for their own good should turn, not so much because doing so will make their borrowings more attractive to lenders, but because such methods of financing their needs should insure the use of proper financial safeguards and keep borrowers from extending themselves unduly. Competition between lenders will see to it that too much conservatism is not demanded. Receivables are an Excellent Form of Commercial Paper. Most of the money raised for merchandise here is obtained through the discounting of single name paper, a form on which renewals are easy and in which loose financing is very possible. A small portion of our commercial paper takes a form which on its face makes renewals difficult. This is the form of receivables, where a sale of merchandise is made, a note given for it by the purchaser to the seller, who accepts it by endors- 46 COMMERCIAL PAPER ing it and gets his money through discounting it himself through brokers or banks. As much trouble and explanation is necessary to get an acceptor of such a note to endorse another in renewal, most receivables appear but once on the market. When they do appear, they necessarily represent real mercantile transactions. Some businesses, like farming or the purchase of raw materials, do not readily lend themselves to this form of finance; but many do so, a great many more than make use of this system. It is interest- ing to notice how other countries look on this method of finance as compared with our more common method. The English have, of course, similar financial problems to ours. They, being an older and a less rapidly growing country, have paid more attention to details and have worked out a conservative and yet a sufficiently broad system as to commercial paper for their needs. A short description of it and of the methods of dealing with this subject in ome or two other countries should help wus appreciate our own problems and their solution. The Bank of England. Quoting from the United States Monetary Com- mission Document entitled “Interviews on the Banking and Currency Systems of England, Scot- land, France, ete.” on the interview with the Gov- ernor and Directors of the Bank of England, we find the following questions and answers: — ~~ THE FORM OF COMMERCIAL PAPER 47 Q. Can you state approximately the average length of time and the average size of bills dis- counted by you? A. Time—forty to fifty days, size probably about £1,000. Q. Do your branches have business relations ‘with merchants, farmers, and all classes of people in their respective localities ? A. There are no restrictions of any kind as to the class of people with whom the bank has business relations. Q. Is the character of your discounts or loans regulated or restricted by law or fixed by the statutes of the bank? A. Regulated by the court of directors from time to time. Q. Will you state (a) the class of bills usually discounted by you, giving the number of names required: (b) the minimum size, and (¢) the maximum length of time to run? ; A. (a) Two British names, of which one must be the acceptor; (b) No minimum; (e¢) Four months, exceptionally six. io It is to be noticed from this that although the Bank of England recognizes that four and even six months’ time is necessary often to conclude any mercantile operation, the working of its system of commercial paper finance in taking receivables or semi-receivables only, that is, paper having the name of the man owning the merchandise or about to buy it and the man to whom it ig to be 48 COMMERCIAL PAPER sold, naturally tends to decrease the time that paper has to run to forty or fifty days. In other words, by eliminating the chance for speculation and by forcing borrowers to confine their opera- tions to conservative business, the Bank of Eng- land has brought borrowers to borrow for only such a time as they can see clearly ahead. The - questions continue: Q. What is the distinction between what are known as prime bills and other bills? A. A prime bill we should define as a bill accepted by a London or provincial bank in first class credit or a merchant or merchant banker of the first class whose business it is to grant credit. Q. Do you discount any but prime bills? A. Yea Q. What is the usual difference in rate charged by you upon a prime bill and for a high class loan secured by collateral having the same period t run’ : A. It is impossible to give a precise answer to this question. Q. Ts the rate for discount at your branches for customers’ paper and for prime bills the same as at the central office? A. The rates current in London are tele- graphed each morning to the branches for their guidance. Q. Do you at times discount bills for parties having no account with you ? A No THE FORM OF COMMERCIAL PAPER 49 Q. Do you allow over-drafts or do you make any advances of the kind made by Scotch banks, called cash credits? A. Except in special circumstances over-drafts jare not allowed by the Bank. The Bank does not make advances of the kind termed cash credits in Scotland. Q. Is it the practice of the bank in times of stress to discount bills of a satisfactory character for its customers freely ? A. At such times the Bank is always ready to discount bills of a satisfactory character for its customers or for the market. INTERVIEW WITH SIR FELIX SCHUSTER, BARONET, GOVERNOR OF THE UNION OF LONDON & SMITHS BANK LTD. Asked regarding the acceptances of the bank, Sir Felix Schuster explained that his bank charged, usually, about one-fourth of one per cent for accepting bills, this acceptance making bills prime bills. He stated that his bank would never accept a bill unless the acceptance of the bill were covered by negotiable securities deposited with the bank, this security being in the form of warehouse receipts, stock, bonds, ete., usually stock or bonds. Q. Ts it the general practice in London to make advances to very responsible people on a single name ? A. Not in London. Q. Quite unusual ? 50 COMMERCIAL PAPER A. Quite unusual. The London banker's practice is only to make an advance against col- lateral ; but in some of the country towns certain banks give over-drafts upon credits, particularly in Manchester, but local practices vary very much indeed. I think the practice tends much more to assimilate between country and London. Tt has become much more the practice in the country to ask and to get security against advances. London banks, it was explained further, and especially the bank of England, act as the banking pivot of the country. Most of the dealings are between banks, or bill (or note) brokers and banks, and only on secured or double name paper. If the bill broker takes a note to the Bank of England for discount he has to endorse it, if it is unen- dorsed, before it is acceptable. Hence only very strong note brokers can do business in England. Their position is criticised because in time of stress their endorsement is weakened. INTERVIEW WITH THE GENERAL MANAGER OF THE LONDON JOINT STOCK BANK LTD. Q. You show about $51,000,000 in bills dis- counted, loans and other securities. About what percentage of that item is in bills discounted ? A. That fluctuates considerably according to the state of the money market. If my outlook is that rates will be lower in the course of the next three months, I hurry up to buy all the bills I THE FORM OF COMMERCIAL PAPER 51 can possibly get today, and so I might have perhaps from thirty to forty per cent on that in bills. QQ. What is the character of those bills? A. Those are all marketable bills, trade bills, you know what they are—they are between the manufacturer and the man to whom he sells. It might be a promisory note endorsed by the payee. Those are the two names on it; the payee perhaps is the manufacturer on a promisory note given by the purchaser. Instead of that here, our manufacturer draws a bill on the person to whom he sells and that man accepts it. Those trade bills are good bills mostly, but we only discount those for our own particular customers, people whose affairs we know all about, but many of them are discounted in the open market to discount houses such as Nugent’s. Then I buy bills with his endorsement, which is very valuable, and get money on these trade bills from him. Q. Do you always require two names? A. Always. i Q. What is the average length of time of these bills ? : A. Those bills are three months to run, and less. Very occasionally I may buy a four months’ bill or a six months’ bill, just according to how I think it promises to be a profitable venture, but as a rule the three months’ engagement is all IT feel free to deal in to any large extent. I want my money. We never rediscount, never turn the bills out again. Tt is enough to wait for their COMMERCIAL PAPER Ot Do maturity; therefore it stands to reason I cannot afford to spend money for six months and sit there and wait for it. Q. Can you give me an idea of about the minimum size of those bills? : A. No. They are of all sizes, from £100 to £10,000. From our own customers I take such bills as they have and they perhaps run mostly in small amounts, but from discount houses I do not want to be troubled with such small bills. Q. How does the small tradesman in London receive accommodation at the bank? A. He must have some sort of collateral to put up. Q. As a matter of fact a small tradesman rarely has the collateral ? A. Then it is not much accommodation he gets. Q. Tt is difficult, is it not, for him to secure accommodation even through a guarantor? A. No, if he gets a good guarantor. We do not care for guarantees as a rule because of the difficulty of enforcing them. Q. You have the accounts of many small tradesmen ? : A. Yes, lots. They get accommodation, say, in our discounting trade bills. A manufacturer of any kind of tin goods or wood goods or anything of that kind—dealers in lumber—they sell to some other fellow in the country, or wherever it may be, and they draw that trade bill upon THE FORM OF COMMERCIAL PAPER 53 them at not more than three months from its date, and that these small traders may bring in to us and we rigidly scrutinize them as to the customer who brings them in, to see that he is a respectable man, doing an honest business, and so we will help him by discounting those bills, if we are equally satisfied with the acceptor, if we think he is doing legitimate business with honest, legiti- mate people. So he gets accommodation there without any security at all. We only get the security of another name. Q. The practice in England is for the whole- saler or large manufacturer to finance the retailer ? A. To some extent, but as a rule that whole- saler draws his bill on his retailer, and so he has a larger volume of these trade bills and he goes to his bank or to the Union Discount Company and discounts these in larger batches. Q. And in that way the retailer pays for his goods by an acceptance ? : A You Q. Which the wholesaler discounts ? A. Yes Q. If you had an account of a man running, say, a hat store, his account was satisfactory in character and had been carried with you for several years, and he wanted to stock up on hats, there would be no way in which he could go to you and borrow the money with which to buy those goods unless it was through a guarantor? 54 COMMERCIAL PAPER A. No, he would then go to the wholesaler from whom he would buy the goods and give that wholesaler his bill, and that bill would be a dis- countable article, od that is how the money would be raised. It was pointed out that honking in London and in the country was very different. London banks and even their branches in the country, to an almost equal extent, confine their discount business to very short loans on trade bills, prime bills or such securities. They also accept bills when covered by a deposit of collateral, for such acceptance a charge being made. They do not wish other business. The so-called country banks, it was pointed out, come into contact with agri- culturalists and weaker borrowers than the London banks do. To finance them, overdrafts have often to be employed. This is the general practice in the country for financing such deals as this sort of customer has to enter. Overdrafts are, of course, only allowed by banks thoroughly ac- quainted with the borrower. Often they are secured. It was also pointed out that if a trade bill in good shape was brought to the bank for discount and also a collateral loan secured by Pennsylvania R.R. bonds, the bank would discount the former at a lower rate than the latter. It was also shown that during the Past year this bank earned about twenty per cent net on its paid in capital. THE FORM OF COMMERCIAL PAPER 55 INTERVIEW WITH THE MANAGER OF THE UNION DISCOUNT COMPANY OF LONDON LTD. (This corporation deals chiefly in selling com- ) mercial paper or bills to the banks in England and on the Continent). Q. Do you guarantee all of the paper which you sell to the banks? A. You Q. Describe the general character of your bills discounted. A. The acceptances of banks and financial firms of good standing. The bills average about £700 in amount and about fifty to sixty days in currency. At least two names are required. QQ. What is the minimum size and what is the maximum length of time to run for bills dis- counted by you? A. Rarely under £10 in size or longer than twelve months. : Q. What is the distinction between what are known as prime bills and other bills? A. Prime bills are the acceptances of banks and leading firms. Other bills are the acceptances of houses in a smaller position. Q. What is the difference between a trade bill and a finance bill? Is the rate the same on each ? A. A trade bill is one drawn on a merchant or retailer for goods actually sold and delivered. A finance bill is one drawn against a deposit of 56 COMMERCIAL PAPER securities or sometimes without any such deposit, for the purpose of creating credit. Rate is higher on finance bills. Scotland. INTERVIEW WITH THE GENERAL MANAGER OF THE ROYAL BANK OF SCOTLAND. Q. Will you state (a) the class of bills usually discounted by you, giving the number of names required; (b) the minimum size; (c¢) the max- imum length of time to run. A. Mercantile bills, that is, bills for the price of goods or merchandise supplied, drawn by the seller and accepted by the purchaser, £2 or £3 in some cases, up to £5/10,000. Their maximum length is six months. Q. Do you discount to any considerable amount for individuals and merchants? A You Q. Explain cash credits ? A. A customer applies to be allowed to over- draw such amount as he may require from time to time up to a specified amount, and he and two or three sureties jointly and severally become bound to repay the amount that may at any time be owing, with interest, on demand being made on them. Each obligant is liable to pay the whole sum, leaving him to obtain payment from his co- obligants. : a -~1 THE FORM OF COMMERCIAL PAPER INTERVIEW WITH THE GENERAL MANAGER OF THE UNION BANK OF SCOTLAND LTD. Q. Will you state (a) the class of bills usually discounted by you, giving the number of names required; (b) the minimum size: (¢) the max- imum length of time to run. A. The bulk of bills discounted represent ordinary mercantile transactions. In practically every case there are at least two obligants. The bulk of the bills discounted do not exceed three months’ currency. It would not be practicable to indicate their average size. Q. Do you discount to any considerable amount for individuals and merchants? A You Q. Explain the phrase cash credits, and upon what conditions they are given? A. A cash credit is simply a current account on which the holder may draw to a fixed amount, interest being calculated and paid on the daily balance. In security the applicant and his sure- ties, termed co-obligants, sign a formal bond under which they jointly and severally guarantee to repay the bank when called upon the amount of the debt and accrued interest. INTERVIEW WITH THE GENERAL MANAGER OF THE COMMERCIAL BANK OF SCOTLAND LTD. Q. Can you state approximately the average | 58 COMMERCIAL PAPER lengtlr of time and the average size of bills dis- counted by you ? : A. Two to three months’ currency. Q. Will you state (a) the class of bills usually discounted by you, giving the number of names required ; (b) the minimum size, and (¢) the max- imum length of time to run? A. (a) Trade bills, with two names, the drawer and the accepter. (b) No minimum. (e) Six months is the maximum in general. Q. Do you discount to any considerable extent for individuals and merchants? A. Yes, it would be perhaps well to point out that in Scotland a large portion of the advances made to traders are granted in the form of over- drafts on current accounts. The number and amount of bills in Scotland are less now than in former years. Cash payments for the purpose of obtaining discount are more frequent, and the number of bills discounted by wholesale houses is reduced in consequence. Q. Explain the phrase cash credits, and upon what conditions they are given. A. A cash credit account is an operative cur- rent account in security of which the principal debtor and two or more co-obligants have granted a personal bond in favor of the Bank. Q. Is it the general practice in Scotland to make advances to very responsible people on a single name ? A. The general requirement is two names, but THE FORM OF COMMERCIAL PAPER 59 each case is dealt with on its merits, and there are many instances where the full requirement is not insisted upon. These interesting interviews all point out (a) that in Scotland and England, whether in the Bank of England, in the great London banks, which finance many of the large short time undertakings of the world, whether in the English country busi- ness dealings with farmers and small producers, or in the larger business of the same kind that comes to the Scotch banks, it is not regarded the thing to grant credit under the loose provisions that surround its granting in this country: (b) that in most cases, whether the credit is to be given in the form of an overdraft or cash credit, or in the form of discount, the names of at least two strong and interested parties are demanded, or in the case of the accepting of a bill to make it a prime bill and to put it in discountable form a deposit of salable collateral is required; (¢) that, owing to joint promises borrowers are forced into putting the proceeds of the notes they discount into those operations which are practically sure to arrive at maturity before the note comes due. France. INTERVIEW WITH THE GOVERNOR OF THE BANK OF FRANCE. Q. What classes of bills are discounted by the Bank of France? 60 COMMERCIAL PAPER A. The Bank of France discounts for everyone who has obtained the opening of a current account, bills of exchange, checks, bills to order, and com- mercial and agricultural warrants of fixed maturity which have not more than three months to run and which bear the signatures of three persons, trades- men, agricultural syndicates or others, known to be solvent. The Bank and the Branches accept without distinction bills which are payable in any one of the 467 towns where we undertake to collect bills. Q. Do you require three names on all the bills you discount ? A. The statutory rule is that bills must have three signatures, but the Bank is also authorized to accept paper bearing only two signatures when the third signature is replaced by a deposit of securities belonging to one of the classes of securi- ties admitted for loans or by a warrant for mer- chandise (warehouse receipt). * At least two signatures on a bill must be given by parties domiciled in France. Q. Is it necessary that one of these signatures should be that of a bank ? A. That is not necessary. Q. Does your annual report show the average life of your bills? A. Yes. The last statement of operations indicates * for the year 1907,—26 days. Q. Does the statement of your operations give the average size of bills in your portfolio? THE FORM OF COMMERCIAL PAPER 61 rE A. Yes, the average value of discounted bills in 1907 was 735 franes, in 1906 it was 683 francs. Q. Do you allow overdrafts or do you make ‘advances of the kind made by the Scotch banks, (called cash credits? A. The law does not permit any overdrafts. It was also pointed out that any depositor with the Bank of France may discount paper in as small denominations as 5 francs; also that the Bank of France has a monopoly of the issue of notes which may be legal tender. Those notes are secured by the bills discounted, as shall appear in the chapter on Banking. INTERVIEW WITH THE ADMINISTRATOR AND WITH OTHER OFFICIALS OF THE CREDIT LYONNAIS. Q. Will you describe the character of the items constituting your portfolio of bills discounted which amount to about $211,000,000 ? A. The bills discounted are commercial or in- dustrial bills, representing normal transactions and having satisfactory signatures as drawers, drawees and endorsers. Q. With two names or more ? A. Always at least two, often three or four signatures, but never only one. Q. What is the size of your bills discounted ? — A. It is very variable, the average is perhaps about 600 francs. Q. While you do not accept a bill with one 62 COMMERCIAL PAPER name, you sometimes arrange with your customers to extend credit to them without guarantee, or without collateral ? A. Yes that is quite right * Q. Can you give us an estimate as to the average life of bills discounted ? | A. The average maturity of the paper which we purchase daily is about 55 to 60 days. Q. Does the Bank of France rediscount bills for the other banks in France ? A. The Bank of France rediscounts all bills when the person presenting the bill is admitted to discount and when the bills have the necessary three signatures, have less than three months to run, and are payable in cities where the Bank has a branch. Q. You regard that item of bills discounted as your practical reserve because of. your ability to rediscount the bills at the Bank of France? A. Yes, bills discounted and cash are, for an establishment such as ours, the most essential part of our liquid assets. Q. Let us take up the question of discount rates. Do your large banks follow the Bank of - France? A. We have two discount rates—that of the Bank of France, which is the official one, and then the rate outside the Bank of France. At the present moment our discount rate is one per cent, the official rate being about three per cent. THE FORM OF COMMERCIAL PAPER 63 Referring to overdrafts which the Crédit Lyon- nais allows. Q. So that in fact they are what we would call overdrafts; they are funds advanced with or with- out security ? A. There would generally be security: it is only with very good customers and exceptionally that securities are not required. Q. What dividend do you pay? A. Eleven per cent. (The Crédit Lyonnais deals in securities). The Comptoir d’Escompte which deals with small tradesmen, will not discount paper without at least two signatures. The same is true of the Crédit Foncier de France. INTERVIEW WITH A CHIEF OFFICIAL OF THE CREDIT AGRICOLE. The Crédit Agricole deals especially with farmers. It arranges for them long time loans CT — . or short loans with the privilege of renewal. The security is a mortgage on land and collective liability on the part of many men interested in the loan, or else in the case of an individual farmer a note drawn on himself and signed by an officer of the Crédit Agricole, which is a co-operative and mutual institution to which the farmer belongs. ~This institution greatly aids the wine growers. No paper is taken by it unless it has the two sig- natures, the maker and an officer of the Crédit 64 COMMERCIAL PAPER Agricole. If the Crédit Agricole has no money to lend a second officer endorses it to give it three signatures. It is then taken to the Bank of France and discounted there. Germany. INTERVIEW WITH THE OFFICIALS OF THE REICHSBANK. Q. You have in your statement bills discounted $221,000,000. Will you kindly describe the class of bills constituting this item ? A. The law prescribes exactly the kind of bills the Reichsbank may take. They must not exceed three months in time and there must be on the bill the names of at least two parties known to be solvent. Q. Are the bills secured or unsecured ? A. They may be unsecured. Q. Would the Reichsbank discount a bill drawn by one merchant and accepted by another ? A. Yes. The Reichsbank is not only a bank for banks but for the commercial and industrial enterprises of the Empire. Q. Do you show what percentage of bills are secured ? A. No. It is the exception to have collateral because the bill is considered on its merits and accepted accordingly. Q. Have you any statistics showing the propor- tion of bills with two names and with three ? A. No THE FORM OF COMMERCIAL PAPER 65 (). What is the smallest bill the Bank will dis- count ? : A. We have no minimum. We discount bills as low as 10 marks. Q. Upon what kind of a bill does the farmer secure an advance from the Bank? A. He sells his produce, draws a bill upon the purchaser, and takes the bill to the Bank as any other man would do, or a bill might be drawn upon a farmer and accepted by him. Q. When he borrows money in the spring with which to buy seed, how does he secure the cash ? A. He goes to his own bank for that. There are co-operative societies for this purpose, which are a great factor in Germany. Q. Will the manager of a branch of the Reichs- bank renew a farmer’s three months’ bill if desired ? A. Yes. An exception is made for the farmer. Other bills are not renewed. Q. Are farmers required to maintain a balance in order to secure accommodation ? A. People who hand in bills for discount are required to keep a satisfactory balance. INTERVIEW With rwe OFFICIALS OF THE DEUCHE BANK. This is a private bank paying twelve per cent dividends. It does mot do much of a straight bill discount business but allows overdrafts or accepted bills, chiefly with America, Russia, etc. 66 COMMERCIAL PAPER What business is done by discount is through receivables. All of these banks deal largely in collateral loans, as do the French and English banks, chiefly on approved stock exchange and Government securities. : INTERVIEW WITH DIRECTORS OF THE DRESDNER BANK. This is a private bank paying seven per cent dividends. Q. Will you kindly describe the item “Bills Discounted” $51,000,000 ? A. The bills constituting this item are what we call prime and merchants’ bills, running to ninety days, with an average maturity of from fifty to sixty days, and bear at least two good names. Q. Are these bills secured or unsecured ? A. They are unsecured. Q. Are most of these bills commercial bills ? A. Many of them are commercial bills. Q. You regard your item of “Bills Dis- counted” as one of practical reserve? A. Yes, it is immediately convertible into cash at the Reichsbank. Q. We understand that your system here is such that when a merchant wants to borrow money for a legitimate purpose he arranges with some bank to accept his bill, which is discounted by another bank and which may be sold at any THE FORM OF COMMERCIAL PAPER 67 moment or converted into cash through the Reichs- bank ? A. Yes INTERVIEW WITH THE SCHULTZE-DELITZSCH CO-OPERATIVE CREDIT SOCIETIES. These societies are for lending to their indi- vidual members on the liability of all members. Q. For what periods would the Schultze Delitzsch Societies loan money ? A. Usually three months. Q. What class of paper do they take in making advances ? A. They make loans in the form of cash advances or in the form of discounting bills of exchange. Q. By cash advances you mean cash credits? A. Yes, they give cash against the obligations of their members. Q. How are these advances secured ? A. Mostly by a guarantee of another member of responsibility, or by endorsement, or by a mort- gage as collateral, Q. They will take two name paper? A. Yes. They buy single name paper or extend cash credit against single named obligations with security or mortgage. The Canadian System. The Canadian Banking System is more like our own than is that of England, France or Ger- 68 COMMERCIAL PAPER many; yet it has absorbed much of the spirit in foreign banking and contains different practices from those found in the United States. Branch banking is extensively carried on, with the result that practically all the banks are very large banks and are able each one of them to do most of the banking business called for by any one customer. This has built up a very close feeling between bank and customer, a considerably closer feeling than exists between bank and customer in this country. Businesses are guided far more in Canada by the banks than they are with us. Most businesses use one only, rarely more than two banks, and largely ad&pt their finance to the sug- gestion of their bank or banks. This association is strengthened by a power given the banks in many cases to claim title to the merchandise of the borrower during the life of any borrowing from the bank by the customer. The merchan- dise, unless in the form of warehouse receipts, 1s not given, but an assignment of stock is given to be used if the bank considers matters going in a wrong direction. Borrowings, too, are arranged for at the beginning of a season for the whole season at a certain rate, not from time to time as need arises. That is, a bank says that such a company may have a maximum of credit and at such a rate, uniform for the drafts as they shall be presented. No other borrowings may be en- tered into without the knowledge of the bank. In the farming districts of Western Canada the mn THE FORM OF COMMERCIAL PAPER 69 banks lend to farmers on their straight paper unsecured by mortgage, but not to buy land or to put up buildings, only to buy seed, tools, stock or for wages, etc. The Western Canadian farmers are successful, a fact which, coupled with the purpose of the loan, ensures their notes to the banks being good. : We Seem Lax in Our Finance. In almost every country lenders are more in touch with the assets back of commercial paper than are the banks of the United States. Our method is to discount, as a rule, the single name paper of the borrower. This is perhaps a satis- factory form of borrowing in the case of the bor- rower’s own bank or banks when the condition of the borrower can be kept closely in touch with. In the larger field, however, of borrowing through many sources at a distance from the place of busi- ness of the borrower, where lenders can be only moderately conversant with the condition of the borrower, such forms of borrowing, unless excep- tionally well protected, are unsatisfactory. Most of our commercial paper offered through respon- sible channels is a safe investment, but to insure safety in commercial paper, where there is ob- viously much chance for leakage and unfair play, certain specifications must be complied with whieh should not really be necessary. At the present time, we are lending on commercial paper in this country fully as freely as are the banks in Eng- 70 : COMMERCIAL PAPER land, France, or Germany; but on paper which is not nearly so well secured. In consequence, ‘though commercial paper, owing to good business conduct, is generally in good repute, there are far more failures of it to bring payment at maturity than there should be, an amount which in golume is considerable. To protect themselves from such disaster American banks are now demanding that borrowers show a larger margin ®of safety, greater in fact than should be necessary. Borrowers Should Show Their Strength in the Form of Their Borrowing. It would be better for the borrowers, as has been shown already in the case of bonds, if they should make the form of their borrowings more attractive to lenders who cannot well be intimately conversant with their condition, for by so doing they could gain broader credit without injuring their own business opportunities. Occasionally they might not be able to gain credit where in the other case they could obtain credit; but as a rule in such cases it would be better for them not to obtain this credit. In cases where credit is deserved, by using some such method as-a borrow- ing through receivables or by a form of distinct double liability on paper, lenders are far more ready to lend than they are under a vague form of borrowing. The result is that having shown the power back of their paper in the paper, the H A — o $8 Bar. Scale 8 28 7 ~rfi- y 77 5 o yr 2324 iW i 5 > 4 “Ny ” i | Fir Copyright 1911 by Roger W. Babson Note: The large black areas are formed by combining and plotting the pub- lished figures for the past nine years on New Building, Crops, Clearings, iron Production, Money, Failures, Idle Cars, etc., in order to give a Composite Plot of actual business conditions, in the United States. The line XY represents the normal growth of the country’s business, the slope being changed whenever there is a change in the trend of conditions as shown by clearings, etc. Based on the economic theory that ‘‘action and reaction are equal’ when the two factors of time and intensity are multiplied to form an area, the sums of the areas above and below said line of normal growth XY must, over a sufficiently long period of time, be equal, provided the line XY is properly located and enough subjects are herewith included, with all properly weighted and combined. More- over, owing to the law of averages, and certain psychological laws, these separate areas tend to be equal in aree, although not necessarily in shape. Thus before 1903 1904 1905 - - - - sone wana ses ss ee - 5 T° -— i 5 BD ee E = il a LS a i rates. ——Rates for Prime Commercial Paper em Price £ 32 active stocks showing important declines and rallies. on fe eu eam me Prices: 10 active bonds, ! i The red figures printed under 1909 refer "to both red plots and show the price that both the 32 stocks and 10 bonds averaged at any "given time. printed under 1905 refer to prime commercial paper Composite Plot of the Summary Barometer Figures for American Business Conditions there is another panic or depression (which will cause another area to be formed below the line XY) the area D will expand to approximately the size of the average of areas “A,” “B’’ and ‘“C.’”" It, however, should be remembered that this next period (v hich will be called “E’’) may be of an entirely different shape from any- thing heretofore witnessed and still contain a similar area, according to whether there is to be a panic or simply a gradual liquidation. Knowing that the areas tend to be equal, one can always estimate the length of any period by watching each week its height, or ‘‘rate of flow,”’” which shows how rapidly it is being con- sumed. The red solid line represents the average price of active stocks, the red dotted line the average price of active bonds, and the solid black line represents the average interest rate for prime commercial paper. A study of these lines shows that the high point of the stock market has come when the prosperity area is about one-fifth to one-quarter consumed and the low point has come 1907 1908 1906 The black figures Entered at Stationers Hall, London when the depression area is about one-fifth to one-quarter consumed, that I money rates and high bond prices have come at the very beginning of a pr perity area and high money rates and low bond prices at the beginning of a d pression area. To use this Composite Plot in connection with one’s own bu ness, the observer should plot his own sales thereon and note what portion the respective areas has been consumed when his own sales were greatest smallest. When using this plot for any purpose, it should be remembered t it refers to the minor cycles and not to the major cycles shown by the dotted Li on the stock market chart filed under Division IX of the Book of Charts a also that this work in its present state should be watched in conjunction wi other data and not be treated ‘“‘as a rule of thumb’ and substituted for indepe dent thought and judgment. 1909 1910 1911 124 » ° aw . E4EETESZRY SmR<=EsAa