Bootleg Loans
THE most conservative bank in my town has a million dollars lent in Wall Street raising the prices of stocks which it advises its clients not to buy because they are too high.
I
When our credit machinery was taken off its old bushings and mounted on new bearings through the establishment of the Federal Reserve System, the prediction was freely made on all sides that we had done with money panics. Credit, which is merely a promise to pay, could, so it was predicted, be spun out and reeled in as business expanded and contracted. There would always be enough, but never too much or too little, to meet the legitimate needs of business. This expansion and contraction would take place largely automatically under an interest rate which would change infrequently. The only dissenting voice I heard was that of a Yale economics professor, a conservative New Englander, who dinned this one sentence into the ears of his classes: ‘Gentlemen, any credit machinery which makes borrowing easy is dangerous.’
Hardly had the new system got under way when seeming necessity demanded the spinning out of an enormous volume of credit to finance the war. More was spun out than could later be reeled in without immediately harmful results to business. Inflation continued to grow and commodity prices continued to soar. The excessive inflation carried the seeds of its own destruction, and the catastrophe came in the spring of 1920, about the time a group of Atlantans went on a buyers’ strike, paraded the city in overalls, and swore that they would wear no more clothes till prices came down. Prices came down with a thud, and with what results business still remembers. But nobody credits the Georgians with having brought about the fall. Prices simply rose till they could rise no more.
There is a tendency in many quarters to blame the Federal Reserve Board’s easy-money policy in the summer and fall of 1927 for the stock-speculation craze which has swept the country. The rate of interest which the Federal Reserve banks charge for loans made to member banks was reduced. The purpose of this reduction was to create a differential between the rate of interest in the United States and that in England and European countries. The higher interest rate in England and European countries attracted funds from the United States and caused an outflow of gold needed by the Bank of England and other central banks. The low interest rate in the United States encouraged borrowing not only on the part of those engaged in industry, but also on the part of those who speculate in stocks. Whether this policy or something else was the immediate cause of speculation, it is a fact that a speculative mania has spread, and stock prices have risen to unprecedentedly high levels. Should a deflation in stock prices occur, the devastation wrought would be laid at the door of the Board.
It is quite likely, however, that even its severest critics could not, or would not, have met the derangements growing out of the war with more fortitude or wisdom.
Whatever the cause of the craze, it is better now to try to cure the disease than to explain how we got it. There may be plenty of time later to reflect.
During all the trying months of 1920 and following, one scarcely ever heard mention of ‘ brokers’ loans.’ This is a term which applies to that class of loans secured by stocks or other securities. To illustrate, suppose the reader who has $10,000 in cash desires to purchase 100 shares of common stock of the American Telephone and Telegraph Company, which, at $212 a share, would cost $21,200. He turns his $10,000 margin over to his broker as agent. The broker, adding $11,200 of his own money, purchases the stock and has the certificate registered in his own name. In order to replace the money which the broker expends, the client borrows from, a bank or elsewhere, pledging the stock as collateral. If for any reason the client desires or has to sell this stock, the broker in effect pays off the loan, releases and sells the stock, and credits the client with the proceeds, less interest, commissions, and expenses. Millions of such transactions, with others like it, are responsible for the increase and decrease in brokers’ loans.
Even at the peak of commodity prices in 1920, the amount of these loans was about one and three-quarter billion dollars, and about half of them were liquidated during the period of deflation. But such loans counted little; and, even if they had counted much, they were under the same direction as other loans. Most credit, regardless of its purpose, was emanating from the same sources, the greater part of it ebbing and flowing through the Federal Reserve and member banks and, therefore, under the observation of the Federal Reserve Board.
But times have changed. We are nowfaced with a novel situation in which at least one half of the credit in speculative use in the stock market is obtained from sources other than banks, and subject, therefore, neither to banking guidance nor to any other unified control. Of the nearly six billion dollars of brokers’ loans, nearly three billions, commonly known as ‘ bootleg loans,’ got into the market in the same helterskelter manner, although not through the same channels, as loans for speculation did prior to the establishment of the Federal Reserve System.
Formerly, corporations and individuals lodged their surplus funds with their local banks, and these passed them on to New York banks and received a small rate of interest on the balances carried. The New York banks in turn passed this credit on into Wall Street in the form mainly of brokers’ call loans. Now banks outside of New York, private individuals at home and abroad, corporations, and investment trusts have come to make their own loans to Wall Street brokers largely directly or through New York banks acting merely as agents. This method of placing three billion dollars on loan in the stock market brings us face to face with the question whether, in spite of all that has been done to prevent and forestall it, we may not yet again run into a money panic similar to those which have occurred in the past. The credit pool in Wall Street, supplied now by two streams, one thoroughly fdtered and metered, the other altogether unfiltered and unmetered, may be no less polluted or dangerous than when, as formerly, it was fed by only one, which was indifferently filtered and metered. Under the old system, there was at least a sort of loose affiliation and understanding among the big New York banks and their interior relatives. The New York banks were held together by their clearing-house association. Now there is not even the semblance of an organization among those who are furnishing more than one half of the funds devoted to speculation.
Just what would be the result if that state of the public mind which has made possible the present inflation of stock prices should receive a sudden shock? No orderly procedure has been followed in placing these loans in the market and none would be followed in withdrawing them in the case of a crisis. There is slight possibility, and less probability, that those individuals, widely scattered banks, corporations, and investment trusts could take concerted action to meet a danger. Should some mishap befall the stock market, each would be so busy saving himself that he would have scant time or inclination to save others. Should a day of retribution come, this class of lenders and the brokers to whom they had made loans could with ill grace turn for help to a banking system whose advice and counsel they had spurned; but this is precisely what they would have to do. Moreover the banks, however forgiving and charitable, might have their hands full handling a situation which they had tried in vain to prevent. Stocks in small amounts are wholly liquid, but in excessive amounts are logy far beyond popular belief. The fall in the price of stocks which could result from the attempted sale of a very considerable portion of the collateral now securing the three billions of bootleg loans would be staggering.
It seems, therefore, that at least as much of the present danger lies in the character of the loans and the way they are made as in their size. Brokers’ loans make for higher stock prices, and higher stock prices make for more brokers’ loans. The fact that the ratio between the value of stocks listed on the New York Stock Exchange and the amount of brokers’ loans remains fairly constant signifies nothing. The ratio could not be otherwise when it is the result of two circumstances which are both causes and effects of each other.
II
As to those individuals who make loans directly to brokers rather than deposit their surplus funds in banks or buy securities outright on their own account, little can be said. One need not try to answer the argument of him who says that it is poor business to keep his surplus idle or set it to work in a bank at 2 per cent when by putting it to work in Wall Street at 8, 10, or 20 per cent he himself can stop work altogether. He is his own master; his obligation runs mainly to himself; and he bears the consequences of his own action.
But corporations and investment trusts stand on an entirely different ground from that of the individual. The officers of each serve in a fiduciary capacity. They are obligated to act in the best interest of those they represent. Lending funds in the stock market on call — that is, on condition that they will be repaid on demand — is a matter of corporate management, and management in the absence of a showing of fraud cannot be interfered with even by the stockholders themselves except by vote.
The calling of the loans made to brokers by a half dozen or so large corporations, if the calls should be made simultaneously, would shock the stock market. It is, of course, a great satisfaction to believe that the directors would engage in no such nefarious scheme as selling the market short and then calling the corporate loans to break it and cover — that is, borrowing stocks and selling them at a high price, and then calling the corporate loans to break the market, in order that they might buy stock at a low price to return what they had borrowed. But, too, there is a restful sense of security growing out of the publicly announced policy of other large corporations that they will avoid even the appearance of evil and make no loans for speculative purposes.
The question of brokers’ loans as it relates to so-called investment trusts presents a peculiarly nice question in business ethics. The fundamental purpose of these institutions is to invest as advantageously as possible, in a wide assortment of stocks, the funds of hundreds and thousands of persons who have entrusted their money to them. What can be said of the propriety of a policy of lending a surplus in the stock market which, although temporary as to any one of these institutions, tends constantly and increasingly to raise to all of them the prices of the very securities which they are supposed to buy as cheaply as possible? On the other hand, how would public sentiment toward all investment trusts be affected if, in order to break the market and buy at a bargain, some should call their loans and force the sale of the stocks which secure them, thus depressing prices? Such a policy would convert what is supposed to be a trust into a speculative pool.
All these bootleg lenders have, in effect, made the stockbrokers their bankers for their most mobile funds. They draw on their broker-bankers at sight when in need of a little spending money. Should any unusual condition arise, they would use these funds first. Just what reserve do these broker-bankers carry against these deposits? The belief that they are Midases who can always turn stocks into gold is their refuge in case of a run.
The brokers’ credit reservoir of six billions is drained and replenished by fits and starts, and the waters are kept constantly troubled. The evidence is an interest rate for call money ranging from 6 per cent to 20 per cent this year, the highest since 1920. The disturbance would be even worse and the call rate even more unstable if the banks were not at hand to pour back what the bootleg lenders drain off. But the member banks of the Federal Reserve System have been requested to stop it. The Federal Reserve Board is using its influence to check the speculative mania. The Secretary of the Treasury has measured his words and given out a sane statement that bonds are now a better bargain than many investment stocks. Even those of us who prefer investment stocks must take heed.
We are witnessing an interesting contest between an institution created by government, whose attributes are continuity and sovereignty, and a bold group of speculators whose tenure in power rests upon public enthusiasm, and whose idea of a Lenten celebration is to run Radio New Common from 68 and something to 109 and something in the face of a reported statement of an official of the company before a Congressional committee that the stock is high even at the former figure.
To those who have observed government at close range the outcome seems inevitable. The individual or institution that enters an endurance contest with sovereignty rarely wins. To the Federal Reserve Board victory means nothing except a delicate official responsibility wisely met. It has no vanity to be pampered. But to those so stiff-necked that they will not hearken, defeat means everything — ruin to themselves, loss to others. It remains to be seen whether the recalcitrants will yield or whether they will have to be broken. They have had their chance, and if they do not yield, then they will be broken, because they drive authority to break them. Or they will pull their own house down upon themselves.
III
Speculation is about to ‘get the bust’ on business. ‘Getting the bust’ is a Southern colloquialism describing a situation wherein a boy, after having roped a calf, has to run as fast as the calf does or get a spill. The accepted method of getting out of such a predicament is to manœuvre the calf toward a sapling, brace up, pass on one side, and, getting a half cinch, allow the calf the privilege of passing on the other. The Federal Reserve Board has shown better manners. It has forewarned its victim.
Speculation has begun to influence general business rather than to discount what business would be under normal conditions. We economists have been preaching the virtues of speculation for a long time. We know that selling short, selling for future delivery something one does not possess and later buying to cover, — that is, buying to fulfill this future contract, — tends to keep high prices from going higher and low prices from going lower. By and large, this is generally true. It might work out that way always if every price situation were a natural one.
Speculative profits depend upon price fluctuations. The wider the amplitude of the price swing, the greater the chances of big profits to the few in strategic positions. For the sake of the big profits, the few may create artificial fluctuations. When this is the case, speculation defeats its purpose and belies its economic significance. With stock-market pools and rumors of pools abroad in the land, it is hard to believe otherwise than that many stock prices have not risen or fallen, but have been put up or down.
The long period of rising stock prices and the general participation of the public have made big profits possible to many for the first time. These profits, which came easily, represent purchasing power which has been leveled against production and has thus stimulated industry. The stimulation up to date has manifested itself in an increase in demand in the sense in which the economist uses that term — namely, that more has been taken at the same price than formerly. This was possible because of the excessive productive power left over and redirected after the war.
Seemingly we have about reached the end of the tether. Some commodity prices are beginning to creep up, and if this continues we may see an industrial boom, commodity inflation, and the inevitable attendant, collapse. Note copper, just admitted to the speculative-metals market. Recently one producer raised the price to twentythree cents a pound. Others did not follow, but the next day it went to twenty-four. Those who use the metal are scurrying around to find substitutes. An increase in the price of copper is no longer good market news.
On the other hand, if speculative stock profits should suddenly vanish, the purchases which they have been supporting would cease, and a backwater in production would result.
Long ago the stock market ceased to be an accurate barometer of future business conditions, and speculative stock profits have begun to weigh heavily in determining those conditions. One well-known economist estimates that stock prices at the present level have discounted the future to the extent of eight years of growth and activity uninterrupted. One may well believe it when he secs the country paying 10 and 20 per cent for money borrowed to buy stocks whose dividends will not pay a quarter of that amount and whose earnings even are not equal to those figures.
So it comes in the end to this, that men are willing to pay exorbitant interest to carry stocks which somcbody will buy from them at a profit; and the number of such has been legion. To such operators altitude of the price is of little concern so long as buyers will take the stocks off their hands at more than they paid for them.
But somewhere in this human chain there is a group of last men, and they must get their operating expenses and profits, if at all, from the cold dividends or earnings of the corporation. If they cannot, they will sell the stock they already have or refuse to buy more on such terms, or do both. These men are now overwhelmed and inarticulate, but they will rise to the surface in time and declare a stock-buyers’ strike. It is this group which finally learned during the Bubble Period that after all it was more profitable to put money into English shipping than into raising jackasses in South America.
How long, O Lord, how long!