CHAPTER XXI COMMERCIAL PAPER HOUSES AND While the chart on page 136 indicates that working capital is typically loaned directly by commercial banks to their customers, it also shows that such credit is often extended indirectly -through the intermediation of commercial paper houses and discount or commercial credit companies. It is the purpose of the present chapter to reveal the nature and the economic significance of the services that are rendered by these recently developed financial institutions. The commercial paper house is an outgrowth of the note brokerage business that existed in this country in the early years of the nineteenth century. It was not until well after the Civil War, however, that the modern phase of the business developed the phase, that is, that distinguishes the work of the commercial paper house from pure brokerage; and its greatest growth has come only during the last fifteen or twenty years. The discount companies are of even more recent development. While some of them purchase accounts receivable from many different types of business, these companies, as we shall see, owe their most significant development to the automobile industry and the exigencies with which its financing has been confronted. A. Commercial Paper Houses The early business of note brokerage arose in response to a very definite economic need. It was often found by the business men of a given locality that at times it was impossible for them to secure from local banks all the funds which they required; and at certain seasons it was accordingly necessary to seek banking accommodation in other centers. And since it was not always possible, or at least convenient, for the borrower personally to arrange for loans at a distance, certain individuals seized the opportunity of obtaining commissions by acting as brokers in effecting the sale of notes and bills of exchange owned by merchants and traders. It should be understood that the note broker did not advance the funds to the borrower: he merely undertook to sell the customer's paper in return for a commission; and in case no sale was effected the paper was returned to the borrower. It goes without saying that in order to effect a sale the broker usually undertook to convince the lending banker that the borrower was a man of high character and ability. It must be borne in mind, however, that the broker in no sense guaranteed the paper; his service was merely that of intermediary between borrower and lender. With the rapid development of the country following the Civil War and the increasing volume of intersectional borrowing that attended the ever-widening scale of our economic and financial structure, the note brokerage business was gradually superseded by the work of the commercial paper house-an institution that has aptly been called a quasi-banking establishment. I. PRACTICAL OPERATIONS The commercial paper house acts as a broker in that it brings buyer and seller-that is, lending bank and borrowing customer -together, and receives a commission, regularly one-eighth of 1 per cent of the face value of the note; but it is more than a broker in that it advances the funds to the borrower and runs the risk of having to hold the paper until maturity. Where the note broker merely said to the borrower, "I will sell your note to a bank if I can and charge you a commission for the service," the commercial paper house says, "We will advance you the funds on your note and then dispose of the note to a banker if we can; but if we cannot dispose of the paper we will carry the loan until maturity." It should be understood that the commercial paper house never desires to hold the paper to maturity, that it seeks to make its profits out of the commissions which it receives as middleman. And since its chance of large profits lies in obtaining commissions on a very large volume of sales, it will be seen that carrying paper serves to reduce the profits that can be made. In fact, moreover, the cases where the commercial paper house does hold the paper until maturity are relatively few. It should be observed, however, that in all cases the commercial paper house may have to make a temporary advance of funds, during the interval of time between the purchase of the paper from the borrower and the sale of it to a commercial bank. This interval is normally very brief, for the marketing mechanism has been developed to a point where most paper can ordinarily be very quickly marketed. The commercial paper house requires relatively small financial resources. The fact that the commercial paper house buys the paper outright and agrees to hold it to maturity in case it is not marketed suggests that the commercial paper house must have large resources of its own. The truth is that the capital employed by commercial paper houses, as in the case of the investment banks, is relatively small in proportion to the volume of business conducted-for the reason that they are in a position to borrow heavily from the commercial banks. In case a house has on hand paper that the market will not absorb, it can borrow the funds necessary to hold the paper until maturity, by using the notes of customers as collateral for a loan. At all times, indeed, the commercial paper house usually borrows a very large percentage of the funds required to finance its temporary holdings of paper. Suppose during its active season a house has on hand a daily average of $1,000,000 worth of paper. On the basis of its own promissory note, secured by customers' notes as collateral, it could borrow from eight to nine hundred thousand dollars from the commercial banks. As the notes which are deposited as collateral are sold, either the volume of loans from the banks will have to be reduced or else other notes (newly acquired) will have to be substituted for those withdrawn from the banks. Through its ability to acquire funds for the purchase of additional paper by pledging the notes of its customers as collateral, a house may pyramid its resources many times and thus receive commissions on a tremendous volume of business. Some houses, indeed, handle several hundred million dollars' worth of paper annually. The capital of the commercial paper house, it will be observed, is thus mainly employed as a basis for credit with the banks from which it borrows. We have said that the commercial paper house seeks to derive its profits from brokerage commissions rather than in the form of interest on loans. It will be noted, however, that interest is received on all paper during the time it is in the possession of the commercial paper house. The profits derived in this connection may be said to represent the difference between the rate which the paper bears and the rate at which the commercial paper house borrows the required funds from the banks. Since the commercial paper house is a very highgrade risk, owing to the fact that it is a responsible financial institution and offers excellent collateral besides, the rate at which it can procure funds is typically a little lower than that of an ordinary borrower on unsecured paper. The commercial paper house may, however, sometimes make a profit and sometimes sustain a loss, owing to a difference between the rate at which it discounts the borrower's note and the rate at which it disposes of the paper to banks. In an ordinarily steady market there is seldom any difference between these rates, but during periods of rapidly changing financial conditions there may be an appreciable margin. When there is a precipitate fall in money rates, the commercial paper house finds its commission, in effect, supplemented; but when there is a sudden rise in interest rates it may find that the loss sustained is more than enough to cancel the amount of the commission. The commercial paper house carefully analyzes credit risks. Since the commercial paper house is a lender of funds, pending the sale of the paper to the banks, and since it risks its own resources in making such advances, it is obviously incumbent upon it to make a careful investigation both of the conditions of the money market in general and of the credit standing of each particular borrower. The broker must exercise great prudence and foresight in making his loans. He must follow closely the trend of the times, be possessed of a good knowledge of business conditions in general, understand and anticipate the effects of larger seasonal demands for money, such as attend the moving of the crops in the fall; he must study the possible results of pending legislation and international entanglements, and be prepared for a multitude of other situations that might affect the status of money and credit in the country.' Since the paper dealt in by commercial paper houses is largely single-name, it is necessary for them to make a careful analysis of the business integrity and of the financial position of the borrower, as recorded by a balance sheet or financial statement. The better houses have, in fact, developed elaborate credit departments, which are equipped to analyze credits with an efficiency equal to that of the credit departments of the large commercial banks. While commercial paper houses analyze the credit standing of borrowers before purchasing their paper, it is important to note that they do not guarantee the paper--they merely warrant that it is legally executed and that it is the genuine promise to pay of an actual person or corporation. The banker buys the paper, not on the strength of the commercial paper house's indorsement, but on the strength of the borrower's own financial standing. Indeed, the commercial paper house does not indorse the paper which it handles. A note is made out "pay to the order of ourselves," rather than to the order of the commercial paper house; and is then indorsed in blank by the makers. It is accordingly unnecessary for the commercial paper house to attach its name to the document, for the title is transferable by mere delivery. In lending funds through the purchase of commercial paper, the bank must either rely upon the analysis that has been made by the commercial paper house or make an independent credit investigation of its own. It will be seen that, since the commercial paper house has risked its own funds, From an address by Walter McAvoy delivered before the Mississippi Bankers' Association, March 12, 1918. |