Stock-Market Credit
THERE are those who believe that the present bank and credit situation is not inflation. They point out that the Federal Reserve ratio is comfortable, there is surplus gold, and commodity prices have not risen. They compare the present reserve statement with that of 1919-20; they point out that business is in a healthy condition, with inventories low and little future commitment. Fundamentally, they believe that no situation can he described as inflation unless commodity prices have gone up and credit is largely extended to commerce and manufacturing to carry a great accumulation of goods at high prices. Inflation, for them, is the artificial increase of credit beyond the requirements of business which is reflected, not in any corresponding increase in activity, hut in a general advance of prices. Some even believe that the extension of credit on securities may increase indefinitely, as it has but slight effect on the consumers’ income and merely consists in taking money out of one hank account and putting it into another.
There is for certain a groat difference between the results of overextension of credit to the Commodity market and overextension of credit to the capital market, Perhaps they should he given different names: inflation for the former and distension for the latter.
It is noticeable t hat, most of the alarmists in the present situation are bankers or financial men. Business men, farmers, and merchants are not worried, and are inclined to wonder what all the row is about. This is natural, as the present typo of inflation or distension concerns the banker and the financial houses almost exclusively.
A bank is liable to its depositors for large sums on demand at a moment’s notice. Experience shows, however, that only about 10 per cent of a bank’s depositors will draw down their deposits at any given moment, and that therefore the bank needs to keep only this percentage in ready money. The rest it can lend to merchants and brokers and depend for its profit on the spread between the good interest thus received and the low interest it pays on deposits. The only important, concern of the banker is that the 90 per cent of deposits which he lends to merchants and brokers should be absolutely safe.
Banks in large cities are subject to large and sudden calls from their depositors, because they hold the deposits of large corporations and out-of-town and foreign banks. Any shifting of funds from one district to another or from one country to another affects these large city banks first and most severely. For this reason they must keep their assets even more liquid than does the average bank, and they are apt to employ a considerable portion in the callmoney market, or in treasury certificates, commercial paper, and acceptances which can he sold at a moment’s notice. The callmoney market is a sort of pool or reservoir of credit under the stock market, into which or from which each eifv hank is pouring or drawing Large blocks of money necessary to offset temporary increases or decreases in its deposits. It is usually considered one of the safest means for employing extra funds, and call-money rates are usually lower than other rates.
It is essential to this safety, however, that the hanks do not lend too much on securities; for, if they should call loans representing any large proportion of the total stocks and bonds listed, the market might be swamped and the collateral not salable. Also, it is essential that tile amount lent on any given stock or bond should not be more than a conservative investor would pay for that stock or bond, else, if the hank or borrower should try to sell it in a declining market, he might never he able to realize the amount of the loan. Even if the banker has lent only a very conservative amount on a certain stock, it may take time to sell that stock if the total of stocks for sale in a given period is greater than the savings available for investment in that period.
The function of the brokers’ loan or callmoney market is to aid in the distribution of securities, just as the function of a commercial loan or acceptance is to aid in the distribution of commodities. From a banking standpoint, the accumulation of large ‘inventories’ of stocks and bonds at high prices is similar to the accumulation of large inventories of cotton, sugar, copper, and other commodities in 1919-20. The principal difference between these two types of inflation is that commodity inflation will soon bring about its own downfall by the paying out of currency into circulation, whereas security inflation may increase almost indefinitely.
If, therefore, the banks’ loan envelopes contain a quantity of stocks which is large in comparison to the current investment demand, their assets may not be liquid; and if the banks’ margin values are not well below the level where the investing public will buy, the banks may not be solvent.
No one can say, of course, at exactly what level the investing public will buy, and, therefore, at exactly what level the stock market might settle after a bad break. However, it is possible to make a rough estimate. The banker must play safe for the sake of his depositors, and so he will assume that the conservative investor is no less conservative than he used to be, and that stocks should yield more than bonds and bonds yield more than short-term loans, which is the normal condition in this country. It is possible that we have entered a new era, and the conservative investor has changed his habits, but it most certainly would be unwise for a banker to make any such assumption.
The Standard Statistics Company’s average of yield on the ninety leading investment stocks (industrial, railroad, and public utility) is now 3.26 per cent, the yield on sixty gilt-edged bonds is 4.68 per cent, and the yield on short-term loans of various kinds is probably about 6 per cent. The yield structure is therefore upside down. For the last year, people have bought stocks not for yield, but to sell out higher up. This is not conservative investment. The banker is not justified in assuming that people will always do this; on the contrary, there are obvious reasons why the stock market cannot possibly go up at the rate of 30 per cent a year (as it did in 1928) forever.
Under present circumstances, the banker is not justified in assuming that the conservative investor will pay more than a 5 per cent yield for stocks. The average price for ninety stocks is now 205.7, at which price they yield 3.26 per cent. In order to yield 5 per cent, the price would have to drop to 136.7, or 34 per cent. The average brokers’ loan among New York City banks is probably protected by a margin not greater than .50 per cent, which means lending 135 on stocks worth 207. If the stock market should decline to a 5 per cent basis, therefore, a large number of loans would be ‘ frozen.’
The total amount of loans on stocks and bonds listed on the New York stock market is now about $10,000,000,000. of which $6,500,000,000 is on call to brokers and dealers. If the average margin is 50 per cent, there must be $1,5,000,000,000 worth of stocks and bonds in loan envelopes of the principal New Aork City banks, of which $10,000,000,000 worth is subject to call. The average price of a share of stock is about $85, so that there are probably more than 100,000,000 shares of stock in these loan envelopes at the present time, subject to call: and an additional 50,000,000 shares of stock not subject to call, but payable at fixed dates. In view of these figures it is needless to emphasize the danger of any proportion of these loans being called within a Week, and the impossibility of finding enough investment money to absorb the pledged securities within that week. The liquidity of these call loans is therefore somew hat problematical at the present moment. We have had twice in the last three months an intimation of how last the stock market could go down, once started. In December the market dropped 10 per cent in three days, one of them a Saturday. In March it has dropped as much as 6 per cent in two days, with several ‘ loan-envelope stocks’ off over 20 per cent in a few hours. It has clearly shown its temper, and on two recent occasions has become thoroughly demoralized.
The alarmist school of bankers and financial men are not saying that the market will have a sensational break. They are saying that, if the market should have a sensational break, a large part of their assets might be frozen. Is it any wonder that they should hesitate to extend further credit to the stock market ?