ae ora irises Sareamreretbat as ree Sea Se esCs eo ean ere a Ss a aoe SSS eae eee } } : 4 i ; : | b | i | 4 Ih | HI VIRGINIA LIBRARY | IU | | UNIVERSITY OF | 609Scr00X gun Vf IKY ta f ae aS ER }j } t | i | .; i : EE rep AE ac Ete NR ANCA Na LA A ANE BINT LR RTI. IE a ae ce a a ;PRINCIPLES OF AGRICULTURAL CREDIT BY VIRGIL Pf! LEE Agricultural and Mechanical College of Texas Copyright 1927 VIRGIL P. LEE Mimeographed and Printed by EDWARDS BROTHERS ANN ARBOR, MICH.Chapter 1, Ze Se ll. 12. 14. 5 CONTENTS The Importance of Credit in Agriculture ... .« Part I - THE INVESTOR Sources of Credit 6 ice 6 sa we = a em ene The Dirgeebiuon oc ohne Blow of Creaat .« vy « =e Part II - THE BORROWER Purpose of Loans - Classification .« « « « « « e Purpose of Loans - Investment . . « « « « « «= = Purpose of Loans - Operating .« « =» « « « « « e Purpose of Loans = Consumption . « « » « « «© « Security fom parm Creadit -5 6 «5 « < = «6 ss Appraisal of Security for Operating Loans Appraisal of Security for Long-Term Loans Forms and Legal Aspects of Farm Security .« » - TUTIONS Part III = BANKING INSTIT for Farmers Development of Credit Institutions for The Commercial Bank and Farm Loans .. « « « e Farm Mortgage Banks «+ « « ee «© «© © © «© @ © 2 Intermediate Credit Banking Institutions . .« « Page 13 33 51 60 ae 89 100 125 153 176 213 232 257 . a | : | 7Chapter i THE IMPORTANCE OF CREDIT IN AGRICULTURE Credit has come to occupy such an important position in the production and exchange of goods in all lines of industry that many writers have described our whole economic system as "a credit society", signifying that the extensive use of credit is the outstanding characteristic of modern businesse More frequently our modern economic system has been called a "capitalistic system", because of the extensive application of capital as a supplement to lobor in production. But students of finance have emphasized the fact that the development of credit has made possible our present extensive use of capital; that although the “capitalist- ic system" had its impetus in the mechanical inventions, the use of credit has been of inestimable importance in concentrating the accumulated capital of whole populations into business organizations of sufficient size to be capable of utilizing the new inventions to the best advantages One writer has given three bases for the developmant of the modern credit system: "First, a sense of business morality, or what may amount to the same thing, a recognition of the fact that honesty is the best policy; second, a relatively stable monetary standard for deferred payments; and third, a legal system designed to safeguard the rights of individuals and to enforce a prompt fulfillment of contracts." He says further that "the evolution of these three suvports of the credit system has been one of the most significant features of the transformation from medieval to modern industrial society*. In order to make any accurate estimate of the importance of credit in our whole business structure, it will be necessary in the beginning to make a clear distinction between credit which is used primarily for convenience in exchange and credit which is obtained because of a lack of funds. It may be found, for instance, that credit has almost completely replaced money in exchange transac- tions, while not more than one-fourth of the operating and investment capital of the country is borrowed. Credit for Exchange Credit is used extensively in exchange transactions. The convenience of the check as a medium of exchange has resulted in the replacement of money in the majority of business transactions. The exact percentage of payments which are 1, H. G. Moulton, The Financial Organization of Society, p. 128.EEC EO made by this type of credit instrument is not known, but estimates have been made which indicate that it is very high. The National Monetary Commission of 1908 found by an analysis of the receipts of a large number of banks "that a large proportion of the business of the country, even the retail trade, is done by means of credit instruments",* The study showed that in the retail trade 50 to 60 per cent of the transactions are settled in this way, and that in the wholesale trade over 90 per cent of the payments are made by checks and other credit instruments. "We may, therefore, safely accept an average of 80 to 85 per cent as the probable percentage of the business of the country done by check."9 Under the caption "Credit without Money" an English writer? very effective-~ ly describes the importance of credit as a medium of exchango by the assertion that it is just as accurate to, say that money is a substitute for credit as to say that credit is a substitute for money. He states that moncy has the two- fold function of being o standard of vaiue and a means of discharging debts, but that in the latter function it has been largely supplanted by credit. Histor-° ically, credit has been substituted for money, but in our daily business trans- actions it can be said that money is in reality used only as < substitute for credit. If we exclude the small rctail transactions in which money is more con-~ venicnt and the relatively small payments made by "strangers", it is not an ex- aggeration to say that money as a medium of exchange in the more highly civilized countries is practically obsolete. Credit for Operation and Investment But credit used to facilitate exchange is only one phase of the subject. In fact in business transactions credit instruments used for convenience in exchange are ordinarily considered as "cash" in contrast to credit, which involves more time and which is obtained becauso of a lack of immediate purchasing power. It is only when referring to the latter type of credit that we speak of the creditor as @ lender and the debtor as a borrower. The most tangible measure of the sig- nificance of credit in business operations is obviously the percentage of the total investment and operating capital which is borrowed. It should be remember- ed though that this measure falls short of fully describing the importance of 2and 3. David Kinley, The Use of Credit Instruments in Payments in the United States (Report of the National Monetary Commission), p. 99. 4. R. G. Hawtrey, Credit and Currency, p. 15.3 credit in production. For instance, if it is found that farmers borrow 20 per cent of their operating capital, it does not follow that this figure measures tre full significance of operating credit. Credit is the flexible element which makes it possible to have the proper amount of labor and supplies at the right time. A timely loan of an amount equal to 20 per cent of the total amount of operating capital used may double the production of the farm. Likewise the acdi- tion of 25 acres to a 100-acre farm by borrowing may increase the farmer's pro- ductivity by more than 25 per cent. It is difficult to make an accurate estimate of the percentage of the oper- ating and investment capital which is borrowed. At present the best way of getting this information is to examine the financial statements of business ¢on- cerns. But even the financial statement does not give evidence of the exact proportion of the credit which is used for securing operating and investment capital. For instance, a part of the funds obtained from a long-term bond issue may be used as operating capital, or on the other hand, funds secured througn short-term notes or bonds may be used for capital investment. The accountant knows that the "current liabilities" should not exceed one-third or one-helf of the "quick assets" of a business, but these limitations scareely form a bésis which is definite enough for a conclusion regarding all business. From a purely logical standpoint short-term credit should be used to secure operating cépital, but in actual practice this is not an inflexible rule. Hence if any definite estimate is to be made as to the extent to which American business is run Om credit, operating credit and investment credit must be combined. Industrial Credit - An analysis of the financial statements of 188 cempanics in the leading industries in 1921 has shown that an average of approximately 25 per cent ef the total capital used is borrowed.” The average percentage of borrowings of these companies varied from 25 to 30 per cent from 1914 to 1921. In 1921 approximately 15 per cont was represented by long-term borrowings and 10 per cent by short-term borrowings. © The percentage of the total capital employed which was represented by borrowed capital varied in 1921 from 14.3 per cent for department stores to 48.6 per cent for slaughtering and meat-packing companies. It is reasonable to assume that these figures are representative of merchandising and manufacturing establishments of the country since they are based upon an analysis of the financial statements of companies representing the leading branches of commerce and industry in the United States, 2 5 and 6 James H. Bliss, Financial and Operating Ratios in Management, p. 175. Loe rree EG teeth UE RES 4 Public Utility Credit - The proportion of borrowed capital in the public utilities seems to be considerably greater than in industrial and commercial con- cerns, if we take railroad financing as being representative. The reports of the railroads to the Interstate Commerce Commission show that an average of 53.8 per cent of the gross capitalization of American railways from 1890 to 1921 was represented by bonds and 46.2 per cent by stocks. / The range of the percentage of bonds during this period was 49 to 59, a gradual increase having eccurred since 21900. Government Credit - Borrowing has likewise come to play a very important part in government financing. It is impossible, however, to trace the relation between the capital employed and the amount of borrowings, since government funds ane@not always invested in what we ordinarily call productive enterprises. Fer example, a large part of the present indebtedness of the Federal Government is due to the recent war from which we expect no immediate financiol returns. Funds spent for public parks or school buildings sre not financial investments in the sense that the purchase of a factory is an investment for the industrial curveration. Hence the relative importance of ercdit in the financing of federa: al, sétatc, and local governments must bo measured in some other way. A measure which at least is suggestive is the. percentage of the annual receipts used to pay interest on borrowings and to provide for payment of the principal of the debt. From 1921 to 1924 the Federal Treasury used an Average of approximately 29 per cent of the total ordinary receipts te pay interest and to provide the sinking fund for payment of the principal of the public debt. Another illuminating comparison is that of our government debt with the total wealth of the country. Such comparison can logically be made since there is a direct relation between the amount of wealth in the country and-the ability of the government to collect taxes. The total debt of the federal, state, and local governments in the United States in 1922 amounted to approximately 10 per cent of the estimated total wealth of the country. The debt of the Federal Government comprises about 72 per cent of the total, while that of counties, muni¢ipalities, and other local units was about 25 per cent, and that of state governments 3 per cent, ® CREDIT IN AGRICULTURE The extensive use of credit by American farmers is a recent development. eat is explained largely by the phenomenal increase in tho value of the invest- ment and operating capital used in farm production, and in the commercialization 7. S. Le Miller, Railway Transportation, p. 472. 8. Bureau of the Census, Wealth, Debt, and Taxation, 1922.5 of agriculture.. The increase in investment capital is due, in the first placc, to the increase in the price of farm lands, building materials, machinery, and livestock; and, secondly, to the improved quality and increased quantity of machinery, livestock, end improvements which are necessary in the more intensive stage of agricultural development which we are onteringe Likewise the commercialization of agricultural production has had a great influence upon the use of credit, particularly operating credit. From the semi- self-sufficing stage of agriculture of the early nineteenth century we have developed to a high degree of specialization. The practice of specinlizing in the production of one or 2 very few crops and depending upon buying in the market, rather than producing a great variety of commodities and consuming them at home, has increased the farmer's credit operations in two distinct ways. In the first place, the necessity of buying the goods he needs during the year, rather than operating on his own stored-up products of the previous year, has led to his dependence upon others, in greatcr or less degrce, for operating capital. That is, instead of storing upethe "cash" which he receives for goods, he spends it and shifts the financing of his next crop to the merchant and banker. The practice of being one year behind in financing is most prevalent among farmers in the one-crop sections of the country, such as the cotton and wheat belts. The crop is usually sold in the summer and fall and the receipts are largely absorbed in the payment of debts incurred during the growing season. It is common practice to begin borrowing again some time during the first quarte: of the following year. The primary cause of this practice is specialization and the resulting dependence upon outside sources for most of the goods needed by the farmer. Also, the farmer's income is in the form of money, and cash is easily spent. In ecarlier days there was no question of spending. The farmer either stored away sufficient provisions or else subsisted upon a scanty supply. Now many farmers look to the future crop to pay for present purchases. This practice accounts for a large share of the modern farmer's operating credit problems. In the second place, commercial or specialized farming has greatly extended the time intervening between the maturity and consumption of agricultural pro- ducts. Time is required to locate markets and transport the commodities to. all parts of the world. -The modern process of refrigeration alone has greatly ex- tended the markets for meats and other perishable preducts.e. In fact one of the purposes of refrigeration is to extend the time between the maturity and con- sumption of the product. While this development has resulted to a great advan- tage of both the producer and the consumer it has, nevertheless, increased the problems of financing the marketing of farm products. Some one must have an investment in the goods for a longer period of time. Ordinarily in the past the6 financing problem in marketing has been looked after by the different middlemen who handle the product, and the farmer received cash at the end of his growing season. But frequently farmers have considered it desirable to held the crop for better market conditions. In such cases the responsibility of having "money tied up" is shifted to the farmer, and he often finds it necessary to borrow from the bank. The recent growth of farmers! cooperative selling agencies, which follow the policy of marketing products gradually through the year, has greatly in- creased the significance of market financing to the farmer. The development of the cooperative marketing movement is of course a direct outgrowth of the problems created by specialization in agriculture. Tho farmer's welfare now depends upon his ability to sell products to best advantarce as well as his ability to produce then. The cooperative selling agency performs some of the merketing functions which were formerly assumed by private middlemen, and one of the important func- tions taken over is that of market financing. The coopcrntive organization may handle its operating capitel probleas in any one of several ways. All of the burden may be shifted to the farmer by paying him nothing until the product is finally sold, a part payment may be advanced by the organization, or Instly the organization may attempt to purchase the product outright. In case the farmer bears & part or all of the burden of waiting for his pay, he is frequently com- pelled to borrow from his merchant or banker. In case the cooperative concern advances all or a part of the purchase price, loans are obtained from the bank on the basis of warehouse receipts. From the standpoint of farm credit it makes little difference whothcer the farmer or the orgnnization looks after the finane- ings ihe Gost in cither case is taken from the sals price of the farmer's products. Extent of Credit Transactions Some iden of the present importance of credit in agriculture can be obtain- ed by observing the average annual amount of money paid out by the farmer in the form of interest on borrowed funds. An investigation for the year 1923 shows that the average cash expenses for over 16,000 representative owner-opereted farms in the Unitcd States were $1,575, and thet $230 of this amount, or 14.6 per cent, was paid in the form of interest. The average interest bill for these farms amounted to 25.8 per cent of the net cash receipts, which averaged 8891.9 9. Crops and Markets, Supplement, July, 1924.it A more accurate analysis, however, is that which shows the actual portion of the investment and operating capital which is porrowed.t9 phat is, in the case of investment credit, it should be shown just how much equity farmers have in their farm property and the percentage of the total value which represents the loans of others. The most accurate figures on this point for the country as a whole are those of the Census on farm mortgage debts in relation to the value of farm property. The total farm mortgage obligations for the country must be estimated, however, since the census enumerators are able to get this informa- tion only from those farmers who own the farms which they operate - about 62 per cent of all farms. Of these ovmer~operators 37.2 per cent reported in 1920 that their farms were mortgaged. The percentage varies from 19.4 in the South Atlantic States to 51.8 in the West North Central States. The total mortgage obligations represent 29.1 per cent of the reported value of the farms mortgaged. The Bureau of the Census and the Bureau of Agricultural Econémics have cs- timated the total farm mortgage debt for the country in 1920 at $7,857,700,000, The total value of farm lands, buildings, machinery and livestock was placed approximately $78,000,000,000, by the 1920 Census. According to these estimates the total mortgage debt amounts to about 10 per cent of the total vdlue of the investment capital of American farms. Some of the funds obtained through mort- gages ame diverted to uses other than the purchase of farm property, but this is probably balanced by the use of credit obtained through short-term loans for the purpose of purchasing farm property. It seems, therefore, that 10 per cent is a fairly accurate estimate of the portion of investment capital which was borrowed in 1920. The indications are that this percentage was greater in 1925, since farm property bad decreased in value and the mortgage obligations had increased. The 1925 Census indicates that the value of farm lands and buildings decreased 25 per cent between 1920 and 1925, while the growing farm mortgage loans of farm mortgage banks and insurance companies indicate a considerable increase in the mortgage indebtedness. Probably about 15 per cent of the farmer's investment capitel was represcnted by borrowed funds in 1925. It appears then that there is not any appreciable difference between the relative importance of investment credit in agriculture and that in industry and commerce, while the relative im-~ portance of such credit is much less in agriculture than in the railroad business. 10. The extent to which farmers use credit instruments for convenience in exchange is not knowm. The above estimates made for all exchanges must suffice.8 The relative importance of operating credit in agriculture is much more difficult to estimate, since no satisfactory information is available as to the annual amount of operating capital used. Kwven though we have estimates of the amount of short-term credit used, operating credit and consumption credit have been combined in these calculations. For the practical purposes of this phase of the discussion, however, these two types of credit can well be combined and considered as “credit required during the year to supply the needed capital and family consumption goods". , Some idea of the importance of the credit secured from time to time through © the year can be obtained by © comparison of the amount of such credit with the annual value of all farm products. Thus the total short-term indebtedness of farmers in July, 1924, was probably about $4,000,000,000,74 while the total value of farm products in 1924 was approximatcly $12 ,000,000,000. +4 If deductions are made from the total value figure for savings and payments on the principal of the mortgage debt, it seems conservative to estimate that 35 to 40 per cent of ‘the total operating capital and consumption goods of American farmers for that year was borrowed. It should be remembered that the figures presented here to show the impor-_ tance of credit in the financing of governments, general business, and agricul- ture, have in most cases no claim to a high degree of accuracy. The cstimates appear, however, to be sufficiently accurate for the illustrative purposes for which they are used. They indicate 1) that the operation of business units, gov- ernments, and farms under the present economic system is not only dependent upon the extensive use of capital, but also that much of this capital is borrowed, 2) thet the interest paid on borrowed capital is a very significant item of expense to be deducted from gross annual income, 3) that credit has attained a degree of relative importance in agriculture comparable with that in industry and commerce. CREDIT IS A PERMANENT PH/Sh OF AGRICULTURAL OPRRATIONS The rapid development of agriculture in this country during the past few decades with the accompanying rise in the price of land, equipment, and supplies, has resulted in an cnormous increase of investment end operating capital required for seach farm unit. In attempting to maintain the required capital to operate most economically the farmer has found it necessary to borrow. The total farm li. Department of Agriculture, Yearbook, 1924, p. 190 and 220. ee 12. Department of Agriculture, Yearbook, 1924, p. 1114.9 mortgage debt approximately doubled from 1900 to 1910, and doubled again from 1910 to 1920. The percentage of farms which were mortgaged increased from 28 in 1890 to 37 in 1920. Meantime, the ordinary bank loans to farmers for season- al operations were rapidly increasing in number and amount. The phenomenal growth from a nation of semi-self-sufficing farmers, using cheap land and a secant amount of equipment, to a commercialized agricultural country with many times as many dollars of capital involved has been experienced in such a short time that we have not yet fully realized the significance of the change. The increasing use of credit, which was inevitable with the increased capital requirements, has becn viewed by some students of the question with a considerable amount of anxiety. It has been feared by many that farmers are getting too much credit. In fact our whole habit of thinking has led us to look upon the farm debt, particularly the mortgage debt, as a kind of evil which is preying upon agriculture, an evil which might properly have been avoided by better management and business acumen. Strangely enough the same attitude has not been taken in regard to the indebtedness of industrial and commercial cor- porations. The fact that a mortgage on the farm means a mortgage on the home may account in part for this attitude. The fact that agriculture is subject to severe temporary depressions due to seasonal conditions creates fear of losing the farm through foreclosure. Again, many farmers have lost mortgaged property because of high interest rates and certain other conditions imposed by the lender such as the methods of repayment and the period of time for which loans are made. The over-valuation of farm lands has also been a great source of trouble for farmers with mortgages to pay. During the recent war period of high prices ther» were numerous examples of over-capitalization of farm property. The perdod of depression and falling prices which followed the high-price climax of 1920 found many farmers unable to pay offsmortgages which were placed during the preceding prosperous years. Finally, many farms have beon mortgaged for consumptive or speculative purposes and lost entirely. Whatever may be the causes for the different views of the same business practice, the fact remains that we commonly look upon tho creation of bonded indebtedness by business corporations as 4 perfectly normal matter of business, while the creation of mortgage indebtedness by the farmer is looked upon bt best as an emergency measure. Explanation for the necessity of credit in any business is found largely of course in the amount of capital required by the business unit as compared with the ability of the operator to accumulate his own funds. The amount of capital necessary bo build a transcontinental railway, a great manufacturing plant, an oil pipe-line, or even the warehouses of a wholesale merchant, can only in ex- ceptional cases be supplied by one individual. Such undortakings are too large to be attempted by one individual. The copporation form of business organizatio:has been devised primarily for the purpose of raising capital for such busi- nesses, 1) by inducing many individuals to come into the business and, 2) by borrowing from the general public through bond issues. But agriculture remains a so-called. small scale business and, contrary to the situation in many branches of industry and commerce, the operating unit does not require the.combined capital of a large number of individuals. It is true, nevertheless, that the capital required by the farmer has increased to such an extent that the accumulation of enough to owm a complete farm unit has come to be practically a life time job. The farmer who started out forty years ago secured land which was free or at least very cheap, He has accumulated his present wealth largely through the increase in values of land since that time. Although the farmer starting out today may accumulate more within forty years than did his predecessor, he must use different methods. His first big hurdle will be the accumulation of sufficient funds for an initial payment on a farme The second achievement will be to hasten his productive powers by obtaining ownership through the aid of credit. That more farms are mortgaged todey than formerly is by no means an indication that agriculture is poverty stricken. 0b- servation shows that it indicates primarily that farming is a bigger business, that more capital is necessary to succeed. In fact, the actual equity which the farmer has in his mortgaged farm may be greater than the total value of the same farm two decades ago. This'is a period of transition from extensive to intensive agriculture. The farming business is characterized by higher land values and a more intensive use of land by the use of more equipment and labor. At any given stage in the development of agriculture there is what is kmown as the most satisfactory eco- nomic unit of operation. In wheat farming at the present time in this country, for instance, several hundred acres of land, a condiderabie amount of plowing, seeding, and harvesting machinery, a truck, or several draft horses, and sever- al buildings are necessary if the farmer is to be a successful competitor in growing wheat. Forty years ago he might have been quite as successful with less equipment, certainly with a smaller total investment. Forty years hence the wheat farmer may have to use still more machinery and equipment to be successful. As this "most cconomic unit", in terms of the total investment, becomes larger, and as the funds needed to employ labor and to buy supplics inercase, the normal credit needs become greater. Pinancing is done on a much larger scale than formerly, yet our ideas about agricultural finance are based largely upon the agriculture of the later decades of the nineteenth century. The em- phasis should be shifted from the fear of farm indebtedness to an analysis of the costs and the proper use of credit.1. @ a QUESTIONS AND PROBLEMS Wheat is the distinction between exchange credit and operating credit? Explain why credit was indispensable in the development of our capitalistic system of production. Show why farmers need more investment credit than they did 50 years ago. Explain the relation between specialized agricultural production and the farmer's operating credit requirements. Compare the credit requirements in agriculture with those of industry and commerce, the railroads, and the government. Do you expect the total farm indebtedness in the United States to increase during the next few decades? Explain. The increasing percentage of mortgaged farms is often given as evidence that the economic status of agriculture is on the decline. Discuss. Does a decrease in the percentage of equity which farmers have in their property indicate a decline in the economic status of agriculture? Why should the cost and uses of credit be emphasized rather than the amount used?ee ox a as i P q Part i. LHe ENVesl OR The billions of dollars of credit which farmers use originate with the investors of the country. On the whole bankers are only middlemen between the ultimate investor and the borrower.- The ability of bankers to supply an adequate amount of agricultural credit and the conditions under which loans are made are dependent in the last analysis upon the investor. In Part I the conditions under which credit originates and the factors which deter- mine the direction of the flow of credit will be consider- ed. In Part II the purposes for which farmers obtain credit and the security offered for credit will be analyz- ed; while the functions of the banker or middleman, will be explained in Part III.13 Chapter 2 SOURCES OF CREDIT A cross-section of the business units of any industry at a given time will show that certain of the businesses are in need of immediate purchasing power with which to obtain certain material goods or labor. Similarly, a cross-section of the incomes and expenditures of all individuals and businesses of the country willsshow.that certain of them have more immediate purchasing power than is needed for their own purposes, either for consumption or for production. It was indicated above that on a certain date the farming business units of the country actually owed some twelve billion dollars because they had borrowed such pur- chasing power some time in the past. Now the inquiry shifts to a consideration of the circumstances surrounding the origin of these surplus billions of pur- chasing power. The owner of a surplus speaks of it as so much "money" to lend; it is often called a "loanable fund"; but since, strictly speaking, it is usually not money and since a loanable fund neither describes the form the loan takes, nor the purpose of the loan, the term loanable purchasing power is used here. The object of obtaining a loan, whether it is in the form of metallic money, paper money, 2 check, a deposit slip, or otvher.form, is to acquire in- mediate purchasing power which can be transformed by the borrower into the goods or services desired. Through credit transactions the capital of the country is directed into those industries and to those individuals who can bid for it most successfully. For descriptive purposes the total available credit of the country at a given time may be thought of as a pool of loanable purchasing power. By the process of borrowing some of this purchasing power the borrower is able to go into the market and demand whatever type of goods his business requires. Thus if he is ea farmer, he converts this purchasing power into a demand for land, farm equip- ment, or farm.labor; if he is a manufacturer of automobiles, the purchasing power is used to obtain the goods or the lebor required in his business; if he is the manager of a railroad, the purchasing power is converted into a demand for railroad equipment or labor. A persistent demand on the part of the business concerns of any one of these industries, with sufficient premium in the form of interest rates, will draw more and more upon the country's pool of loanable pur- chasing power, and the resulting increased demand for the particular goods and labor required by that industry will actually cause more of these goods to be produced, The resulting increased production will actually take labor from other industries and cause raw materials, which would otherwise have been used in other industries, to be used in the industry which is drawing most heavily *GT EL EOL BT TY iat 14 upon the pool of credit. To illustrate: By the use of credit our agricultural lands may be made to produce more commodities through drainage, irrigation, and fertilization. The competitive bidding of our farmers for loans may direct certain raw materials from other industries into machinery and buildings for farms, Likewise, labor may be directed from other industries to agriculture. It is in this manner that the process of advancing and receiving credit actu- ally directs the production of material goods. Credit operations thus exercise an important measure of control over pro- duction and consumption. Through the ability to borrow, a whole industry may be expanded. Conversely, a lack of the ability to borrow may contract a whole industry. The origin of lending power and the conditions under which credit is directed are, therefore, extremely significant to the agricultural industry. The country's pool of loanable purchasing power may be divided into two rather distinct compartments: 1) purchasing power which owners desire to lend for a considerable period of time, ise., with which they desire to make what are ordinarily called permanent investments; 2) purchasing power which is available only for temporary loans, 1. Sources of Investment Credit There ure two distinct sources of supply for the "permanent investment" section of the pool of loanable purchasing power: 1) the great flow of current savings of individuals and business concerns; 2) the intermittent flow of old savings, or aceumulations, of individuals and business concerns which are ready to be re=invested from time to time, Current Savings of Individuals The current savings of the individual may be a part of a wage, a salary, or the income from investments. Upon receiving such income the individual may spend it for his immediate enjoyment, or he may set aside a part of it as a basis for future income. In the latter case he may choose to apply it ina business of his own, or he may choose to lend it to some one else. If he chooses to transfer a part of his income to the use of others it becomes a part of the country's pool of loanable purchasing power. Thousands and thousands of salaried people and wage earners annually choose to set aside a part of their incomes and, since many of them are not in position to go into a business of their own, they add their savings to the loanable pool of purchasing powere The individual may lend his savings directly or indirectly, The latter practice is illustrated by the payment of life insurence premiums. Since life insurance is becoming a very popular means of investment, a large amount of15 savings is annually "stored up" on the installment plan through the payment of premiums. The enormous growth of the business of insurance companies and the necessity of their maintaining large surpluses have made them an important source of the country's investment credit. These companies are among the largest farm mortgage investors in the country. In addition to wages and salaries, income from investments is an important source of the current savings of individuals. Included here is the annual or semi-annual income from bonds, mortgages, and stock. Strictly speaking, stock- holders are owners of the business rather than lenders or creditors, but actually in most cases only a few of the larger stockholders of corporations actively direct the policies of the business. Even the few larger stockholders very often delegate the active management to a hired manager. Hence, stockholders are classified here as lenders, or creditors, along with bondholders and mortgage~ holders, and the income from stock is considered individual income rather than business income. Current Earnings of Business Concerns The second great flow of current savings originates in the current carnings of business concerns. This classification includes all business units from the individual farming or merchandising unit to the great corporation, and is dis- tinguished from individual savings in that the income arises not from a wage, or a salary, or the interest or dividend from the investment of a passive investor, but from the active management of a business. In the case of the corporation it is that part of the net earnings of the business which is not distributed as dividends to stockholders. According to the National Bureau of Economic Research, the corporations of the country distributed from 1909 to 1919 an average of only 61.4 per cent of their net earnings. The earnings which corporations set aside as surplus (savings) have been estimated at about one-half of the total savings of the country. © Such corporate savings may either be applied in expanding and improving the business or they may become available to borrowers of other concerns. A glance at the balance sheets, particularly of the older and larger corporations, will show investments in the stocks and bonds of other concerns. Investments in the stock of other corporations may be made primarily for the purpose of gaining partial control of their policies, but the investments in bonds, in particular, are usually made for the purpose of accumulating a sinking fund for the payment of the 1. National Bureau of Economic Research, Income in the United States, Vol. II, pe Ons d 2. W. Ie King, Journal of the American Statistical Association, December, 1922.: i | 16 bonded obligations of the investing corporation. Moreover, a part of the cur- rent earnings of the corporation is frequently set aside with the view of exe panding the business at some further date. In the meantime, these funds are invested in securities to mature at times appropriate to the requirements of the business, The current earnings of thousands of the smaller individual and partner- Ship business units of the country are an important source of credit. Prac- tically all farmers end the great majority of the retail merchants of the country are included in this classification. The earnings of the merchant are probably most commonly absorbed in paying living expenses and in expanding his own business, but many of the more successful merchants regularly make invest. ments outside their own business. In the case of the farmer it seems to be the general opinion that current earnings are ordinarily entirely absorbed in paye ing living expenses, improving the farm, and paying off mortgages, This view overlooks a large number of our farmers who supply a significant part of the investment credit for agriculture by lending to neighbors or by investing in farm mortgages in other sections of the country. This applies more particular~ ly to the farmers in the older and more stable farming areas. Another great class of businesses which supply from currenttearnings a large amount of the investment credit of the country includes the so-called professional businesses, such as those of physicians and lawyers. They differs from the businesses discussed above in that their income is derived from the rendition of personal service rather than from producing or merchandising ac- tual material goods. From the standpoint of investment possibilities, they differ further in thet the capital requirements of their businesses are rather strictly limited. The necessary office equipment is not very extensive. These businesses are expanded chiefly upon the basis of skill in rendering service rather than upon the amount of capital which is invested. They are thus rather strictly limited to the alternative of applying their savings in outside invest- ments. Old Savings Ready for Re-Investment In eddition to.the current savings of individuals and business concerns, a very considerable part of the turrently available investment credit arises in the process of the re-investment of past savings. As bonds and mortgages mature, as stocks are sold, as property is sold, or as gifts and endowments are received, a new source of loans arises. It should be remembered, however, that this re-investmont seldom means an addition to the country's total pool of loan- able purchasing power, since the individual or business organization which pays for the bond, stock, property, or makes the gift, has withdrawn the same amounti, from the general pool of purchasing power. But from the standpoint of any given industry or individual the returns from the matured investment or from the sale of property become a source of credit. For example, if a certain farmer sells his farm to a merchant in the neighboring town and in turn lends the money to another farmer, no addition to the total savings of the community has occurred, but there has been a transfer of credit from the merchandising business to agriculture. This, while "cashing-in" on investments of old savings may not mean an addi- tion to the total available savings of the country, the process is of great sig- nificance from the standpoint of any given industry. The burden of the recent plea for the prevention of further issues of tax-exempt securities was that “capital is being directed into abnormal channels”, This applies equally as well to the re-investment of old savings as to the investment of current savings. Furthermore, it is obvious that when - we say capital is flowing very rapidly to the automobile industry, for instance, the "flow" is by no means limited to the investment of current savings and earningse Old investments which are maturing are likewise "flowing" into the automobile industry. Hence, from the standpoint of agricultural credit, both the new savings and the old savings compose the sources of loanable purchasing power. Probably the largest single source of investment credit for agriculture is the farmer who sells his farm for part cash and takes a mortgage on the farm for the remainder 6f the sale price. The farm represents the stored up savings of the seller and, in the process of sale, a part of his savings have been immediately invested in a farm mortgage. This transaction is different from that of the sale of a farm, a bond, or a stock for cash, and then lending it out, in that there has been an addition to the country's pool of credit by an amount equal to the mort- gage. Nobody paid for the old investment and thus suffered the loss of loanable purchasing power; it was simply created in the process of extending credit to the buyer of the farm. It is in this way that farmers make their chief contribution to the supply of investment credit required within the industry. 2 Sources of Operating Credit The source of supply of the operating-credit section of our pool of loanable purchasing power centers largély in our commercial banking system. The retail merchant often extends credit to the customer directly, but he is able to do this largely because he can obtain loans from the bank, or from the wholesaler who in turn borrows from his bank. There are some business concerns which -occasionally make short-term loans directly from their own earnings, but this practice is ex- ceptional, especially in the case of the smaller business units. The larger cor-~ porations under certain circumstances invest a part of their earnings in short- term securities with a viewsto expanding their business in the near future.ia i ee ie ; it i is ie 18 Since the great bulk of the available credit for short periods of time comes through the commercial banking system of the country, some light can be thrown on the original sources of the short~term loanable purchasing power of the country by studying the sources of the lending power of the banking system, The primary source of the lending power of commercial banks is the deposits of customers who for convenience and safety have temporarily left their savings in the keeping of the bank. The original source of loanable purchasing power here is the savings and accumulations of individuals and business concerns just as is the case with investment credit. The only real difference is thet the owner doesnot care to have his savings tied up for a long period of time. His funds are always available for his use upon demand or at the end of a short period of time agreed upon, The other source of lending power of the commerciel banking system is the capital stock and accumulated carnings of the banks. While ordinarily a large part of the capital stock is represented by investments in real estate, build- ings, and equipment, the remainder is available for use as a basis of loans. The past earnings of the bank, whether in the form of' surplus or undivided profits, have the function of strengthening the bank's position in serving its borrowing customers. Earnings here arise in a similar manner as in any other business, but in the case of commercial banks they are specifically devoted to the purpose of making short-term credit available to the public. INCREASING THE TOTAL SUPFLY OF LOANABLE PURCHASING POWER Saving is the only real source of capital creation. Moreover, saving is the only source of supply of loanable purchasing power, whether the loans be used to purchase capital or consumers! goods. On first thought it might seem that an increase in the amount of currency issued by the Government and the banking system would increase the loanable purchasing power of the country, but this process only increases the number of dollars which can be lent and not the amount of actual purchasing power. More will be said on this point later. The ways and means of increasing savings are of paramount Significance here, 1. Increasing Savings Savings may be lent for two purposes, 1) for the purpose of obtaining pro- duction goods and services, and 2) for the purpose of obtaining consumption goods and services. The greater part of the credit extended is of course for produce tion purposes, and savings for these purposes will be considered first.ug To illustrate the fact that an increase in the savings of the people of the country may result in an increase in the production goods, or capital, of the country, let us take the case of the savings of a wage-earner in a cotton mill. If he receives wages amounting to $1500 per year and saves $500 he has saved purchasing power which, instead of being used by himself to buy goods to consume, may be used to buy stock in the company. The company in turn may use the new purchasing power to buy equipment or to expand the plant. Or the laborer may deposit his $500 in a savings bank. The bank then in turn may lend it to some business concern which desires to purchase new capital. In either case the purchasing power created by the laborer is used to buy capital instead of con- sumption goods, The demand for capital goods, such as raw materials, building materials, and machinery is increased by $500. This induces an increase in the country's supply of production goods, The full meaning of saving can probably be visualized better by imagining the situation which would exist if every income receiver in the country were to spend his entire income for goods to be consumed in the present. If this practice were followed no new business houses would be built, no new machinery would be manu- factured, and land would deteriorate because of lack of improvements and ferti- lizer. At the end of a relatively short period of time under a non-saving regime only labor and deteriorated land would be left as bases for production. But the actual practice is to consume less than we produce, to save. The ability and will of the people to save form the basis of permanent prosperity for any country. There is no more fundamental factor in modern pro- duction than capitel, and capital can be created only through saving. Moreover, saving is the original source of all loans. But not all savings become a part of our loanable pool. Many people apply their savings in businesses of their own. The motives for saving, however, are the same regardless of the application.of the savings. The savings of the country may be increased 1) by decreasing consumption, 2) by increasing efficiency in production, or 3) by a combination of these two methods. In considering these means of increasing savings the above classifica- tion of the sources of savings into individuals and business units will be used. Probably the greatest possibility of increasing the savings of the business or- ganizations of the country lies in the ability to increase efficiency in produc- tion. A+large share of the total savings comes from the net earnings of the business units of the country. Net earnings may be increased by reducing costs of production, or by getting higher prices for products, or by both, Costs are reduced by the elimination of waste and by increased efficiency in the use of jabor and capital. Prices may be increased by better knowledge of markets and the proper adjustment of supply to demand.Sit ly ESE Sree TEE ce PME EE INTE TT GRE 20 Since the loanable savings of the country come chiefly from the surplus earnings of individuals, this phase of the subject will be taken up in greater detail, In the case of the individual, the most fruitful method of increasing savings is to forego spending. Of course, the individual may so increase his efficiency that his income will be greater, but the possibilities for a great amount of increase in the incomes of all the individuals in the country ere rather strictly limited. The fundamental motives of the individual in saving are 1) to accumulate suf- ficient funds to go into a business of his own at some future date, and 2) to be comfortably supplied for a "rainy day" or for old age. Anything which emphasizes these motives will of course tend to increase savings. The better the business opportunities of the country, other things being equal, the greater the incentive to save for a future business. Likewise, the emphasis which is placed upon the necessity for saving for a "rainy day" will affect the amount of savings. The amount of savings which result from these individual motives is greatly affected by the extent of the opportunities for investment. Whether the individe val is saving for a future business of his own or saving to be able to live come fortably in old age or to leave some means of support for his dependents, good investment opportunities are an inducement to saving. These motives are suffici- ent to cause many people to save without the supplementary incentives of invest- ment possibilities, In fact some individuals are so impressed with the desira- bility of being financially independent that they would save even if they were compelled to pay a premium for the safekeeping of their savings. But there is a tendency, even among the most thrifty, to save more in case someone can be found who is willing to pay en attractive rate of interest for the use of the savings and give assurance of their return in the future. From the standpoint of the individual investor, the investment opportunities of the country might be improved in five distinct ways: 1) by offering a higher interest rate for savings; 2) by increasing the safety of investments; 3) by better adapting investments to the requirements of investors; 4) by increasing the amount and the accuracy of information available to prospective investors; 5) by increasing the availability of investments. Increased Interest Rates The amount of interest which is actually:paid varies greatly among different investments because of the variations in the attractiveness from the standpoint of sefety, adaptability to investors, etc., but at any given time money is said to be worth @ certain annual rate of interest. This is what is sometimes called pure interest, i.e., the value of a loan for a year excluding the element of risk and the costs involved in making the loan. That is, pure interest is the premium which borrowers are willing to pay to get money now rather than wait till a later datesGAL This level of pure imterest in the country may be raised by increased pros- verity in business. A good example of the general increase in interest rates is that of the recent war period. Business opportunities were good, and a loan was actually worth more than in times of depression or even in periods of normal business. Profits were greater, Business men were anxious to use more capital in order to increase their profits. As a result, higher interest rates were offered. The ievel of interest rates is determined at any given time by the demand anc supply of loanable funds. In 1921, for instance, business conditions were such as to prevent expansion and hence the demand for loans was not very greate Con- sequently, interest rates decreased, The fact that interest rates were ordinarily higher in a newly developing section of the country is due largely to the low supply of, and exceptional deman for, loanable funds. In the older sections more savings are accumulated and no rapid development is in progress and interest rates are usually lower. Of course, the risk may be greater in the newer country, but even if this factor is excluded the interest rate would tend to be higher because of the relation of demand and supply of loanable funds in the newly developed section. Increased Safety The degree of safety greatly effects investment opportunities ,and, therefore, the amount of saving. Here, again, there are all degrees of safety among the different investments of the country, but there are certain underlying influences which affect the general level of safety of investments at any given time. In- vestments in any country are affected by the power and stability of its govern- ment. Frequent changes in governmental policies are detrimental to capital ac- cumulation. One of the functions of any government is to protect the property rights of citizens, and if the government is unstable there is irregular protec- tion of these rights. Observe the present anxiety of investors in properties in Mexico, also the timidity of foreign investors in Russia. The degree of safety of investments is also affected by the specific policy of the government in regulating business. The government may interfere with busi- ness to such an extent as to discourage investments. On the other hand, govern- ment supervision can be a great stimulus to savings and investments, Such is the case in the government supervision of our banking system, the trust companies, and building and loan associations. One of the chief attractions of investors in the stock of building and loan associations in certain states is that they are super- vised by the state government. Savings banks are rather strictly supervised with the avowed purpose of protecting the savings of small investors. The constant government supervision of the commercial banking system has done much during the eesb+ i ; iF t ee 22 past fifty years to encournge tho individual to run checking accounts with the banks. Only a few decades azo a great number of people could be found who lacked confidence in the banks and refused to deposit their money and run checking ac- counts, This was particularly true among the farming population. When the far- mer sold his products he commonly required cash payment and in turn made his pure chases with cash. This meant that in the aggregate a great amount of cash was held by individuals for considerable periods of time. During the time between the sale of products and the purchase of other products the money was useless. But with the continued government supervision of our banking system confidence has been well established and the extensive use of the check has become almost universal. Confidence in the safety of money deposited with banks has greatly increased deposits, and therefore, the lending power of the bankse The level of safety of the investments of the country is also affected by general business and financial conditions, The safety of all investments is affected by the upward and dovmward swings of the business cycle. During periods of prosperity there is a greater derree of certainty in the regular payment of interest or dividends and the full repayment of the investment, But the general level of safety of investments running over long periods of time, say thirty to one-hundred years, depends fundamentally, aside from conditions of the government, upon the business ability of the people of the country ond the natural resources with which they have to worke Adaptation of Investments to Investors The investment opportunities of the country might be enhanced by the better adaptation of investments to the investor. That is, if individual investors were able to make investments at the time ind in the amounts most suited to their convenience there would be an added inducement to save, aside from any increase in interest rates or increase in safety. Aliso, investments would furnish an added attraction if they could be re-sold at any time when the investor might need the ioney. Financial institutions have long known of these inducements toe investors. It has become common in the sale of bonds’ to divide them into denominations sufficiently small to attract the smaller investor, One great disadvantage of many farm mortgage companies in the past has been that they attempted to sell the mortgage in lump sum. There was always some difficulty in finding an investor who was prepared to invest the exact amount of the mortgage. Savings banks have a particular attraction in the policy of accepting any amount at any time. Building and loan associations, as well as many of the leading investment banks, have already increased the attractions of their investments by providing _for payment on securities in small amounts at regular specified intervals adapted28 to the investor's receipt of income. This practice is based largely upon the psychology of the investor. If he is bound by the responsibility of making cer- tain payments at certain times, he prepares for them in advance. The possibility of losing what has been invested, or of failing to gain the full advantage of the investment, often calls forth special effort to meet every payment. The policy of investing by installments is probably one of the most effective methods of en- couraging saving which has ever been devised. There are possibilities of apply- ing this policy more extensively. The amortization plan of repayment of loans is based upon the same principle of adjusting payments to income, Another very important step in the adaptation of the investment to the re~ quirements of the investor is that of providing a ready re-sale for the investment. The attraction of "marketability" is very real to the investor. The individual often hesitates to invest at all because of the uncertainty of being able to "cash-in" on the investment at any time that he may need the funds in his own business or for his own personal use. This advantage has been recognized by finan~ cial institutions. Most of the investment banks and mortgage companies offer, as a special inducement, to attempt to sell the bond or mortgage upon request. Some companies actually offer to buy them in at any time. Building and loan associa- tions usually permit the investor to withdraw his stock ab par on 30 or 60 days notice. Of course the most important ready market for the re-sale of securities after they have been issued and sold to the public is the stock exchange. The investment bank ofton proudly announces to prospective investors in a particular security thet it is expected that the issue will be placed upon the New York Stock Bxchange or some other important exchange of the country. The important stock exchanges are limited, however, to a relatively few securities when the total stocks and bonds outstanding in the country ere considered. The "curb" market has developed as a supplement to the regular stock market. It handles certain securities which do not meet the requirements of the regular exchange or whose applications for admission on the regular exchange are yet pending. More Investment Information Probably the greatest handicap the individual investor experiences is his lack of knowledge of investments. He not only lacks knowledge of the existence of investments which are well adapted to his particular needs, but he often lacks the ability to distinguish between good and bad investments. The amount of in- vestment information which is available to prospective investors can be greatly increased. Moreover, the accuracy of this information can be improved, and much misrepresentation can be avoided, Also, the investing public can improve the situation by studying the general principles of investment and improving their ability to distinguish between good and bad investments. The actual technicalt a4 analysis of a specific security must of caurse be made by experts in accounting and finance, but the ordinary investor can learn the more obvious general prin- ciples governing investments and be able to avoid many mistakes which are commonly made. Also, the ordinary investor can be made to realize the necessity of seeking the advice of investment specialists before investing his savings. The total savings of the country would doubtless be increased if prospec- tive investors were supplied with information regarding the existing investment possibilities which are available. Good intentions to save frequently fail to materialize when the proposed savings take the form of ready money or a checking account with the bank, whereas, if a dependable source of information were available, the savings might be immediately put into a more stable form of in-- vestment. Since there is always a very strong temptation to spend ready money, the practice of prompt investment is basic in saving. The local banker is the chief adviser for the community in all matters of finance, and his advice is usually sought in investment matters. This phase of the banker's business has become so important that many of the larger banks have established investment departments. This department is prepared at all times to recommend securities and arrange for their delivery to the investor upon the receipt of a certain commission. These investment departments in com- mercial banks are rendering a great service to the public in that they are able to reach many small investors who have no established relations with the large investment banks of the larger cities. There are possibilities of further de- velopment along this line. The great bulk of the banks of the country have no such departments. Moreover, many of the smaller bankers are unable to give advice to their customers who are seeking investments. Furthermore, it must not be overlooked that investment advice given by a banker may mean the immediate loss of deposits for his bank and it may not appeal to the banker as being a sensible policy to recommend investments for which he gets only a small commis- sion. At least it can be seen that in the absence of pressure on the part of his customers and competitors, or a very long-sighted view of his bank's welfare, the tendency is for the banker to accept deposits without offering ad- vice concerning outside investments. A large share of investments are made without the advice of a friendly local banker. Unfortunately the smaller investors who need such advice most are less accustomed to seeking it from a third party than are the larger investors who are in position to know more about investments. The necessity of seeking the right kind of advice cannot be overemphasized. It is one thing to get in+ formation about the existence of available investments, and quite another to get accurate information about the safety of a particular investment. Saving is20 greatly discouraged by the experience of losses through the inaccurate investment advice of third parties and through actual misrepresentation by concerns offering the investments. For the ordinary investor it is difficult to distinguish between a safe in~ vestment and a speculative investment. For him the financial statement of the business corporation is nothing short of an abstract puzzle. The actual analysis must be made by specialists, such as investment banks (bond houses), and real estate mortgage companies. Investors often fail to realize the complexities of modern business and, therefore, the necessity of a careful analysis of the busi~ ness of the concern issuing the securities. Moreover, many of the smaller in+ vestors have yet to learn that a safe investment should be sought, even if the yield is low. Millions of dollars are lost annually by small investors through the practice of investing in highly speculative securities with the hope of enor- mous dividends. Losses through the purchase of 0il stocks in this country during the past ten years have done much to prejudice the minds of many investors against making investment in any type of securities. This tends to discourage saving. The so-called "blue-sky" laws in some of the states are attempts to prevent misrepresentation in the sale of securities and to reveal to the investor the real nature of the available investments. Also, the Federal Government has been active in preventing the misrepresentation of securities. A number of prosecu- tions have recently been made against the fraudulent use of the mail to induce unsuspecting investors to buy spurious stocks. The Federal and state governments can do much to eliminate the more obvious cases of fraud and misrepresentation, but it+seems that the more fundamental and permanent cure for this evil is the education of the investing public. The smaller -investors, in particular, need 1) to be able to distinguish broadly between a conservative and a speculative investment, 2) to realize the necessity of avoiding the more speculative invest- ments, and 3) to realize the desirability of seeking expert advice. Something is being done on such an educational program in this country at present. Many reliable periodicals which are widely distributed over the country regularly set aside a certain space for discussions of the investment problems of subscribers. Some magazines even recommend specific investments for the sub- scriber on the basis of a description of his particular financial situation. Private organizations, such as that of Brookmire, Babson, and the Harvard Economic Service, specialize in the study of business conditions and give advice to their clients concerning investments. Many investment banks, or bond houses as they are usually called, follow a well defined policy of instructing their clients in the general principles of investment, as well as that of assisting the pros- pective investor in the process of analyzing specific securities. All tooae ek iss. ss a aie ade eo. Sak i } 26 frequently, however, there is less of general training in the principles of in- vestment and more of recommendation of the particular securities which the bank is undertaking to sell to the public. Several books have been written on the subject of investment with a view to giving investors a better understanding of the whole subject. Securities are classified and discussed from the standpoint of their safety, the rate of return, and the stability of value. Many colleges and universities are offering courses in investments. Probably the most important criticism which could be made against our present methods of educating the investing public is that the investing public gets little unbiased instruction. In fact, so much bias enters into the ordinary investment advertisement that the investor is at a loss to know when he is really getting reliable instruction in investment. Make Investments Available The fifth great factor which affects investment opportunities and, there- fore, the amount of savings of the country is that of the availability of in- vestments. An excellent illustration of the situation among the smaller inves- tors of the country is shown in recent experiences of the Bell Telephone Securi- ties Company. This company was organized by the American Telephone Company primarily for the purpose of aiding its own employees and other small investors of the country in becoming its owners. David F. Houston, President of the Bell Telephone Securities Company, makes the following comments concerning the experi-~ ences of the Company: At the beginning, in the work of aiding small investors to secure stock of the American (Telephone and Telegraph) Company in the market, they were told that they could secure the aid of bankers and brokers and purchase the stock through them. It soon developed that very few people had experi- ence in dealing in securities, and had few or no banking connections or experience. People of small means generally are not only unacquainted with investment processes, but they are shy of such an undertaking. They began to ask whether: they could not secure stock directly through the telephone employees. Plans were, therefore, made under which they could have their orders taken by telephone employees and executed by the Securities Company, the company buying the stock in the market at the prevailing price, paying the brokers the normal commission, and charging nothing for its own SErviceS.eee The work of aiding small investors to become owners of the Bell System has confirmed a number of impressions. It has strikingly emphasized several things. It has brought out sharply the facts that there are vast numbers of people who have saved part of their earnings and who are willing to invest it; that they will invest it in good things if they can, but at any rate they will invest it; and that, in the large, machinery has yet to be developed which can or can afford to reach the hundreds of thousands of small inves- tors whose aggregate savings are large. There has also been further developed the fact that there are large numbers of people in the Nation who work and save money, but make no use of it whatever -- not even depositing it in a bank, but hiding it avay.° Savings which are not invested by the owner in his own business ordinarily take one of the following forms: demand or time deposits with the bank, savings accounts, an insurance policy, a real estate mortgage, stocks,.bonds, short-term notes of corporations, or the promissory note of an individual. There is little or no difficulty involved in finding an..investment for savings if a demand deposit account is sought. Banks are sufficiently accessible in all parts of the country for the needs of any individual for the safe-keeping of his funds. But demand deposits usually yield no return and are very easily spent. Many bankers do not accept interest-bearing time deposits. Approximately one-fifth of the "country" 5 Moreover, a very large portion national banks* do not accept savings deposits. of the people of the United States do not have direct access to regular savings banks. About 96 per cent of the mutual savings banks in the country are located in the Rastern and New England States, and 86 per cent of the stock savings banks are located in the state of Iowa.® Savings may be offered in return for a promissory note of some individual, The opportunities here, however, are rather limited because of the difficulty of finding. a borrower of the right type and at the right time. The great majority of loans on promissory notes are made by the banks, and the individual who-does the saving ordinarily functions as a depositer in the bank, 3. The Outlook, January 20, 1926. 4, This includes all national banks in towns having a population under 25,000. Also it includes banks in larger cities which prefer to be designated as country banks. 5. Comptroller of the Currency, Annual Report, 1924, The percentage of national banks which do not accept savings deposits varies from about 5 per cent in Virginia to about 70 per cent in Texas, 6. Comptroller of the Currency, Annual Report, 1924.28 A very large part of the annual savings of individuals of this country is used up in the payment of insurance premiums. The life insurance companies in particular have been very active during the past few decades, and they have achieved excellent results in inducing the smaller income receivers to use this method of laying something aside for a "rainy day". They have established Agencies at every crossroads in the country. Some companies offer a seore of different varieties of policies and are able to meet the needs of all types of customers. Insurance has been so well advertised through personal solicitation and through the experience of policy holders that it is accepted today as a purely business proposition by most people. Insurance offers an excellent opportunity to individuals with small incomes to accumulate something for their ovm use in old age or for the use of their dependents, If all our facilities for finding invostments for savings were working as efficiently as are the in- surance companios, there could scarcely be any question of their adequacy. Stocks, bonds, and reel estate mortgages are made available to investors chiefly through 1) advertisements, 2) personal solicitors, and 3) local finan- cial institutions. The advertiser and the personal solicitor are ordinarily biased, and the investor is somewhat handicapped in selecting investments from brief advertisements or in-buying from a clever personal solicitor. His safety in the use of either of these methods lies largely in his knowledge of the repue tation of the concern which is offering the security. There are a number of nationally knorm investment houses and mortgage companies whose reputations for fair-dealing are such that the investor can safely accept their securities, but the difficulty here is that the small investor in an out-of-the-way place has little opportunity to know of the more reliable investment institutions of the country. By far the most satisfactory method of purchasing stocks, bonds, and mort~ gages is through a local institution whose reputation and personnel are well known to the investor. The bank with an investment department is well equipped for this service. There are also well established local agencies which sell a variety of securities. Then there are possibilities of investing in the stock of local building and loan assosiations or in local real estate bonds and mort- gages, The great advantage in these last named investments is that the investor is able to use his own judgment as to the security back of the mortgage. 2. The Fallacy of the "Monéy Factory" Probably the most elusive fallacy which has been discovered in economic thought is that an increase in the amount of money in a country means per se an increase in general welfare, an increase in economic goods and services.ao The doctrines of the Mercantilists of the sixteenth, seventeenth, and eighteenth centuries were based largely on this fallacy. Nor has the fallacy disappeared in the nineteenth and twentieth centuries. It is still very commonly held. This fallacy seems to be based on two things: 1) the fact that an increase in the amount of money in the hands of one individual does actually mean that he has greater purchasing power, provided that the total amount of money in the country has not increased in the same proportion, and 2) the fact that money is merely a means to the acquisition of goods and services, If an individual who has $1,000 obtains another $1,000 his power to buy goods and services is ordinarily doubled, but if the total amount of money in circulation in the country is in- creased 100 per cent it docs not follow that the purchasing power of the country is doubled, since prices tend to rise when the amount of money is increased faster than the amount of actual goods and services exchanged. The history of this country is replete with examples of the money-factory fallacy. The "Free-Silver" campaign of the 1890's was based largely upon the idea that the country would become prosperous automatically if we could only get more money into circulation, The agitation for a more liberal policy of issuing federal reserve bank notes during the depression following 1920 was based on a similar fallacy. Certain representatives of the farming interests, for instance, maintained that the agricultural depression was due chiefly to an insufficient expansion of the currency. Money versus Purchasing Power The economic welfare of a country depends upon the ability of the people to purchase economic goods and services and this ability is not accurately measured by the amount of money: in the country. Our supply of gold in 1914 was $1,871,611,723 and in 1924 it had increased to $4,490,807,404, ! The amount of paper money in the United States was increased from $1,097,352,915 in 1914 to $4,672,821,666 in 1920,° It is obvious that there was no corresponding increase in the available economic goods in the country. The fact is that the country was in poorer economic condition after the war than it was before the war. All this is obvious, but some how in our every day thinking we overlook the important fact that from the standpoint of the country as a whole more money does not necessarily mean more goods or more purchasing power. The confusing thing is that a dollar will not always buy the same amount of goods. If it takes $1.50 now to buy what $1.00 would buy in 1914, a fifty per-cent increase in the amount of money 7. Director of the Mint, Annual Report, 1924, p. 105. 8. Secretary of the Treasury, Annual Reports.30 would mean nothing in the way of increased purchasing power. The fact that the general price level of goods tends to go up concurrently with an increase in the amount of money in use makes the dollar an unstable measure of actual purchasing power. And in connection with our discussion of the country's pool of loanable purchasing power it must be remembered that this purchasing power is accurately measured from time to time only in terms of goods and services. That is, in reality the loanable pool is made up of surplus goods and services, and money and credit serve only as a means of transferring these goods and services to the ac- tual users. The Individual Point of View The other important basis for the fallacy that an increase in the money supply of a country means an increase in economic welfare is that the question is usually analyzed from an individual point of view. The obvious fact that the receipt of money increases the individual's purchasing power is taken to mean that an increase in the amount of money in the country would mean an incrense in the purchasing power of the people of the country. But since the price of goods (general price level) goes up as the amount of money is increased, there is no actual increase in the purchasing power of the people. When the individual receives purchasing power in the form of money he is taking purchasing power away from someone else. Likewise, when a bank in one section of the country receives money from a bank in another section, the pur- chasing power of one section is increased only at the expense of that of the other section. They are simply receiving the savings, of others. Those on the receiving end of such transactions have observed the wonderful results and have thought it would be wonderful for the government and the banking system to provide all sections and 211 individuals with an adequate supply of moncye Higher general price levels are not always associated with an increase in the amount of money of the country. - C. W. Thompson, Hearings Before the Subcomnittee of the Joint Committee on Rural Credits, 64th Congress, lst Session, p. 98-99.4 } 48 indications are that ten years later the avercge cost of such loans did not ex- ceed seven per cent.° During this ten-year period federal and joint stock land banks alone lent more than $150,000,000 on Texas farm mortgages, and there is good evidence that other financing institutions have greatly increased their loans during this period. In other words, investment credit was attracted to Texas agriculture at a rapid rate during this period and it is evident that the interest rate paid by the farmer did not furnish the impetus. Neither has there been any very significant increase in the prosperity of the agriculture of the State. In fact, there was widespread depression among Texas farmers during three or four years of this period. What then accounts for the inflow of invest- ment funds? The only obvious explanation is the keen competition supplied by the federal farm loan system which was established at the beginning of this period. This new banking system has produced significant results: 1) by standardizing the farm mortgage as an investment under the supervision of the Federal Government; 2) by offering tax-exempt securities to the investing public; and 3) by selling bonds on a large scale through well established investment houses. It is difficult to estimate the effegt which the new system would have had if the tax-exemption feature had been omitted, but the greatly increased efficiency in handling farm mortgage sepprities, along with the confidence established by government super- vision, woyld doubtless have resulted in some reduction of rates and at the same time increased the flew of farm investment credit to the State. The safety of Texas farm mortgage Ipans {at least when obtained through this system) has been increased by a more efficient and conservative system of appraisal of farm pro- perty. The investing public is convinced of this greater safety because of gov- ernment supervision. In spite of the fact that interest rates to investors in these mortgages were actually decreased, the added safety of the securities and the greater efficiency of the financial machinery have undoubtedly hastened the flow of credit to Texas agriculture. 5. See Texas AgriculturalsExperiment Station, Bulletin No. 330, 1925.5 Oe 49 QUESTIONS AND PROBLEMS Give reasons for the relatively high interest rates paid on farm mortgage loans at the end cf the nineteenth century. Show how the exemption of federal land bank bonds from taxation has aided in directing credit into the agricultural industry. Why are interest rates commonly higher in the West than in the East? How have federal reserve banks and federal land banks reduced this variation in rates? What can be done by formers to attract credit to the agricultural industry? What can be done by financiel institutions to reduce the cost of credit to tthe farmer? How have government control and regulaticn of banking institutions assisted the farmer in getting credit?Rl aa Deion oe meagre See Tra 50 Part II. THE BORROWER The investigation now shifts to the borrower. What inducements does the farmer have offer to investors? How does he apply his loans? How does his security compare with that of the merchant, the manufacturer, and other types of business concerns? Farmers' security ; and the purpose of farm loans will be analyzed in the next eight chapters.51 Chapter 4. PURE OSE SE OF LOANS CLASSIFICATION In the extension of credit the leading question is: How is the loan to be applied? The lender deserves to know and insists upon knowing the use which is to be mde of his loan. The safety of his investment and the certainty of the annuel returns on it depend upon its successful application. Of course the borrower may protect the lender with personal or mortgage security aside from the protection inherent in the immediate process of the application of the loan. The best business practice, however, requires that in so far as possible loans should be applied in such manner that both the interest and principal can be paid from results of the use of the borrowed funds. A close analysis of the proposed use of the lomn is, therefore, basic to the farmer, the lender, and the financial nstitution which shares in the responsibility for the repayment of the loan. A description of the general principles involved in agricultural credit must accord- ingly be based upon the purposes for which farmers obtain loans. The usc made of a loan determines the length of term for which it is desired and, therefore, the type of financial institution which shall supply it. Also, the use made of the loan partially determines the original source from which the credit is ob- tained, the kind of security offered, the means and methods of repayment, and the interest rate which is paid. If the farmer desires a loan for the purpose of buying land, he will ordinarily require ten, twenty, or thirty years to pay it off. He will go to the farm mortgage bank or some other institution which, be- couse it seeks investors who desire long-term investments, is especially adapted to making long-term loans. He will give his personal note and © mortgage on the land as security. His means of repayment of the loan will be the net returns from the land. WNormelly the payments will be adjusted to the borrower's income periods, i.e., the obligation will be divided into equal annual payments. The interest rate will be affected by the length of term of the loan and the type and location of the land offered as sacurity. If the farmer desires asloan to buy feed to fatton steers, he will require only two or three months to pay it off. He will go to-the local bank which is especially adapted to m-king short-term loans. He will give his personal note and possibly a mortgege on the steers a5 security. His means of repayment of the loan consist or the sale price of the steers being fattened, ond the note will normally be paid in lump sum when they are soid. The interest rate paid will be governed by the general and local market for short-term loans of this type.52 If the farmer desires a loan to buy a pleasure automobile, the situation is different from either of the above cases. He will require one, two, or three years to pay off the loan. Neither the farm mortgage bank nor the regular com- mercial bank will care to make such e loan, since the period is too short in the one instance and too long in the other. Moreover, these banks prefer to make loans which are applied in production of some kind. The borrower will usually get credit for this purpose through some automobile finance company. These companies have recently been developed to supply just this type of loans. They find invest- ors who are willing to make investments for this period of time and who are willing to risk their funds in loans made for other purposes than production. These com- panies are willing to advance funds to the local dealer provided the farmer is able to pay one-fourth or one-half in cash, and provided the car is properly in- sured. The security offered will be the farmer's note, usually with the indorse- ment of the local dealer, and a mortgage on the car. Repayment will in most in- stances be made in monthly installments, since the finance company desires to collect as rapidly as possible due to the rapid depreciation of automobiles. The interest rate paid will normally be higher than that on either the loan to buy land or the loan to fatten steers. An automobile bought for pleasure purposes is not productive. The loan is not applied in such manner that it will pay itself out. The risk is greater. We might thus go on through the long list of specific purposes for which farmers obtain loans. However, if these purposes or uses of farm credit can be classified into a few distinct groups it will facilitate the analysis. That is, if it is found that there are many farm loans similar in type to automobile loans and many loans similar to land loans, and many which are similar to loans made to fatten steers, these may well ail be divided int» a few general types of loans. PRODUCTION CREDIT VERSUS CONSUMPTION CREDIT On the basis of use, all farm credit may be classified as production credit and consumption credit. The former is used to aid in producing agricultural products, the latter to supply the personal needs of the farmer. Credit to buy land and credit to buy feed are two kinds of production credit, while that to buy pleasure autoinobiles is consumption credit. The most significant distinetion between production and consumption credit from the standpoint of financing is that in one case the loan is applied in such manner that it is expected to pay itself out, while in the other case payment must be made from other resources of the borrower, No farmer borrows funds for produc- tion purposes unless he thinks that the application of the loan in his business53 will increase his income at least enough to pay the principal and interest of the loan. But in the case of consumption credit there can be no hope that it will increase his income. He is simply drawing on his future income without increasing it. The significance of this distinction is not very generally realized. Credit used to buy farm land clearly comes under the head of production credit, and that used to acquire-a piano is clearly consumption credit, but there are many cases in which the classification is not so distinct. Credit to purchase auto- mobiles has been considered by bankers as consumption credit. This is not wholly correct since the farmer's car has come to serve him in his business. It saves him time in making business trips to town. It supplies a satisfactory means of transporting his fruits, vegetables, eggs, etc., to the local market. In fact many farmers have come to consider the automobile as a necessity for business pur- poses, as well as for pleasure. The banker objects to making loans for this pur- pese because it is not at all evident that the borrower's productivity is increased in proportion to the cost of the car and its upkcep. Unless the borrower has ample means of paying the obligation from othereresourees, the banker looks upon such loans 8s poor risks. On the other hand, credit obtained to purchase a truck is distinctly production credit. It is bought only in case the farmer thinks it will increase his income enough to cover the extra expénse involved. Production and consumption credit may be further classified according to the durability of the goods and services secured with the credit. All goods or ser- vices acquired by the farmer may thus be divided into two classes, 1) those goods or services which endure only one or less than one turnover period! of the farmer's business and 2) those goods and services which endure for more than one turnover period of business. Thus credit secured to buy gas for a pleasure car would be classified as consumption credit under the first class above, while credit to buy the car is consumption credit of the second class, assuming that the car lasts more than one year or one turnover period. Credit secured to buy gas for a truck would be classifed as production credit under the first class, and credit to buy the truck is production credit of the second class. In credit transactions it is pre- sumed by the lender that the obligation will be repaid at the end of the first period. of turnover, or at least before the goods bought ate used up. In the case of production credit it is expected the obligation will be paid from the results of the application of the loan, and the time required to pay it will be regulated by the time required to get full results from the use of the loan. In the case of consumption credit payment must be made from sources independent of the use of the loan, and the lender expects the obligation to be settled at the end of the bor- rower's first turnover period or at least before the goods bought are used ups 1. That is, one year in the case of crop production and one year cr more in the case of livestock production.r : ies ” “ ee 54 Thus in the case of the purchase of corsumption goods which are used up within the year they cre bought the merchant requires payment when the crop is gathered, wheras, if the merchant is selling pianos he may allow the farmer to make two'or three payments extending over as many years. In the latter case the goods are more durable and some security remains over a period of years. Loans to buy feed and seed are expected to be paid pff at the end of the first year, while loans to buy a thneshing machine may be paid over a period of years, never, presumably, after the machine is worn out. It should be recognized of course that loans are not always paid off as is indicated here. The farmer experiences crop failures. The prices of his products sometimes suddenly decline, and he is unable to pay his obligations according to his plans. Likewise, it is not to be assumed that the goods bought, or even crops produced by the use of credit, are always offered as security for the loan. A mortgage is sometimes given on 2 team, for instance, to get credit to buy family supplies. Moreover, it is very often the case that no direct mortgage is given on anything. The personal note of the farmer is often considered entirely adequate. In fact the farmer commonly trades with his merchant on an open account. Nevertheless, the fundamental policies of the lender in maling loans are regulated by the use which is made of the loan. The farmer's personal note or his open account is good only in case he is able to apply his credit successfully. PRODUCTION CREDIT On the basis of use, production credit may be classified as exchange, operate ing, and investment credit. Exchange and operating credit involve a period of time equal to, or less than, one period of turnover, while investment credit in- volves a series of turnovers of the business. Exchange Credit Exchange credit as exemplified by the check is not used because of a lack of purchasing power, but rather for convenience in extdhange transactions. Time is insignificant in exchange credit, whereas, in other types of credit, time is the most significant clement. No interest charge is made for exchange credit unless the exchange transaction requires several days time. Credit involved, for instance, in the use of a draft, bill of exchange, or acceptance, sometimes requires the payment of interest. If several days é#ntervene between the beginning and the completion of an exchange transaction, it is customary for the seller to charge interest on the draft or bill of exchange. But the draft, bill of exe change, and acceptance have all been devised primarily to facilitate exchange and not as a means of borrowing. The seller may wait fifteen or thirty days for his55 pay, but he does not wait because the buyer does not have the purchasing power, rather because the buyer wishes tc receive the goods before making payment. Often a considerable period of time is required to prepare and ship.the goods, Exchange credit used by the individual farmer usually takes the form of a check, although the draft is frequently used when he deals with individuals or business concerns located at considerable distances. It has been pointed out above that the extensive use of the check by the farmer is a comparatively recent devel- opment. Even at the present time many farmers prefer to use cash in their exchange transactions. The practice of maintaining a checking account with the local bank has been encouraged by the increasing safety of our banks due to their strict supervision by the government. Also, as the country has become more and more densely populated, banks have been made more easily available to farmers. More- over, the use of the automobile has had the effect of bringing the farmer closer to town and the bank. But it is probable that the farmer's increased knowledge of business methods has done more than anything else to cause him to take advantage of panking facilities. He is learning the advantage of obtaining credit from the bank rather than the merchant, and a loan from the bank ordinarily means that a checking sccount will be established. The increased commercialization of. agricul- ture calls for more exchange transactions and increases the need for checking accounts. The greater use of exthange credit by the farmer should lead to beneficial results, aside from the added convenience in his business transactions. It should teach him the advantagesof system in keeping his records. It gives him the oppor- tunity to establish closer red&tions with his banker, who is, in position to offer financial advice. The practice of maintaining checking accounts is beneficial to the community in general in that it increases the lending power of the bank. Money in the pockets of the farmer is useless, while money in the bank serves as a basis for extending loans to those who are in need of credit. Operating and Investment Credit In contrast to exchange credit, operating and investment credit are obtained by the borrower because he lacks immediate purchasing power. Operating credit extends over a part or all of one period of turnover of the business, while in- vestment credit extends over more than one period of turnover. In agriculture the most usval period of turnover is one year. That is, the expenses involved in mak- ing a crop come back to the farmer in the form of gross income at harvest. Ex» penses which are to be covered in their entirety by the income from the crop will in this discussion be considered operating expenses, and credit obtained by the farmer to pay these expenses will be considered operating credit, Whether the7 RTE SEE ASAI cE i AEN TEAMS RABIES MAGS gi RN ICT REY AER OEE SPL DAI TTF 56 expense should be covered entirely by the income from one crop depends on the durability of the goods acquired with the credit. Credit to buy seed for a corn crop or a cotton crop is operating credit. The seed serves in making only one RS Crop and should be paid for out of the proceeds of that crop. Expenses which are to be covered only in part from the income of one crop will be considered as in- F vestment expenses, and credit obtained by the farmer to pay such expenses will bo considered investment credit. Credit to buy land is investment credit. The land iS serves in making many crops and, therefore, may be paid for from the proceeds of many crops. Credit to buy seed should clearly be classified as operating credit. But how shall we classify credit used to pay labor? The same rule applies. In producing a crop certain services or labor are as necessary as material goods, If the results of the application of the labor end with one crop, the debts in- curred to employ the labor should be paid out of the proceeds of the crop. Credit for labor to cultivate or harvest the crop is operating eredit, while that obtain- I ed to hire labor to build a barn is investment credit. The barn remains over i several crop turnover periods. There are questions of greater difficulty in this connection. Credit to buy land is obviously investment credit. But how should credit to pay interest on the debt be classified? Since the interest on the debt is in reality payment for the use of the land for that year, it is operating credit. But what of credit to pay an annual installment of the principal of the debt? The annual installment here ie actually represents part payment for the land and credit for this purpose should logically be classified as investment credit. The payment of the installment: on a the principal of the debt actually increases the permanent equity in the land, - while the payment of the annual interest bill is only the compensation for the i. use of the land for one year. Whether such fine distinctions as these are always of practical significance or not, they illustrate very well the bases of the above classification of credit. There are certain types of farming in which the period of turnover of the i business is more than one year. Beef cattle producers, for instance, have turn- iP: over periods ranging from one year, in the case of sale of "baby" beeves, to two, three, or four years for steers and cows. Credit to pay the expenses of raising a and maturing the three-year old steer is operating credit and should be terminat- ed upon the sale of the steer. Credit to build fences, dipping vats,. and corrals is investment credit, since these improvements will endure more than one turnever he period. Likewise, credit to buy cows for breeding purposes should be classified as investment credit.57 This classification rests fundamentally, as was indicated in the first part of this chapter, on the durability of the goods or services which are bought with the credit. From the standpoint of logic and all business principles, the produc~ tion-credit obligation should always be met before the goods or services cease to be useful in creating income. Failure to realize the significance of this prin- ciple has caused many farmers to become so deeply involved in debt that it is next to impossible ever to pay off their obligations. Of course, it may not rain, or it may rain too much, and the crop may fail to mature, but these are normal risks of the farmer-entrepreneur. The principle remains: Each crop should pay for it- self. CONSUMPTION CREDIT Credit used for consumption purposes was classified above on the basis of the durability of the goods obtained. Probably a more significant basis for classifi- cation is that of necessity. That is, are the goods to be bought necessary to the maintenance of efficient labor and the prevailing standards of living, or is it unnecessary to either? Necessary Consumption Credit A minimum of food, clothing, and shelter is in reality necessary to produc=2: tion, and credit for such purposes could be classified as production credit. But since such credit is obtained primarily for personal satisfaction and only second- arily for production it is more properly classified @&s consumption credit. Necessary consumption credit is granted by bankers and merchants on similar terms as production credit. In general it is expected that the return for the farmer's labor will be sufficient to pay off loans for the necessities, just as it is expected that the returns from the application of capital are expected to be sufficient to pay off the strictly production loans. Unnecessary Consumption Credit In the case of loans used in extravagant expenditure for food, clothing, shelter, etc., or for goods which are obviously not necessary in maintaining a minimum standard of living, the situation is different. It cannot be expected that the application of such credit will result in tincereased production. There is no relation between such expenditures and the productivity of labor. The ability to pay off the loan is in no way enhanced by its application. The policies of bankers and merchants are, therefore, very different in the extension of necessary consumption credit and unnecessary consumption credit. Even the farmer is common- ly avoided unless exceptional security is offered.ig io I Var Lana dq “4 t 58 SUMMARY AND CONCLUSION The use which the farmer makes of a loan determines, at least in part, 1) the length of term for which the loan should be made, 2) the type of financial institution which is adapted to making the loan, 3) the original source of the loan, 4) the kind of security offered or required, 5) the means and methods of repayment, and 6) the interest rate which is paid. All agricultural credit may be classified on the basis of its use as pro- duction and consumption credit. Each of these types is further classified on the basis of durability of the goods or services bought with the loan. The three types of production credit are: 1) exchange credit, which is used for convenience and in which the time element is of little or no significance, 2) investment credit which is obtained to secure goods or to hire services which endure more than one period of turnover of the farmer's business, and 3) oper- ating credit which is obtained to »uy goods or services which endure one, or less than one, period of turnover. A clear distinction should be made between necessary and unnecessary con- sumption credit. The former is similar in some respects to production credit, while the latter is wholly non-essential in production. The use of loans is very closely relatéd to their liquidation. The best business practice requires that each production loansand each necessary con- sumption loan be self-liquidating. Unnecessary consumption loans are never self-liquidating.QUESTIONS AND PROBLEMS What is the significance of the distinction between production credit and \ consumption credit: a) yt to the farmer, b) to the banker and investor? From the standpoint of economics, are the necessary family supplies consump-- tion goods or production goods? Explain. g What is the meaning of the "tvrnover period" as it is used here? What is the distinction betvreen operating turnover and investment turnover? How is the interest rate affected by the purpose of the loan? incial institutions cre adapted to making operating loan Oo Explain how some fin while others are adapted to moking investment loans. s _a a eg Se a ee ca La SCNT ROOT ena cain «sed cae nia a 60 Chapter 5. PURPOSE OF LOANS (continued ) INVESTMENT The term "investment" commonly denotes value or purchasing power as evidenced by notes, mortgages, bonds, and stocks, or by the actual goods, as lands, build-~ ings, livestock, and machinery. When we speak of an investment in a bond or in a piece of land we have in mind so many dollars of purchasing power, —- a certain value measured in terms of the monetary unit. Also, the term investment carries with it the idea of permanence. The investment involved in e business unit is thought of as the value of the permanent capital which is required in the business, in contrast to that of current or operating capital which is used for only a short period of time. Certain capital goods, such as land, machinery, and buildings, are permanent necessities. The value of the farmer's land, or the manufacturer's factory building, is a part of the permanent investment of the business, while the value of feed for the farmer's stock or coal to run the manufacturer's machinery is considered an expenditure. In reality, of course, there is an investment in the feed and coal, as well as in the land and machinery, and the owner expects a return on it, The difference is that feed and coal involve only a temporary in- vestment and they are designated in business practice as operating capital. The fundamental distinction between investment capital and operating capital is their durability. Investment capital is used more than one period of turnover of the business, while operating capital is consumed within one period of turn- over. The length of term of loans is regulated accordingly. The investment capital required in the farmer's business includes, 1) land, 2) buildings, and 3) machinery and livestock. ach of these forms of capital is used to produce several crops, Land has certain qualities which are indestructi- ble-.and with proper treatment will last indefinitely. Buildings deteriorate more rapidly than land regardless of efforts to maintain them. Machinery and livestock deteriorate still more rapidly than buildings. There is such a great variation in the degree of permanence of the different types of investment capital that the question of the length of term of investment loans should be considered separately under each type. In the case of any partic- ular loan a part of it may be used to buy land, a part to buy buildings, and the remainder to buy livestock and machinery. In fact, in some cases a part of the long-term loan is used to obtain operating capital. This, however, does not alter the principle that each item of capital obtained through credit should be made to do its part 4n the liquidation of the loan.61 CKEDIT TC BUY LAND Land constitutes about 70 per cent of the Sarmer's investment capital, ac- cording to the United States Census for 1920.1! farm for the country was $8,503, while the average value of buildings per farm The average value of land per was $1,781, of livestock $31,243, and of implements and machinery $557. Although we are equipping farms with better buildings and more machinery, land will continue to represent the greater portion of the farmer's permanent investment. With the increase in population there will be a tendency toward fewer acres per farm, but at the same time the value per acre will increase. Land values are inevitably forced upward because of the increased demand of a growing population and the limited supply of usable land. With the increase in the investment in land there is normally an increase in the farmer's credit requirements. That there is a close relation between land values and credit requirements is indicated by the fact that the value of land and buildings per farm increased approximately 90 per cent from 1910 to 1920, and the average mortgage debt per farm increased about 95 per cent.* The value of lands and buildings per farm increased from $5,470 to $10,284, while the mortgage debt on the farms which were mortgaged increased from $1,715 to $3,356. Meaning of "Land" Before discussing the principles involved in the application of credit used to buy land, some explanation of the term land isnnecessary. The purchase price of land should include the-outlay for such permanent improvements as clearing, drainage, terracing, wells, and irrigation. Clearing away the brush or timber is done once for all and serves for all future operation of farm. In many sections s of the country clearing is a very large item in the purchase price, sometimes even more than the price of the uncleared land. Jt often takes numerous crops to yield a net return sufficient to pay for the clearing of the land. Since clearing endures as long as the land, the cost of clearing should be considered as a part of the purchase price of the land. 1. Fourteenth Census, Vol. V, p. 24, The Census classifies all farm property as land, buildings, implements,and machinery, and livestock. The term "farm property" in the census is practically idémtical with investment capital in the above discussion. 2. Thirteenth Census, Vol. V, p- 162; Fourteenth Census, Vol. VI, Part I, pe 47.SRNR ta cies Sok ee acer eli alpaca aaa aca ae 62 Drainage, irrigation, and terrace systems should likewise be considered a part of the land, and the original cost of construction should be included in the purchase price of the land. There is a great amount of farm land in the country which would be worthless if systematic drainage were not provided. The construc- tion of drainage systems in the future will make possible the reclamation of thousands of acres of useless swamp lands. Similarly, irrigation is necessary to the utilization of much of our land. The original expense of constructing an irrigation system often amounts to far. more than the purchase price of the land, Without irrigation much of our western lands are practically worthless. The con-~ struction of terraces to prevent erosion and to retain moisture is becoming very common. The terrace is essentially a part of the land. Wells to supply water for livestock and for family use should also be considered a part of the land. All these forms of improvement involve certain operating expenses each year for upkeep, but the original outlay should be considered as a long-term investe ment. A drainage ditch, a terrace, a well, or a dam to impound irrigation water is a permanent improvement. Of course, they all depreciate and require expendi- tures for maintenance, but the same is true with the soil. The ditch, the terrace, the well, and the dam do not require construction each year. They may need re- pairs each year, but the original structure lasts many years. These improvements differ from buildings and fences in that they are more permanent and in that they are practically immovable. For all practical purposes they may be considered azpart of the land. Length of Term of Land Loans From the standpoint of credit, land and the permanent improvements which go with it are distinguished from buildings, machinery, and livestock chiefly by their durability or degree of permanence. Land is not only more durable normally, but it is less likely to be destroyed by fire, storms, floods, etc. Also, land tends to appreaiate in money value with the passage of time, while buildings and other ‘Lypes of capital tend to depreciate in money value. The supply is more strictly limited in the case of land than in the case of the other types of in- vestment capital. Time is a primary consideration in any loan. The rate of interest multiplied by the number of years for which the loan runs gives the cost per dollar of the principal of the loan. A loan for 20 years costs twice as much as a loan for 10 years at the same rate of interest. It is necessary of course, that the borrower have sufficient time to liquidate the loan with the return from his capital, but it is also important that a limit be set to the length of term of the loan.63 Just what is the proper length of term for loans which are used to buy lands? There is no définite answer to this question. In European countries land loans are commonly made for terms of 80 to 50 years. In the United Stetes prior to 1916 the two terms of land loans which were probably most common were five and ten years. The federal farm loan system created by Congress in 1916 provides for a maximum term of 50 to 40 years, but a considerable number of borrowers have liquidated their loans with federal land banks within a ten-year period, It is evident that there is no such thing as a specific term for which land loans should be made. A number of factors are effective in determining the proper length of term for such loans. For loans which are used to buy livestock, machinery, and other types of capital, excepting land, a definite. maximum is set by the durability of the capital. But with certain quaiifications land is permanent. If we used the same reasoning in regard to land loans, they might never be paid. It seems, however, that it is a reasonable gencral policy to pay off land loans as soon as it is possible. It is normally advisable for the farmer to have full equity in his land at the earliest possible moment. Loans to Buy Land should be Paid as soon as Possible ~ Many business corpora- tions have some bonded indebtedness permanently. The farmer's business, however, does not require such a large investment that it is not feasible for it to be owned entirely by the operator. It is duite generally conceded that it is desir- able for the operator of any business to ovm the capital involved in the business when it is possible, In the case of the farmer it is a matter of home ownership, as well as ownerBhip of the capital of his business. Just so long as there is a mortgage on the farm there is a mortgage on the home and a possibility of fore- closure and loss. It is scarcely possible for the farmer to find a better use for his savings -than to apply them in liquidating the debts incurred in buying the farm. At the present stage of development of the investment facilities for farmers a higher rate of interest is usually paid for loans than the rate which can be obtained on outside investments of equal safety. Payments made on a loan for which the farmer is paying 7 per cent are obviously better investments than if he uses the funds to buy G per cent bonds. Also, the application of all his savings on his loan can be made without the expense and trouble of finding good investments from time to time. Aside from the saving which is likely to come from a difference in actual interest rates, there is a saving in time and trouble. The farmer avoids the great risk of making unwise investments. Arrangements, therefore, should be made when the loan is obtained to pay off the obligation as soon as possible. It can be estimated about how much he will be able to pay each year. Moreover, arrangements should beVe i a ) Sd ee ee ca RC ae ok la oad sak male aea aa a a 64 made whereby he can pey more than the stipulated amount in case he has an excep- tionally good year. This latter policy is especially advisable since there is always the possibility of a poor crop. The farmer should make advance payments in good years in order to hasten the final payment of the debt and to prevent embarrassment in the bad years, Furthermore, there are many occasions in the farmer's financing when it is very advantageous to have full equity in his land. It can often be used as security for loans to buy livestock, machinery, or buildings. When land is available to use as security, loans can be obtained at a lower interest rate than if buildings and machinery are offered. Factors Determining how soon Land Loans Can be Paid - The first and most ob- vious consideration here is the amount of the loan. If the loan is equal to 70 per cent of the value of the farm it is evident that it will take approximately twice as long to pay it off as it would if the loan is only 35 per cent of the value of the farm. Secondly, the rate of interest which is paid greatly affects the time required to pay off the loan, It is not generally realized that in paying off a long-term loan the total of the interest payments usually exceeds the principal of the loan. Take for illustration a loan of $3,000 made for 34% years at the low rate of 5 per cent, If this loan is paid on the amortization plan of the federal land banks, the total amount paid over this period in the form of interest is 95,700, or $700 more than the original principal of the loan. It can easily be seen that an increase of one per cent in the rate would amount to a total of several hundred dollars, and would donsiderably lengthen the time necessary to pay the loan. Thirdly, the time required to accumulate funds with which to pay off the loan will be greatly affected by the productivity of the farm. That is, if the pro- ductivity of the land is properly maintained by the use of commercial fertilizers, rotation of crops, drainage, terracing, etc., the payment of the loan can be hastened. A period of twenty or thirty years is ample time for a very great decrease in the productivity of the land, unless it is given proper care. Another very important factor in connection with productivity is the price of farm pro- ducts. :Productivity, in so far as it has to do with the ability of the farmer to liquidate debts, includes not only the physical amount of products, but also the price of the products. The gross return from the land is calculated by multi- plying the physical products by the price received, The chief difference between productivity in terms of physical products and productivity in terms of price is that the individual farmer has much greater control over the former. He can - maintain the physical productivity of the soil, but his control over prices is infinitesimal,65 It should be pointed out here that there are certain opportune times to pay off land loans. These are determined by the movements of the business cycle. A périod of rising prices is a most excellent time to liquidate loans. Conversely, during a»period of falling prices it is very difficult to pay debts. The price of farm products usually rises faster than the general price level in the upswing of the business cycle and falls faster in the downswing. Substantial payments could easily have been made on farm mortgage debts during the five years prior to 1920, whereas, during the five years following 1920 it has been difficult in many cases to avoid bankruptcy. The fourth important factor in determining the time required to pay for land is the ability of the farmer himself. There is of course 2 wide range of ability among farmers. One man may require twice as much time to pay off his loan as another, although they are operating the same kind of land under identical condi- tions. Some farmers could never pay for a piece of land, even under the most satisfactory conditions, while others under the same conditions could pay for the land within five years. The length of term required for land loans probably depends more on. the ability of the individual farmer than on all other factors combined. In the fifth place, the thrift of the particular farmer has much to do with the time required to pay off loans. Thrift may be defined as that characteristie which is revealed 1} by saving, 2) by wise spending. The less of the current income which is used up for immediate satisfaction the more there is to pay off debts, ‘Zhe quality of being able to spend wisely is really one of the measures of farmer's ability as a producer, but the quality of being a good "saver" is.not necessarily connected with technical or business ability. The effect of thrift in the full sense of the word is very noticeable among our European immigrant- farmers. It is a very common observation that our recent immigrants are thrifty. Ordinarily they are particularly geod savers. They scem to pay for their farms more rapidly than do the older inhabitants of this country. The discussion of the length of time required to repay land loans may be summed up by saying that it depends on the amount of the loan, the interest paid, and the borrower's ability and willingness to accumulate a surplus from his annual production. For example, if he buys a sixty-acre farm at $100 per acre and borrows $3,000, or one-half of the purchase price, at 53 per cent interest, and pays according to the federal land bank's amortization plan, he must set aside $195 per year in order to be able to pay off the loan in 345 years. That is. he: must accumulate and set aside each year for 34% years an amount equal to eo .3 ; el Goecd per acre of the land.® This means an annual net return of Se per cent on 3. See Federal Farm Loan Bureau, Circular No. 7.66 the total investment in the lend. If the dorrower can and desires te do so, he may pay off the loan in 17% years by setting aside $390 each year. In this case the investment in the land must be made to yield a return of 63 per cent. If the interest rate paid on the loan is inereased and the annual payments remain the same, the time required to pay off the loan will be increasod accordingly. Investments in agricultural lands yiclded an exceptionally high return in this country during most of the last century, but the return has tended to de- crease during recent decades. Farm lands have been capitalized at such a high figure that it has become impossible to make them yield the farmer a high net re-~ turn. The result is that farm mortgage loans must be made for longer terms. While farm land ir-vestments a few decades ago yiclded 10 to 15 per cent, farm ovmers ore now coming te be fairly content with 5 to 8 per cent. In fact they are getting much less in innumerable cases. If the average return on investments in farm-lands decreases by one-half, thé time requircd to pay off mortgage loans doubles, assuming thatStha interest rate on loans remains the samc. This doés not necessarily mean thet our lends are decreasing in physical productivity or that American farmers are decreesing in efficiency, but simply that the money value of farm land has become so high that it is impossible to accumulate enough from the net earnings to pay it within the short periods which were formerly customary. It should be remembered though that during recent years the interest rates on farm mortgage loons have decreased, This naturally has a tendency to reduce the time required to pay off loans. The decreasing yeturn per dollar of investment has, however, much more than counteractcd the decrease in interest rates on leans. The combined results has been the lengthening of the term of farm mortgage loans. It was the judgment of the Congress of the United States in passing the Federal Farm Loan Act in 1916 that the borrower should have a maximum of 30 to 40 years to pay off mortgage Loans, and that he should have an opportunity to pay it off at any time after 5 years. CREDIT FOR BUILDINGS About 15 per cent or a little more than one-seventh, of the value of, the average American farmer's farm property* is fepresented by buildings. The types 4. Residences are included in this discussion. They are in reality consumption goods and not investment capital, but since the farmer's home is so closely connected with his business and since the characteristics of the residence from the credit standpoint are similar to those of other farm buildings, it is discussed here. Further discussion of residences will be found in Chapter Ve67 buildings as well as the value of buildings per farm, differ considerably in dif- ferent sections of the country. The type of buildings needed depends primarily on 1) climatic conditions, 2) the type of farming, and 3) the stage of progress of the community. In the northern sections of the country more and better buildings are needed for the protection of the family and livestock during the winter. In the humid sections more shed protection is required to store crops and machinery. More buildings are required in those sections where dairying and livestock farming are carried on extensively than in strictly crop farming sections. Generally, more and better buildings are found in the more progressive farming sections. It seems only logical to classify fences, sheds, windmills, pumps, water Pipes, etc., with buildings. From the standpoint of durability, mobility, and the causes for deprecietion they are very similar. Buildings proper include, 1) residence, 2) barns and silos, and 3) stables and sheds. Characteristics of Buildings from Credit Standpoint From the standpoint of financing, buildings are a rather distinct type of farm investment capital. Farm mortgage banks and insurance companies have long recognized the importance of the distinction betveen land and buildings in making loanse They are usually appraised separately and loans are made under separate consideration. Normal Durability - The primary basis for the distinction here between build- ings and land is their durability. Normally, farm buildings depreciate rapidly. Moreover, the depreciation of buildings is due primarily not to use but to climatic conditions. Soil is worn out with use, while buildings depreciate whether they arc used or not. In fact the soil is often improved by letting it "lie fallow". Buildings depreciate more rapidly when they are idle, not because they are idle, but because they are not properly cared for when not in use. Estimates of the period of usefulness of farm buildings range from 10 to 50 years. Much depends of course upon the kind of buildings under consideration and the care given them, The wide variation in the rate of depreciation is indicated in a footnote of the "Farmer's Account Book" issued by the Extension Division of the Michigan Agricultural College. It is stated that "it is customary to allow an annual depreciation of 2% to 10% on farm buildings". In the "Simplified Farm Lecount Record Book" of the Extension Division of the Oklahoma Agricultural and Mechanical College farm buildings are classified as "dwellings, tenant houses, barns, silos, and other buildings", and the following percentages of depreciation are suggested, "providing good care will be given the buildings": dwellings, 3 to 5 per cent; tenant houses, barns, and other buildings, 4 to 8 per cent; and silos, 4 to 12 per cent. Studies made in California indicate 20 years as the7 pat | is 68 average life of farm buildings.° For purposes of illustration it seems that 20 years may be accepted as representing the average durebility of farm buildings in this country. Destruction by Accident - Not only do buildings differ greatly from lands in their normal durability, but they are also subject to sudden destruction by accident. They are subject to destruction by fire, storms, and flood. Regard- less of the care which may be exercised to prevent fires, some destruction by fires is inevitable. A fire may be started by lightning or by incendiarism, as well as through carelessness. Storms and floods are of course unpreventable. The bank or insurance company which loans on buildings must consider that on the average there will oe a certain percentage of destruction of buildings by such accidents and, unless the buildings are insured, this consideration directly af. fects the length of term for which the banker is willing to make an advance. It is coming to be a common practice to insure buildings against accidents, particularly fire. Most banks and farm mortgage and insurance companies require that buildings be insured against fire. To the extent that buildings are insured, the consideration of accidents as affecting their durability is of course elimin- ated so far as loans are concerned. Depreciation in Money Value - It has been mentioned above that buildings characteristically depreciate in money value with the passage of time, while land increases in money value. Buildings depreciate in money value chiefly because of the actual depreciation of the materials of which they are constructed, but also in part because of the inadaptability of buildings to new uses or new locations once they are built. it is expensive to move a house cr a barn. Also, moving is harmful to the structure. A barn cannot be adapted to any other use without great difficulty and expense. Fences can be moved only at great expense in breakage. Land on the other hand can easily be used for one purpose this year and an entirely different purpose next year. Its physical and chemical depreciation is much more gradual. But most important of all is the fact that the physical land supply of the world is strictly limited and the ever increasing population, with its increasing demand for agricultural products, compels an increase in land values over a long period of time. Although there is an increasing limitation on the supply of building materials, the limitation is by no means as definite and effective as that in the case of land. With the tendency for land values to increase and the value of the buildings to decrease it is obvious that different considerations are involved with loans to buy land and loans to buy buildings. 5- R. Le Adams, Farm Management.69 Length of Term of Loans on Buildings Loans should not be made for the full period of usefulness of buildings. If the banker extends a loan for one-half the value of the buildings, the term should not exceed one-half the period of their durability. For example, suppose the mortgage banker is willing to lend $1,0008 on a $2,000 building. This means that the farmer must use $1,000 of his own funds in constructing the building. Now if the building lasts 20 years and the borrower requires the whole period to pay off the loan, he has lost the $1,000 with which he started. If he pays it off in 10 years he has 10 years in which to save another $1,000, and at the end of the twenty-year period he is in exactly the same position as when he started. But it is presumed that he desires finally to have full equity in the building, in which case the loan must be paid in less than 10 years, The general rule thet farm loans should be paid as soon as possible is even more &ppliceble here than in the case of land loans. The higher rate of normal depreciation of buildings makes rapid liquidation of building loans more vital. Also the uninsured risks should effect a reduction in the term according to the estimated chance of loss during the normal period of durability. But we have been assuming in the above discussion that the loan was used only for the purpose of purchasing buildings. It is a common practice to use one farm mortgage loan to buy both land and buildings. Then the question arises as to how long such loans should run. The fact that the two types of capital differ greatly in their permanence must be considered in determining the proper length of term for the loan. The part of the loan which is invested in buildingseshould have the effect of reducing the length of term which would have been proper had the whole loen teen used to buy land. If we assume, for instance, the proper length of term for a loan to buy land to be 30 yeers anc that the proper term of a loan to buy buildings is 20 years, then a loan one-half of which is used for lend and one-half for buildings should be made for 25 years. It is hardly likely that such accurate calculations can be made, since future income from the land cannot be estimeted with any high degree of accuracy. Nevertheless, whether or not an attempt is made to make an accunate estimate of the future income, the fact that a part of the loan is applied in securing property subject to rapid depreciation should affect the term of the loane The borrower should remember that farm buildings may require complete replacement before a thirty-year loan is liquidated, Proper provision should be made, either by paying off the mortgage at a more rapid rate, or by systematically building up a fund with which to construct new buildings. 6. Federal land banks lend on the combined security of land and buildings, and élimit the loan to 50 per cent of the value of the land and 20 per cent of the value of buildings.70 To summarize: 1) loans used entirely for buildings should be made for terms considerably shorter than the period of service of the buildings; 2) in determin- ing the proper term for loans used to buy both land and buildings due considera- tion should be given to the fact that buildings are subject to a much higher rate of depreciation than is land; 3) if buildings are not insured against hazards, the percentage of depreciation should be increased according to the estimated likelihood of destruction. CREDIT FOR MACHINERY AND LIVESTOCK According to the 1920 Census, about 15 per cent of the value of the average farmer's investment capital is represented by implements and machinery and live- stock. The average value of implements and machinery per farm was $557, or 4.6 per cent of the total value of all his investment capital. The average value of livestock per farm was $1,243, or 10.3 per cent of his investment capital. The amount of machinery and livestock per farm varies in different sections of the country, and on different farms, chiefly according to the type of farming. Machinery is used more extensively in the wheat growing stetes, for instance, than it is in the cotton growing states. The investment in livestock per farm is naturally greater in the dairying, ranching, and feed-growing sections than in the truck and cotton sections. The classification of machinery and livestock as a type of investment capital distinct from land or buildings is purely arbitrary, and is based upon their durability or rate of depreciation. The only similarity of machinery and live- stock is that on the average their period of usefulness is about the same. From the standpoint of credit financing this is fundamental. Machinery The term machinery is used here to designate what is usually called "tools; implements and machinery". There is of course a technical distinction between a tool, an implement, end a machine, but such distinction is of little or no impor- tance here. When the word machinery is used alone it will designate the pick and shovel as well as the complicated threshing machine. A broad classification of machinery according to its use should be helpful in visualizing just what the farmer's requirements are along this line. The fol- lowing list illustrates the great variety of such equipment which is necessary on the farm: 1) machinery used in preparing and fertilizing the soil, such as break- ing plows and manure spreaders; 2) planters of many different types, according to | the kind of seed to be planted; 3) cultivating tools and machinery, such as hoes,ee cultivators, harrows, and the like; 4) harvesting machinery, such as binders, mowers, rakes, and cotton pickers; 5) manufacturing or processing machinery, as threshers, cream separators, and silage cutters; €) transportation implements and machinery, as wagons, buggies, anc trucks; 7) engines or power machinery used on pumps, plows, threshers, etc.; 8) tools and machinery for repairing, as carpenter tools and blacksmith equipment; and 9) supplementary tools and equipment, such as hammers, wrenches, harness, etc. Livestock Not all livestock is investment capital. Whether e particular class of farm animals should be considered as investment capitel or operating capital depends on the nature of the sexvice they render. Some animals are useful only when they are slaughtered, others are useful both during their life and when they are slaughtered, and still others are useful only during their life period. From the standpoint of financing, the farmer's livestock may thus be classifed as, 1) animals used only for meat, 2) animals used for meat and other products, and 3) draught animals. Beef cattle and hogs come under the first classification. These livestock, except those kept for breeding purposes, last onlv one period of turn- over of the business and should, therefore, be considered as operating capital. They produce no income until they are sold for slaughter. Dairy cattle, sheep, goats, and fowls come under the second classification. They not only supply meat but they are useful in supplying other products before they are slaughtered. Theyysupply milk, wool, mohair, and eggs. They represent an investment from which an income is being derived. They are investment capital. Credit to buy dairy cattle may safely be secured for terms of 3 tr 5 years, while credit to buy hogs should be for only one year, or for one turnover period, what- ever that period happens to be. Horses and mules come under the third classification. Like dairy cattle, sheep, goats, and fowls, they are distinctly investment capital. The chief dis- tinction from the standpoint of credit is that they have no meat-value at the end of their life period. There is no value with which to pay off..a loan or to assist in their replatement. Characteristics from Credit Standpoint 5 The most important featuressof machinery and livestock from the standpoint of rai financing is that they have a high rate of depreciation. Machinery wears out with use and "rusts out" when it is not in use. Investment ‘capitel in the form of livestock depreciates with age and it is subject to destruction or depreciation by accident.Wie Machinery - The length of time which a farm implement or machine will last varies with the care which is given it, the type of machine, the types of farming, climatic condition, etc. The significant thing here is that the normal life of: an implement or machine is considerably less than the normal life of a building, and is considerably more than one period of turnover of the farmer's business. Estimates of the durability of farm machinery have been made in various sections of the country. In Minnesota it was found that a threshing machine lasts about § years, @ sulky plow about 12 years, a grain drill 16 years, and a hay tedder about 20 years. | In Oklahome the farmers have been advised that with "good care" farm implements and machinery will last from 8 to 20 years.® It was stated, for example, that a wagon should last about 20 years, a corn binder cbout 10 years, and a manure spreader about 8 years. An estimate made for Michigan indicates 7 to 12 years as the average period of usefulness of form machinery? Studies made in California indicate that farm implements and mechinery are subject to an aver- age annual depreciation of 10 per cent, or that their life period averages about 10 years. -0 Since the period of usefulness: of farm machinery is greatly affected by climatic conditions, the banker is interested in kmowing what provisions are made for its protection from the elements. The iron parts of implements and machinery are particularly susceptible to depreciation from rust when exposed to rain and other moisture conditions. Livestock - Certain livestock differs from machinery from the financing standpoint in that after the regular period of usefulness there is left a sale value. After the dairy cow has past her period of service as a dairy cow she can te sold for beef. Breeding cattle, sheep, goats, hogs, and fowls can likewise be sold on the basis of their meat value at the end of their regular period of use- fulness. It is only in the case of work stock that this final sale vAakhue does not exist. Horses and mules are useless at the end of their regular period of service. The fact that certain livestock has a sale value at the end of its regular period of usefulness has the effect of reducing the rate of depreciation. From the standpoint of the borrower who has obtained loans to buy livestock this simply means the final sale value of the animals will assist in paying off the .%» Minnesota Experiment Station, BulletingNo. 117. 58. Extension Division, Oklahoma Agricultural and Mechanical College, Simplified TQ. Extension Division, Michigan Agricultural College, Farmer's Account Book. ——— —--——_ 0. Re Le Adams, Farm Management.73 joan or in replacing the stock. The average useful life of sheep is 4 years, according to the above noted estimate, but sheep will sell for mutton at a price equal to about 75 per cent of their value while producing wool. Similarly, breed- ing hogs after their 6 years of service are worth about 50 per cent of ‘the first price for slaughtering purposes. It is estimated that after 8 years of use the average dairy cow will sell for beef at a price equal to 50 per cent of her origi- 2 ] nal. value as a dairy cow. *+ That is, in the latter two cases the borrower should pay the loan within 6 or 8 years respectively, but it is necessary for him to save an amount equal to only one-half of the total value of the animals. There is another important difference between livestock and machinery from the financing standpoint. Under ordinary conditions livestock which is used purely for meat products appreciates in money value throughout its life. Draught animals and livestock used for meat and other products appreciate in value only while they are growing to maturity. But machinery is at its best when it is bought. It has a continuous period of depreciation thereafter. In young live- stock the farmer has a type of investment capital which will increase in value at least for a certain period. Whether the lower price for which young animals can be bought is 4 real advantage will of course depend upon the cost of bringing them to maturity. The point here is that from the standpoint of liquidating a loan the young animal is accumuloting value, while machinery is dissipating values. In this connection it should be remembered that there is a constant expense involved in keeping livestock, whether it is being used or not. it certain times during the year draught animals are not in use but they continue to eat. There is no parallel expense in the case of machinery which is not being used. Machinery depreciates some, but mature horses also depreciate in that they are getting. olde: The fact that livestock involve continuous expense for upkeep tends to counteract the advantage which they may have over machinery in their appreciation in value while growing to maturity. It has been estimated that the normal period of usefulness of livestock ranges from an average of 2 years for fowls to an average of 10 years for horses and mules. 22 ‘Dairy cattle have a useful life of about 8 years, breeding hogs about 6 years, and shcep are useful for cbout 4 years. From these figures of the average normal period of usefulness of farm animals there should be deducted certain percentages of depreciation for accidents and disease. For example, on the basis of normal death rate of horses and mules their period of usefulness is placed at 10 years, but death from abnormal causes amountsta 2 per cent. This ll. All figures are purely illustrative. fhey are estimates made by investiga- tion in California. See Rk. L. Adams, Farm Management, p. 361-362. 12. Re L. Adams, Farm Management.74 means that the normal rate of depreciation of horses is 10 per cent and the actual rate, after taking accidents and disease into consideration, amounts to 12 per cent. That is, the average actual period of usefulness is only 8 years. Length of Term of Loans On the basis of the durability of the capital, the maximum period for which most livestock and machinery loans should be made is from 5 to 10 years. But the loan often amounts to only 50 or 75 per cent of the vurchase price of the livestock or machinery. In fact the banker or merchant is usually careful not to lend 100 per cent of the value if the security is limited to a mortgage on the animals or machinery which is bought. It is quite common for the borrower tO have cash sufficient to pay one-half or one-third of the purchase price and to borrow the remainder. The maximum period of the loan in such instances should be reduced by one-half or one-third, respectively, for if the entire period of service of the livestock or machinery is used in accumuluting enough to pay off the loan the borrower may find it necessary to replace the capital at a time when no savings are available for the purpose. If the borrower has cash sufficient to pay one-half of the purchase price for horses which will be useful for 10 years, he should pay off the loan during the first 5 years and have the remaining 5 years in which to accumulate one-half enough to replace the horses. But this is assuming that he is to be in debt forever. For him to be able to have full equity in his horses he must save faster. If he can pay his loan within 2 or 3 years he has some chance to accumulate enough during the remaining years of service of the horses to replace them without further borrow- inge Livestock and machinery are often acquired after a part of their period of usefulness is past. This is especially true in the case of livestock. The price paid should be reduced according to the part of the life period which is past. Also, the term of loans to buy capital which is partly used up should be reduced accordingly. The important thing for the purchaser to consider, whether he is buying with his own savings or with borrowed funds, is the length of time which he can use the livestock or machinery before replacement is necessary. The borrower will make no mistake if he can arrange to pay off the loan and accumulate enough to replace the livestock and machinery entirely with his own funds at the end of their period of service. As in the case of credit to buy buildings, the loan to buy livestock and machinery is ofter a part of a farm mortgage loan on land, The borrower may use a part of the mortgage loan to pay for land, a part to construct buildings, and vhe remainder to buy livestock and machinery. It should be remembered in such75 cases that the latter ere subject to a much higher rate of depreciation than are land and buildings. The larger the portion of the loan which is used to buy live- stock and machinery, the shorter the term for which the loan should be made. If a large portion of a long-term is used to buy capital subject to a high percentage of depreciation, there is great danger of the accumulation of a large debt. Sup- ~~ bose the borrower obtains a loan of $10,000 for a term of 40 years and uses half + of it to buy livestock and machinery. If he pays off the principal of the loan in equal annual installments, at the end of the first 8 years he has paid only one- fifth of the loan, yet one-half of the capital which he borrowed is used up and must be replaced. He still owes $8,000 of the original loan and is:inneed of another loan of $5,000 with which to replace his worn-out livestock and machinery. The foregoing brief description of farm investment capital indicates 1) the care which the banker or investor must use in the choice of mortgage security and in determining the proper term of loans, and 2) the care which the farmer must use to avoid bankruptcy through long-term debt obligations. Rates of depreciation and costs of replacements of farm capital are keynotes in investment credit analyses. i yi , i j 6 ie a is E 76 QUESTIONS AND PROBLEMS From the standpoint of credit what are the more significant differences between land and buildings? What determines the proper length of term of land loans? Explain. Why are annual payments advisable on investments? What are the advantages of flexibility of maximum annual payments on investment loans? Classify the following items of farm investment capital on the basis of the maximum length of term of loans made for their purchase: a) 10-year-old draught horse; ») 5eyear-old dairy cow; c) new grain drill. Classify these items on the basis of the percentage of value which the conservative banker might be expected to lend. Should the farmer permit loans on buildings, livestock, and machinery to run during the full period of service of the capital? Explain. Assume that the banker lends 75 per cent of the value of land, barns, binders, dairy cows, horses, breeding hogs, and sheep. 1) After taking into consideration, a) normal rates of physical depreci- ation, b) susceptibility to accidents, c) long-time price trend, d) sale value at the end of the regular period of service, and e) cost of upkeep, classify the above items of investment capital on the basis of the inherent safety of loans made for their purchase. 2) On what loans would you expect interest rates to be highest? lowest? 3) Compare the following methods used by bankers in counteracting the inherent risks involved in investment loans: a) reduction of ratio of loan to value of property; b) reduction of term of loan; and c) increase in interest rate,a _ Chapter 6 URPOSE CF LOANS (continued) IR. OPERATION Farming involves a series of applications of capital and labor during the period from the time the soil is prepared to the time the product is ready for the market. The farmer buys land, buildings, machinery, and livestock as a basis for production, but in operating this capital further expenses are involved. He must feed his livestock, repair his machinery and buildings, buy seed, hire labor, and pay taxes and interest on debts. That is, he requires operating capital, labor, and ready cash as well as investment capitai. The expenses involved in securing operating capital and the services of laborers and in paying taxes, interest, etc., are called operating expenses, Credit for these purposes is operating credit. In addition to the operating expenses involved ir. the growing and harvesting, the farmer sometimes has the problem of financing the marketing of his produce. The goods are often held for a time by the individual farmer or by his marketing organization. He may be able to hold the product for a better market only by borrowing. Often the farmer's cooperative ussociation holds the product and uses it as security on which to borrow funds te advance to members. It makes little difference whether the individual or the association holds the products. Financ- ing is necessary in either case and if the farmer is unable to do it, he must borrow or the association must borrow for him. There are then two types of operating credit, 1) credit used in paying the expenses involved in growing and harvesting, and 2) credit used in financing marketing. OPERATING CREDIT FOR FARM PRODUCTION Operating Capital The operating capital used in agriculture may be classified as follows: 1) feed, 2) seed, 3) repair materials, and 4)miscellaneous supplies. Feed - It seems that under ordinary conditions the farmer would raise suf- ficient feed for bis needs, and that feed financing would not be necessary. The 1920:Census indicates, however, that of about seven billion dollars worth of feed consumed on American farms in 1919 over one billion déllars worth was bought. 1 That is, about 15 per cent of the feed was purchased. This meant an averago 1. See United States-Department of Agriculture, Yearbook, 1922, pe 1005; 1924, pe 1114; and 1921, ps 495./ He ty er eo 78 expenditure of $312 per farm.’ Feed prices were of course extraordinarily high in 1919, An estimate for 1923 places the averege expenditure for feed at $210 per farm.5 The indications are that whether prices are high or low the farmers of the country buy about 15 per cent of their feed. The heaviest expenditures for feed are found in the dairy sections and in those regions in which beef cattle and hogs are produced. There is a natural tendency of course to produce animals and animal products in the regions which are particularly well adapted to the production of feed. In the Corn Belt, for instance, beef and hog production are important. Strangely enough, however, a greatsomount of fecd is purchased by farmers in this particular area. Some farmers of this section specialize in crop production, while others emphasize livestock production. The Corn Belt farmers nob only raise livestock extensively, but they buy many beef animals from the western ranges for fattening. The dairy producing regions on the other hand are determined largely by the distance from the market, rather than the location of the necessary feed.. Thus most of the dairy regions are near the great centers of population. The dairyman may even find it more economical tg buy a large portion of his feed rather than attempt to raise it, even though the land is well adapted to the production of feed crops. While the average expenditure fer feed per farm in this country in 1919 was $312, the farmers in the dairying states of Massachusetts and New York spent an average of $728 and $524, respectively. Nebraska farmers feed beef cattle and hogs extensively and, in spite of their ovm great corn production, they spent $703 per farm for feed. Arkansas farmers, who do very little dairying or beef cattle and hog raising, spent only $149 per farn. Texas farmers spent $282. In Texas the heaviest expcnditure for feed is found in the best cotton growing arease These farmers specialize in cotton and depend on the farmers of other sections for a large share of their feed. The farmer's expenditures for gas or other fuel with which to operate gasoe- line and steam engines used in production should be classified along with feed for draught animals. The motor is substituted for the draught animal and the fuel consumed is comparable to the feed consumed by work stock, Gasoline for tractors, pumps, etc., is a considerable item of expense on some farms and it is unlike feed in that it must be bought. I% cannot be produced on the farm. 2 United States Department of Agriculture, Yearbook, 1922 pe. 1005; 1924, Pe Y114; and 1921, p. 495, 5. United States Department of Agriculture, Yearbook, 1924, p. 1131.79 Seed - Although the annual expense involved in supplying the necessary seed for the farms of the country is in the aggregate an important item, for the indi- vidual farmer it is comparatively insignificant. Seed is usually retained from the previous crop. The average expense per farm for seed has been estimated at $43 in 1922, and $40 in 1923.* ‘The necessity of buying seed arises after a crop failure, when the farmer desires to improve the quality of his product, or when 4 new crop is being introduced. Repair Materials - The annual expense for the upkeep of farm investment capi-~- tal is an important item. In the first place, the land itself requires repairs of various kinds. The soil must be repaired from time to time. This may be done by crop rotation, by decay of products of the soil, by animal manure, or by the use of commercial fertilizer. Ordinarily the last named is the only type of fertilize: which must be bought and is, therefore, the only method which involves financing. Commercial fertilizer is being used in increasing quantities, particularly in the older farming regions along the Atlantic Coast. It is estimated that the farmers of the South Atlantic States spent an average of $178 per farm for fertilizer in 1922, and $210 per farm in 1923.9 In the states farther west more of the original fertility remains and fertilizer is not used so extensively. The average expendi-~ ture for fertilizer for the whole country has been estimated at $57 in 1922 and 860 in 1923.5 The permanent improvements on the land, such as drainage and terrac« systems, must be repaired frequently. The expense for such repairs is largely for labor, however, and is included under the discussion of labor as an operating expenses The farmer has an annual expense in keeping his buildings in repair. The barn needs repainting, window panes are broken, shingles rot off, etc. Also, farm machinery requires repairs. Plow points must be sharpened; occasionally new parts are needed for the binder, tractor, and thresher; a new bed is needed for the wagon, etc. Miscellaneous ~ It is impossible to list all of the different kinds of mis- cellaneous supplies which are needed in operating the farm. They include such things as medicine for livestock, oil and grease, twine, salt for animals, etc. In those sections of the country in which irrigation is required an important operating expense is that for water rights. 4, arid’ 5s°. United States: Departmentiof Agriculture | Yearbook, +1924, -p. 1131. 6. These estimates are based on reports received from farm owners by the Division of Farm Management, Bureau of Agricultural Economics. See United States De- partment of Agriculture, Yearbook, 1924, p. 1131.i be : AE Me ee, Cae 3 eer a ee en SS ee ee Set ke ae eee EL at ee CR SSA gee Re ala seg ghia Gaal uk ane Me a a 80 Labor and Services Since the seasonal character of farming prevents an even distribution of labor through the year, many farmers find it necessary at certain times to sup- plement their own labor force with hired labor. The harvesting season is a notable example of the need for extra labor. There are certain crops in particu- dar which must be harvested within a very short period of time to prevent weather damage and to prevent deterioration from other uncontrollable conditions. Many farmers, however, used hired labor throughout the year. They¥operate on a scale too large for their own labor supply, and in order to get the maximum returns from their capital and management they employ extra labor regularly. About 45 per cent of the farmers of the country hired either scasonal or regular labor in 1919.’ The average number of lcborers employed per farm was about one and one-half end the average expense per farm for the year was $470.8 This is equal to 15 to 20 ver cent of the total value of their products that year.? Wages are paid from time to time through the year and unless the farmer has surplus funds he must borrow from his banker and make final settlement when his products are sold. The volume of financing required to pay for laborers in 1919 has been placed at $1,356,403,000, or about 8 per cent of the value of the products of all the farmers in the country, if crops fed to livestock are ex- cluded. The indications are that the percentage of farm labor which is done by hired laborers is increasing. In 1880 the farmers in Minnesota, for instance, did 75 per cent of their own labor, while in 1890 they did 69 per cent, in 1900 they did 66 per cent, and in 1910 they did 61 per cent. 2° Besides the ordinary farm labor there are certain professional services which are required. Such specialized services as those of the veterinarian, the mechanic, and the lawyer must be employed. The farmer may avoid the necessity of financing labor by doing his owm labor, but in the case of the special services financing is always necessary whether they are paid for in cash, secured on time, or paid for with funds borrowed from the bank. Investment Capital Expenses, In addition to the expenses involved in purchasing operating capital and hiring labor and services, the farmer makes cash payments for taxes, rent, inter~ est on debts, and property and crop insurance. Such expenses are usually called p. 1123. 2 J. United States Department of Agriculture, Yearbook, 1924 B. United States Department of Agriculture, Yearbook, 1922, p. 1005. 9. United States Department of Agriculture, Yearbook, 1924, p. 1114. It is assumed here that these farmers produced 45eper cent of the total farm pro- ducts of the country. 10. Minnesota Experiment Station, Technical Bulletin Noi A. 1922.81 fixed charges. All these except crop insurance are annual expenses on investment capital. The greater part of the farmer's taxes represents anmal contributions to the government on the basis of the amount of his investment capital. Rent is an annual payment for the use of investment capital, while interest on the mort- gage debt is an annual payment for the use of funds. The payment of interest on the mortgage debt is essentially a rent charge on a part of the investment capital in which the borrower has an equity. Premiums paid on property insurance are likewise an investment capital expense. Premiums on crop insurance are an ex~ pense on operating capital. Such insurance is a guarantee of a certain return for expenses involved in the production of the crop. Taxes - A large part of the burden of financing local and state governments falls on property, particularly real property. Since a very large share of the real property or lands and buildings of farming communities is owned by farmers, they pay heavily for the upkeep of the local and state governments. It has been estimated that the farmers who operate their own farms paid an average of $174 each in taxes on farm property in 1922, and $190 each in 1923.71 Property taxes are collected soon after farmers have harvested and sold their crops, and for that reason it may be thought that the payment of taxes should never involve the use of credit. Under ordinary conditions the farmer does have cash with which to pay his taxes. However, when prices are very low or when there is a crop failure, borrowing is often necessary. At any rate the payment of taxes in January or February helps to drain the farmer's cash resources and has the effect of hastening the time when he must start on a credit basis in the purchase of operating capital. Rent - About one-third of the farm tenants in the country pay cash rent for the use of the landlord's investment capital. Ordinarily rent is paid at the end of the year and involves credit finaneing only in case of crop failure. Interest on Debts - Interest on operating loans is normally paid at the end of the crop production period and can be paid from the returns of the crop along with the payment of the principal. In the case of loans in livestock production, however, interest payments may be required before the end of the turnover period. Interest payments on loans for investient purposes are often made semi-annually. Such payments can be made in some cases only by borrowing. The total expenditures in 1923 for interest on loans of all kinds by farmers who own their farms has been estimated at an average of $230 per farm. 1¢ Insurance - The most important item of expense involved in property insurance consists of premiums on fire insurance. In 1920 the value of farm property which was insurable against fire amounted to approximately $26,000,000,000. Just how 11. and 12. United States Department of Agriculture, Yearbook, 1924, p. 11351.82 much of this property is insured is not known. Farmer's mutual fire insurance Companies are probably the most important typesof insurance company handling this business. In 1920 these companies were carrying risks amounting to about $8 000,000,000, 23 Another important type of property insurance is that which covers the risks of windstorms. No information is available regarding the average amount expended by farmers on such insurance, but it seems to be increasing in importance. In- surance against disease or accident to livestock is used quite extensively in many European countries and is coming to be used in this country to some extent, A% present it is applied chiefly to horses. Hail insurance is practical}ky the only type of insurance against crop risks which has been made available to farmers. The total hail insurance policies carried in 1919 have been estimated at about $500,000,000. This means that only about 3 per cent of the crop values for that year was insured against hail. Some states have taken the responsibility of insuring farmers against hail risks. Notable instances are North and South Dakota, Nebraska, Montana, and Oklahoma. Length of Term for Operating Loans, The length of term of loans made for the purposes described above is deter- mined largely by the period of turnover. If the farmer's expense for a crop begins in January and the crop is sold in November his period of turnover is 10 months. If a beef calf is born in April, 1923, and sold in April, 1926, the period of turnover is 3 years. But it is the usual practice to buy operating capital in installments during the period of crop or animal production. Then strictly speaking the investment in capital bought in May before -the crop is sold in November has a turnover period of only 6 months, and the investment in feed for the calf in April, 1924, has a turnover period of only 2 years, The banker usually dates his operating loans to farmers so they will mature at the time the products are ready for sale. He may make the loan for a shorter period, but he seldom makes it for a longer time. This practice is Significant not only. from the standpoint of convenience to the banker, but also from the standpoint of the farmer's ability to pay. If the borrower is not able to liquid- ate this year's debts from the returns of this year's crops there is little hope of his being able to pay it next year, when a new set of operating expenses must be paid. The accumulation of Operating expenses for a few years would create an indebtedness which could be liquidated only with great difficulty. This fact is brought out very strikingly when a given district suffers a crop failure. Two 13. United States Department of Agriculture, Yearbook, 1924, p. 239,85 crop failures in succession are almost enough to ruin any farmer who borrows mos% of his operating capital. When the farmer carries the operating expenses of one year over to the next, whether it is due to crop failure or slip-shod methods of liquidating operating loans, he is treading on financial quicksands. The proper length of term for operating loans varies 1) according to the particular time when the loan is made and 2) according to the type of agricultura!. production. If the loan is obtained at the first of the turnover period it shoulda mature-at the end of the period; if it is obtained in the middle of the turnover period, :it should run only for the remainder of the period. The turnover period itself varies with the type of agriculture. In most cases of crop production the turnover is determined by the seasons. One year is required to produce the crop. But in the various kinds of livestock production the period varies from a few months in the case of poultry to three or four years in the case of-beef steers. CREDIT FOR MARKETING The process of marketing agricultural products involves two types of financ- inge In the first place, funds must be advanced to pay for the marketing services, such as transportation, warehousing, and insurance. These funds are returned in the form of a higher price for the product when it is sold, but from the time the expense is incurred to the time the product is sold an investment is involved. In the second place, the value of the product when it starts through the marketing process represents an investment. Whoever advances the funds to pay for the mar- keting services and whoever owns the product is financing marketing. Often this financing is done by borrowings Marketing credit can properly be discussed as agricultural credit only when farmers do their own marketing. Otherwise it is called mercantile or commercial credit. In the past farmers concerned themselves chiefly with growing and harvest- ing their products and left the function of marketing to merchants or soecalled middlemen. The farmer matured and harvested his crops and immediately sold them to some merchant who in turn passed them on to another merchant or manufacturer and so on until they finally reached the consumer. But American farmers have been demonstrating during the last three quarters of a century that they are not con- tent with the services rendered by middlemen. There has been a great amount of propaganda amohg farmers for the "elimination of the middleman". Farm leaders have emphasized the necessity of selling directly to the manufacturer or consumer so that the farmer may receive the profits which have been going to the merchant. Since the organization of the Grange just after the Civil War there have been numerous. attempts both on a local and nation-wide scale to organize the farmers.UL ARES wees cil. la fala ica aa a a Ra 84 The chief purpose of these attempts, especially those since the seventies, has been to solve the farmer's marketing problem. The notable success of cooperative marketing in certain European countries and the experience gained by American farmers through the several efforts eat organization seem to have resulted in es- tablishing cooperative marketing on a permanent basis in this country during the past two decades. It seems probable now (1926) that about 20 per cent of the farm products of the country are handled by farmers! cooperative concerns. Farmers who are not members of marketing assaciations often prefer to hold their products for better prices. This involves warehousing and continued invest- ment in the commodities. That is, the farmer assumes some of the marketing func- tions. He must make an advance for warehousing and insurance or else store the products on the farm and take the risk of loss by fire or deterioration. Much more difficult is the process of waiting for the returns on the crops Even if the farmer has no old obligations to meet, he usually finds it necessary to borrow for the next crop. Necessity for Credit If farmers had sufficient funds to advance for marketing expenses and aa conveniently wait for their returns until the product is finally sold, the problem of marketing credit for farmers would never arise. But it must be re- membered that the marketing process requires considerable time and that .the mar- keting period for one series of products usually overlaps on the production period for the next series of products. The transportation of goods from the farmer to the consumer requires time, and the process of finding buyers requires time. The basis for the most important time element, however, is found in-the fact that consumers take goods regularly through the year while the farmer, espec- ially the crop farmer, has his whole year's product ready for the market at one time. Somebody must hold the product over until the consumers call for: it. Farmers' marketing organizations propose to take over this job of holding the product until the consumer is ready for it. They hope to get a higher price by selling the product gradually through the year. In fact this is the most ‘import~_ ant phase of the "orderly marketing" program of the cooperative associations. ‘It. is maintained that dumping the whole year's product on the market within a short period of time has been one of the chief causes for low prices of farm products, and that the cooperative marketing association must remedy this evil by Balidan the product in an orderly manner through the year. One of the most difficult problems which the cooperative marketing organiza- tion has is that of financing. The membership of the association consists of farmers who as indiwiduels have the problem of financing production prior to85 marketing. In addition to the credit required during the production period, the cooperative program requires an extension of the time on production loans, the creation of new loans, or both. Production loans can be paid only when the product is sold, and the orderly marketing policy extends the time of sale. Co- operative marketing not only extends the time of sale but it involves certain expenses. The farmer must make advances to cover marketing expenses and weit lenger to receive the returns from his products. Even if he has been able to finance himself in the growing and harvesting of the products, he may find it necessary to borrow before the goods are finally sold. Borrowing is all the more necessary in those cases in which credit is used in producing the crop. Cotton farmers, for instance, borrow extensively while producing the crop and in many cases find it almost impossible to wait longer than the end of the year for the returns from the crop. Merchants and bankers who have advanced loans often insist on payment immediately after the cotton is picked. This precludes an orderly mar- keting program unless the local creditors can be satisfied in some way. There are two ways of handling the situation. The merchants and bankers may be induced to extend their loans for a longer period of time so the farmer will have ample time to carry out his orderly marketing program, or the marketing association may offer the product as security and obtain credit to advance to the farmer and thus enabie him to pay off his local creditors. The significant point here is that the co- operative marketing program has increased the farmer's credit needs. He has assumed the responsibility of financing the marketing of his product as well as its production. If he needed credit to grow and harvest his products, more credit is needed for their marketing. Even if he needed no production credit, he may find it necessary to borrow before the product is finally sold. To sum up, the farmer has four types of funds invested in the product as it goes through the marketing process, 1) operating funds which he has borrowed during the production period, 2) funds which he himself has advanced during the production period, 3) funds advanced to pay marketing expenses, and 4) the profits of the year. If he had to borrow during the production period it-is evident that he will require either a new loan or an extension of the old l#an. Furthermore, it is evident that if he did not have sufficient funds of his own to finance the growing and harvesting of the crop he will not be able to pay marketing expenses without borrowing. Whether he will have to obtain loans in lieu of the profits and his own investment in the form of funds expended during production period, will depend upon his needs while he is waiting for the returns from his products. Since the marketing period for one crop overlaps the producing period for the next crop, it seems obvious that borrowed funds must take the pbace of the farmer's ownF. is 86 funds until the crop is sold. Whether the farmer can forego his profits until the product is sold depends of course on the amount of his obligations. Profits are used by many farmers in paying for land and other investment capital. Such payments would simply have to be adjusted to the income periods created by the extension of time in selling products. Length of Term of Loans The length of term of marlzeting loans is determined by the marketing policy. If the products are sold 6 months efter they are matured and harvested the mar- keting loans required should be made for that period of time. That is, the old production loans must be extended 6 months, and new loans arising in the market- ing process should be made to mature at the time of sale. But since products are sold continually throughout the year, the length of marketing loans varies con- “siderably. The term for any particular loan is determined by the time expiring before sufficient products are sold to pay it off. Cotton farmers, for instance, who market their products through the cooperative association adjust the length of their loans to the regular periods at which they receive payments from the association. The Texas Farm Bureau Cotton Association makes four payments to its members at certain specified dates during the year. Loans secured by the members of this Association should be made to mature on these dates. The dates when the loans are made will of course depend upon the financial situation of the borrower. It should be remembered of course that not all cooperative organizations follow the same policy regarding the time of sale of the product. In fact it is coming to be the policy of most associations to sell when in their judgment the best price can be obtained. In most cases no effort is made to sell a definite amount of products each month. Likewise the individual who holds his products has no definite time schedule for sales. He sells when he thinks the market is most satisfactory or when he needs the money. In this connection it should be pointed ovt that the time required in market- ing varies considerably with different farm products. In the first place, animals are sold when they ere in the proper condition. Holding them off of the market is too expensive, since their upkeep is usually more than enough to counteract any increase in price which might be received. Whether the animals are marketed by the individual producer or by an association of producers, comparatively little time is involved, and marketing credit is insignificant as compared with that involved in marketing other products. Marketing credit may be required before the products reach the consumer, but a very large part of the financing arises after the livestock leaves the hands of the farmer or his association. The: packer and merchant have the more important credit problem in financing the mar- keting of meat products.87 In the second place, there are certain farm products which are very expensiv< to hold over any great length of time because of their perishable nature. Financ. ing the marketing of fresh vegetables isaa relatively short time process. Fresh vegetables require cold storage in warm weather and freezing must be prevented in cold weather. Either process is sufficiently expensive to prevent keeping them over for any considerable period of time. In the third place, there are certain types of farm products which can be kept in their raw state with very little expense. In this class are such import- ant crops as cotton, corn, wheat, and tobacco. It is in the sale of such products as these that the farmer has his greatest problem of market financing. These crops may readily be held by individual farmers or by associations for many months with little or no deterioration and at comparatively little expense. Methods of Financing The extra financing involved when the farmer performs marketing functions may be done in several ways. It is possible in some cases for the farmer to do all the financings He may be able to wait for his returns until the product is finally sold and he may even have sufficient funds to pay the expenses of market- ing- It is more usual, however, for the farmer to require credit for at least a part of the financing. He may need funds to pay old obligations, he may need funds to start another crop, or he may need both. The most common practice in case of the association handling such products as cotton, wheat, and tobacco seems to be for the farmer to do &iapart of his own financing and borrow the remainder. A part of this borrowing is done by the farmer and a part of it by the association. The associations commonly advance the farmer 50 to 75 per cent of the value of the product when it is received. They are able to make such advances by borrowing on the basis of warehouse receipts for the commodities held. The additional credit needed by the farmer before his product is sold is usually secured individually at his local bank. ei iPe \ i a 88 QUESTIONS AlD PROBLEMS Classify the purposes of operating credit in farm production, and estimate the relative importance of each on the basis of the amount of credit required. The average farmer in Massachusetts probably buys twice as much feed as does the Texas farmer. Yet Texas bankers are more emphatic than are Massachusetts bankers in urging farmers to produce their own feeds Explain. Under what conditions do you consider it good business policy for the farmer to hire labor even though he must pay wages from borrowed funds? In what sections of the country and at what seasons of the year would you expect the heaviest loans to pay for seasonal labor? In what sections would you expect the reeular enployment of farm laborers to be most prevalent? How is the term for operating loans determined? For what purposes is marketing credit used? Compare the amount of financing. necessary in marketing a crop and the amount necessary in producing and harvesting the crop. In which case is the farmer likely to need more credit? Explain.89 Chapter 7 PURPOSE OF LOANS (continued) + CONSUMPTION It is commonly assumed that farmers should not borrow for consumption pur- poses. Authors of books on banking and credit usually leave the consumption credit problem with the advice that there shovid be no such thing. But as a mat- ter of fact a very large part of the credit secured by farmers is used to buy family supplies and to pay for family services. Such credit should be condemned only with sufficient reason, or it should be encouraged with proper limitations. At least it should be explained. Consumption credit is distinguished from production credit in that it is usod to buy goods or pey for services which are not directly connected with the pro- cess. of production. , Funds borrowed for this purpose are’ spent, while funds bor- rowed for production are invested in the product which is being grown. Consump- tion. goods are used for the immediate satisfaction of the farmer and his family, while production goods and services are used to assist in creating an income. When it is stated that consumption goods and services have no connection with productive processes the question of the necessity of a minimum of food, clothing, etc., immediately arises. Food is as necessary in the human-labor supply as feed is in the horse-labor supply. It cannot be said without qualifica- ion that a minimum of family supplies is not necessary to production. There are, however, many consumption goods and services which have no direct connection with efficiency in production. Automobiles used purely for pleasure, pianos, pleasure trips, etc., are evidently not directly related to ferm production processes. There Are then two types of consumption credit. These will be designated as 1) necessary consumption credit and 2) unnecessary consumption credit. Necessary Consumption Credit Without any great violence to logic credit to buy family necessities might be classified as production credit used to maintain the familyelabor force. Ger- tainly such credit should not be confused with credit which is only very indirect~ ly connected with production. Bankers and merchants clearly recognize this dis- tinction in extending loans. Credit for the necessary family supplies is rec- ognized as being an essential pvart of the farmer's financing. But bankers and merchants are very cauticus in extending credit beyond the amount recuired to maintain the family in working condition. Such practice is based on the factTI ee 90 that the family labor which is being thus maintained will ordinarily yield enough to pay the obligations. From a purely business standpoint, credit for food and the other necessary family supplies is largely production credit in the same way that credit to buy feed for work stock is production credit. There are, however, certain reasons for classifying it as necessary consumption credit rather than production credit. In the first place, consumption goods and services are obtained primarily for personal satisfaction and only indirectly for the purpose of carrying on production. Because of this fact no definite line can be drawn between what is necessary and what is wnnecessary. The motive is immediate self-satisfaction, and this can easily lead to expenditures which have no relation to the produc- tive efficiency of the farmer. The purely production expenditures are never made unless there is prospect of increased income sufficient to pay them and to have a profit left, whereas, in the case of expenditures for personal satisfac- tion, consideration of the effect on production is by no means uppermost. in the second place, not all the necessary family supplies and services are used directly in maintaining farm labor. Several members of the family may not assist in the farming operations. For the younger members of the family the food and clothing reouired are out of all proportion to the amount of farm labor they can supply. In the third place, family supplies and services have long been classified as sonsumption goods and services. Economists have considered the expenditures for personal setisfaction as separate and distinct from production expenses. It is indeed common in industries other than agriculture to keep separate accounts for business end family expenses. Of course an item of family expense would be out of place in the accounts of @ business corporation. But with the farmer the situation is different. Farming is almost entirely an individual business. There are no stockholders or partners to whom a farmer must make an accounting. He combines his total expenses for the year without any distinction between family items and purely production expenses. However, as the farmer recognizes tne necessity cf keeping strict account of his operations, he will make a clear distinction between consumption and production expenses. In spite of the similarity between necessary family supplies and production capital, credit used in the former case should be distinguished from purely production credit. It must be admitted that no general statement can be made as to just what is necessary and what is not necessary. Supplies which are commonly recognized as necessities include 1) food, 2) clothing, 3) fuel, 4) house furnishings, and 5) certain incidental supplies. Services commonly recognized as being necessary include those of the physician, the dentist, the nurse, ste. Just what the91 necessary minimum of these supplies or services is, or should be, for credit pur- poses,:is a problem for the credit merchant, the banker, and the borrower to decide in particular cases. Unnecessary Consumption Credit It was pointed out above that necessary consumption credit is rather closely connected with production credit in that 1) certain consumption goods are ac- tually necessary to production and 2) the returns from family labor can ordinaril; be depended upon to pay necessary consumption loans. But unnecessary consumption credit has no such direct relation to the productive activities of the farmer. The use of what is here called unnecessary consumption goods are services does not perceptibly increase production and the application of loans for these purposes does not provide for their liquidation. Debts so acquired cannot be considered as expenses of business. They must be paid from net income. Musical instruments and pleasure automobiles are distinctly unnecessary to production. Their use is purely for personal satisfaction. Passenger automobile are sometimes considered instruments of production, but their use as income is as yet quite insignificant. They are rather noted as consumers of income. For this reason bankers ordinarily refuse to make loans for the purchase of automobiles. They are highly desirable but the expense of upkeep and their insignificance as a factor in the productive operations of the farm seem to indicate that it is poor business policy for the farmer to purchase them on an anticipated income. Other unnecessary consumption expenses include all forms of extravagant expenditures for food, clothing, and household supplies. Expenses for amusements and travel should also be included. CONSUMPTION EXPENDITURES If it could be ascertained just what portion of the farmer's annual income is spent for living expenses, or if living expenses could be compared with the annual expenditures for operating and investment capital, some ideatof the impor- tance of the problem of financing the family could be obtained. Unfortunately these facts are not known for all the farms in the country. The United States epartment of Agriculture and certain state experiment stations and extension services have realized the importance of collecting such data and during recent years have secured many samples of data on farmers! incomes, costs of living, and costs of production. Data collected in certain counties in New York, Texas, Kentucky, and Tennessee from 1919 to 1921 indicate that the average cost of family living was $1470 per year.t This cost-of-living figure should be reduced 1. United States Department of Agriculture, Yearbook, 1923, p. 580. oP eC he TB ese Oe A SP SEP en ee en anlar a me re eeBe ee OR les , 92 to $1437 since an average of $33 was spent for life insurance premiums, which should be considered as savings or investments and not as expenses. The $1437 was divided as follows: 1) food, $652 (45 per cent); 2) for clothing, 9248 (17 per cent); 3) for advancement including education, recreation, social contact, and travel, $115 (8 per cent); 4) for health, $66 (5 per cent); for personal items, $17 (1 per cent); and 6) for miscellaneous expenses including fuel, household supplies, and the estimated rent on the residence, $339 (24 per cent). About $540, or 38 per cent, of the total family living costs was furnished . by the farm and, therefore, does not directly involve financing. From 40 to 70 per cent of the food and a large part of the fuel consumed vas supplied by the farm. Also the rent did not involve an actual outlay. It was estimated by taking a normal rate of interest on the value of the building. After deducting items furnished by the farm the net actual outlay for living in these states is estimated at $897. A comparison of living expenses with gross income and production expenses should be illuminating here. According to an estimate made for ovmer-operators for the whole country, the average gross receipts per farm from ali sales was $1,972 in 1922 and $2,240 in 1923.¢ For these two years an average of about $1,300 was actually paid out for livestock, feed, fertilizer, seed, taxes on property, labor, machinery, and tools, and miscellaneous items of operating ex- penses. Zhe actual outlay for family living then seems to be about two-fifths as much as the gross income and ebout two-thirds as much as the outlay for pro- duction capital. These figures are presented to show that financing the family is one of the farmer*s most important credit problems. It is recognized of course that the general price level was higher in 1919 when most of the figures on the cost of living were collected than it was in 1922 and 1923. This discrepancy is partly offset, however, by the fact that the cost-of-living figures for New York were for the year ending September 1, 1921, when prices were at a low level, Also, it is recognized that these figures cannot be accepted as being accurate in ree presenting either the average family expenditure or the gross receipts of all the farmers of the country, In the first place, the data on family expenditures represent samples from only four states and they include only white families; in the second place, the gross receipts figures ere restricted to farmers who own their farms and to a limited number of these. However, in spite of these limitations, they do show something of the relative and absolute importance of the farmer's expenses for conswnption goods and services. @- United States Department of Agriculture, Yearbook, 1924, p. 1131. These estimates are based on reports from 6,094 farmers for 1922 and 16,183 far- mers for 1923.93 IMPORTANCE OF CONSUMPTION CREDIT It might be assumed that the profits and the return for labor from the last crop would cover the family expenses while the next crop is being produced, but as a matter of fact a large percentage of farmers use credit for this purpose. The farmer sees no particular reason why he should restrict his credit to the pur-~ chase of operating capital. Both the operating capital and consumption goods which he buys will be paid for from returns of the crop. Although no definite in- formation is available as to the amount of consumption credit obtained by farmers, observation and certain investigations show that it is rather extensive, particu- larly in some sections of the country. A large part of the credit obtained from merchants is consumption credit. That American farmers have used, and are using, merchant credit extensively is a well known fact. An investigation made by the United States Department of Agri- culture in 1922 indicates that over 50 per cent of the farmers were obtaining credit from merchants.° Only 1 or 2 per cent of the farming communities of the country reported that no merchant credit was being used. Answers to a question= naire sent to Texas bankers by the writer in 1925 indicate that slightly over 50 per cent of the farmers obtain merchant credit. About 60 per cent of the farmers in Dane County, Wisconsin, received merchant credit in 1915.* An investigation in North Carolina in 1921 shows that over 54 per cent of the farmers use merchant credit,° and about 50 per cent of all short-term farm credit was received from merchants. & study made in three representative counties in New York indicates that of a total of 320 country stores 307 extended some credit.© About 53 per cent of the customers had credit accounts and 53 per cent of the total sales were made on credit, either on open accounts or on the basis of customers! notes. Just what portion of the merchant credit obtained by farmers is consumption credit is not known. Credit to + buy machinery, feed, and fertilizer is of course production credit. In some cases these items account for a large part of the merchant credit received. In certain North Carolina Counties, for instance, it has been estimated that about 44 per cent of the inerchant credit obtained by far- mers was used to buy fertilizer.’ Farm machinery is quite commonly bought on 3. United States Department of Agriculture, Yearbook, 1922, pe 25-50. 4, University of Wisconsin, Agricultural Experiment Station, Bulletin No. 247. 5. North Carolina Department of Agriculture, The Bulletin, May, 1923. -» Cornell University, Agricultural Experiment Station, Bulletin No. 430. “4 © * North»Carolina Department of Agriculture, The Bulletin, May, 1923.94 credit, but practically all the goods bought from grocers, dry goods merchants, furniture and drug stores are consumption goods. The study made in New York indicates that 83 of the 191 stores whose records were analyzed were general stores, and that 44 per cent of their sales were credit sales. Since general stores handle consumption goods chiefly these figures give some indication of the importance of consumption credit in New York. Farmers also use a considerable portion of their bank loans for consumption purposes. In fact there has been a noticeable tendency among farmers during the past few years to avoid the high interest rates on merchant credit by borrowing from the banker and paying cash for goods. The replies from Texas bankers in 1925 indicate that an average of about 40 per cent of the loans to farmers is used for consumption purposes. It is evident from these investigations and from ordinary observations that an important share of the total short-term credit received by the farmers is used for consumption purposes. Also, it is evident that some of the farmer's most difficult credit problems arise in connection with consumption credit. Un- like land credit, the goods bought seldom serve as security for the loan. By the very definition of consumption goods and services there is no hope that their use will direatly increase the farmer's income. Hence this type of credit has been very expensive. Bankers heave standard requirements for security and many farmers have found it easier to depend on the merchant. In order that the merchant might be able to carry such accounts he has been compelled to borrow frem the banker. Thus the farmer has receivec credit indirectly. The merchant has tended to make himself safe by increasing the price of his goods, by charg- ing a high interest rate, or both. He has carried very doubtful credit risks and has penalized the better borrowers by forcing them to pay enough to cover the bad debts. THE TERM OF CONSUMPTION LOANS Consumption loans should be paid at the earliest possible time, The cost is great and it should be decreased as much as possible by the early liquidation of the loans. But payment can be made only when the borrower sells his products. All goods bought on credit and consumed during the period of production should be paid for when the products of the period of turnover are sold. This suggests thenclassification of consumption goods mehtioned in Chapter 4, i.e., 1) goods, such as food, which endure only one period of turnover of the farmer's business, and 2) goods such as automobiles and victrolas which last more than one period of turnover.95 Current Goods and Services - Consumption goods which are currently used up include groceries, clothing, household supplies, fuel, school supplies, and such ‘things as tobacco, candy, etc. Although these goods may have little or no direct relation to the productive activity of the farmer, they should be paid for from current production. A new supply of such goods must be bought during each suc- -ceeding turnover period and, unless the farmer pays for goods currently consumed from current production, he will soon accumulate debts which he can never pay. The. banker and merchant will cease to carry his accounts. Practically all of the expense for services employed by the family should be included as current expenses and, therefore, should be paid for out of the current products of the farm. Doctor bills, expenses for travel and amusement, and wages for household labor should all be paid promptly when the crop is sold. Permanent Goods = Just as is the case with production goods there are certaii. consumption goods:which are more or less permanent and which may, therefore, be paid for from the returns of several turnover periods of the farmer's business. The farmer's residence is the most important type of permanent consumption goods. Residences were included in the classification of farm buildings in Chapters 4 and 5 because of their similarity to investment capital. It was pointed out that the farmer's residence is also his business office, that it is subject to the same type of depreciation as are other farm buildings. Unlike the residence of the merchant, the farmer's residence is invariably bought and sold with the business. They are inseparable. But the residence is primarily a consumption good. Its size and expensiveness are not determined by the needs of the farmer's business, but by his personal tastes and his purchasing power. Mortgage banks frequently find, for instance, that the residence is valued out of proportion to the production needs of the farmer, and the size of the loan allowed is limited accordingly. This indicates that in practice the banker considers the residence as a pert of the farmer's production eouipment when it is not valued out of pro-~ portion to the value of the farm as a whole. The fact is that the residence is primarily a consumption good and when it is not too expensive the owner is ex- pected to be able to pay for it from the net returns of his business in the same way that he is expeated to pay for his current consumption goods, except that he must be allowed to pay for it from the sale of several crops. The time allowed in paying for the residence is affected by its rate of depreciation. Ordinarily it must be insured against fire before the banker is willing to make the loan, and 2 wide margin must be allowed between the value of the building and the amount of the loan. The federal and joint stock land banks, for instance, lend only 20 per cent of the value of farm buildings. If the residence lasts twenty-five years the banker can afford to make the loan for that96 period of time, providing the loan is being paid off as the building depreciates, It was pointed out in Chapter 5 that investment capital loans should be paid off as soon as possible so that the farmer might heve tho maximum of freedom in the control of his business. This is all the more true in the case of the residence. The inherent fear of mortgage debts seems to be based largely on the fear of losing the home. Home ovmership is the worthy motive of most farmers and the sooner the mortgage debt is paid the sooner will this end be realized. Little need be said concerning the term of loans for house furnishings ex- cept that the maximum time allowed should not extend beyond the period of useful- ness of such equipment. Such equipment as furniture, stoves, victrolas, radio sets, and pianos are subject to rapid depreciation. The merchant who sells them on credit is sufficiently enlightened in his owm interest that he will require partial payment at the time of purchase and payment in full before they are worn out. Finally, mention should be made of the automobile. The passenger car has been classified as a consumption good despite its use in a limited way in pro- duction. The important characteristics of the car from the credit standpoint are 1) rapid depreciation “and 2) high cost of operation. The first characteristic indicates that automobile loans must be paid off rapidly, while the second characteristic has the effect of decreasing the borrower's ability to pay it off rapidly. The result is often disastrous, This situation along with the high cost of automobile loans should cause the prospective credit purchaser to hesitate. The necessity for rapid payment and the heavy cost of upkeep of automobiles have been effective during the past ten years in preventing many farmers from achieving financial independence. THE ECONOMICS OF CONSUMPTION CREDIT From the standpoint of general economy and from the standpoint of the indi- vidual borrower and lender, there is some question of the advisability of loans for consumption purposes. In the case of production credit it is always expected that it will be used in such manner as to increase the productivity of the bor-~ rower. The production loan is secured by the prospective returns from its appli- cation, and the only question as to the advisability of a preduction loan is: How productive will its application be? If the borrower and lender think that the loan can be applied so that the borrower's totel income will be increased enough to pay the loan with interest, the matter of its advisability is settled. But there is no such basis for determining the advisability of consumption loans. Here it is chiefly a question of the relation of the amount of the proposed loan to the net income and the capital assets of the borrower. The uncertainty of thaOi existence of enough net income to meet the obligation accounts in part for the extensive practice of requiring a mortgage on some of the borrower's capital assets, such as teams, machinery, or lands. In considering the propriety of consumption loans the distinction made above between necessary consumption goods and unnecessary consumption goods is impor- tant. It could hardly be said that the farmer should not borrow to obtain the necessities of life. Of course it is advisable for him to have a surplus suffici- ent to maintain his family, but this is not always possible. A crop failure may force him to borrow; he may be starting in business; or he may have to borrow because of a lack of thrift. In any of these cases it may be to his own interest to obtain credit. Also, it is probable that in a majority of cases the interests of society as a whole are served since such credit makes possible the continued productive activity of the borrower. The case is quite different with loans for extravagant expenditures for food, clothing, and the other family supplies, or for any expenditure for the type of goods which do not aid in production. It seems advisable for all concerned to delay such purchases until the income to pay for them is realized. There are several definite reasons why such eredit should never be obtained. In the first place, such loans are usually very expensive. Installment purchases of consump- tion goods usually involve the payment of a very high rate of interest. The in- terest paid: on such loans is entirely out of proportion to the rate the farmer would ‘be able to receive on an investment. The installment purchase of consump- tion goods, such as musical instruments and automobiles, decreases savings. A more economical method is that of accumulating the full purchase price before buying. The high interest charge of the installment purchase is equivalent to an increase in the price of the article, The buyer's purchasing power is thereby greatly limited. Of course the expensiveness of the unnecessary purchases is not limited to installment buying. It is perfectly normal that the interest rate should be high on unproductive loans. The risk is normally greater, unless the assets of the borrower are sufficient to secure the loans. In the second place, unnecessary consumption loans are not advisable from the standpoint of general economy. Such credit tends to develop extravagant and thriftless habits on the part of borrowerse If the goods desired can be had in advance of the effort required to earn the purchase price, the stimulus for sav- ing is decreased. Ordinarily the stimulus to saving is greater if the satisfac- tion to be derived is in the future than if the goods have already been consumed. Borrowers come to depend upon the banker rather than their ow effort and thrift. The encouragement of borrowing for unnecessary consumption purposes would undoubt- edly be disadvantageous to the economic welfare of the country.98 In the third-place, borrowing for unnecessary consumption tends to weaken the whole credit structure. The unsowndness of such credit is particularly evident during periods of depression. The borrower usually has very little equity in the capital which he uses, and adverse price conditions often result in bankruptcy and default in the payment of loans. The banks have partially K avoided the evil effects of consumption credit by carefully restricting the fF amount of such loans. But they have suffered greatly from the liberal credit , policy of merchants. Every period of apricultured? depression takes its toll of banks which have become heavily involved in financing credit merchants. There ES is an increasing sentiment at present to discourage the extension of such fh credit by merchants. Farmers are encouraged to obtain loans from the bank and pay cash for supplies. Such practices would not only tend to decrease the amount of unnecessary purchases and increase the thrift of farmers, but it i would put the whole agricultural credit system on a sounder basis. Loans would be based on better security, interest rates would be lower, and in the long run bank failures would be less frequent. eS i 7 , a F b SeeWE, QUESTIONS AND PROBLEMS Describe unnecessary consumption credit from the standpoint a) of the banker or merchant, b) of the borrower, and ¢c) of the public as a whole. Why is the distinction between necessary and unnecessary consumption credit important? Why do'merchants supply a large proportion of farmers* consumption credit? Explain the high cost of consumption credit.EF TCL IP PPPS 100 Chapter & SECURITY FOR FARM CREDIT It was pointed out in Chapter 1 that the credit transaction is essentially the exchange of potential purchasing power for immediate purchasing power. The borrower has personal qualities and property which are capable of producing an ie income in the future, but he needs cash or immediate purchasing power. The ih banker or lender supplies immediate purchasing power on the basis of his con- L fidence that the borrower's income will be such that he can repay the loan at , some specified future date. This confidence is strengthened by the entrance of 7 @ third party to the transaction - the state. A contract enforceable by the state is entered into by the borrower and lender. This simply means that if the ee borrower is unwilling to pay, the lender has recourse to law and can force payment. But suppose the borrower failed to receive the prospective income from which it was expected that the loan would be repaid? In this case the ; | | Ls law permits the lender to take payment through the sale of some of the borrower's i property, on which the borrower may or may not have a mortgage. The particular advantage derived from having @ mortgage on certain specific properties is that it establishes priority of claim. The plain personal note makes the borrower | liable in law to the extent of his assets, but there may be other creditors i with prior claims,-or the property may be entirely exempt from attachment under the homestead laws, etc. Hence when we say that the credit transaction is based on confidence it means 1) tonfidence that the borrower will receive income sufficient to pay the | obligation when it is due, 2) confidence that the borrower will be willing to pay, 3) confidence that in case he does not receive sufficient income his assets i’ or net worth will be great enough to liquidate the debt, and 4) confidence that A the courts will actually enforce the contract if necessary. Credit then is } based immediately on confidence in the ability and integrity of the borrower and te ultimately on the extent of his net assets and the laws regulating contract. ee DESCRIPTION OF SECURITY FOR FARM CREDIT i, From the standpoint of legal enforcement there are two types of credit con- fs tracts - the general and the specific. That is, the borrower may obtatn credit a on such security as a plain personal note or an Open account, or he may mortgage i such specific property as land, buildings, machinery, livestock, crops, or other property. In the former case the borrower is liable to the extent of his total101 assets, except such as are specifically mortgaged or exempted otherwise by law, for the payment of the obligetion. Nothing is specifically mortgaged. Credit obtained on such general security is usually called personal credit. It is ex- tended on the good name and reputation of the borrower, but implicitly his avail- atle assets are pledged for the repayment of the loan. The banker frequently prefers a mortgage on certain specific property because 1) the assets of the bor- rower may not be sufficient to pay off all his creditors, 2) there may be prior claims or mortgages on a part or all of the assets, and 3) the borrower is either not well known to the banker, or his reputation for integrity and ability is not satisfactory. It should be stated in this connection that although the banker or lender has recourse to the law, it is always presumed that such recourse will be unnecessary. The banker attempts to place his loans in such manner that legal enforcement is not necessary. Lawsuits and foreclosures are both troublesome and expensive. Lawsuits for the recovery of loans made on general security and the foreclosure o7 specific mortgages are resorted to only in extreme cases. Hence our study here involves primarily the description of farm security rather than the legal phases of the enforcement of credit contracts. The great majority of credit contracts are actually made and settled without recourse to the law courts or foreclosure proceedings. 1. General Security The farmer's general security consists of three types: 1) his personal. qualifications, 2) his prospects for income, and 3) his net assets of financial condition. These are the basic considerations in extending loans on personal notes or open accountse Personal Qualifications Bankers often assert that the personal qualities of the borrower are more significant than is the property which he may have to pledge or any property which may be available for attachment through a lawsuit. At first thought it would seem that the honesty of the borrower would mean little since the law is back of the lender in forcing repayment of the loan, either from pledged property, or from the general assets of the borrower. But it is probably not an exaggera- tion to say that any banker would rather forego making a loan than to make it ana have to go to the.trouble and expense of a foreclosure or lawsuit. The property of the borrower, whether it is specifically mertgaged to secure the loan or in- directly available for its payment through process of law, is merely a guaranteea a 102 for the loan in case unforeseen conditions arise. It falls so far short of guaranteeing the banker a profit that he uses his best effort to avoid the necessity of using such means to force payment. Hence honesty and integrity are very significant in the prospective borrower. Another personal quality somewhat closely related to honesty is that of promptness in meeting obligations. Promptness is important in all credit transactions, but it is particularly important to the commercial or deposit banker. One of the difficult tasks of the deposit banker is to be able at all times to meet the demands of his depositors. He attempts to do this by making his loans $0 that they will mature at such intervals that a sufficient supply of funds will be available at all times. Lack of prompthess on the part of borrowers obviously disrupts this program. Moreover, a lack of prémptness increases the cost of credit. Slow payments increase the clerical work of the bank. Notices and special letters to one or only a few customers are relatively inexpensive;, but in the aggregate they are significant. Prompt. ness of borrowers places the banker in better position to serve his depositors, decreases the expenses of the banker, and should reduce tho cost of credit to the borrower. A thitd essential personal qualification of the prospective borrower is the ability to produce an income. After ell, honesty and promptness alone do not pay debts. These are essentially supplementary qualifications while ability as a producer is a primary qualification of the good credit riske The ability to use loans properly seems to be far less common among farmers than is honesty or integrity. Proper use of loans is dependent on the native ability and experience of the farmer. Of two farmers on adjoining farms with similar land and equipment one may be a notable failure while the other is just as notably a success. Closely related to the quality of personal ability as a producer is that of thriftiness, The/thrifty farmer not only has saving habits, but he knows how to spend his income to the best advantage. He is continually investing his surplus earnings in such a way as to increase his future income, while the less thrifty farmer invests in something which actually decreases his future net earnings. For example, if the question arises as to whether to spend $1,000 fof the year's earnings for the improvement of the farm or to spend it for an automobile, the thrifty farmer is likely to improve his build- ings, machinery, or soil, while the less thrifty farmer is likely to buy an automobile. Farm improvement increases future income; the automobile dis~- sipates future income. Hence the farmer with a reputation for thriftiness properly has a great advantage in obtaining credit. He is a better risk.103 Prospective Income Since it ts usually presumed that loans will be paid from the income of the borrower, the prospect for income is by far the most important consideration in the extension of credit. It was pointed out above that personal ability has mich to do with the earnings of the borrower. Other important factors affecting income are: 1) the adequacy and quality of land, equipment, and labor; 2) the type of farming; and 3) market conditions. The banker must of necessity be familiar with the agriculture of the community as well as the particular situation of the pros- pective borrower. Indeed he should be familiar with the market conditions of the products of his community. The type of farming and the condition of the-market for farm products are ordinarily fairly uniform for the whole community. Knowledge of the requirements of the particular type of farming followed and market condition are presumably the banker's background for the extension of loans. There remains then the problem of analyzing the individual farmer's credit needs as he makes re- quests for loans. That is, he must be able to pass judgment on the need for more land, equipment, and labor. Supply of Capital and Labor - Prospects for income depend then in the first place on the capital and labor with which the borrower has to operate. From the standpoint of the banker it is essential that the borrower have a sufficient. amount of productive land. In practice this is readily estimated by a consideration of the type of land, the common size of farms in the community, the available equip- ment and labor, and the ability of the borrower. ‘Income prospects can often be improved by the use of more land or by the use of fertilizer. On the contrary, more land is sometimes a detriment and the use of fertilizer is not aoa here The banker must satisfy himself on these points. Prospects for income are enhanced by good buildings, mavhinery, and livestock. The importance of buildings depends to a considerable extent on the type of farm- ing and the section of the country. To the dairy farmer in the Middle West a rather large investment in buildings is necessary. Lack of proper care of dairy herds during the winter season greatly decreases their productivity and the income of the farmers Likewise in the grain producing sections adequate buildings are essential for storing and protection from the elements. Even cotton farmers have ' eRperienced extensive losses because of inadequate storage facilities for cotton. Teh adequate supply of machinery of the proper types is also necessary in the creation of a maximum income. The banker must pass judgment on the requirements of the prospective borrower who proposes to use the loan to buy machinery. For example such questions as the following might arise: Is a threshing machine appropriate to the needs of a farmer who has only one hundred acres: of grain? Is a tractor appro- priate for the small scale farmer? Does this particular farmer have enough hauling to make’a truck economical, or if he has enough are the roads adapted to the useiy | le i ie as eA coe ea a Re a 104 of a truck? It might be supposed thet the prospective borrower would know all of these things, but the banker representing the investors! interests must be satisfied. Repayment of the loan depends primarily on the success of the borrow- erts undertaking. Livestock is a particularly important factor in the creation of farm income. In fact it is so important that bankers and agricultural papers have been con- ducting extensive campaigns to induce more livestock production in certain sece tions of the country. The close connection between livestock and the certainty or adequate income on the one hand and the interests of the banker on the other is well illustrated by the fact that American Bankers! Association and the state banking associations, as well as individual country bankers, have during recent years made special efforts to educate the farmer to the usefulness of livestock. Bankers have in many cases made special arrangement for financing the farmer an the purchase of more and better beef and dairy cattle. Bankers, county agri- cultural agents, and the agricultural agent for a certain railroad conducted a tour in the summer of 1925 from Texas to Wisconsin and Minnesota through some eight or ten states for the purpose of studying dairy farming methods = not because they expect to go into the dairy farming business, but because they expect to encourage cotton farmers to supplement their crop with dairy products. The banker is thus attempting to make a better credit risk of his fnrmer-customer by increasing or stabilizing his income. “Farmers are encouraged to have & few chickens, hogs, beef cattle, dairy products and the like to sell during the crop producing period. The banker frequently points out that the proper amount and quality of livestock not only increases the amount of income, but that it in- creases the regularity of income. The production of livestock is coming te be more and more significant in the care of the soil. Certain leguminous crops are grown for the purpose of building up the soil, and economy requires that these crops be fed to some Kind of livestock. Also, the manure is important as a fertilizer. Broadly speaking, livestock production becomes & more significant basis for credit as the native fertility of the soil decreases, There is probably no question which the banker more commonly asks the pros- pective borrower than that concerning his labor supply. This question applies particularly to family labor. The size of the farmer's family and the number who can be profitably employed on the farm are significant in determining the amount of net income. Extra labor is often required during the cultivating and harvest- ing seasons, and the banker is usually ready to extend credit for such purpose. Type of Agriculture - In the second place, prospects for farm income are affected by the type of agriculture. The income of the one-crop farmer, for in- stance, is quite uncertain, since a crop failure means the loss of a whole year'ts105 income. From the point of view of the banker the one-crop farmer is comparable the investor who fails to diversify his investments. His condition is really 4. co worse, Since there are many investments which are more certain than a farm crop. The probability is that the one-crop farmer will occasionally suffer a complete failure. Some farmers are overcoming the hazards of one-crop farming by the pro- duction of two or more major crops, or by supplementing the crop with livestock and livestock products. The latter practice at least seems to be capable of wider and more successful application. Livestock production serves the double purpose of diversification and soil maintenance. Even though diversification may not increase the income for a particular year, it tends to guarantee regularity of income. If the crop is a failure, the farmer has another major product to. carry him over. The hazards of one-crop farming force the banker to loan more conserva- tively on general security. In addition to the one-crop and diversified types of farming, there is the: type which involves specialization in producing livestock or livestock products, such as range cattle and dairy production. The ranchman is commonly a_ specialist, although it is becoming common in certain sections of the country for him to combine cattle, sheep, and goat production. The dairy farmer sometimes produces hogs from the by-products of the dairy, but in most cases he is essentially a specialist. It should be pointed out here that the financial problem of the dairy farmer is different from that of the other types of farmers in that his income is fairly regular through the year. He receives payment for his products day by day as they are sold, or at the end of two weeks or 2 months The ranchman who specializes in beef cattle production is in a position somewhat similar to the one-crop farmer, except that risk of failure for a particular year is not.as greate A crop of calves is more certain than a cotton or wheat crop. But there are elements of uncertainty, particularly in the price for which they will sell. Beef cattle production is similar to crop production in that income is received ordinarily only once a year., Dairy farming differs from one-crop farming and beef cattle production chiefly in that income is received throughout the year and there seems to be preater certainty of income. Market Conditions #« In the third place, the prospect for income is affected by that more or less intangible and insoluble factor called market conditions or, more specifically, the prices of farm products. The net income of the farmer is measured by the emount of products, their cost of production, and their sale value. The leading problem of the farmer in regard to prices is the regulation of supply. Prices are of course determined by both supply and demand, but in the case of the farmer the supply is by far the more significant since the demand remains comparatively constant from year to year. The supply of aazparticular farm: / ' a a ree Bo ae SN ga een 106 product may vary as much as fifty per cent from one year to another. The most unsatisfactory phase of the situation is the great difficulty of control of the supply. Small production units, wide dispersion of farmers, and the uncontrol- lable climatic, insect, and disease conditions seem to prevent any high degree of control or any accurate estimate of production. The uncertain conditions of supply are a disadvantage to the individual farmer in two ways: he is uncertain as to what he will produce himself, and he is uncertain as to what the total supply and the price will be. Such conditions force the banker to lend conservatively. His position as trustee of depositors! funds forces him to lend only such amounts as borrowers are fairly certain of paying, even though prices drop severely. If the degree of uncertainty seems too great, the banker requires a mortgage on specific property in addition to a personal note. The Financial Position of the Borrower In addition to personal qualities and prospects for income, the financial position of the borrower serves as general security for loans. The banker in the farming community ordinarily knows the approximate net worth of his customers. He knows the size of the farn, something of the value of the equipment, and in a general way the indebtedness of the borrower. The farmer whose net worth is $25,000 is obviously in a better position to obtain a loan of $1,000 on his personal note than is the farmer whose net worth is $1,000, since unencumbered capital is available for attachment in case of failure to pay the note. The farmer who has the personal qualities of honesty, promptness, and ability, good income prospects, and a substantial amount of unencumbered property is an ideal credit risk. His personal note is adequate security for operating loans. Extent of the Use of General Security it has been estimated that about two-thirds of the operating credit extended by commercial bankers to farmers is secured by general security, as evidenced by personal notes.! About one-third is secured by the plain note of the borrower and one-third by the borrower's note with the indorsement of' one or more persons. Personal notes with indorsements are general security just as are individual notes except that the unencumbered property of more than one person-may be taken in payment of the loan. Frequently tenants and others who have limited assets, whose personal qualifications are not well known to the banker, or whose reputa- tion is unsatisfactory, must obtain the indorsement of their landlords or friends of good standing in the community. 1. United States Department of Agriculture, Yearbook, 1924, De colo) tit.107 Another form of general security is in common use by farmers in certain sec- tions of the country, i.e., the open account with merchants. Merchants often require a personal note or even a mortgage on specific property, but the plain charge account seems to prevail. 2e Specific Security Under certain circumstances and with certain types of loans the banker re- quires specific security of one or more of the following kinds: 1) the farm mort- gage, which usually includes both land and buildings; 2) the chattel mortgage on livestock, machinery, etc.; 3) the crop lien; and 4) the warehouse receipt or othe: collateral such as stocks and bonds. The Farm Mortgage The most common and by far the most important type of specific security which the farmer uses is the farm mortgage. Practically all credit for the purchase of land and buildings is acquired on the basis of a mortgage on the farm whether the loan is obtained from the ordinary bank, the farm mortgage bank, the insurance company, or an individual. Also, a mortgage is often given on the farm for the purchase of livestock and machinery. In emergencies short-term credit obligations are sometimes funded by securing a long-term loan on the farm mort gages The farm is the greatest asset of the farmer. It forms the great property bulwark of his credit of all kinds. Its use as security for loans hastens the process of ownership for young farmers. The significance of its use for this pur- pose is indicated by the fact that in the United States in 1920 over 37 per cent of the farms operated by owners were mortgaged for debts amounting to over $4,000,000, 000. “ The total farm mortgage indebtedness at that time on all farms in the country was estimated at approximately $38,000,000,000, an amount which is probably twice the total farm loans of all other kinds outstanding at that time. Strange as it may seem on first thought, the most progressive and richest agricul- tural sections of the country seem to have the highest percentage of farms mort- gaged. This high percentage of mortgaged farms simply reveals an active struggle for farm ownership by the extensive use of the farm mortgage as security for loans to buy farms. The states which have the highest percentages of mortgaged farms almost invariably have low percentages of farm tenancy. The mortgaged farm seems to be a normal step in the advancement of the individual farmer from tenancy to full farm ownership. é- United States Department of Agriculture, Yearbook, 1924, p. 190.r 108 The Chattel Mortgage | The chattel mortgage is next in importance as specific security for loans. According to a recent estimate more than 15 per cent of the short-term bank loans to farmers in the United States in 1923 were secured by mortgages on livestock and between 3 and 4 per cent were secured by mortgages on farm machinery.® A considerable portion of the credit extended by merchants is secured by such mortgages. Also, the recent development of the installment sale of automobiles has created an enormous farm debt based partially on the security of chattel mortgages on the cars. Mortgages on teams and machinery are particularly im- portant bases of farm credit in the cotton growing states, while mortgages on livestock are most prevalent in the range and cattle feeding states. Crop Liens Crop liens were used as security for about 6 per cent of the short-term bank loans to farmers in 1923.4 This type of security is found chiefly in the South and is used most commonly by tenant farmers. Over 29 per cent of the short-term bank loans to farmers in Alabama in 1923 were made on crop liens.5 It was pointed out above that the banker usually looks to the income of the bor- rower for the payment of the loan, and that loans obtained on personal notes are based largely on the prospects of the borrower for income. But bankers sometimes consider that the obligations of the borrower are such that safety must be sought in a specific mortgage on a part or all of the crop. It is common for Southern bankers to take a lién on the first bale of cotton or the first five, as the case may be. This simply establishes a first claim on the income of the borrower. Collateral The warehouse receipts on farm products is not as yet used vsry extensively by the farmer, although its use is increasing with the recent development of our warehousing system, The farmer has in the past done very little warehousing, but with the increasing sentiment for the “orderly marketing" of farm products the use of the warehouse receipt will serve as a basis for credit and will become more and more important. The extensive use of the warehouse receipt will be re- stricted largelyaté the cooperative marketing associations. Already many co- operative organizations are using the warehouse receipt on a large scale in ob- taining loans to advance to members while the product is being marketed. A 3. United States Department of Agriculture, Yearbook, 1924, p. 223,f. 4 and 5. United States Department of Agriculture, Yearbook, 1924, p. 223.109 warehouse receipt from a standard warehouse makes exceptionally good security since it carries insuramee against Mire and other losses, Also the product is readily salable. The warehouse receipt held by the banker is essentially the same as a mortgage and it has the advantage over mortgages on other property of the farmer in that it can be sold readily in case of necessity. Farmers have not used stocks and bonds to any great extent as security for loans, chiefly because they have not had such securities. Ordinarily the farmer can invest his surplus earnings on the farm. If he does have a surplus for out- side investment, he is proverbially afraid of stocks and bonds. He usually prefers to invest in something with which he is more familiar. However, the ex~- tensive purchase of government bonds during and after the recent war seems to have done much to break down the old prejudice against investment in bonds. Our recent development in investment banking facilities should also do much to induce farmer: to buy corporation stocks and bonds as well as government bonds. It is to be ex- pected, therefore, that stocks and bonds will become more and more important as a type of specific security for farm loans. Almost 3 per cent of the short-term loans of bankers to-farmers in 1923 were secured by stocks and bonds .® 3. The Security of the Bank Since most farm loans are not received directly from the original owners of loanable purchasing power but through an intermediary financial institution, the investors or original lénders have the double security of the banker and the far- mer. The investors who place funds with the mortgage banker, or the depositors who patronize the deposit banker, naturally look to the banker for safety. This he attempts to guarantee with general or specific security, or with both. The deposit banker guarantees his depositors with whatever specific mortgages he may have on the property of borrowers, with personal notes of borrowers and-with his own capital-and sumdivided earnings. In the case of all national banks, and some state banks, the law requires additional security of an amount equal to the capi- tal stock of the bank. Investors who place their surplus funds with farm mort- gage bankers invariably have the guarantee of the farm mortgage. In the case of the regular private farm mortgage bankers the investor usually obtains and holds a particular mortgage, while in the case of the federal and joint stock land banks he obtains a bond which is secured by a Gollection of farm mortgages held by the bank. Most of the regular private mortgage bankers simply set] mortgages to investors and make no attempt to guarantee their safety. That is, they follow the same policy that is practical almost universally.by investment banks - they 6. United States Department of Agriculture, Yearbook, 1924, p. 224.6SELES ATE Pat 110 recommend the security but do not guarantee it with their owm assets. They merely act a5 middlemen. But a few of the private farm mortgage bankers and all of the federal and joint stock land banks pledge their own assets to guarantee the in- vestors against loss. They not only attempt to guarantee the safely of principal, but also the regular collection and payment of interest. In case of the necessi- ty of foreclosure, the procedure is directed by the banker without cost to the investor. The federal land bank goes one step further in guaranteeing the safe- ty of its farm mortgage bonds, since its bonds are secured by the combined capital and earnings of the whole-system of twelve federal lend banks. A very large amount of savings is invested in farm mortgages through savings banks and insurance and trust companies. These investments are secured by the farm mortgages in the hands of the banks and companies, and by their capital and undivided carnings. Alsoy they are protected in a general way by Special laws regarding the policies of such institutions. Savings banks and insurance and trust companiesrare particularly well supervised by the state governments for the special reason that the savings of large numbers of small investors.are involved. Then the original owmers of the funds which are loans to farmers through financial institutions have the double security of the farmer and the banker, This is not peculiar to farm credit in the base of loans through banks and companies other than farm mortgage banks, since all depositors of banks, policy~ holders of insurance companies, and wards of trust companies are similarly pro- vected whether their funds are lent to farmers or other borrowers. But the double security is peculiar to farm mortgages, since the investment bankers who sell the securities of industrial and commercial corporations seldom, if ever, attempt to guarantee the investment. DETERMINATION OF FARM SECURITY TO BE OFFERED The particular type or types of security which the farmer will offer in ob- taining a loan depends chiefly on his personal reputation, the amount of his assets, and the purpose of the loan. Loans made for the purpose of buying in- vestment capital are practically always based on specific security. The land, buildings, machinery, teams, or cattle bought with the loan are commonly mort- gaged as security. On the other hand, loans made to purchase operating capital or to pay labor are most commonly made on the general security of the borrower in the form of a personal note. But why this distinction of security according to the purpose of the loan? Is the risk greater in the case of investment loans? Why, flor instance, are banks not willing to take the personal note of the best farmers for loans to buyala land, whereas, they will take the personal notes of farmers of poorer reputations > > ¥ d=! for loans to buy feed, seed, and other operating capital? In the first place, the wf ? ? iF & Pp > permanent nature of investment capital makes possible a mortgage on the capital bought with the loan. Overating capital changes form or is used up during the production period, while investment capital remains in salable form for many pro- duction periods. It is impracticable for the banker to take a mortgage on a suppl Ss of horse feed, while it is both practicable and common to take a mortgage on the horsese The only way to obtain specific security on operating capital is to take a mortgage on its final form -- the crop or animals which are being produced. This is practiced to some extent, as was noted above, but over the country as a whole crop liens are not a very common type of security. It seems only normal and logical that the particular capital which is bought with the loan should be pledg. ed as security, but the temporary life of operating capital makes this impractica- ble. Plain personal notes, crop liens, or mortgages on other capital of the bor- rower are taken instead. In the second place, specific security is used in obtaining investment loens because of their longer term. The banker may be willing to risk the exingencies of the borrower for a year, but not for ten yearss When a crop is well started the chances for income within a few months seem fairly sure, but for a period of ten or twenty years the chances of a decrease in income are too great. The bor- rower may become incapacitated or market conditions may become such as to prevent payment of the loan. In the third place, specific sedurity is desirable because farm investment loans ordinarily involve a considerable amount of money. The banker is often willing to take a plain personal note on small loans, but banking policy requires that he set a rather definite limit to the size of loans not specifically secured. In the case of operating credit there is little uniformity of security4 Whether the banker accepts a plain personal note, a personal note with indorsem ments, or some sort of mortgage security depends largely on the personal character- istics and financial position of the borrower. If he has a good reputation and owns a farm, his personal note is usually sufficient, whereas, if he is not well known to the banker, has a questionable reputation, or has little or no wealth, additional security is ordinarily required. The additional security may be in the form of an indorsement by a neighbor of good financial standing, or a specific mortgaze on the borrower's teams, equipment, or drop. Thus the practice of taking a lien on the crop is found to be the most prevalent among negro and poor white farmers. The same seems to be true of the chattel mortgage. In those sections o: the country where a considerable amount of capital is necessary and where there is a higher type of farmer the personal note, with and without indorsements, is most common.ie i he 112 The security offered for consumption credit is dependent chiefly on the particular purpose of the loan, If it is to buy groceries, general security in the form of a personal note or an open account is most common. If the loan is used to buy an automobile, a piano, or a radio set, the mortgage is most common. Usually the article bought is mortgaged and payment is made in installments. DESIRABILITY OF FARM SECURITY It is scarcely possible to arrive at any definite conclusion as to the rela- tive soundness of the security of whole industries. Probably every one would agree that the crude oil producing industry is a more hazardous undertaking than is farming; but when we compare agriculture with the more stable industries of manufacturing, merchandising, and transportation the difference in safety is not so clear. Agriculture is proverbially called the "basic industry", or the indus- try upon which all others depend. It would seem, therefore, that farm credit wea:. would be based on the soundest security to be found. It is entircly possible on the other hand for an industry to be fundamentally sound and yet have many weak- nesses from the credit standpoint. Rather than attempt to compare the safety and general desirability of farm credit with that of other industries, certain points of special weakness and special strength of farm security will be pointed out and compared with similar phases of the security offered by other industries. Some phases of agricultural security are notably strong as compared with those of other industries, while on the other hand some phases of farm3security are notably weak. Ll. Security for Operating Credit Loans which are most desirable to the commercial banker have three important characteristics, e.g., 1) a short term, 2) salability, and 3) safety. Farm. security often falls short on one or more of these reouirements. Wealmesses Length of Term - The fact that farm operating loans often run for six months or a year has in the past been one of the most undesirable feathres of agricul- tural loans from the standpoint of the banker. Bankers who had a large share of their loans out for such periods were frequently embarrassed by the demands of their depositors. A large percentage of their deposits was subject to withdrawal on demand and the banker sometimes had great difficulty in keeping his vaults supplied. His only outside source of supply of funds was his correspondent bank. Moreover, there was only a fair degree of uertainty that the correspondent would113 be in position to supply the funds or that he would desire to do so, even if he could. This situation has been greatly improved since the introduction of the federal reserve system in 1914, particularly for banks which are members of the system. Each member bank now has its federal reserve bank, one of the chief aims of which is to supply the needs of member banks by rediscounting their notes. If the local member bank becomes hard pressed for funds and is unable to collect his outstanding loans, he may be able to have them rediscounted with the federal re- serve bank. Special provision was made in the original Federal Reserve Act. which permits rediscounting of agricultural paper for a maximum period of six months, ana the igricultural Credits Act of 1923 carries an amendment to the Federal Reserve Act extending the maximum period to nine months. The turnover period of the farmer is essentially longer than that of the merchant or manufacturer and the above provi+ sions are an attempt to adapt the banking system to his needs. The weakness seems now to lie chiefly with the farmer in failing to supply his banker with rediscount- able notes. Since federal reserve banks are located at grcat distances from the community of the local member banks and do not know the individual borrowers, they require a financial statement of the business of all borrowers whose notes are rediscounted. This requirement was relatively easy for merchants and manufacturers to meet, but it was not so easy for a large percentage of the farmers. The result is that a very large percentage of agricultural paper remains ineligible for re- discount. Many ranchmen and the larger farmers keep accounts or at least are able to present fairly accurate financial statements of their business, but the great bulk of farmers are yet unable to make acceptable statements. Hence bankers have been depending chiefly upon notes other than those of farmers for rediscounting purposes. Insofar as this is the case tlhe mine-months rediscouznting privilege is worthless« The situation is of course greatly improved in thet the local banker has a more ready rediscount market than was available to hin before the establish- ment of the federal reserve system. The farmer can improve it further by being able to describe his security in a standard financial statement. Also, in this connection it should be remembered that a large percentage of the state banks of the country are not membors of the federal reserve system and therefore do not have direct access to these banks. In fact a majority of the banks serving farmers are. smell state banks. Of course the new system improves the situasion even of the non-member stete banks in thet it makes credit easier with the correspondent member bank, but the usefulness of the federal reserve ban for farmers might be increased greatly be getting the small banks into the system. 1 KE The state bank membership is increasing at a very slow rate.114 Parmers not Prompt - Aside from the fact that farm operating loans are nsuelly made for longer periods than are those of merchants and manufacturers, the farmer has long been accused of not being prompt and businesslike in settl- ing his obligations with the bank. Insofar as this is the case it represents a weakness of farm security. It seems, however, that the point has been streesed more than the facts warrant. Since the farmer lives at considerable distance and has less dealings with the bank, there is of course a tendency toward slack- néss in such matters. But the distance from the farm to the bank has in effect been greatly reduced by the automobile and good roads. Also, the introduction of records and accounts, slow as it is, should have the effect of making the farmer more businesslike. Uncertainty of Income - Probably the most serious weakness of the farmer's security is the uncertainty of his production and the uncertainty of the total a ony marketable supply of his product. That is, the incividusal farmer is uncertain @s to how much he will produce and as to what price the crop will bring. The uncertainty of the total supply of « particular farm product is due 1) to the tack of information about how much to attempt to produce, because of the fact that production is carried on in small, widely distributed units, and 2) to the uncertainties of climatic, pest, and disease conditions, Menufacturing is far less subject to the latter list of uncertaintios. Moreover, manufacturing is ordinarily carried on in larger and more concentrated units. The United States Steel Corporation, for instance, hes little difficulty in ascertaining how much steel is being produced. fend? are relatively few Seats and information con- cerning their output is easily available. The steel manufacturer can, therefore, estimate the supply sites a accurately, He has a still greater advantage over the farmer in that he can control his own supply. The cotton or wheat farmer must take the wildest guess at the probable total supply and price of his pro- duct in adjusting nis acreage. Even after he hes decided ona particular acre- age for the year, he hes no accurate indication of the amount he will produce since he has little or no control over climatic and pest conditions.e With the manufacturer or merchant there are no parallel uncertainties as to the amount of output. The risks involvec in the uncertainty of supoly and price of farm vroducts are difficult to eliminate. There are, however, at least three ways in which the uncertainty of supply and its effects can be reduced: 1) by increasing the amount of available information as to the probable supply, 2) control of insects and diseases, and 3) diversification in production. With more satisfactory in- formation as to the probable production of the different crops and animal pro~ cuevs the farmer can better adjust his acreage and the number of animals. The United States Department of Agriculture is attempting to supply such information115 to a limited extent at present. Estimates are made, for instance, of the number of hogs being produced in the country, and many farmers of the Corn Belt are regu- lating their production of hogs accordingly. Likewise, the Department is attempt- ing to supply farmers with estimates of “intentions to plant" for various crops, But all these efforts are yet in the initial stage of development. Much more in- formation can be collected and certainly more effective methods of getting the estimates to the farmer can be devised. Farmers! cooperative marketing associa-~ tions should become very effective machinery for collecting and distributing such information. Just as long as the individual farmer has little or no knowledge of what other farmers are doing, there will remain the present uncertainty of suppl; and prices Of course there will always be uncertainty because of uncontrollable climatic and other conditions, but the acreage of crops and the number of live- stock are subject to a greater degree of control than prevails at present, The uncertainty which arises from the lack of control of individual production can be-decreased only to a limited degree. It is only in exception cases, for in- stance, that the farmer can afford to irrigate or to use artificial heat. He must take a change on rain and warm weather. Insect pests and diseases can be con- trolled to some extent, but the damages done by the cotton bollweevil and wheat rust are important examples of our lack of control of such destructive agencies. The chances of failure on account of climatic and other partially uncontrollable conditions and the uncertainty of price are so great that the generally accepted opinion is that "there is safety only in diversification", If one source of in- come fails, another may succeed.’ It is then through scientifie discovery of ways 7. The banker's view of the necessity of diversification is indicated in the fol- lowing statement made in a footnote of the financial statement blank of the Dallas Federal Reserve Bank: "The character of the Cropping System of a farm business has a credit value of the highest importance to both the farmer and the lender; and as farming is the annual investing of capital and labor at one place, safety requires, as in other investments, that all the capital and labo: be not invested in one thing, or in the production of one crop. In order that farming operations may be conducted on a safe and profitab1 basis every year, diversification is absolutely necessary. Every farmer shoul: raise enough poultry, hogs, milk cows, vegetables and fruit to supply the fami} with most of their necessary food. A sufficient number of acres should be ’ planted in feed crops to feed the stock on the farm or to feed stock for the market, if desired; part of the land should be planted in food crops for the market and the balance in other crops, BUT NOT MORE THAN 50% OF THE CULTIVATED LAND SHOULD BE PLANTED IN ONE CROP. Such a plan should enable the farmer to pay his debts promptly every year and result in greater prosperity for him."ete _ ee ee c — 116 to control insects and diseases md diversification of production that the une certainty of individual production can be reduced. These efforts together with a more intelligent control of crop acreage and livestock production will result in greater certainty of income. Commodities not Salable During Period of Léan - It has been suggested that _farm operating Yoans involve a peculiar risk in that farm products are worth little or nothing until they are harvested.8 That is, feed, seed, fertilizer, labor, ete., do not immediately become marketable wheat, cotton, or corne There is an interval in which there is nothing which could be sold on the market, whereas, in the case of a loan to a merchant the stock of goods remain as sala- ble security. As the goods are sold the loan can be paid. There is at all times a stock sufficient to cover the remainder of the loen. Likewise in manu- facturing-there are usualiy stages of production in which there is a salable commodity, although it may not be in the final stage of production. In the pro- duction of machinery, for instance, there is the iron-ore stage, the pigeiron stage, the steel, the finished parts, and finally the machines There is a salable product at each step. The temporary absence of a salabic commodity in agricultural production is truly a handicap in farm credit, but its relative importance may easily be over- emphasized. As a matter of fact there are stages in the manufacturing process in which there is no salable product. In the production of machinery, the whole period in which the mining shaft is being sunk and other preparations are being made to extract the ore there is no tangible or salable product. Also some time elapses between each of the above named stages of machine production. Iron ore does not suddenly become pig-iron, nor does pig-iron suddenly become steel. Even in the case of the merchant who handles only finished goods there are rather definite limitations to the sabability of the product. The goods may be out of date or consumers may be unable to buy them. Hence the lack of salable products ts show for the operating capital and labor used in their production is not wholly peculiar to agriculture. The Strength of Farm Security for Operating Credits From the above discussion one might wonder if there are any strong points in farm security. There is indeed fundamental strength in this security, It can be summed up in the following words: the relative stability of the demand 8. W. H. Steiner in Some Aspects of Banking Theory points out three risks peculiar to agricultural loans, e.g., 1) the product is worth little or nothing until it is finallv produced, 2) the risk of superabundance of yield and the resulting low price, and 3) lack of diversification in farm production.neat, for agricultural products. The weaknesses peinted out above had reference to the business methods of the farmer, the banking machinery, and the supply of agricul- tural products. In these instances farm security seems to be more or less at a disadvantage as compared with that of most other industries, but in the stability of demand for his products the farmer has the advantage. Compare, for instance, the certainty of the demand for such raw products as cotton, corn, and wheat with the instability of the demand for a particular style of clothing which the mer- chant has in stock. Compare the stability of demand for cotton, corn, and wheat with the demand for the various types of products made from these crops. While there is fundamentally regular demand for the product in its raw state, the demand for special manufactured products may be very irregular. The manufacturer and the merchant must take the risk of finding a market for the special products made from the basic commodity. Usually the greatest problem of the manufacturer and the merchant lies in estimating and regulating demand, while this is a comparatively minor problem for the farmer. It is true of course that the demand for farm products is not constant and the farmer must adjust his supply to a varying demand. yet the demand is relatively stable as compared with the demand for products of most of the other major industries. Producers of the leading agricultural pro- ducts seldom find it necessary, for instance, to resort to advertising or demand creation, while whole manufacturing and merchandising industries have been es-= tablished and maintained by advertising. In making loans to farmers the banker is not dependent on the prospective sale of a new and unknown commodity or a commodity for which the demand is subject to wide fluctuations. If the supply is not extraordinarily great, sale at a fair price is almost a certainty. This is an important and fundamental element of a safety in the security offered for farm operating loans. Farmers have an acutal or - potential advantage in the diversity of commodi- ties which they can produce. While manufacturing and merchandising are becoming more and more specialized, the tendency in agriculture is toward diversification. Farmers can produce several varieties of food products to be consumed at home, as well as several kinds of commodities for the market. A sound program of diversi- fied farming should counteract in part at le:st the farmer's disadvantage in regulating supply. That is, although the manufacturer may be able to adjust his output more readily, the farmer may partially overcome the disadvantage by divers-~ ifying his price and production risks over a large number of commodities. 2. Security for Investment Loans Different considerations are involved in estimating the strength of security offered for investment loans. In the first place, specific security is usually o required, whereas, general or personal security is more comaonly offered for118 operating loans. In the second place, investment loans are made for several years and the soundness of the security must be measured from the long-time point of view. Hence the strength of security depends chiefly on maintaining the value of the property mortgaged. Farm Land Mortgages on farm land have long been recognized in this and other countries as being one of the very safest types of investment to be found. They are listed by many of oyr states as second only to governmert bonds as desirable investments for saving banks, insurance, trust and other companies which are required by law to seek safety above all else in the investment of their funds. fhe enviable reputation of the farm mortgage as a safe investment is based fundamentally on two factors, e.g., the limited supply of productive land and the constant tendency of the demand for land to increase. It was pointed out above that agriculture suffers a disadvantage in the control of the supply of products from year to year and that most other industries have great difficulty in measuring and controlling the demand for their products. Generally speaking, there are no such difficulties in measuring and controlling the supply and demand for farm land. The limited area of the productive land and e steadily growing population are a practical guarantee for the maintenance if not an increase in the value of farm land over the period of a twenty or thirty-year mortgage. But we do have foreclosure of farm mortgages; occasionally the wanker or the relatively fixed the invester loses 4 part of his investment. In spite o/ a supply of land and the tendency toward an ever increasing demand, the price of 1imself with insuffici- ent security. In fact, the total market value o ind in the United States a decreased about 26 per cent from 1920 to-1925. That is to say, the price of land farm land sometimes falls and the mortgage inves Byo nie ° ry +4. . fe) DS te @ PB wn roy! arbitrarily fixed on the market sometimes becomes higher than the actual demand and supply conditions warrant. Prices were thus inflated in 1920. Buyers over~ estimated the value of land as measured by its future earning power. Thus, while the stability of supply and demand is the fundaméntal basis of the soundness of the farm mortgage, it is highly significant that supply and demand be interpreted Or measured accurately and that loans be made accordingly. There are then two supplemer.tary factors in the safety of farm mortgage loans: 1) a value must be placed on the land which is commensurate with its earning capacity over-a long period of time and 2) the loan must be of such size that, even though unexpected conditions should arise to cause a decrease in the value of land, the investor hes & fair margin of safety.119 The prevailing practice of lending only 40 to 50 per cent of the value of the land has done mich to establish the present reputation of the farm mortgage for safety. On the other hand, the practice in the Middle West and the Southwest in the seventies and eighties of lending a much higher percentage of the value of the land greatly retarded the development of the farm mortgage business,? During the so-called farm mortgage craze of the eighties loans were made which were approximately equal to the value placed on the land. Moreover, the value placed on the land was far above what the conditions actually warranted as was seen a few years later. The result was bankruptcy for many farm mortgage bankers, losses to thousands of investors, and the temporary disrepute of the farm mortgage as an investment. This illustrates very well the necessity of accuracy in estimating demanc and supply conditions - of a conservative valuation. With conservative valuations and a good margin between the value and the amount of the loan, the investor's chance of loss on a farm mortgage is very small. Compare, for instance, the stability of the demand and supply of farm land and city real estate. On the whole, city real estate is subject to greater and more sudden increases and decreases in value. The price of city real estate is based largely on location or site, which is arbitrary and changeable, while the price of farm land is based chieflyl© on soil and climatic conditions which are relatively fixed. The earth has a plentiful supply of sites for cities and city lots, but good soil is scarce. Again, compare the stability of value of farm land with that of industrial sites. As in the case of city real estate, if not to as great a degree, the value of a factory is greatly affected by the location. A shifting of the manufacturer's market or the depletion of a conveniently located supply of raw materials will greatly decrease the value of his plant because of the great difficulty and expense of moving it. Also manufacturing machinery is subject to sudden decreases in value because of the invention of new types of machinery. Furthermore, as was explained above, the demand for many manufactured products is subject to sudden change; whereas the products of the farm are basic raw materials, the demand for which is relatively stable. A mortgage on farm land then seems to have certain elements of basic soundness which are not found in the mortgage on city real estate or in the mortgage on the manufacturing plant. 9.. M. T.. Herrick and R. Ingalls, How to Pinance the Farmer - Private Enterprise ~ Not State Aid, ch. 2. 10. Obviously farm land values are affected by such f#ctors as the development of transportation facilities, but they are less sensitive to such develop- ment than are city land values.120 The uncertainties of production and the price of agricultural products were discussed above as the chief wealmesses of security for operating loans. But in the case of loans made for a period of years the uncertainties of a particula year are less significant. Here the average production and price or income are more Significant. It is important, of course, that the borrower be able to make regular interest payments, but failure to make an interest payment on an investment loan is far less serious than the failure to pay the principal of an operating loan. If the average income is adequate to make payments of interest and principal, the borrower can cither be carried over a poor crop yoar or obtain a temporary loan to meet the annual payment. The uncertainties of farm production are also less significant to the farm mortgage than to the deposit bavker because the former has a wider distri- bution of loans. "Jsuallv the farm mortgage barker operates over a considerable territory. It is quite comnon for the banker tc make loans in two or more states. In this wey the risk of crop failure is distributed and the banker is fairly certain of a good percentage of annual payments from borrowers. The local banker on the other hand stakes everything on &@ small community. One flood, one hailstorm, or e local drought, mey prove destructive to his business. His situation is somewhat comparable with that of a fire insurance company which places all its risks in one town. So much for the strength of the farm land mortgage as security for loans. There has long been, and still remoins, an outstanding wealmess - the lack of marketability. The ready salability of an investment means much to the-investor. He is often willing to forego a high interest rate or some degree of safety in order to obtain an investment which can be sold readily in case of necessitye There is no fundamentally sound reason why the farm mortgage can not be made readily salable, since tne interest rate paid is notably high when its basic safety is considered. Two factors have prevented the ready marketability of farm mortgages: 1) the failure to develop market machinery, and 2) the lack of standardization of farm mortgage security. There is no. market for farm mortgages in eny way comparable to the New York Stock Exchange - the great central market place for the stocks and bonds of business concerns in industries other than agriculture. But standardization of the security is e prerequisite to the development of market machinery through which owners of farm mortgages can readily reach the possible buyers of the country. The failure to develop marketability has been 4 sreat handicap in farm mortgage financing. It has made necessary the payment of an interest rate out of all proportion to the safety of the investment. Marketability will be taken up more fully below under the dis- cussion of standardization oi farm security.Led Mortgages on Other Farm Property Mortgages on farm buildings, machinery, automobiles, and livestock can scarcely be placed in the same class with the farm mortgage as security. It was explained in Chapter 5 "that the value of these types of investment capital char- acteristically decreases as time passes, while the value of land tends to increase. Thus before a twenty-year loan is paid off the building mortgaged will probably have lost most of its usefulness. Farm buildings are commonly neglected. Repairs are delayed or never made, and many farm houses are never painted. Relatively few farm houses are insured against fire. That farm buildings have low value as security for long-term loans is indicated by the fact that the federal land banks will lend only 20 per cent of their value with the special requirement that they be insured against fire and kept in good repair. Some mortgage, insurance, and trust companies will allow nothing on the value of buildings in making farm mort- gage loans. Farm machinery and automobiles are used for security on the shorter term loans. They are subject to rapid depreciation partly because of their nature and use and partly because of lack of proper care. It is quite common for farmers to leave their machinery out in the open unprotected from the elements. The same is often true of automobiles. Hence the banker or merchant who takes a mortgage on machinery and automobiles must require a rather heavy initial payment and complete payment within a very short period of time. Livestock is not used very extensively as security for investment loans. Livestock is subject to accident and disease and to rapid depreciation in value after maturity. Dairy cows, beef cattle, sheep, and goats are ordinarily better security than honses and mules because of their sale value for meat after their regulat period of usefulness is paste THE STANDARDIZATION OF FARM SECURITY Probably the greatest handicap which agricultural credit suffers is the lack of standardization of security. Investors whether they be bankers, other business concerns, or individuals seek security which has a ready sale, as well as safety. The sale of security can be made to best advantage only through access to a wide market, and a wide market can be hand. only in case the security is well~ known. The stocks and bonds of industrial concerns and railroads and the short- term notes of merchants in the form of "commercial paper" or the "trade accept- ance’ have an ever-widening market because the security is well known. The security back of stocks and bonds listed on the New York Stock Exchange may easily be examined at any time by dealers on the Exchange. Financial statements of the corporation are available at all times, and if desirable the officialsie bus io a o Hee of the Exchange can make special investigations of the actual condition of the corporation. Buyers and sellers are continually making estimates of the value of security. Likewise, prime commercial paper or trade acceptances are well . known. In fact an important branch of the commercial benking system - the com- mercial paper house - has been developed for the purpose of buying and selling this paper. These "note brokers" are continually seeking buyers and sellers of commercial paper.41 "Commercial paper" has a definite meaning in the money market. It signifies that somewhere in the merchandise markets of the country there is a definite quantity of goods which can be sold readily to cover the note or acceptance. In contrast, whet does the farmer's short-term note or farm mortgage mean? Who knows whet a particulftr note or farm mortgage means in the way of security? Generally only the local banker and the farmer know and often this is only a Vague estimate. Such vague, uncertain, and nestricted knowledge of security inevitably prevents sale in a wide market, and accounts in part for the high interest rates commonly paid on farm loans. The limited lmowledge of farm security also is a partial basis for the wide variation of interest rates in different sections of the country. Standardizing the Farm Mortgage/ Two things are necessary before the farmer can obtain the full advantages of a wide market for his security: 1) uniform methods of appraisal of his security must be adopted and 2) accurate financial statement of his business must be easily available at all times. Thus if it were widely known that the farm mortgage always means that farm land, conservatively appraised, equal in value to twice the amount of the mortgage, exists as a guarantee f6r the loan investors would have no fears - either of the ultimate payment of the loan, or of the ready salability of the security. The federal land banks are making a beginning in accomplishing this very thing for the farm mortgage. They not only maintain a uniform standard of conservative land appraisal for the whole country, but also guarantee each investment by pledging the capital and earnings’ of the whole system of banks. There is some evidence that the regular private mortgage bankers are also making some progress in standardizing the farm mort-~ gage.e Much remains to be done. The great number of foreclosures of farm mort- gages in this country from 1920 to 1925 indicates that loan policies cah be im= proved. Probably much of this wasteful procedure could be prevented by keeping in closer touch with the financial situation of the borrower. Probably fore- closures and losses to investors could be reduced by more conservative appraisals. 11. For a discussion of the origin and development of note brokerage, see Gu che Pitbiaps,, pane Credit, ch. 7.123 . Also it is possible in the future that farm mortgage bankers will be able to fore- see a fall in lend values such as that which occurred fron 1920 to 1925.12 The fact thet federal and joint stock land banks and a few of the farm mort- gage companies place their own guarantee on the mortgages gives the farm mortgage an advantage over industrial and railroad bonds. Farn mortgages also pay a higher rate of interest, but they lack marketability. % is probable that some time in the future they will be listed on the big security exchanges of the country, or probably special farm mortgage. exchanges will be developed. At any rate, standard- ization of appraisal methods is a necessary prerequisite to the establishment of a wide market. Moreover, the investor and the banker must be able at all times to ascertain the financial condition of the borrower. Standardizing Security for Operating Loans Security for farm operating loans can probably never be as highly standardized as is commercial paper. A large part of this security is in the form of personal notes and no specific property is mortgaged, whereas with the merchant there is always a finished and salable stock of goods. But the loan policies of bankers can be made more uniform than they ere at present. They can also be made more con- servative. The federal reserve banks are attempting to achieve both purposes by the requirement of a financial statement before rediscounting farm paper. A more extensive use of farm paper by the thousands of member banks throughout the country for rediscounting purposes should result in a fair degree of standardization of short-term farm production paper. To achieve such standardization many country bankers will be forced to make more conservative loans and farmers will be compeli- ed to keep records of their business. Both practices would probably be beneficial to the bankers and farmers in many ways, aside from the creation of a wider-market for farm papere A commendable start has been made in the standardization of the paper of far- mer's cooperative marketing associations through the use of the warehouse receipt. The cooperative cotton marketing associations, for instance, are able to obtain loans directly from large central banks of the country by the use of teceipts from standard warehouses. Warehouses are inspected by federal or state officials who require a certain standard type of building which protects the cotton from the elements and which is relatively fireproof. Furthermore, the warehousemen are duly bonded and the cotton is insured against fire. Notes secured by the receipts of such warehouses and with such staple and marketable products as cotton, corn, wheat, or tobacco, find an easy monsy market anywhere. Unlike the loans made on 4 pros- pective crop,tthe crop here is already produced and in salable form. 12. The Federal Census for 1925 indicates that the total value of farm property in the United States had decreased approximately 25 per cent since 1920.Ze 3. Pet a ee Cert ce a ae ae ase 124 QUESTIONS AND PROBLEMS Contrast general or personal security with specific security. Compare the importance of net worth, prospects for income, and personal characteristics of the borrower as bases for loans. How does one-crop farming affect interest rates on farm loans? Explain. What are the leading factors which determine the kind of security offered for loans? Compare the security offered by farmers for operating loans with that offered by merchants and menuracturers on the basis of a) the desirability of the term of the loan for the deposit banker, b) the marketability of the note, and c) the safety of the loan. What are the fundamental bases of safety of the farm mortgege investment? What is the meaning cf the phrase "standardization of farm security"? Why is standardization desirable? What is being done toward the standardization of farmers! short-term paper, and how can further standardization be accomplished? Should farm mortgages be admitted cn the New York Stock Exchange?125 Chapter 9 In the process of making a loan the banker must make an estimete of the bor- rower's personal characteristics, of the value of his property less his indebted- ness, and of his prospects for income. In Chapter & the farmer's security was described in a general way and compared with the security in other industries; here his security will be considered from the standpoint of the lender in deter- mining its loan value in specific cases. A farmer comes to the banker or the merchant for credit. He may be a good credit risk for $10,000, $5,000, $1,000 or $100, or he may be a poor credit risk for any amount. Just what information does the banker need in passing judgment on a credit risk? How does he get the information? How does he determine the amount which can be safely advanced? It is probable that from two-thirds te three-fourths of all farm operating credit is obtained on personal security. This security takes the legal forms of plain personal notes with one or more indorsements, and open accounts. Merchant credit is commonly extended on plain charge accounts, although in many cases a note or even a mortgage is required. The indorsed note is rapidly losing its popularity with bankers and is being replaced by the plain personal note and the personal note secured by collateral. In 1880 approximately 75 per cent of the loans of all national banks were securéd by indorsed notes, while in 1924 only about 35 per cent were so secured. © During the same period the percentage of national bank loans made on single-name paper without collateral increased from 5 to 25. Although these figures show the trend for all national bank loans, it is evident that loans to farmers have had a part in the trend toward a more extensive use of singleename paper.® The increasing use of the plain personal note is due to several factors. First, bankers have come to realize the uncertainty of the value of an indorsemente . For instance, the indorser may be an indorser for several other borrowers. George 1. wees le! ciewit) » yo ye Bari eOf ou oe ge Gee Shere genes « I make the following statement of all my assets and liabilities as at the Glose of business on . » «© + © » » © + « e » « « and give other material in- formation for the purpose of obtaining advances on notes and bills bearing my Signature or indorsement and for obtaining credit generally upon present and future applications. If any change materially reduces my means I will immedi- ately notify the bank. (Please answer all questions and fill in all blanks) Assets Liabilities Cash on hand and in bank. .«. weve Accounts and notes owed by me Loans and accounts due to me without security . « » » « » © » © sess (2000) ee as) sete ot es »s--» Notes or mortgages owed by me HaEM PROUUCUS: sans 6 «5 6 6) a serve With real estate ds sectirity « s 6 sese MVESCOCK a 6 6) ws ns 8s eeee Notes owed by me with chattel Farm land and buildings (see mortgage @S SGOUrlty « 2 « © 5 8 «wees BCNEAUIG)svidcs Sel wuss ota 6 ees Other: indebtedness (itemized). ss «s-. Other property (itemized)... Genre o Feud Mii Mbaae <5 oo eee ae Ris (0 5 ho Sele) cs) ay oie ee) lew) 6 cscs Total ViabPiNGres es. mam) ei eererars Net worth. © 0 6 « © 6 yu = 8 toh cas B16 eek fei ele ts 8) sw gels) ein misi9_ 0) Total . 2. «a 6 6 8 8 © Se ee vincetle TOCA) ve: wie 4 «see ae) ane sere Location of Land Owned Acres Estimated Value Assessed at Mortgaged ftr:Rt. oS pe ea ae ee 150 Title. The title to all.above described real estate is in my name solely, Ue ELM SMNOUMAGWI S(t! Gs)! og 5 MCR cit iehte ei Gehteo wes 6 5 6 6 6 6 6 uw be el 6) 6 e e ee 8. e 6) 0 5 u © @ <3 e © 86 6 e Buildings. State general charecter . . Contingent Liability as indorser or Seco (If any are past due state amounts and reasons) guarantor . . Accounts and Notes payable. e e cy e s e se . e 8 v ° ° ° e: Xe ° ° ° e278 s e e ° Implements. State general character of Emouceliusbed as assctsSes « ‘ss « wes Life $. . .. Other Liens. (If any other liens on Who is beneficiary? . . . 6 « + © « « «. assets, state amount and circwnstances) tnsurances Fire $. .. es % * wove. *o's as Ue @ CC CS 6 C8 I hereby certify that the figures and statements contained on both sides of this sheet are true and give a correct showing of my financial condition. Signed this ehU8e o. 46": 6-18 . day Gh. ° e . e * @ . 19. e . Nome. e e or oS . ° e ¢ Reverse Side of Form character of, loans and accounts listed as assets. . ». « «sss». es e e e s . « e e s e ° e . e es a s . * ° ° e e ° . e cs e s ° s . s . s . s ® « e . e . e e . 6 e ° ° 9 e ° e . es e e e ° e we e ’ . . . . e . . s . e . e , e+e s e * e . e e ° ° e ° « « ® e ° ° ° ® . ° ° . e ° e ° . . e . ® s . s e ® . . s . * e . e e . ° . s e . J . e ° * s ° * ® o o . e . e s . o ° e s e . es e e « . ° . ° e ° e . ° e ° . e e e . s . . s . e . e o . e * e . s . s e e eebes ° e . ° e e s . ° . se . 6 e . . . . s e ° e ° a a . ° e e s . s . ° ° Seen 88a) ie we 6S el U8 CO Ce fu Cel oe 8: @ 8 € 6 8: 6 8 BB @ SD Be a 6 8 ee NE CE a ey ee ee ee er ee er er ee er eee ry (The balance of this space may be used for printing any to be asked amplifying statement of condition as shown * Journal of the American Bankers! Association, Volume 10, 1917, p. 35) ff. questions desired on opposite page. No. 5, November, )151 FORM OF STATEMENT USED BY THE NEW YORK FEDERAL RESERVE BANK FOR FARMERS * Statement ofse eu Fa tees oe Fe COURRTSHSR 2H 2 of 4 st 6. 8 BUSINCSS* o@etewe Sle S FOE SUC QURG a) AGEreS Se i 5ise ae Ee oe tea « See eer a fy 6 TO we ee a ORS recmntencenersities »Bank of. e ® e e . e . e e. . » . e ° Shieh i 0 I make the following statement of all my assets and liabilities as at the Glose of DUSINESS Ofte. < 6 s.0 & +19 # & ow © 6 6 eg CeO emeennes material information for the purpose of obtaining advances on notes and bills bearing my signature or indorsement and for obtaining credit generally upon present and future application. (Please answer all questions and fill in all blanks) Assets Liabilities Cash on hand and in bank. ». « » « « Accounts owed. by me. « & sysis 2,0, 5 «3 Accounts due to me = Good « « « « »« Notes owed by me without security. » « « Unsecured loans due to me - Good. . Notes owed by me with security other Secured loans due.to.me. ..s.s + 0.» than real estate. & & = 6 «6 6 sm Mortgage loans due to me « « » « +.» Notes or mortgages owed by me with real Parm products on hand. . e« « « + « » estace as Security = « 6 « b = 6 6 = = « Livestock on hand. « « « « « « « « @ Notes owed by me with chattel mortgage Farm land (See schedule) . « .. « « security « ss 6 = & Sos oo es rE Burtdines © e ge eC a) Wee ste ea Other indebtedness (Itemize) « »« « « « » Farm Implements and Machinery... + aiirs-tihamdre or tyreoigobtiieraie hese Rol oneenineieliien ipaleinet testis aaa anee Othern property. (Ttemize becsoesn . . A°R, . acteg . | DaRNO beet Becagegeeee Se 6 Fee a ee te 6 ee a 8 Total Liabilities i Poe e ee ee oe ee Oe Net-Worths « & « s 6% + 6 6 © © BOR ee Total Total | = ai 7 Location of Land Owned | Acres Estimated | Assessed Mort gaged Insured Jalue | at for for ss 3h ROY OH S09 SN bo aga Ele GP ee AO iL oOo Ry ee aL ARSE ciel = | aa bee sense ereckeset a tataccah er@aaO tl Bale VERS pELe cee Gh Vn Met Bm Goo eh) one che esate tetosenetessis che tees owsuscacarn rrr rere ee Se eke ee ee SO OOD Gath «ea ew fe we * oo Bl ye ee ee eee ees ew we ff wo « als 0 o © Gerber UBM i FOES «, (Riel cote Coen Title. The legal and equitable title to all pieces of above described real estete is in my name solely, exeept as follows: seecese + «© « + © «© » 2 ©Maumee Ot, T2bor , « « .. eG Cae Age-s: GERRI 152 Buildings, State general character . . ueeeoeshroyed. by fire? »« » + esr Implements, State general character of SeEemrcred as Assets. « «sc ac ss Growing Crops. Outlay to dateis as é re nnencennneyepeiene cement follows: BRIS RSCG os 5 6 ke ob 3 SemoGerercil zor: . . so Gb 6 6 ele $ Baeemes ess (Thentac)s sos koa Sw es Total. . e a’s¢s se e se . Contingent Liability. As indorser Ge Ses we As, guarantor Sie... ceur. ete Beek ee ee As. bondsman for others.$ . « « sisi« & Accounts and Notes Payable. If any are past due state amounts and reasons wR bbe SearGsa- 6 Orbos on seee b seen Maximum Debt. During last calendar year, my total indebtedness was at a Maximum (oe « « « » +) Of. « sta = ceeeeee at~a-maximm ($. ~~ s~s 6 *5)-One soe Other Liens. If any other liens on assets, state amount and circumstances . s e . . « . ° e . e« . e e s > s s s ° ’ . o . . ° . e . ° . . ° s . . s * a” =e 8" 6 . . ° a 6; 7a . o ° es e@ «€ ee e@ « 2 6 4 : ® A, ° 5 Agee; *My age Ws =. °¥ Single e ° ° ° a ee Le a e . So 2 3 2s @ I hereby certify that figures and statements contained on both sides of this sheet are true and give a correct showing of my financial condition. BMEG UNAS bi 5) = - = » « « « Gay Of . o% 9 (EOL « «= « co NOMGs 1s ss a te ee Location of Land Owned Acres Estimated Assessed Mort gaged Insured Value at for for oe es Se Oe ll lUelUlU Ue lle le lk . @ ee Ss Me Be 64 © SO, @) 7-6, 0, 8 ° . -¢ e 8s e@ a: S 2» . « ° s . . ° e » es 8 sc e¢© @ 88 7 e@ * @ . ° e e £ 2 8 ® . 2 © “es « « > «© ce ° . ° . . . ve . . * 8 ba Sie) SO 8 Titles. The legal and equitable title to all pieces of above described real estate is im my name solely, except as follows: ...... ¢ sO ne be as Ws are * GlemG. Munn, Bank Credit, p. 102.Chapter 10 THE APPRAISAL OF SECURITY FOR LONG-TERM LOANS The factors that determine the credit risk in long-term loans are the same as those which determine short-term credit risks, e.g., the personal integrity of the borrower, his prospects for income, and his net worth. The longer term of the loan, however, calls for different emphasis on these factors and different methods of analysis. The personal element is of less relative importante in the long- term loan, while property values are of greater relative importance. The prospect for net income is the heart of the credit analysis in long-term credit, as well as short-term credit, but there are many new factors to be analyzed in the estim- ate of net income over a long period of years. No attempt is made here to minimize the importance of personal integrity in farm mortgage loans. It is obviously an important factor. The reputation of the borrower for personal integrity usually determines whether or not a loan shall be extended. When the banker learns that the prospective borrower has a good reputa- tion, he is ready to begin the more difficult problems of appraisal. He must in- vestigate and analyze the factors that determine the amount which can be loaned with safefy, e.g., 1) the ability of the borrower to make annual payments on the loan and 2) the emergency sale value of the property to be mortgaged. Estimates of annual paying ability and the emergency sale value of the farm involve two distinct lines of investigation and analysis. The price at which the mortgaged farm will sell under foreclosure does not indicate the ability of the borrower to make annual payments of interest and principal; neither does the annual paying ability of the borrower indicate the emergency sale value of the farm. But why is it necessary to consider the possible sale value of the farm, if the ability of the borrower to make his regular annual payments can be determined? Indeed the investigations of sale value would be unnecessary if the lender could deter- mine accurately the annual paying ability of the borrower throughout the term of the loan. This is obviously impossible. The emergency sale value of the mort- gaged farm is simply a protection to the lender in case he has overestimated the borrower's ability to pay the loan from his regular earnings. The final decision of the banker as to the size of the loon to be granted can be made by checking the results of the two lines of investigation indicated above. THE ABILITY TO MAKE ANNUAL PAYMENTS The process of making a scientific estimate of the ability of the prospective borrower to pay the interest and principal of a loan involves a thorough analysis of his business. It involves an appraisal of the personal ability of the borrower and an examination of the capital and labor with which he has to operate.ee = 154 1. Bases for Determining the Ability to Pay There are four distinct factors which must be analyzed in determining the probable ability of the borrower to meet the payments of a long-term loan. First, the appraiser must size up the land, equipment, and labor which the borrower will have after the loan is applied; second, he must estimate the ability of the bor- rower in using the land, equipment, and labor at his command in the production of commodities; third, he must ascertain the business methods of the borrower; and fourth, he must verify the borrower's equity in the operating and investment capital employed. Land, Equipment, and Labor Naturally the first question which arises in the analysis of debt-paying ability concerns the amount and kind of land, equipment, and labor at the command of the borrower. These are his income-producing tools. Land - The most obvious fact regarding the land is its physical area. Less Obvious is the amount of land which the borrower can use to best advantage. The proper amount of land is determined by the type of farming, the conditions of cultivation, the farmer, and the amount of labor and equipment available.: Thus the amount of land required by the ranchman, the wheat grower, the cotton farmer, the dairy farmer, and the truck grower varies widely. Also, the amount of land required in any one of these types of farming varies widely according to condi- tions of cultivation. For instance, the cotton farmer cultivating the clean soils and level fields of West Texas can operate many more acres than the farmer in the weed-infested and hilly farms of Arkansas. Again, some farmers have the ability to manage farm operations on a very large scale, while others are so- called one-horse farmers. Moreover, the area of iand which can be operated to advantage is rather strictly limited by the amount of .equipment and labor at the disposal of the farmer. All these factors must be taken into consideration by the appraiser in passinge judgment on the proper area of land for the farmer. The physical structure and chemical content of the soil must be considered not only as to its present vroductivity, but also with a view to long-time pro- ductivity. That is, is the land naturally fertile? How long has it been culti- vated, and how long can it be cultivated without the necessity of applying artificial fertilizer? In many oi the older agricultural secvions of the Mmited States farmers are finding it necessary to spend considerable sums for artificial155 fertilizer.! For this reason the farm mortgage banker finds it necessary to con- sider the probability of decreased production, or else the annual expense of fertilizer. Closely associated with the land as a productive factor are climatic condi- tions, such as rainfall ani temperature. The average rainfall and distribution of rainfall through the year are, of course, very significant in farm production. Some sections of the country have too much rain, while others have insufficient amounts. Moreover, crop production is very uncertain in some sections, not because there is too little or too much rainfall, but because it is poorly dis- tributed through the year. This may mean flood conditions in one season and de- structive droughts in another. The importance of temperature conditions on crop production is obvious. In considering the land of the borrower the appraiser will measure the ad- vantages or disadvantages of its location with regard to local and central markets. The farther the farm is located from the central markets of the country, the greater are the railroad transportation costs which must be deducted from the central market price of products. Also, the farther the farm is located from the shipping point and phe poorer the roads, the greater are the costs which must be déducted from the local market price. Buildings, Livestock, and Machinery - The adequacy and efficiency of build- ings, livestock, and machinery at the disposal of the borrower are important measures of his productive ability. Some farmers attempt to farm with machinery which is inadiequate, or inefficient, on the theory that machinery costs too much; others are overstocked with machinery. Thus in certain sections of the South the one-horse plow is often used at a great loss of time and labor. On the other hand, some farmers use tractors where the size or contour of the farm is such as to make such machinery impractical. Likewise it is very significant that the farmer have an adequate supply of efficient work animals and other livestock. The old saying that such and such a horse "eats his head off" is in point here. Many work animals used on farms are effective in consuming feed, but very ineffective in producing an income for the producer. The necessity of efficiency in livestock is strikingly illustrated in dairy-farming. Here income is most directly affected 1. Fertilizers were applied on 94 to 98 per cent of the cotton acreage of North Carolina, South Carolina, and Georgia in 1925 at an average cost per acre of $7.00, $5.00, and $4.00, respectively; while in Texas and Alabama fertilizers were applied to only 6 per cent and 1 per cent of the cotton acreage at an average cost of $3.25 and $2.25 per acre. See United States Department of Agriculture, Yearbook, 1925, p. 1423. 2. Professor G. C. Haas has derived a method by which to calculate methematically the effect of the condition of roads and the distance to market upon land values. See Technical Bulletin No. 9, University of Minnesota, Agricultural Experiment Station.caer 156 by the efficiency of the animal, The difference between an efficient herd of dairy cattle and an inefficient nerd may be that of failure and success of the whole undertaking. An illustration of the importance of efficiency of livestock to the banker is found in the reply recently made by a Middle West banker to a dairy farmer who desired to borrow $50 to buy another cow. It seems that the farmer had a herd of seven or eight cows of a very mediocre type and felt that another cow would increase the volume of his production sufficiently to make his business more profitable. The banker soon came to the conclusion that the far- mers chief difficulty was in maintaining a herd of poor producers, and refused him the $50 loan. Instead, he offered him a $150 loan to buy a good cow. From the point of view of the appraiser, buildings serve to protect and prolong tne period of usefulness of livestock, machinery, and products. Inade- quate sheds for machinery and shelter for livestock simply mean more rapid depreciation and shorter life. For instance, if machinery is left out it may be necessary to replace it within three years instead of five years. The farm mortgage banker considers not only the present status of buildings, livestock, and machinery, out also their rate of depreciation. They may have to be replaced long before the loan under consideration is completely paid. If this is likely %0 be the case the appraiser must allow the borrower a greater portion of his anrueal income for replacement and repair. Labor = The labor situation with the farm borrower is largely a question of the size and working capacity of his family. The farmer with three or four in- dustrious sons growing up has a distinct advantage over the farmer whose sons have all married, or who, if they are still with him, have not developed habits of industry. Since the mortgage banker lends for a long period of years, the age of the farmer himself and the future growth of the working force of the family are important considerations. Ability as a Producer The best land, labor, and equipment become ineffective under poor direction and management. The appraiser must investigate the production methods of the borrower. The first question that arises here is the maintenance of land and equipment. Does the farmer appreciate the necessity for soil maintenance? If so, what are his methods? The second question concerns the ability of the bor-~ rower to apply his land, equipment, and labor to the best advantage in produce tion. Maintenance of Land and Equipment - The kind of soil and equipment with which the borrower has to work when his tenth or twentieth annuel payment is due depends to a great extent on the man himself. Of two farmers starting out with Similar land, buildings, and machinery, the one may, at the end of fifteen years,157 finds himself in possession of land which is badly eroded, the soil poorly supplied with certain necessary chemical elements, and buildings and machinery in bad repair; while the other who has terraced his land, rotated his crops, and promptly repaired his buildings and machinery, will have retained the full pro- ductivity of his land and decreased the rate of depreciation of his equipment. The necessity of devising ways and means of soil preservation scarcely occurred to the American farmers of the nineteenth century; during the past few decades the great majority of farmers have -thought of such necessity, many have attempted in a more or less haphazard manner to carry out a program of soil maintenance, and a few have fully realized its necessity. The farmers of the Atlantic Sea- board States are suffering a rude awakening as they find their land stripped of half of its productivity of thirty or forty years ago. Farmers of the newer Middle West and Southwest seem on the whole to be gradually adopting farming methods which will prevent the degree of depreciation suffered by the older farm- ing regionse The banker who makes loans for periods of ten, twenty, or thirty years cannot afford to overlook the probability of soil depletion. Some of the leading methods of maintaining the productivity of the land are: terracing; crop rotat- ing; planting certain crops, such as legumes which maintain the supply of certain chemical clements; using commercial fertilizer; and producing livestock. Some of the questions in the mind.6f the farm mortgage bank appraiser are: Does this particular farmer realize the significance of soil maimienance? If so, does he know how to apply maintenance methods? Is he actually applying them? Similarly, buildings, machinery, and livestock require good care rf There productivity is to be maintained over a period of years. Prompt repair of build- ings and machinery is not only less expensive than delayed repair, but it increases the period of usefulness. “Sheds for machinery and livestock prevent deterioration and increase their efficiency. Does the borrower in question have any definite idea of the relation of the cost of sheds: to the loss suffered by not having them? Ability in Applying Land, Equipment, and Labor in Production - Even though the borrower is well supplied year after year with adequate and efficient land, equipment, and labor, there remains the question of his ability to use these factors to best advantage. This problem can best be described by certain ques. tions such as the following: Does the farmer know the importance of timeliness in planting, cultivating, and harvesting? Does he know how to adjust his crop and livestock production in such a manner that his labor and equipment have as cone tinuous employment throughout the year as possible? Is he using the land to produce crops ta which it is best adapted? Is he an effective manager of his labor force? Common observation shows that a negative answer to one or more of these questions would indicated decreased net earnings, while positive answers to all of them would reveal the leading characteristics of a good farm manigere158 Business Methods The above discussion of the prospective borrower has had to do primarily with his ability as a producer of physical commodities. But we are rapidly be- ing convinced that the size of the mass of products of the farm is not in itself an accurate indication of the farmer’s earnings in terms of money. That is, the market price and the cost of production must be considered. During the past twenty years our agricultural colleges and agricultural leaders in general have come to realize, in a measure at least, the significance of adjusting farm pro- duction to the market. The farmer himself is learning from bitter experience the necessity of first looking to quality and quantity of particular products required by the market and then producing accordingly. This realization together with the increasing competition in agricultural production is forcing the farmer to adopt better business methods. It seems that the time is rapidly approaching in this country when the farmer who is to survive and be successful must inevit- ably use better judgment. The prospective borrower's understanding of this problemand his ability to practice scientific business methods will have an important bearing on his credit standings Keeping Records - The heart of the problem of the individual farmer can be reached only through a-definite knowledge of his business, and this can be accurately achieved only by keeping a record of his transactions and operations. The method which was formerly almost universal among farmers, and which is still all too common, was to follow blindly a customary line or procedure for years before it could be determined whether it was successful or not. The farmer planted a certain amount of corn, wheat, cotton, etc., year after year and de-~ pended on fate to bring him success. He knew little of the cost of producing particular urops or animals products. To him the whole business was a relative- ly fixed procedure. If he had anything above his total costs and family ex- , penses at the end of the year he was thankful. If he received insufficient + returns to cover costs and family expenses "it was just bad luck”. Fate had mistreated him. Of course this so-called fate was really a combination of market conditions, costs of operations, and the weather. The purpose of keeping a record of the costs and returns is to determine promptly whether the present method of procedure is yielding maximum net returns. The farmer can always tell in a vague way within a few years whether his busi- ness as a whole is progressing or not, but even then he has a very indéfinite idea about what particular phase of his business is putting him ahead or behind. Is he getting ahead because he has reduced labor costs per unit of product, or because he has reduced capital costs, or because he is using commercial fertili= zer, or because he is practicing diversification, or because ha has happened te have good markets? Only the shrewdest and most'experienced farmers are able to discover the strong159 and weak features of their busiress without definite written records. They do it more or less accurntely by means of mental records. For the great mass of farmers, written records of some kind are necessary if they are to know what their business is doing or what to do to improve it. The appraiser soon becomes adept in ascertaining about how much the farmer knows about his business. iis confidence in the ability of the borrower to make adjustments with changing market or production conditions is measured large- ly by the amount of information which the farmer is able to give concerning the details of his business. Diversifying. Risks - Good business methods require that the farmer diversify his production. There may be, of course a few outstanding exceptions to this rulee There may be some small areas which are so eminently well adapted to one particular crop that it would be folly to use the land for any other purpose. The indications dre, however, that such cases are very exceptional in the United tatese The farmer who has two, three, or more sources of income is ordinarily a far better risk, other things being equal, than the farmer who depends on one crope Bankérs seem to be in unanimous agreement on this point. Other advantages such as the preservation of soil fertility, are to bezachieved through diversified production, but the greater certainty of income with which to pay debt obligations is also an attraction to creditors. In estimeting the prospective borrower's ility to make regular interest and principal payments the appraiser of a farm mortgage bank will be attracted by those farmers who use the good business sense not. to depend on one source of incomes Selling Products - In addition to business methods applied to the internal affairs of farm operations, in uity and business judgment must be used in the a marketing of farm products. Good business methods applied to the internal affairs of the farm have to do chiefly with the reduction of costs to a minimum, while the use of good business sense in marketing has to do with getting @ maximun price for products. A good system of marketing raises the upper margin of net earnings, while reducing costs lowersi.the lower margin. The farmer who recognizes only one of these means of increasing net earnings is greatly handicapped. Farmers have, of course, always realized the importance of price, but they have been slow to discover methods of price controls The importance of adjusting the quality and quantity of production to the demands of the market was discussed above. Here we are interested primarily in the methods of selling the commodity once it is ready for the market. The appraiser of the future earning power of a prospective borrower finds the marketing methods used by the latter an important consideration. Probably the First consideretion is that of the borrower's freedom in. the sale of his products.150 Is his credit situation such that he must sell immediately to pay off pressing debts, or is he in a position to hold the product for a better market? Secondly, what is his warehousing system? Many cotton farmers, for instance, suffer con= Sidereble reductions in price due to poor warehousing, or to no warehousing at all. Thirdly, does the borrower know the advantages of cooperative selling? Of course,ethe appraiser must decide for himself whether or not there are such advantages. Equity in Operating and Investment Capital The ability of the prospective borrower to make annual payments on the loan under consideration is contingent upon his other annual credit obligations. For instance, if the farmer commonly borrows: little or no funds to pay operating expenses; ho is in much better position to make the annual payment on the mort- gage loan in case of an emergency, such as a poor crop year. This high percent- age of equity in his operating capital serves as 1 sort of guaranty fund for the payment of his mortgage debt. On the other hand, if he commonly borrows a large portion of his operating capital, the emergency year finds him ir the embarrass- ing position of having borrowed well up to the limit with the local banker. He often finds it exceedingly difficult to pay his mortgage loan obligations and get funds on which to operate the next year, It is in such a financial pinch that many of the delinquencies on farm mortgage loan payments occur. Two or three poor years in succession lead to the foreclosure of many mortgage loans. ihe borrower who has small equity in his operating capital is usually in rather severe straits with one year of bad businessi Likewise, the ability to pay interest and principal of the loan is limited by other long-term loan otligations which the borrower may have. If he has a 950,000 equity in a $40,000 farm, the full current returns on the $40,000 worth of capitel ore available to meet current obligations. ‘This seems to be a safe proposition for the lender. But suppose the borrower shrough the use of a second mortgage or by some other means obtains $25,000 more and has an equity of only $5,000. Annual debt obligations have been so increased that there is little margin of safety. The element of flexibility in the borrower's financial posi- tion is largely gone. His reserve earnings can with great difficulty be stretch- ed over one bad year, not to mention his situation over a period of bad years such as occurred for most American farmers during the years immediately following 1920. 2. Methods of Getting Information on Ability to Pay The above outline of the more important bases of ability to pay mortgage loan obligations appears rather forbidding when it is considered that the bank: 161 or insurance company os located far from the farm and that ‘the appraiser can use only a short period of time in making his appraisal. In the case of making operating loans the local banker has been able to observe the borrower year after year; he knows something of his ability as a producer and his business methods. But when a representative of a farm mortgage bankecomes into the community to investigate an application for a loan, he usually has everything to learn except the general farming conditions of the section of the country in which the appli- cant lives. Even when the mortgage bank or insurance company has an agent in the community, or in a nearby community, the task of appraisal seems rather formidable, _ There are three commonly used methods of securing credit information for mortgage loans, e.g., 1) personal inspection of the farm, 2) interviews with the prospective borrowers, and 3) individual reports from business men and neighbors of the community. To begin with, it is assumed, of course, that the mortgage loan appraiser is familiar with the best farming methods for the territory in which he operates. Also, it is assumed that he has had experience in sizing up the situation of individual farmers. His first step then in the investigation of the affairs of a particular applicant will be a personal inspection of the farm. Having a definite idea of what good land, equipment, and livestock are, the appraiser can soon pass judgment by an inspection of the farm. Also, he can soon determine whether the farmer takes good care of his equipment and livestock. Meantime, the farmer is probably with him and can answer questions concerning his labor supply, his methods of soil maintenance, his cropping methods, and something of the amount of commodities he has been able to produce during recent years. Furthermore, a brief interview will reveal something of the business methods of the borrower. Pointed questions will easily show whether or not the farmer knows ‘anything of the costs and earnings of particular phases of his busi- ness, whether he is getting ahead, or falling behind, and the reasons therefor. In the interview the appraiser will secure some kind of financial statement of the business. It may be guesswork or a broad estimate on the part of the borrower. If it is guesswork, this in itself will compel the appraiser to make a conservative appraisal. The fact that the farmer is wicertain regarding his financial stavus not only indicates inefficiency, but it probably means that he will make.a liberal estimate of his condition, since he is anxious to obtain a loan. What the appraiser needs above all else in estimating the ability of a bor- rower to meet his annual interest and principal payments is an accurate and com- plete statement of his financial status and a profit snd loss statemeht for the past few years. Such statements would indicate present assets and liabilities and something of the progress of the borrower over a period of years. Until such statements are required, or until they are voluntarily provided by the farmer,Rf 162 the farm mortgage banker and other farm mortgage creditors will be unable to make the most scientific estimates of credit riskse This forces the lending agencies to lend very conservatively and to depend on recovery through foreclosure and forced sale of the mortgaged property in case the estimate of the future earnings of the borrower is too liberal. The credit records suggested in Chapter 9 for the customers of local banks would be a most excellent source of information for the farm mortgage appraiser. If such records for a period of five or ten years were accessible to the appraiser, less interviewing and inspection would be necessary and, more important, a much mere accurate estimate could be made of future .earnings. In the absence of credit or financial records, the banker in the community is usually able to aid the appraiser considerably from his knowledge of the bor- rower. He can furnish information as to the borrower's reputation for honesty. and promptness in paying debts, something of his indebtedness, and something of. his ability.as a farmer. -Such information from the banker often serves as a good check against similar information received from other business men and neighbors of the borrower. The experience of appraisers however indicates that information received from local parties must be carefully checked and often discounted because of bias in favor of the borrower. 3. Determining the Amount to Lend On the basis of the above information the appraiser must make specific recommendations as to whether the loan should be granted to the applicant and, if so, the amount that can be safely advanced. If he finds that the prospective borrower has a2 good reputation for honesty and square dealing, he is ready to recommend the loan, provided there is a good prospect for earnings that are not claimed by other creditors. The exact amount of the loan to be recommended on the basis of the prospective earnings may be arrived at by some such process as follows: First, determine the gross income received by the borrower the past year, or better. the overage gross income of several years. Second, determine for the past,year, or several years, how much was left over after the obligations (leaving out of consideration for the moment the repairs and replacements of capital) involved in the year's production and the family running expenses were paid. The amount left over will probably be found in one or more of the following forms: a) bank deposits, b) loans, ¢c) additions to capital. For instance, suppose the net earnings are represented wholly by bank deposits and it is found that on January 1, 1925, the farmer had a clean slate for his 1924 obligations and has $500 in the bank. The appraiser finds163 on January.], 1926, that the 1925 obligations have been met, and that the borrow- er has $2,000 in the bank. This means that aside from the depreciation of capital he has had net earnings of $1,500 during 1925. Then if 1925 is taken as a repre- sentative year, it seems that the banker could very safely make a loan suffici- ently large thet the annual interest and principal payment would amount to $750, But there are two other points to consider: 1) Is it probably that the borrower can earn an average of $1500 per year during the period of the loan? 2) What will be the annual average expense for upkeep and replacement of land, buildings, machinery, and livestock? Third, estimate future net earnings with past earnings es a starting point. The two main factors to consider here are, 1) probable general increase or de~ crease in the farmer's costs of production, and 2) probable increase or decrease in the prices of farm products. These are factors of general agricultural condi- tions which the farm mortgage banker or other lending agencies must interpret for themselves, The wisesfarm mortgage loan agency could see the likelihood of an impending slump in agricultural prosperity in the year 1919. Likewise, the like- lihood of improved conditions could be foreseen in the year 1921, It is, however, more difficult to foreseesthe agrigultural ecnditions for a twenty- or thirty-yeer period. Nevertheless, the farm mortgage banker who makes a twenty-yeor loan in 1927 must necessarily interpret agricultural conditions from 1927 to 1947, The question of the future trend of prices and the costs of producing agricultural products must be considered from the long time point of view. Another question arises in comection with a particular loan. In case costs should increase out of proportion to price increases in the particular line of production in which the borrower is engaged, can he easily shift to the production of other commodi- ties? For purposes of illustration,,suppose that farmers are not likely to be as” prosperous on the average during the next twenty years as they are at present, and that after considering the individual case of the applicant, the appraiser decides that net ecrnings of $1,200 instead of $1,500 would be a more accurate estimates Then in order to allow for a bad year or a series of bad years he would probably not desire to make a loan the annual payments on which would atiouht to more than half of 91,200. Fourth, estimate and deduct the amount which must be allowed annually for the upkeep of land and equipment. There will be some years in which very little repairs or replacements are necessary, but there will be other years in which very large amounts must be spent as, for instance, when buildings, expensive machines, and teams must be replaced. The appraiser must look to the average annual upkeep expenditure which is likely to be necessary over the full term of the loan. The average annual expense for replacements can be estimated fairly accurately bySeer hatiaraacas ee eee nae ea 164 dividing the average period of usefulness of the various kinds of farm equipment into the purchase price in each case.9 For instance, if barns with a replace- inent value of $8,000 are expected to last twenty-five years, $325 per year will be necessary for their replacement.+ The annual cost of repairs or upkeep must also be added to this figure. Suppose that a total deduction of $500 per year must be made for repairs and replacement, there remains then $700 as the estimate ed future annual net earnings which are available to pay the annual interest and principal bills on the mortgage. Pifth, determine a desirable ratio of net earnings to annual interest and principal payments. Safety requires that prospective earnings be considerably greener than the debt obligation. No conservative investment banker, for instance, would underwrite an industrial bond for a corporation which shows earnings of gust enough to pay interest on bonds. He would find their sale impossible, be- e&use investors insist on 2 margin of safety - a margin to guarantee the regular peymeont of interest. Similarly, the farm mortgage banker must insist on a margin of safety. The industrial corporation whose bonds are considered a safe invest- mont will usually be able to show net earnings ye to at least twice the amount or the annual interest payment required on the bonds in question. In fact it ig very common to see this rotio advertised to investors as being 3 to 1, although in many cases deductions must be made for a sinking fund from which to pay the Principal of the bonds when they mature. It has been assumed above that the Tarm mortgage borrower makes payments on principsl each year. Where this is the ase it seems that a 2 to 1 ratio is satisfactory for the investor or the farm mortgage banker. If this retio is satisfactory to the farm mortgage banker, a loan could be made in the above illustration the annual interest and principal Q payment on which amounts to $350 Sixth, calculate the emount of a loen which calls for the annual payment of $350. The amount will depend on the interest rets, the length of term of the loan, and the method of repaynent. Assume, for instance, that the loan is to be repaid on the amortization plan which requires equal annucl payments. If the rate of interest is 54 per cent and the last of the series of annual payments is to be made thirty-years from date, a loan of approximately $4,000 can be made on the basis of annual payments of $350. If the interest rate is higher, om the term —_— “is shorter, the amount of the loan must be reduced accordingly. 3. See Chapter 5 for a discuss of the life pericd of the various types of « farm investment capital. 4, This leaves out of consideration the possible earnings cf the replacement oy fund.165 4. Influence of Community Standards The amount of a loan based on the estimated ability of the individual to pay will require some adjustment when the efficiency of the borrower is considerably above or below that of the average producer of the community. The necessity for this adjustment arises because of the likelihood that the mortgagor will transfer the indebtedness to some other individual before it is fully paid. The probability of such transfer is particularly great in the case of loans for long-terms of twenty, thirty, or forty years, Even if the borrower does not transfer the obliga- tion to others through sale or inheritance, the active operation of the farm is likely to be left to other members of the family, or to a tenant outside the family. Obviously the likelihood of changes in management is greater the longer the term of the loan. Also, the significance of possible changes in management is greatly affected by the method of repayment of the loan. For instance, suppose the loan is to be repaid in lump sum at the end of a term of forty years. There is rela- tively little certainty that the earnings of the present mortgagor will be applied on the note forty years hence. On the other hand, if the period of the loan is ten years and it is to be paid in equal annual installments, the earning capacity of the present mortgagor is extremely significant. If the loan is paid by annual installments, the earning capacity of the mortgagor is very important, even though the loan is made for the long period of forty years. His earning capacity will at least indicate the certainty with which prompt and regular payments can be expected for the first part of the period, In view of the uncertainties of the continuous active management of the mort- gagor, the lender must take the precaution not to make an estimate of earning capacity which is very far above the average earning capacity of other farmers in the community. When the management of the mortgaged ferm is passed on to another man, there is no certainty that his efficiency will be above the average of the communitye Indeed his earning capacity may be less than the average for the com- munity. Specifically, if the prospective borrower is exceptional in directing labor, maintaining soil fertility, and choosing and maintaining efficient equipment and livestock, the banker must discount the estimate of ability-to-pay. The amount of the discount for exceptional ability should be regulated according to the length of term of the loan and the method of repayment. EMPRGENCY SALE AND RENTAL VALUE But suppose an emergency arises making it impossible for the borrower or his successor to make the required payments, Long continued illness of some of the members of his family may place such a burden on him that he will be compelled to ROE EG SEE SURED A OID ERE OE ES So ESO NSE RITE eas ee aka166 Surrender his land to the bank. Other contingencies, such as fire, tornadoes, floods, successive years of poor crops, or 4 prolonged period of low prices may make payment of the loan impossible. In case such unexpected and unpredictable event prevent liquidation of the debt in the regular manner, the lender may force an immediate settlement by taking over the farm through the legal process of foreclosure. Ordinarily the lender sells the farm and retains enough to pay the debt plus the costs of sale, the remainder of the sale price going to the borrower. The other alternative is for the banker to hoid the farm for rental or future sale. Present Sale Value The lender must be assured that in case foreclosure should become necessary he can either obtain a price sufficient to pay the loan, or collect enough rent from the farm to pay the annual obligations of the loan plus the expense of collection. Present sale value is the practical starting point in estimating the probable emergency sale value. The present sale value may easily be ascere tained in case the loan is obtained to purchase the farm to be mortgaged, but frequently a farm owner mortgages his property for the purpose of refunding an old debt, making improvements, or buying land not mortgaged. In such cases the selling price of other farms in the community which have recently changed hands supplies a good basis for estimating the sale value. of the farm in question. Future Sale Value Of greater importance to the lender, however, is the future selling price of the farm. He is interested in the price that can be obtained when foreclosure becomes necessary. But since the exact future price cannot be determined the banker must make an estimate on the basis of the factors which may affect farm values during the period of the loan. Depreciation - Probably the most obvious factor which affects the future value of the particular farm under consideration is the depreciation of land and buildings. During the term of a twentyeyear loan the soil may be robbed of a large percentage of its fertility and the buildings may become practically worth- less. The rate of depreciation of the land must be estimated largely on the t= basis of cropping methods used, while the rate of depreciation of the buildings depends on the repair and replacement policy of the borrower. In addition to depreciation from use, buildings are subject to complete loss by fire and tornado. Loss by fire is so common that most mortgage bankers and insurance companies re- quire that buildings be insured. Because of fire and tornado hazards and the rapid normal rate of depreciation of buildings, many lending agencies refuse to lend on the value of buildings. The federal and joint stock land banks consider167 building values only to the extent of lending twenty per cent of their value, with provision that they be insured ageinst fire hazards. Thus, from depreciation alone land and buildings may lose a considerable percentage of their value during a period of twenty or thirty years. It is like- ly that soil depreciation will come to have greater weight with bankers than it has in the past, since its full significance is just coming to be realized in this country. Analysis of Present Sale Value + In estimating the probable trend in farm property prices, the present price must be analyzed. Is the present price inflat- ed? That is, in the. judgment of the lender, have buyers so over-estimated future prices that present prices will actually decrease? The prevailing farm land prices in this country in 1919 and 1920 furnish an excellent illustration of in- flated prices. The 1925 Census indicates a decrease of about twenty-five per cent in the total value of farm:property in the country since 1920. If this is true for the country as a whole, it is apparent that many farms sustained a greater decrease in value. During this period many lenders have foreclosed on farms which could not be sold for a price sufficient to cover the loan. An analysis of the business cycle should heip the farm mortgage banker in estimating future land valuess The year 1920 marked the crest of high prices in general. Many bankers were able to foresee a drop in the price of agricultural products and with it a period of depression and decreasing land values, while others were carried along with the wave of enthusiasm which stimulated buyers to pay unreasonable prices for land. If the cycles of prices in general are studied,+it will be found that the prices of farm products are usually subject to greater and more suddensdecrease in periods of depression than are those of most other commodities. Aiso, an ex~ tensive fall in the price of farm products is usually accompanied by a fall in ‘farm land values, although land prices do not decrease in proportion to the com~ modity prices. it is conceivable on the other hand that land prices may become unreasonably low during 2 period of depression such as that which followed 1920. Probably the 1925 prices for farms are too low and a rise can be expected with the next decade. This brings up the question of what are too low and too high prices for farm land. On what basis does the banker determine whether land prices are too high or too low? Aside from the home attractions and the social advantages of a particular farm, the selling price of the farm is determined by buyer’! and sellers' estimates of its present and future earnings. If the prospective future earnings or the prospective future selling price of the land is over-estimated the present selling price is too high. The lender must simply balance his judgment of future sale value against that of the present buyers of land., LEB Other Future Price Factors - In addition to the knowledge of the general trend of business or prices, the banker's estimate of the future price of land will be influenced by such factors as future tariff policies of the government, the probability of increased taxes, and the demand and supply conditions for the products of the particular land under consideration. A well established protec~ tive tariff policy for agriculturel products which compete on the home market with foreign products would tend to increase farm land prices, while a reduction or abolition of the tariff would have the opposite effect. An increase in the taxes on farmers and farm products out of proportion to the direct benefits received tends to reduce the price of farm land, and vice versa. The farm mortgage banker finds it to his interest to study the demand and supply conditions affecting the products of the farming section in which he is Operating. Suppose, for instance, he is making loans in a cotton producing regione His estimate of land prices over the next twenty years will be affected by @ possible increase in the demand for cotton due to an increasing population, or & possible increase in demand due to the substitution of wool, mohair, and silk. On the other hand his estimate of land prices will be influenced by the prospects for boll-weevil control, and by the prospects for increased production of cotton in Brazil, Egypt, India, and other cotton producing areas of the world. Moreover, the possibilities of producing other types of products on the cotton land, in case demand and supply conditions arise which should make cotton production unprofitable, must be considered. Banker's Valuation is Conservative - The banker is likely to make a more conservative estimate of the future price of land than will the land buyers In the first place, the banker is not expecting a speculative gain through increas~ ed land values, whereas, the buyer usually expectts o rise in price and is wille ing to advance a part of the expected gain in the form of 2 higher present price. In the second place, buyers are frequentiy induced to pay high prices by the salesmanship method of professional land dealers. No such influence is present in the banker's valuation. In the third place, the buyer may hope to sell ata time when. land prices are highest, while the banker has little choice as to the time he will sell since he cannot anticipate the time that foreclosure will be necessary. As a matter of fact, the farm mortgage banker usually experiences the greatest necessity for foreclosure during a period of low prices. Ordinary Sele versus Forced Sale = The question of the difference in the price of land sold under ordinary saie conditions and that under forded sale Suggests itself at this point. The banker not only makes a more conservative estimate of the future price of land under ordinary conditions of sale than does the land buyer, but he also deducts some for the disadvantage of a forced sale, Buyers at public auction or at a forced sale of mortgaged property expect a169 bargaine It is generally understood that the farm must sell. This can result only in a lower price than wovld prevail under normal competitive sale conditions. The conditions of ordinary sale and forced sale differ further in that the farm on which foreclosure proceedings are instituted is commonly in a run-down condi- tion due to indifference of the mortgagor or to lack of funds. Annual Rent The lender is concerned with the rental value of the farm, since he may prefer to acquire full title to the land and rent it out instead of selling at a loss. The gross amount of rent which the land pays can be ascertained with little difficulty in those sections in which cash rent is paid. In case of share rent, the gross rent can be estimated by the average production of the farm. A more difficult problem is that of determining net rent. Taxes, expenses for upkeep, insurance, and the cost of looking after the farm must be deducted from gross rent in order to determine the net return from the farm. It is particularly difficult for a mortgage bank or insurance company to look after a rented farm, since they are located a considerable distance from the farm. Even though a local agent of the bank or company has charge of the farm the result is usually unsatisfactory. He looks on the task as a side line to his main business and commonly neglects it. Unless an exceptionally good tenant is found for the farm, the buildings and improvements are likely to be neglected. Aliso, not mony tenants take particular interest in maintaining the fertility of the soil, since the interest in the farm is only temporary. Cn the whole, the renting problem is so great that the banker usually prefers to sell the farm, even if it must go at a loss. Ratio of Loan to Forced Sale Value After the lender makes his estimate of the probable forced sale value of the farm, he still has the problem of determining what per cent of this value he is willing to lend. The most scientific estimate of future land value may be inac- curate. The investor in farm mortgages desires some margin of safety regardless of his confidence in the ability of the banker to predict land values. Just how much margin does conservative investing and banking policy require? Cana loan amounting to seventy-five per cent of the estimated ‘sale value under foreclosure be made with safety? Would eighty-five per cent be too high? Or, can more than fifty per cent be lent with safety? A definite answer to these questions is impossible, if applied to all loans. Some lands have a more stable value than otherse Some farmers are known to be excellent caretakers of soils and buildings, while others are not. The percentage to be lent on a particular farm will be affected, 1) by the degree of accuracy with which the banker feels that he can estimate the future value of the farm, 2) by the method for repayment of the loan, and 3) by the policy of the lender.170 ‘Assumed Accuracy of the Sale Value Estimate - In a newly developed section of the country where future land values are more uncertain than they are in the older sections of the country, the lender will find it necessary to make more conservative loans. In the latter case land values are more stable; farming methods and farm earnings are more thoroughly established... There is a greater background of experience on which to base land values. Again, there is a variation of certainty of future land values according to the type of commodities produced. The future market for some products is more certain than for others. Thus, farm products may be classified roughly ae staple products and specialty products. Cotton, wheat, hogs, corn, beef cattle, and other such basic commodities should be classed as staples, while many vegetables, fruits, and nuts are, more or less, specialties. Obviously, no hard and fast lines can be drawn in this classification, since wide fluctuations in price are often experienced with the "staple" commodities and frequently "specialty" prices are fairly regular. But it can easily be seen that the banker can estimate the future value of cotton or corn land, for instance, with greater certainty than that of land particularly adapted to onion or grape fruit production. The accuracy of the estimate of the future value of a farm is also affected by the farmer himself. The rate of depreciation of soil and improvements is greatly affected by the man in charge. If the borrower has been farming long enough to demonstrate his methods of soil maintenance and general care of pro- perty, the banker has some definite basis on which to estimate depreciation. On the other hand, many borrowers are young and inexperienced. Their reputation as husbandmen has not as yet been established. Their efficiency as caretakers is uncertain. Methods of Repaying the Loan - Under ordinary circumstances a large per- centage of the estimated emergency sale value of the farm can be lent if the annual payment method is used in paying the principal of the loan. With this method the investor or banker has a greater margin of security with the passing of each year. The same amount of property is martgaged, yet the amount of the debt is annually decreased, Other things remaining the same, the loan becomes a safer loan as time passes; whereas, in the case of a loan the principal of which is to be paid at the end of the term, there is no such increasing margin of safety. future sale value of the farm land will also depend on the policy of the morte gage banker and the investors to whom he sells the mortgage. Some bankers and investors are willing to forego some of the safety eleinments in order to obtainara. higher interest rates. Borrowers who have very little funds with which to buy a farm or who are heavily indebted are freguently willing to pay an attractive interest rate to get a maximum loan. FINAL APPRAISAL Final decision of the amount of the loan to be extended should be fixed by checking the amount determined on the basis of ability to pay the annual obliga- tions of the loan against the amount determined on the basis of emergency sale value. Suppose, for instance, that the amount set on the basis of annual paying ability is $10,000 and that on the basis of emergency sale value is $12,000. Un- questionably, the loan should be limited to the former amount,:since the banker wishes by all means to avoid foreclosure proceedings. Suppose, on the other hand, that these estimates are reversed and it appears that on the basis of annual pay- ing ability the borrower can safely be depended on to pay a $12,000 loan, while the amount as set on the basis of emergency sale value is only $10,000. In this particular case the wise banker will probably set his figure at $12,000 if thet much is desited by the borrower. This simply means that he will lend sixty per cent of the estimated emergency sale value instead of his usual maximum of fifty per cent, or seventy-two per cent instead of sixty per cent, as the case may be. In this example it scems that the annual paying ability basis governs in any case and that emergency sale value is useless as a basis for determining the ainount of the loan to be extended. But that such is not the case can be shown by another illustration. Suppose that instead of $10,000 and $12,000 in the first case above, the estimates are $10,000 and $20,000. Unquestionably, again the conserva- tive banker will limit the loan to $10,000 in order to avoid the necessity of foreclosure. Now suppose these estimates are reversed and annual paying ability calls for a loan of $20,000 while emergency sale value calls for a loan of $10,000. In this case the banker will probably place the amount of the loan at $12,000 to $15,000. If he lends the full $20,000 he will probably have extended more than his estimate of the total emergency sale value of the farm, which is seldom if ever,advisable. To sum up: 1) Take the estimated emergency sale value of the farm, or say eighty or ninety per cent thereof, as the upper limit, and 2) fix the loan at the amount determined on the basis of the annual paying ability, provided it does not exceed the upper limit set in 1) above. The safety of the investor requires that the loan not exceed emergency sale value, and the desire of the banker to avoid foreclosure induces him to emphasize annual paying ability in fixing the exact amount of the losn below this maximum. On the whole, farm values are more constant eid ne ee aee an an ee L172 over Aagperiod of years than is the annual peying ability of individual borrowers and, hence, estimated emergency s@le price should determine the maximum Limit of loans. Yet, if this value alone is used the banker is courting foreclosure troubles. His accurate estimate of the annual paying ability of the borrower and his conservative loan policy on the basis of this estimate makes his busi- ness 4 smeoth running financial business rather than a business of troublesome litigations and forced land sales. COMMON METHODS OF APPRAISAL The traditional system of appraisal used by farm mortgage loan agencies in this country is based largely on the reputation of the borrower and the value of the property to be mortgaged. On learning that the prospective borrower has a reputation in his community for honesty and square dealing, the appraiser begins the process of setting a value on the farm. Because ofatheir relatively rapid depreciation, buildings are usually appraised separately from the land. It is customary to use replacement value in their present condition in appraising buildings. The practice among mortgage bankers and insurance companies varies considerably with regard to the part that building'values play in determining the amount to be lent on the farm. Some agencies will lend nothing on building values, while others are purported to vary the percentage advanced on 4and some- what according to the value of the buildings on the farm. The federal and joint stock land banks lend twenty per cent of the value of the buildings, and some agencies simply sum up the value of buildings and the value of the land and lend a certain vercentage of the total amount. The amount to be edvanced on the land is commonly determined by the sale value of the farm, iess the estimated value of the buildings. In case the land is not being sold at the time the loan is made, the appraiser usually accepts the price at which it sold the last time it changed hands, or sets the price on the basis of the present selling price of land in the surrounding community. The maximum loan on land commonly ranges from fifty to sixty per cent of the sale yalue, according to the policy of the banker. The amount allowed on build- ings is added to the amount on the land to determine the maximum loan on the whole farm, But during the past few decades farm mortgage loan agencies have come to question the propriety of accepting sale price in determining the amount of loans. Bitter experience has taught farm mortgage bankers and insurance companies that the sale price of a farm is not an accurate indicator of the borrower's ability to pay the loan. The inadequacy of sale price as a basis for determining the amount to lend was first clearly revealed in the 1880's during the so-called173 "farm mortgage craze".° During this period the budding farm mortgage business of this country suffered a collapse which was fatal to a large percentage of the farm mortgage bankers. Their failure was due to a too liberal loan policy, which in turn was based on the over-valuation of land. The sale price of farms in the Middle West, the Southwest, and the Prairie States had advanced far out of propor~ tion to their earning capacity. A lull in the "land boom" in the latter 1880's resulted in falling prices and slow sales. The relatively few farm mortgage bankers who found themselves in a solvent condition after the experiences of this period determined to establish their business on a more scientific basis. Their chief problem was to discover better methods of appraisal. Earnings of the farm began to be talked about as a basis for appraising land values. The Federal Farm Act of 1916 provides that in the valuation of lands “the earning power of said land shall be a principal factor".® The following ruling has bedn made on this point by the Federal Farm Loan Board: "The appraisement of a farm should represent the best judgment of the members of the Loan Committee as to the value of the land in question, the principal factor being the productivity of the land then used for agricultural purposes, but taking also into consideration the salability of the land and the prevailing prices of the community."" The enormous increases in farm land prices during and immediately following the recent war, with the sudden fall in prices which occurred from 1920 to 1925 resulted in extensive losses to many farm mortgage loan agencies. The experiences of this period again forcefully emphasized the necessity of more scientific appraisals. Again the farm mortgage lender was impressed with the inadequacy of sale value as the sole basis for appraisal and with the advisability of emphasiz- ing earnings in farm land evaluation. Yet no farm land appraiser or farm mortgage agency has discovered a scientif~ ic methods of determining land values on the basis of the earning power of the land. In order to determine the value of farm land on the basis of its earning power the net earnings of the farm must be ascertained and capitalized on the basis of an arbitrary rate of interest. Of these two processes the first is impossible and the second is impracticable. The net earnings of the land cannot be isolated from the earnings of the farmer and his equipment. Suppose that after the actual expenses of the year for extra labor, materials, taxes, fertilizy er, repairs, etc., are paid the farmer has $2,000 lef: from the gross receipts of the year. In order to determine what portion of the $2,000 is earnings of the 5. M. T. Herrick and R- Ingails, How to Finance the Farmer - Private Enterprise Not State Aid, Che 2a -_—— 6. Federal Farm Loan Act, Section 12. 7. Federal Farm Loan Bureau Compilation, Minutes, p. 20B.174 land, the appraiser must determine how much should go to the farmer os wages and profits and how much should go as earnings on the investment in livestock, machinery, and other ecuipment. Since these latter determinations must inevita- bly be arbitrary there remains no way of setting the amount of the total $2,000 which should be assigned as net earnings of the land. The $2,000 simply comprises the composite earnings of the whole farm unit, including the farmer's labor supply, his managing ability, and his equipment, as well as the land. Furthermore, if the net earnings of the land could be determined, the value set by capitalizing earnings would be based on an arbitrary rate of interest. Shall it be capitalized at four, five, six, or seven per cent? Presumably, the rate should be governéd by the rate that could be obtained from investments in other forms or in other lines of industry. But these rates vary so widely that it is impracticable to attempt to set a definite rate. Suppose on the basis of four per cent the earnings are such that the land will be valued at $100 per acre. Then at five per cent, the value would be $80. Here a change of only one per cent in the rate of interest makes a difference of $20 per acre in the price of land. The inevitable conclusion is that even if the net earnings of the jand could be ascertained no satisfactory rate on which to capitalize could be discovered. In the appréisal of security for long-term farm loans the lender is vitally interested in earnings - the earnings from which the interest and principal of the loan are to be paid. These earnings will in reality be a result of the ability of the farmer with his land, equipment, and laber to produce marketable commodities at a low cost. They will be the earnings of the whole business unit. Likewise, the lender is interested in the value of the farm which is morts gaged - the emergency sale value, not the regular sale value nor the value cal- culated on the basis of the supposedly net earnings of the land. The only possible interest the lender can have in the value of the farm is that he may be forced to sell it in order to recover the loan. This means emergency sale value. It must be admitted, of course, that there is some relation between the so-called earning power of the land and the emergency sale value, but there are many addi- tional considerations, such as the home attractions of the farm, the self- estimated productive ability of buyers, and conditions of sale under foreclosure.Ze 3 2 175 QUESTIONS AND PROBLEMS Point out the chief distinctions between the credit analysis for short-term loans and for long-term loans. In the credit analysis for long-term loans, which do you consider more funda- mental 1) analysis of ability of the borrower to make annual payments, or 2) analysis of the value of the mortgaged property? Is there any relation between the ordinary sale value of the mortgaged pro- perty and the ability of the borrower to repay the loan? Is the value of the property an accurate indicator of the borrower's ability to make annual payments, and vice versa? Discuss, What are the chief difficulties involved in making long-term loans on the basis of value as determined by capitalizing rent? Explain why it is necessary to analyze both the borrower's paying ability and the emergency sale value of the mortgaged property? Explain the process of making a scientific analysis of the credit risk for 2 long-term loan, indicating the influence of the following factors: 1) busi- ness methods of the borrower, 2) stage of economic development of the com-= munity in which the borrower lives, 3) diversification of production, 4) the length of term of the loan, 5) the general rates of interest preveiling in the country, 6) the methods by which the loan is to be repaid, and 7) the stage of the business cycle.Chapter 1i FORMS AND LEGAL ASPEOTS OF FARM SECURITY A credit transaction involves a contract which is enforceable by law. The state becomes a third party to the agreement, and in case of failure of the bor- rower or lender to live up to the contract the injured party may appeal to the courts for justice. Most credit contracts are written, although verbal agree- ments are equally binding. They take the form of promissory notes, mortgages, pledges, liens, open accounts, and verbal agreements. From the legal point of view, credit contracts may be divided into two main types: those which involve no specific security and those in which certain property is designated as 4 guar- antee for the fulfillment of the contract. CONTRACTS WITHOUT SPECIFIC SECURITY Loans obtained on open accounts, personal notes, and verbal contracts are based on the general assets of the borrower. Such loans are commonly called un- secured loans, since they are not secured by any specific items of the borrower's capital; but in reality they are secured by all of the borrower's capital which is not svecifically pledged, mortgeged, or otherwise exempted at the time the loan is due. 1. The Open Accoun The open account, such as thot with the merchent, is probably the most in- formal credit contract which is made by the farmer. Although the farmer secures supplies on account without making an agreement, either verbal or written, to pay the account, he has made a legal contract, In legal terms, he has made an implied contract, which is as enforceable as a contract expressed in writings From the point of view of the borrower, the open account has the disadvantage of being uncertain. Unless he keeps a record of his purchases he is uncertain as to the amount of the debt. Also, the open account gives opportunity for fraud. The merchant may "pad" the account without the knowledge of the customer. Even if the borrower suspects fraud on the part of the merchant, he is at great disad~ vantage to prove his point, since the latter usually has the only available records of the transactions. The result is that in case the creditor brings suit for payment the court determines the amount of the debt by inspecting the mer- chant!s books.iT 2. The Promissory Note The promissory note is simply a written promise to pay a certain amount of money at a designated time, or on demand of the lender. Its chief elements are: the name of the lender, the signature of the borrower, the amount of the loan with or without the interest charge, the rate of interest, the date the loan is made, and the date it is to be paid or the designation "on demand", Figure 1 shows a typical form of promissory note used by bankers. Bryan, Texas, 192 $ after date we, or:either of us; jointly and severally promise to : pay to the order of THE FIRST NATIONAL BANK OF BRYAN, TEXAS, at Bryan, Texas, Dollars for value received, with interest at the rate of Ten per cent, per annum from maturity until paid, the interest payable annually. ll past due interest on this Note shall bear interest from the maturity thereof until paid at the rate of Ten per cent. per annum. And in the event default is made in the payment of this Note at maturity, and it is placed in the hands of an attorney for collection or suit is brought on the same, then an additional amount of ten per cent of the principal and in- terest of this Note shall be added to the same as collection fees. Each maker, surety and endorser hereon waives grace, protest, notice and presentment for payment and consents that the time of payment may be extended without notice. Due No. Address Figure 1. Typical form of promissory note used by bankers. This is “known yk E J ¥ as the "discount" form, since interest is specified only "from maturity until paid". -\The plain note form specifies interest "from date until paid". Liability of the Borrower The maker of a promissory note is liabl2 to the full extent of his assets on which there is no prior claim or exemption. Prior claims include mortgages and taxes. Also, most states provide for certain personal and homestead exemptions. The assets which can be attached for payment of a promissory note consist of what is left over after all taxes, mortgages, liens, and pledges have been paid and all personal and homestead exemptions have been made. If the available assets are in- sufficient to pay all promissory notes and open accounts of the borrower, an equal percentage is paid on each note and account. To illustrate: suppose that after178 the borrower's mortgages and taxes are paid and exemptions are deducted he has remaining assets amounting to $1,000 and he has an open account with his mer-. chant for $500 and a promissory note at the bank for $750. This means that 80 per cent of these obligations can be met, = $400 on the open account and $600 on the note. The question arises here as to the possibility of collecting the remainder of the open account and note from assets which may in the future accrue to the borrower. Under such circumstances, the merchant and the banker may secure what in legal terms is called a "judgment", which attaches the future income of the borrower until the debts are satisfied: Liability of Indorsers The indorsers of promissory notes become liable in a similar manner as does the maker. The assets of each indorser after his mortgages and exemption have been deducted become available for the payment of the note. The holder of the promissory note may sue the maker or any one of the indorsers for the full amount of the debt, or he may sue the borrower and all indorsers simultaneously. In case an indorser is forced to pay the note, he may in turn recover by collecting from the borrower or by obtaining a judgment against the borrower. Legal Process of Colle¢gtion Merchants and bankers ordinarily hire an attorney to collect debts which involve lawsuits. Th: larger banks and mercantile establishments employ a lawyer for this special purpose. It is his duty to take the case to court and secure immediate payment of the note with the costs of ligitation, or to obtain a judgment against the borrower. CONTRACTS WITH SPECIFIC SECURITY The essential difference between credit contracts which do not involve specific security and those in which certain specific properties are pledged or mortgaged is that in the latter case a definite prior claim to certain assets is established. From the point of view of the law the borrower's pro- perty may become available for the payment of a promissory note, but this is possible only after prior claims have been satisficd. A loan securédeby a fitst mortgage on the farm must be paid in full before the property can be used to pay any other obligations, excevt taxes and public assessments; whereas, in the case of a promissory note or an open account any number of other obligations may be established with prior claims to the property of the borrower. The hold+ er of a promissory note must give way not only to prior claims of holders of mortgages, but he must share his claim on the available assets of the borrower179 with other holders of promissory notes and all general creditors. The mortgage or pledge establishes on specific property a prior claim which cannot be changed until the debt is paid, while the promissory note or open account establishes only a general claim on the assets of the borrower, and the status of this claim may be greatly affected by other obligations assumed by the borrower before the note or account matures, The pledge and the mortgage are the two chief forms of specific security for loans. The term "lien"°is often used, but it has come to have about the same meaning as “mortgage”. "Vendor's lien", “mechanic's lien", “thresher's lien", “erop lien", etc., descripe what are essentially mortgages. 1. The Pledge The pledge hes been defined briefly as "a deposit ef personal property as security".] Although cattle, machinery, jewelry, cto., might be pledged as securs ity for loans, incorporeal-property, such as stocks, bonds, notes, mortgages, insurance policies, and warehouse receipts, is much more commonly used. These represent rather definite values and are acceptable as security for loans. Stocks and bonds which have a ready market are particularly attractive security, since they can be turned into cash on short notice in case the borrower fails to meet his obligation. Similarly, warehouse recétpts on non-perishable farm products are excellent security. Suppose the farmer has invested his surplus funds in United States Government bonds and sometimes during the year desires to pledge these as security for operating loans. Ordinarily, he will keep the bonds in a safety-deposit box of the bank. On extending the loan the banker will simply attach bonds approximately equal to the amount of the loan to the personal note of the borrower. Or suppose the farmer has products stored in a warehouse and is in need of funds to carry hin until he is ready to sell the commodities. If the goods are insured against fire and are kept in a standard warehouse, a receipt from the warehouse is acceptable as security. The pledging of a warehouse receipt is the same as pledging the goods, since the reccipt gives the banker the right to attach the goods upon default of the borrower. Loans secured by pledges such as those described above involve two distinct contracts: the note and the pledge. The note of course is a written contract, but the pledge -agreement need not be written exeept in the case of corporate stock. The fact that the borrower delivers the bond or warehouse receipt into the hands of the banker implies a contract. The banker has recourse to two remedies in case of default of the borrower: 1) he may sell the pledged property, and 2) if > the returns from the sale are insufficient, he may sue on the note for payment. from the general assets of the borrower in the way that he would if no pledge had existed. 1, Modern American Lew,(1924), Vol. IV, p. 116. eae ell180 The pledge of stock, bonds, and warehouse receipts is not commonly used by farmers in obtaining loans, chiefly because such instruments are not widely held by farmers. Few corporate bonds and stocks are held, partly because the invest- ment in the necessary farm capital is often great enough to absorb all surplus earnings, and partly because the farmer has traditionally preferred to invest his surplus funds in farm property or in farm mortgages. The individual farmer seldom has warehouse receipts to pledge, since he customarily either sells his products immediately after they are harvested or places them in the hands of a cooperative marketing association. The cooperative associations are, however, making rather extensive use of warehouse receipts as pledges for loans. Mem-~- bers of the association are usually in need of some advance on their products which advance is made from bank loans obtained by the cooperative organization by the use of warehouse receipts on the products delivered. LAWRENCE WAREHOUSE Bryan, Texas, 192 No. Received of mm eee eee ie One bale of cotton on storage, marked as stated herein, to be de- livered to bearer only upon return of this receipt and the payment of all charges. Not responsible for loss by fire, acts of providence, natural shrinkage, old damage, or for failure to note concealed damage. Weight | Marks | Gin No. Properly | Hoops | Condition } Heads | Grade Covered off Out | | ) LAWRENCE WAREHOUSE ; Weighing, pies Under Shelter This is to certify that I 1) and Hendling..... oc Iron House have this day weighed the above i Storage and Handling| Not Insured by cotton and thet the weights and a DEM MONEE 70 = 5:6 25c} Warehouse Co. eee aber ates? ATS YE ogee gAeons a t : , B. Priddy, Ht Certified Public Weigher a ‘Go oO 4 Ba eye mee ee rn tenes nee Figure 2. Typical cotton warehouse receipt. As farmers’ cooperative marketing associations develop and expand their business the use of warehouse receipts as security for loans will become more and more important to the farmer. e181 2e Mortgages Practically eli agricultural investment loans, as well as many operating loans, @re secured by mortgaszes on farm property. It is probable that well over two-thirds cf the total volume of credit extended to American farmers is secured by farm real estate mortgages and chattel mortgages. The use of the mortgage is an important means of acquiring farm lands. After the farm laborer or tenant farmer has accumulated forty or fifty per gent of the value of the farm he is able to obtain owmership by borrowing the remainder on a mortgage. The chattel mortgage is used chiefly for loans to buy livestock, machinery, feed, or family supplies. A mortgage has been defined as "a contract by which specific property is hypothecated for the performance of an act, without the necessity of possession".@ In law it is distinguished from a pledge chiefly in that the latter involves actual possession of the property offered as security, whereas, mortgaged property usually remains in the hands of the borrower or mortgagor. Sutherland describes the relation between the mortgage and the pledge in the following statement: "A transfer of interest in property, other than in trust, as security, is always a mortgage, except when in case of personal property it is accompanied by actual change of possession, in which case it is a pledge."9 The mortgage differs from the pledge further in the matter of transfer of title. The banker or other credi- tor who takes a mortgage always acquires legal title to the property mortgaged. In the case of the chattel mortgage the title becomes absolute upon default of the borrower. In the case of the real estate mortgage the title becomes absolute upon default, foreclosure, and sale of the mortgaged property. On the other hand, the creditor never acquires title in any form to pledged property.* Of most sig- nificance here is the fact thet in the case of both the mortgage and the pledge the property offered as security for the loan can be sold to satisfy the debt. The difference lies chiefly in the legal procedure. The Chattel Mortgage- In most of the states a chattel mortgage is a conditional sale of personel property-to secure a debt. The sale becomes void and the title is returned to the borrower if the conditions of the contract are satisfied. Jones in his Law of Mortgages of Personal Property describes the chattel mortgage as follows: 2. We A. Sutherland, Code Pleading Practice and Forms, Vol. IV, ch. 137. te Oe Se Op. Cit., ps 3223; 4, Goddard, Bailments, Section 72.182 "A mortgage on personal property is a conditional sale... 2. +++ ees eee Such mortgage is something more than a mere seéuritye It is a conditional sale of chattels (personal property), and operates to transfer the legal title to the mortgage, to be defeated only by a full performance of the condition”.> A brief form of a chattel mortgage is given in Roberts' The Farmer's Business Handbook, as follows :§ Know All Men By These Presents, that I, John Brown, of Ithaca, Ne Y., hereby sell and assign to John Jones, of the same place, one democrat wagon, one lumber wagon, one set of single harness and one set of double harness, all of which are now in my barn at Ithaca, aforesaid. This grant is intended for security for payment of Thirty Dollars ($30), with interest, on or before the expiration of three months from date thereof, which payment, if duly made, will render this conveyance voide In Witness Whereof, I have hereunto set my hand and seal this . « « « « « « Rete s «4 Fay Of « . «5 st 5 «© & 6 sw yg 190 acre © 8 Re 64 kN oe Kae ee ee The phrase "sell and assign" gives this document the appearance of a simple bill of sale. The chattel mortgage as defined in most states is indeed a bill of sale with the condition that the sale becomes void if the obligations sét forth are duly performed. Personal property commonly mortgaged by farmers includes livestock, farm machinery, automobiles, furniture, and musical instruments, In certain sections of the country it is common for the merchant to take a chattel mortgage on the machinery, furniture, etc., sold on credit, while general family supplies are often bought on the security of any or all of the above forms of personal pro- perty. Automobile finance companies take a mortgage on cars sold. Bankers frequently take a mortgage on teams, dairy and beef cattle, and farm machinery. Loans obtained from cattle loan companies are almost invariable secured by a mortgage on cattle. The Real Estate Mortgage In contrast to the chattel mortgage, the real estate mortgage involves property in land primarily, although it commonly involves buildings and other permanent improvements as well. Legally, the most fundamental difference be- tween a real estate mortgage and a chattel mortgage is that the former is re- garded in most states’ as mere security for a debt, while the latter is regarded 5. Ls A. Jones, Law of Mortgages of Personal Property, Sth Edition, p. 1-2. 6. I. Pe Roberts, The Farmer's Business Handbook, 2nd Edition, p. 226. 7. That is, in those states in which the method known as "foreclosure by equit- able action" prevails.183 as @ conditional sale. That is, in most states, the chattel mortgage carries with it more extensive rights in the property mortgaged than does the real estate mort- gagee Under the old common law the real estate mortgage and the chattel mortgage were similar in that both were considered as a conditional sale, but through statutory enactments and the decisions of the counts of equity the former has come to be considered as a mere security in England and in a majority of our states. Jones describes the meaning of akchattel mortgage and its relation to the real estate mortgage as follows: Such a chattel mortgage is something more than a mere security. It is a conditional sale of chattels, and operates to transfer the legal title to the mortgagee, to be defeated only by a full performance of the condition. Upon breach of the condition the mortgagee may take possession of the property, and, so far as the legal rights of the parties are concerned, he may thenceforth treat it as his own; he may sell it or give it away, squander it or destroy it. In this respect a mortgage of personal property is like a mortgage of real estate under the old common law, and differs widely from a mortgage of real estate, as the latter has gradually come to be viewed within the past half century in many of the States and Territories of the United States; for while in these States such a mortgage is regarded as conferring no legal title upon the mort- gagee, but as being a mere lien or security; in these same States, with some few exceptions, a mortgage of personal property is regarded as not being a mere secur- ity, but as passing the legal title which becomes absolute in the mortgage upon default.8 The question then arises: What is the difference in the meaningeof the phrase "mere security" used in describing the real estate mortgage and "condition- al sale" used in describing the chattel mortgage? In actual practise the differ- ence seems to lie chiefly in the fact that in the case of a chettel mortgage, the mortgagee can obtain possession of the property without the necessity of foreclosure and sale, while in the case of a real estate mortgage the mortgagee can become ovmer of the property only by buying it at a public sale condutted » under the direction of the court. In keeping with the general principle that the mortgagor retains greater rights in the case of real estate mortgages than in that of chattel mortgages, the period during which the mortgagor may redeem his property after default is usually longer with real estate mortgages. Moreover, the mortgagor always has the right to recover the excess or the value of real estate to the debt, while in the case of a chattel mortgage the mortgagee may retain the excess provided he 8. L. A. Jones, Law of Mortgages of Personal Property, Sth Edition, (1908) p. 1-2.184 chooses not to sell the property.9 Yet the mortgagee may always recover a de- ficiency in the value of the chattel mortgage by selling the property and suing on the note,10 A, Default of Mortgagor What Constitutes Default ~ Just what shall be considered a default depends on the provisions of the mortgage contract. Wiltsie says: . .. . "The right to foreclosure arises only where the condition of the mortgage has been forfeited by failure to pay the principal or interest when due, or by some similar breach of contract", 11 Agreements commonly found in contracts provide that the mort-~ gagee shall have the right to foreclose the mortgage and sell the property of the borrower in case of his 1) failing to make payments of either the interest or principal when due, 2) failung to pay taxes and assessments on the property, 3) failing to keep premises in repair, 4) failing to maintain insurance on prem- ises, and 5) abandoning the premises. In most states it is necessary that these conditions, with the exception of the payment of principal and taxes, be spec- ifically agreed upon in the contract. Otherwise, failure to perform any of these conditions cannot be considered a default and, therefore, reason for fore-~ closure. Remedies of Mortgagee or Creditor - In case of default of the borrower, the lender may either bring suit on the note or foreclose the mortgage; or he may sue on the note and foreclose the mortgage concurrently. The procedure in bring- ing suit on the note is similar to that on any promissory note. Foreclosure proceedings may take any one of four forms: 1) foreclosure by entry and poss- ession, 2) strict foreclosure, or foreclosure without sale, 3) statutory fore- closure, or foreclosure by advertisement, or 4) foreclosure by equitable action. According to Wiltsie the last named method of foreclosure ". . « « «ee « » eiS now the almost universal procedure among English-speaking races . . « « « 6 « te In behalf of this method this authority says: "It is the most direct and cer- tain practice, affords the largest opportunities for readjustment and enforce- ment of the rights of all parties interested, is the quickest in final results, produces the strongest and firmest titles, and does the greatest justice to both mortgagor and mortgagee".12 9. Jones, Op. Cite, pe 978-979. 10. Landon v. White, 101 Ind. 249. ll. C. H. Wiltsie, Foreclosing Mortgages of Real Estate Property, p. 40. 12. OC. He Wiltsie, Op. Cit., p. 8-9.185 The first named method “= foreclosure by entry and possession - is confined chiefly to New England and a few of the Southern Stetes. Briefly the procedure under this method is as follows: The mortgagee.records a certificate or declar- ation of entry with the vroper public official and publishes the declaraction in the local newspapers. Then after one to three years (the time varying with the different states), if the borrower has not paid the debt, the lender's title to the property becomes absolute. The second method ~ strict foreclosure, or foreclosure without sale - is the usual procedure in only two states, Connecticut and Vermont. This method was common in Englend at one time, its purpose being the immediate perfection of absotute title for the mortgagee instead of obtaining a decree for sale. It was long ago recognized in England as being unjust to the mortgagor and has become practically obsolete. In.this country "...... .. » the courts in most states recognize this method, but allow its use only in exceptional cases, owing to its severity upon the rights of the owner of the equity of redemption" +5 The third method - statutory procedure - is sometimes applied. All the steps in this method of procedure are specifically prescribed by statute. The legislatures of practically all the states have passed laws providing for this method of foreclosure, but ". 2... . . « owing to its extreme technicality and insufficiency of remedy, it is seldom practiced where an equitable action is al- lowed". 14 Foreclosure by equitable action is by far the most common method in use, and will be described in more detail. Upon default of the mortgagor, the first step in the process of foreclosure is for the mortgagee to obtain from the court a degree of foreclosure, or order of sale. This decree usually contains a statement of the amount of the debt, directs that the mortgaged property be sold according to law, and that the proceeds of the sale be applied to the payment of the ex- penses of the sale, the costs of the action, and the debt, 15 The second step in the process is to publish notice several days in advance of the sale in the local. newspapers or by other means. Since the sale is to be made at public auction, the law requires that the public be given o reasonable opportunity to learn the time, place, and nature of the sale. The third step is the appraisal of the property by the court. An up-set price is determined and the court refuses to sell at less than this price. The fourth step is the sale itself. The court is the vendor and actually has the responsibility for the sale of the property, but it usually designates the county, sheriff or some other representative to maize the sale. The sale is 13. and 14. C. H. Wiltsie, Op. Cit,, p. 5-6. 15. See W. A. Sutherland, Code Pledding Practice and Forms, Vol. IV, pe 3260.TE Sa ae 186 made at the seat of justice © usually at the door of the county court house. Ac- tion must be brought and the sale made in the county in which the mortgaged pro- perty is located, regardless of the ptace at which the note is made payable. In most states the mortgagor or mortgagee may become the purchaser at fore- closure sale, although some courts make certain reservations. Purchase by the mortgagee does not, however, affect the amount of the debt. If he pays less than the amount of the debt the borrower still owes the remainder. The question arises here as to the procedure in case the mortgaged property does not sell for onough to pay the debt. If the mortgage:is not accompanied by a note, no other recourse is available, but this is seldom, if ever, the case. Any deficiency left after the mortgaged property is sold may be collected through a "deficiency judgment". The debt has an independent existence and remains with its original validity, notwithstanding a release of the mortgage. 1® The unsatis~ fied balance will be levied on other property of the mortgage debtor, or if the remaining property is already mortgaged or otherwise exempt from attachment, the mortgagee by properly recording the deficiency judgment may lay claim to property which may be acquired by the debtor in the future. On the other hand, if the sale price is more than sufficient to cover the debt and the costs of the fore-~ closure proceedings, the surplus goes to the mortgagor. Right of Redemption - In keeping with the development of law for the protec- tion of the interests of the debtor, most states have passed laws which give the mortgagor the right to redeem property, even after it has been sold. The right of redemption is a personal privilege given by statute to the mortgagor after real estate has been sold under mortgage.t7? At one stage in the development of the law of mortgages the right to redeem the property extended only to the time of foreclosure and was definitely barred afterwards, but at present many states allow the debtor to redeem his property at any time within one or two years after foreclosure by paying the purchaser the price at which the property sold, plusé the expenses of the sale and the costs of improvements bought by the purchaser since the date of sale. This leniency in behalf of the mortgagor creates consid- erg@ble uncértainty as to the final status of the title to real estate sold under foreclosure. The property can be redeemed, however, only by full payment of the debt, even though it was sold for less at foreclosure. B. Priority of Claims on Real Estate Most states have laws which give taxes the first lien agaist property, whether the taxes are assessed before or after the property is eee The 16. C. H. Wiltsie, Op. Cit., p. 21. 17. Sec C. H. Wiltsie, Op. Cit., p. 1416, and Le A. Jones, Law of Mortgages of Real Property, Vol. II, pe 629.187 property can be sold by the state to satisfy tax claims at any time regardless of other claims on the property. A judgment against the owner of the property also takes priority to the claims of a mortgagee, provided the judgment was filed in the records of the county before the mortgage was made. The proceeds of a sale to satisfy claims against real estate would then be distributed in the following order ;18 first, taxes and the expenses of the sale; second, judgments recorded prior to the time the mortgage was made; third, the first mortgage on the property; fourth, the second mortgage; fifth, the third mortgage, etc., sixth, personal notes and open accounts held against the owner. C. Farm Mortgage Certificates and Bonds Due to the fact that the denominations and the date of maturity of farm mort-~- gages are often ill-adapted to the requirements of investors, the farm mortgage banker sometimes holds the mortgages and issues certificates or bonds which are better adapted to the needs of the investing public. Thus, all the banks of the federal farm loan system and a few other farm mortgage banks issue and sell bonds which are guarantéed by mortgages held in trust.!9 When the federal land banks are in need of more funds to lend to farmers they simply deposit farm mortgages with the farm loan registrar for an amount equal to the amount of the proposed bond issue. In turn the farm loan registrar gives the bank a deed of trust for the mortgages. By issuing bonds the bank can make available investments in denominations of $100, $500, and $1,000, orgeven wider variations. Also, the bonds need not be made Por the same length of time as are the mortgages. Most of the federal land bank bonds in fact have been made for twenty years, whereas, their mortgages run more than thirty years. The farm loan registrar must simply see that he at all times has mortgages whose total amount is equal to the amount of the bonds outstanding. In order to proportion big farm mortgages, some farm mortgage bankers make a practice of issuing certificates of various denominations which are adapted to the requirements of investors. The banker holds the mortgage as security for the certificates. Suppose, for instance, that the banker receives a mortgage for $7,500. He may find some difficulty in setlifg the whole mortgage. Then instead of attempting to sell the mortgage, he may issue fifteen mortgage certificates for $500 each and sell these separately, 18. See William Lilly, Individual and Corporation Mortgages, p. 41-43. 19. In such cases the trustee holds what is knovm as a "deed of trust". The trustee represents both the mortgagor and the mortgagee.4e P 9. 10. ll. ie 12, Sater 188 QUESTIONS AND PROBLEMS From the point of view of the lender, what are the advantages of specific security over general security? Contrast the open account and the promissory note as types of credit con- tracts. When the banker takes a warehouse receipt for the borrower's commodity, does he have a mortgage on the property, or does he own the property? Explain. From a legal standpoint, what are the chief differences between the chattel mortgage and the real estate mortgage? Why has this difference developed? Wherein is a-crop lien similar and dissimilar to 1) a pledge, 2) the chate tel mortgage, 3) the real estate mortgage? What constitutes default of the mortgagor in the real estate mortgage? Are the conditions of default determined by the state or by agreement between the mortgagor and mortgagee? What is the chief distinction between equity and law? Explain the process of foreclosure by equitable action. Why is foreclosure by equitable action preferred in most states to the other methods of foreclosure? Why have governments considered it necessary to establish the “right of redemption"? How may the redemption laws of a state affect the flow of farm mortgage loans to that state? List the claims on the real estate of a debtor inathe usual order of their priority. Explain why farm mortgage bankers often hold the mortgage rather than pass it on to the investor. In this connection explain the function of the trustec.189 Part III. PANKING INSTITUTIONS Banking institutions are middlemen between investors They buy farmers! notes and mortgages and Banking insti- and borrowers. sell deposit. slips, bonds, and mortgages. tutions are described in the following chapters from the What factors point of view of their service to farmers. What de-~ determine the lending power of the farmer's bank? termines the length of term of Loans which the bank is adapted to make? How effectively are farmers* banking in- stitutions connected with the whole banking system of the country and with the ultimate sources of loanable funds? Lastly, what are the methods used by the banks in obtaining loaneble funds and extending loans to farmers?ir i eS ie 190 Chapter 12 DEVELOPMENT OF CREDIT INSTITUTIONS FOR FARMERS The problem of accumulating the loanable funds of investors and placing them at the disposal of borrowers has been assumed by banks and such semi-financial institutions as insurance and trust companies. The commercial banker not only pools the surplus funds of his community, but he also makes it his business to secure additional funds from outside the community to meet the needs of his cus- tomers. Thus he provides for safekeeping of the funds of his depositors and serves borrowers by maintaining a supply of loanable purchasing power. Similarly, the farm mortgage banker serves both investors and borrowers. For the investor he finds investments; for the borrower he marshals funds. The statement was made in Chapteril that credit directs capital. But the banker supervises the extension of credit. He determines whether credit, and therefore capital, shall be directed to particular individuals and industries. He is the governor of the flow of credit. ' Of course a considerable amount of credit is obtained directly from the ° original owmers of surplus funds, but such direct borrowing falls far short of meeting the credit needs of the farmers. The limited acquaintances and connec- tions of. the individual farmer usually make it impossible for him to obtain ~ credit at opportune times and in sufficient amounts withoutithe aid of the bank- ere The commercial banker, for instance, maintains a place of. business in the center of the community which is easily accessible to both depositors and bor-~ rowers. Here surplus funds are assembled and from the bank they are dispersed. Also, the banker establishes connections with bankers in other communities. Through these connections a surplus which accumulates in one section of the country.can easily be transferrdd’to other sections which are in need of funds. Such cornections are impossible for the individual farmer. In the case of the farm mortgage banker, funds are collected from a still more widely distributed group of investors. While the commercial banker eccasionally is compelled to request funds from other communities, the farm mortgage banker makes a common practice of obtaining funds from distant communities. The larger mortgage. com- panies usually sell their bonds or mortgages over several states and in several financial centers. The development of financial institutions to receive and dispense surplus funds was as inevitable as the development of merchandising to assemble and dis- tribute goods. The banker is indeed a purchaser and seller of credit in very mach the same sense that the merchant is a purchaser and seller of goods.sESL The orgenizgation of farm credit institutions and the adaptation of the com- mercial banking system to the reonirements of farmers is a recent development in the banking history of the country.. The earlier development of a banking system to serve-merchants and manufacturers wes normal, since the credit needs in mer- chandising end manufacturing businesses developed earlier. The farmer. remained more nearly self-sufficing. The money value of the investment and operating capital needed for a farm unit was relatively small up to the latter part of the last century. Land was cheap and his implements and improvements were scant and inexpensive. Moreover, his cperating capital, such as feed, seed, etc., as well as his consumption goods, was furnished largely from his own farm. Jn other words, his whole capital outlay was small and « large share of his consumption goods were obtained from the farm. On the other hand, merchandising and manufac- turing have long involved a relatively large outlay of capital. Also, the mer- chant and manufacturer have long been almost wholly dependent upon-the market for their capital and ee goods. The manufacturer must buy all his raw mater- jals and the merchant must buy his finished products. : The extensive capital requirements of manufacturers and merchants are largely responsible for the type of business ne steiowe eh known as the corporation. As early as the seventeenth century, English merchants evolved the joint stock form of organization primarily for the purpose of raising the required amount of capi- tal to operate such a large business, for instance, .as the East IndiasCompany. The mechanical developments which occurred in the manufacturing industry in England during the latter part of the eighteenth and the first part of the nineteenth centuries resulted in greatly increasing the amount of capital required by the individual manufecturing unit. The process of capital raising for large manufac-~ turing and merchandising concerns gave rise to the development of what is known as the investment benking system. The investment banker assumed a large share of the function of finding investors and lenders for large manufacturers, merchants, and transportation companies. Also, the credit needs of manufacturers and merchants led to the early devel- opment of ovr commmercial banking system. These banks of course~ served to facilitate exchange transactions in all industries; but so far as the function of supplying loaneble funds is concerned, the commerciel banking system, including both state and national banks in this cowmtry, was established primarily for the purpose of supplying the needs of merchants and manufacturers. It is only during the present century that any extended effort has been made to adapt the system to the requirements of the farmer. Although the credit needs of the farmer developed later tuan those of the other industries, they have, nevertheless, developed very rapidly curing the past half century. The money value of the farm unit has doubled two or three times Pio og 5 De ree ee ce ta ee ae es take edhoz during this period. The acquisition of a farm and the necessary equipment has become more and more difficult. Moreover, agriculture has become commercialized to a far greater extent during this period. The farmer is more dependent on markets since he produces less of his own operating capital and consumption goods. Instead of using a large percentage of his own goods, he has been emphasizing commercial production. The period of time involved in getting returns for his efforts has been extended and, hence, more financial aid is required. This point is particularly well illustrated in the cooperative marketing movement, one of the basic principles of which is the orderly marketing of products. Orderly marketing extends the time which the farmer must wait to get the returns from his product, and in many cases delayed payment is possible only if credit is accessible. At present (September, 1926) there is 2 considerable amount of agitation for the development of better methods of supplying farmers! cooperative marketing associations with the necessary credit. The modern cooperative, market- ing movement is transferring a part of the problems of financing the marketing of farm products from the local buyer to the farmer or the farmer's cooperative organization. Just as the investment banking system was instituted to raise investment funds for manufacturers, merchants, railroads, etes, the farm mortgage banking system has been organized to raise investment funds for farmerse The function of supplying the increasing needs for farm operating credit has been assumed largely by the commercial banking system, although some banking institutions, - such as the credit unions in North Carolina, the cattle loan companies and the federal intermediate credit banks, have been established primarily for the pure pose of supplying farm operating credit. In the development of agricultural financing machinery during the past. fifty years, progress has been made along three rather distinct lines: 1) the adapta- tion of the old commercial banking system to the needs of agricultures 2) the organization of new:banking institutions which limit themselves strictly to agri cultural financing; and 3) the development of insurance and trust companies and other businesses which are not strictly financial institutions, but which supply farmers with a large amount of credit. | THE ADAPTATION OF THE COMMERCIAL BANKING SYSTEM In the development of commercial banking in this country since the establish- ment of the national banking system in 1863, Congress -has been concerned chiefly with the following objects: 1) the selection of a desirable monetary standard, whether it be gold, silver, or both; 2) the development of a currency system which wouldtreadily permit expansion or contraction of the currency according to193 the needs of the country; 3) the establishment of such inter-relations among bankers as to make possible an equitable distribution of the loanable funds of the country, ‘ith the evolution of our present gold standard we are not special-~ ly interested here; with the adoption of a currency system which is flexible enough to supply the verying needs or the country we are interested inasmuch as a more elastic currency system was a direct benefit to agricuiture; but we are primarily interested here in the development of ways and means of equitably dis- tributing the funds in existence. The farmer has been at a disadvantage in com- peting with other industries for funds. State Banks Lose Note-Issue Privilege The National Banking and Currency Act passed by Congress in 18635, with emendments which followed shortly after this date, deprived the state banks of their privilege of issuing currency. A unified national currency system-was of course highly desirable, but unfortunately it worked a hardship on the agricul- tural communities served by state banks. In the first place, the National Bank- ang and Currency Act definitely limited the total amount of currency which could be issued by the system to $300,000,000, and rendered further inflexibility in wre currency by requiring that issues be based on the purchase of government bords; secondly, the currency~issuing banks (national banks) were required to have & Minimum capital stock of 950,000, which was entirely too large for profitable opezation in the smaller agricultural communities; and, thirdly, no effective system was provided for a proper distribution of funds over the country. The 97000 900 ,000-limit on the total issue of national banks proved to be inadequate to-mext the needs of the country; the $50,000 minimum stock of national banks resulted in depriving @ large majority of agricultural communities of a note- =o ssuins bank; anc an attempt to apportion the currency in such manner as to serve : 1 secsions: of the country proved to be a failure. Currency was apportioned to Vet E ct & 1 he difierent sections of the country roughly according to the banking facilities and credit needs, but it would not remain apportioned. Bankers found more favor- able lend‘ng conditions in the large financial centers of the East and a large e of the money wes soon concentrated there to the disadvantage of the The Act of 1875 Congress attempted to improve the banking situation in 1875 by removing the absolute limit on the amount of currency which could be issued by the national banks. But it so hapoened that ot this timc the price of government bonds, upon which benk-note issues were based, increased to the point that the issue of notes194 was unprofitable. The result was that the total supply of currency actually decreased in 1876. As for the old system of apportioning funds over the country, Congress simply admitted that it was a failure and abandoned it. That the problem of supplying the farming communities and the smaller tovms and cities with currency remained unsolved twenty years after the passage of the Act of 1875 is indicated by the report of the Indianapolis Monetary Commission in 1898. This Commission was elected to investigate the monetary needs of the country and to make suggestions for improvement. One of its recommendations was that a banking system be provided which would furnish credit facilities to every portion of the country, and that the loanable capital of the country be distributed in such manner as to equalize interest rates in the different sections. The Act of 1900 The year 1900 is notable in the adaptation of the banking system to meet the needs of agriculture. The minimum capital-stock requirements of national banks was reduced from $50,000 to $25,000; the tax on note circulation was re-} duced; and the percentage of notes issued to the amount of government bonds on which they were based was increased from 90 to 100. The first provision of this law made possible the establishment of national banks in smaller country towns, and, therefore, greatly improved the farm credit situation. The other provisions made bankenote issues more profitable to the banks and hence tended to increase the amount of money in circulation. These provisions helped the banking situa- tion in all communities, but they were particularly welcome to the isolated farming communities which had suffered most from a Shortage of credit facilities. That the reduction of the minimum capital requirements was welcomed, is indicated by the fact. that more than half of the new national banking charters granted between 1900 and 1920 were obtained by banks with a capital of only $25,000. Just slightly more than one-third of the national banks in existence in 1919 had less than $50,000 capital. Report of the Country Life Commission Students of agricultural problems realized that farm credit facilities were far from adequate. In 1908 President Roosevelt appointed the'-Country Life Com- mission to make an investigation of rural life problems in general. The report of the Commission indicated that one of the most important factors which was hindering the propersdevelopment of agriculture was the lack of sufficient credit. It was pointed out that country banks were not only unable to supply the amount 1. Comptroller of the Currency, Annual Report, 1919, Vole IE, .p.. 38s195 of credit needed at certain times of the year, or in special emergencies, but that interest rates were very highe The Commission, therefore, recommended a more adequate system of ‘rural crecit. The National Monetary Commission The financial panic of 1907 emphasized the weaknesses of the whole banking system - weaknesses which were inherent in the system from the date of its organ~ ization. The Indianapolis Monetary Comnission referred to above had pointed out ertain of these short-conmings, but aside from the few changes made by the Act of 1900 nothing had been done. In 1908 while the memory of the disruption of the 1907 panic was still fresh, the National Monetary Commission was established and delegated to make @ thorough study not only of our monetary and banking sys- tem, but also of the monetary and banking systems of Canada and many of the leading European countries. The Commission reported its findings to Congress in 1912. Seventeen specific defects in the banking system were pointed out. Certain of the criticisms apply to agriculture in particular. In the first place, the inequitable distribution of funds and the great variation of interest rates in the different sections or the country were emphasized, as had been done ten years earlier by the Indianapolis Monetary Commission. Thus, it was pointed out that the limited discount market for the ordinary banker led to heavy concentration of the funds of country bankers in New York and other financial centers. Second- ly, the Commission reiterated the old criticism that the amount of currency in. Circulation could not be contracted or expanded according to the needs of the ; country. Hence, the problems of an appropriate amount and an equitable distribu- tion of funds had been present since the National Banking and Currency Act was passed in 1863. Thirdly, too much of the banks! funds was tied up in reserves. The Creation of the Federal Reserve System The Federal Reserve Act of 1913 was passed with a view t5 the elimination of the defects of the old banking system. Certain of the provisions of the Act, and the amendments and rulings which followed, were particularly effective in improv- ing the credit situation in the farming sections of the country. Notable among these were: 1) the reduction of the reserve requirements for country banks from, 15 to 7 per cent of their deposits, with the provision:cthat the bank could in case of necessity borrow-its reserve from the federal reserve bank of the district; 2) the creation of flexibility in the currency supply of the country; and 3) the creation of a discount market more readily available to country bankers» Reduction of Reserves - Under the old national banking system country banks were required to keep monéy in reserve to the extent of 15 per cent of their deposits. According to the law 6 per cent must be held in the banks! own vaults196 and 9 per cent might be deposited with other banks. This meant that a bank with deposits omounting to $500,000 was required to store away a minimum of $30,000 in cash and maintain a deposit of $45,000 with other banks. That is, so far as the extension of loans was concerned the full $75,000 was useless to the bank. Tt was a kind of non-usable confidence fund. The Federal Reserve Act, with its amendments, and the rulings of the Federal Board have reduced the “idle” money of the bank of the above illustration from $75,000 to $35,000. Moreover, the bank may borrow the full amount from the federal reserve bank in case of a Shortage of funds. In other words, the full $75,000 has been made available to lend to the customers of the bank. Plexible Currency Supply » For the perennial problem of an inflexible supply of currency, the Federal Reserve Act offers a solution by making it possible to. issue currency on the besis of commercial paper. Under the old national banking law, banks could issue currency only purchasing government bonds with which to secure the issue. The result was that when the price of government bonds was high, note issuing was unprofitable to the bank and, conversely, when bond prices were low, note issuing was profitable. But it so happens that when business conditions are good and a great amount of currency is needed the price of gove ernment bonds is likely to be high,and when less currency is needed the bonds are likely to be cheap. There was, therefore, little or no correlation between the need for currency and the amount of currency issued. In fact,,it frequently hoppened that the currency supply was actually decreased just at a time when | business required an increase. The Federal Reserve Act provides for the issue of currency by the federal reserve banks on the basis of 40 per cent of gold and 60 per cent of commercial paper. As the requirements of business increase member banks will require more currency, and in order to get the additional supply of currency they rediscount their customers! notes with the federal reserve bank. Thus the federal reserve bank obtains the basis for currency issue in proportion to the increased needs for currency. On the other hand, the amount of currency in circulation contracts as the currency requirements of business decreases. This, process is inevitable since the local bank cannot afford to pay the reserve bank interest on ide funds. When the currency requirements of the local bank's customers decrease, the notes are returned to the federal reserve bank and cancelled, unless they are needed elsewhere. Discount Market ~ The Federal Reserve Act vrovides for a ready market for agricultural and commercial paper. Under the old banking system one of the chief difficulties of bankers not located in the great financial centers was that of finding a market for customers' paper. The country banker who found himself in need of extra funds either issued new currency or was compelled to seek direct loans from his city correspondent. The correspondent was a very uncertain source, sinee he would extend loans only in case he could not find some more satisfactory use for his funds.197 Since there was scarcely any such thing as teking the notes of his farmer and merchant customers and selling them on a discount market, the country banker was in poor position to meet an emergency by liquidating his holdings. He was attracted by the New Yor! market for "eall" loans which, presumably at least, could be turned into cash on a moment's notice in case an emergency arose. Hence, instead of using all the funds in the home community, most country bankers were continually placing funds in New York. * By attempting in this manner to maintain the liquidity of his funds the country banker was frequently unable to supply the credit needed at home. The federal reserve system makes such maneuvering un- necessary. The country banker may now feel safe in using all his funds at home. If he should happen to need more cash for emergencies he has a federal reserve bank, one of the-primary purposes of which is to rediscount the notes of its mem~ bers. He simply bundles up some of the notes which have been made to him by far- mers and merchants, indorses them, and passes them on to the federal reserve bank and receives cash in return. Not only is the local banker supplied with a ready market for his securities, but also the federal reserve bank of the district may find a ready market in other sections of the country in case more funds are needed. The law requires that in case of necessity any one of the twelve federal reserve banks, which may have a surplus of funds on hand, may be required to rediscount the notes of any reserve bank which is in need of funds. In this manner the mar- ket for the commercial and agricultural paper of a country banker is nation-wide. Surplus funds flow readily within each of the twelve rederve districts and from one district to another. The disccunt market established by the Federal Reserve ict has gone far in solving the half-century-old problem of equitable distribution of funds over the country. "Agricultural Paper" - In keeping with the general plan of creating a better discount market for paper held by banks, Congress took special cognizance of farm credit needs in the Federal Reserve Act by providing a longer rediscount period for "agriculturel paper" than that provided for commercial paper. The maximum rediscount period for agricultural paper was set e% six months, while commercial paper was limited to three months. One of the chief disadvantages the banks had found in lending to farmers was that farmers needed loans for a period which was longer than the banker desired to have his funds tied up. Farm paver was looked upon as more or less "fvozen" security - paper which could not be turned into cabh on short notice. The limited ability of the banker to replenish his funds because of the lack of discount market and the slow and, sometimes, unprofitable business of issuing currency keptithe banker in fear of not being able to meet 2. This of course was not the sole reason for investing on the call-loan market. Country bankers often invested funds in call loans during the slack periods of the year when little credit was needed in the home community.eee cerd 198 emergency demands for funds. The result was that the ordinary commercial leans or the New York call loans were more attractive investments than were farm loans. When loans were made to farmers they were usually made for one, two, or three months with a probability of renewal, regardless of the time the farmer needed the loan. Thus the banker attemptcd to maintain short-term, liquid securities. As a matter of fact, the practice of lending to farmers for three months when his crop would not be ready for the market for six months afforded the banker protection which was large psychological. Since the farmer was usually unable to pay until his product was ready for the market, the only alternative for the banker who insisted on payment before that date was to foreclose mortgages which he might hold against the borrower, or to force collection from indorsers of the note. In reality the banker almost invariably went to the trouble of renewing the note, and waited until the normal time for its repayment. Strangely enough, the practice of limiting farm loans to three months is common in many sections of the country thirteen years after the creation of the federal reserve system. The recognition by Congress that the farmer's business requires operating loans of a distinctly longer period than that of merchants and manufacturers marks a very significant step in the process of adapting what was essentially a commer¢ial banking system to the needs of farmers. Now the farmer's bank not only has a market for its commercial paper, but alse a market specially adapted to its agricultural paper. It is true that difficulty has been experienced by bankers in securing the required financial statements from farmers, but this is no fault of the banking system, After the federal reserve Bystem was established, and particularly during the time of the agricultural depression following the period of war prices, there was considerable agitation for some sort of reform which would supply the farmer's needs for loans to extend for a period longer than the six months allowed by federal reserve banks and yet shorter than the minimum: 6f five years allowed. by the federal farm loan system. As a result of this agitation the Federal Reserve Act was amended in 1923 so as to permit rediscounting of agricultural paper for & maximum period of nine months. This extension of the rediscount period seems to have established a discount market for farm paper which will serve all the demands of the local banker in supplying farmers with the ordinary operating loans. Non-Member Banks -. There remains, however, one missing link in the banking system designed to establish ready connection between all industries and the’ loanable’ funds of the country, e.g., the great majority of the state banks are not members of the federal reserve system. And it happens that a majority of the farmers of the country are served by state banks. Thesesbanks of course have correspondents who are able to obtain the full advantages of the discount market of the federal reserve system, but the service is not directly available for non- member state banks. During recent years efforts have been made to get more state99 banks into the system, but without very great success. Either the minimum capital requirement ($25,000) is too high, or certain other regulations and requirements are unsatisfactory to most of the small state banks. Membership in the system involves a loss of interest on the reserve balance with the reserve bank and for some banks it involves a loss of income in the form of charges for exchange. Other state banks object to the so-called "red-tape" of the federal reserve system, while some object to the financial statements required in connection with paper offered for rediscount. THE ESTABLISHMENT OF AGRICULTURAL BANKS During the past fifty years certain banking institutions have been developed for the distinct purpose of supplying the credit needs of farmers. In most cases these banks have been designed to supply either investment credit or operating credit which is needed for a longer term than that to which commercial banks are adapted. Farm Mortgage Companies The first and most pressing credit need to develop in agriculture was for Joans to buy and improve farm land. Commercial banks were at least partially sup- plying the limited need for operating credit, but investment credit banks were scarcely heard of in this coutry wntil after the Civil War. The farm mortgage banking business in the United States originated in the Middle West between 1840 and 1850.5 Prior to this time the comparatively small amount of mortgage credit used by American farmers had been obtained either from the Government in purchasing public lands on time, or from neighbors and individuals of the near-by towns. Lands were either free or very cheap and very little capital was necessary. But with the opemmng up of the great agricultural areasof the Middle Western States a consider- able amount of capital was required. The one place these westerners could expect to obtain capital was “back home" in the East. Hence, certain business men in the growing towns, confident of the future of this newly settled country, began advanc- ing money to farmers and, in turn, selling the mortgages. to investors in the east- ern financial centers. The business required a very small amount of capital. The first few loans could be made and, through the sale of mortgages as they came in, a continuous supply of funds from the East to the western farming communities could be maintained. At the same time companies were organized in certain cities of the East, particularly in New England. The managers of these oompanies obtained mortgages from the West and sold them to their neighbors and friends. 3. M. T. Herrick, and R. Ingalls, How to Finance the Farmer - Private Enterprise ~ Not State Aid, ch. 2.200 But these early so-called "farm mortgage companies" were engaged in this business along with other business and handled securities other than farm mort- g2ges. It was not until the "seventies that the farm mortgage business became r i rr ie ie specialized. With the new spurt of development in the West after the Civil War these farm mortgage companies experienced a rapid development. New companies were organized in great numbers, and loans were readily made at 10 and 12 per cent interest with a 10 per cent cash commission. The enthusiasm for development of the West with capital secured through farm mortgages developed into the so-called "farm mortgage craze" in the ‘eighties. The "craze" proper lasted from 1586 to 1893. At its height there were 167 licensed companies selling western and southern securities along the Atlantic Seaboard. Thirty-nine companies had nearly 800 agents in New York State alone. There were no lews regulating the business up to 1887, when Connecticut Legislators became aroused and passed a law creating the office of commissioner of foreign mortgage companies and requiring licenses fer such companies. Similar laws were passed an other states and many companies failed to qualify. Numerous complaints by investors swamped the commissioners! offices in New England. Newspapers took up the matter and forced investigations. The result was that a large percentage of the farm mortgage companies were placed in the hands of receivers. Land had been appraised very liberally and loans were made in many cases which amounted to almost as much as the over-capitalized value of the farms. Debentures were issued and, at times, sold below par as an added inducement to the investor. Such haphazard business was doomed to the ruin which occurred during the great crisis and general financial panic:of 1893. . The farm mortgage business required many years to regain a respectable place in the financial system of the United States. In 1894, the year after the panic, only fifteen companies renewed their licenses to do business in the East and, f for a time, no company was doing active business in the South. With the general a linprovenent of agricultural conditions after 1896 the farm mortgage banks, which fF had maintained their solvency, began to re-estabiish and expand their business. Sobered by the recent experiences, these banks followed a conservative policy of gradual expansion. More scientific land appraisals were made and loans were placed with greater care. Another phase of the development of a more stable busi- ness was theyadoption of more uniform practices among these bankers. Farm mort- gage banking was becoming, for the first time in our history, a well organized branch of our financial system. In 1914 the Farm Mortgage Bankers! Association of America was organized for the general purposes of securing greater uniformity of practice among themselves and of supplying the public with current information regarding the business. Several hundred of the better knowm banks are members of201 the Association. It was estimated* in 1921 that the members of this organization had in force a total of approximately $2,000,000,000 in farm mortgages. This was 25 per cent of the estimated total farm mortgage indebtedness of the country. Farn mortgage companies not members of this Association had about $1,200,000,000, or 15 per cent of the total for the country. The Federal Farm Loan System Although the interest in banking reform from the time of the appointment of the Indianapolis Monetary Commission in 1897 to the passage of the Federal Reserve Act in 1913 was centered in the reform of the commercial banking system, the agri- cultural interests:never lost sight of the need for a better system for farm mortgage financing. Students of the question pointed out four fundamental defects of the farm mortgage system then in existence: 1) interest rates and commission charges were disproportionately high when compared with those paid in other in- dustries; 2) the term of farm loans was far too short for repayment of the loan out of the products of the land; 3) the methods of repayment were not satisfactor; and 4) the possibility and conditions of renewal were uncertain. Here, as was the case with commercial banking reform, we looked to the exper- ience of Eurgpean countries. Certain European countries, especially Germany, had developed a system of cooperative agricultural banks. Reports of the success of these banks had by the middle 1900's “aroused public interest over the possibil- ities of cooperative credit for farmers in this country. By 1911 such widespread interest in agricultural credit had developed that the American Bankers’ Associa- tionttook up the matter. A committee was selected from this body to undertake a study of agricultural credit at home and abroad. The next year President Taft requested our ambassadors to Germany, France, and Italy and the Ministers to Belgium and the Netherlands to investigate the agricultural credit systems in operation in those countries. The three major politital parties in the campaign of 1912 adopted planks favoring the improvement of agricultural credit facilities. In March, 1913, the United States Commission of seven members was created to make a further study of agricultural credit organizations in European countries. Co- operating with this Government Commission was the American Commission created by the Southern Commercial Congress. This latter Commission consisted of seventy members representing twenty-nine states, the District of Columbia, and four Cana- dian provinces. Some of the main features of thesreports of these commissions are as follows: 1) that long-term and short-term credit cannot properiyjbe supplied by the same institution, since two distinct types of banking service are involved; 2) that 4, E, D. Chassell, Chicago Journal of Commerce, Feb. 27, 1922.FE FREE BNET A ou) 202 reform in our long-terin credit system is the most urgent and must come first; 3) that the German cooperative system is not entirely adapted to Americans and to American conditions; and 4) that the part of the. government in agricultural credit reform in this country should be limited to the establishment of suitable banking machinery and the strict supervision of operations. Three years more of discussion and consideration of the question resulted in the Federal Farm Loan Act of 1916. ‘The system of farm mortgage financing created by this Act includes many of the features of European farm mortgage banking sys- tems such as: 1) the amortization plan of repayment of loans; 2) the tax-exemp- tion feature; 3) the sale of bonds based on a collection of farm mortgages; 4) specific requirements concerning the ratio of loans to resources; 5) strict limits as to interest charges; and, 6) the cooperative: principle. The cooperative feature was included, however, only in a modified form. The Federal Farm Loan Act provided for a dual system of farm mortgage banks, namely, a2 system of twelvé federal land banks to be organized and established by the Federal Government, and a system of joint stock land banks, unlimited in number, to be established strictly by private enterprise. To supervise the whole system a Federal Farm Loan Board was created. The capital stock of the federal land banks was subscribed in the beginning by the Federal Government, but has since been purchased by the borrowers.5 The capital of the joint stock land banks was supplied from the beginning by private enterprise. The loans of both types of banks are made from funds obtained through the sale of bonds. Bonds are issued under the supervision of the Federal Farm Loan Board and sold to the public directly, or indirectly through investment bankers in the larger financial centers. The bonds are secured by a collection of farm mortgages. Loans are made directly to farmers by joint stock banks, while the federal land banks extendsloans through local farm loan associations organized by borrow~ ing farmers specifically for the purpose of handling such loans. Federal land banks are cooperative concerns in thet, 1) each borrower is required to buy stock in the bank to the amount of five per cent of his loan, and 2) each borrower must join the local loan association and become jointl responsible for the payment of the loans made to his fellow-members, 5. December 31, 1925, the Federal-Government owned only $1,331,930.00 of a total capital stock of $53,769,567.50 for the twelve federal land banks. See Federai Farm Loan Board, Annual Réport, 1925.203 Credit Unions The widely heralded possibilities-.of cooperative credit banks in this country during the early part of the present century resulted in the establishment of co- operative credit unions or associations in several states. Special laws were | passed from 1908 to 1915 providing for their organization in New Hampshire, Mass- achusetts, New York, North Carolina, Rhode Island, Texas, Oregon, Utah, and South Carolina. However, little has been done in the actual organization and operation of credit unions in any states except Massachusetts, North Carolina, and New York. North Carolina is the only state in which there has been any extensive develop- ment of such organizations among farmers. In this State the Superintendent of Cooperative Associations and Credit Unions supervises the organization and opera- tions of thezc#edit unions. According to the reports of this official twenty-two credit unions were operating in North Carolina in 1921. The credit unions of North Carolina were organized primarily for the purpose of avoiding tthe high costs of merchant credit and to promote the cooperative purchase of certain farm supplies. They operate on a very small scale, the total assets of the twenty-two unions in 1921 being only $90,819. Loanable funds are obtained from shareholders and depositors, who are almost universally farmers of the communities in which the associations: operate. The agricultural credit union in this country is only in the experimental stage¢and, with our well organized commercial banking system, it is doubtful whether such local credit organizations will ever become very important. It is simply an attempt to marshal the surplus funds of the community and lend them to the farmers who need funds. Since this function is now being performed by the local banker in a fairly efficient manner, it will be difficult to replace him. - Cattle Loan Companies The inadequacy of the commercial banks in supplying the credit needs of cattle producers led to the organization of "cattle loan companies” shortly after 1900. Cattlemenéwho operated the larger ranches of the West and Southwest were often unable to secure loans of sufficient amounts from local banks, partly be- cause of the normally small size of the hocal banks and partly because the banks were restricted by law from lending more than ten to twénty-five per cent of their capital and surpbus to any one borrower. Frequently cattlemen desired loans which amounted to more than the total capital and surplus of the local bank. In addi- tion to the large size of cattle loans, they were often required for a longer period of time than was desirable for the local banker. 6. Bureau of Labor Statistics, Bulletin No. 314. ae De sh ce Pn MIS ee ae ee | Saek < rete OS oe ot a tad204 During the latter part of the nineteenth century, livestock commission firms located in such livestock centers as Chicago, Kansas City, East St. Louis, Fort Worth, and Denver attempted to supply the credit needs of customers as an induce-~ ment to obtain and hold the commission business of cattlemen. But their facili- ties proved inadequate and the first regular cattle loan company was organized in 1902.7 The new credit agencies developed rapidly in the livestock marketing centers. They obtained a large share of the cattle loan business which had formerly been done by the commission companies, the local courjtry banks, and the larger commercial banks of the livestock markets. Two main types of companies develpped; the independent company and the company closely allied with the big commercia) banks of the livestock centers. The latter type of company was in fact often organized and managed by the directors of the commercial bank. In this manner the legal limitation set on the size of loans of commercial banks was avoided. The cattle loan companies obtain their funds largely by the sale of cattle paper to commercial banks, federal intermediate credit banks, and individual in- vestors. They are not deposit banks and their capital stock is small as compared with the total amount of loans. In these respects they are similar to the farm mortgage bank. Also, they are similar to the mortgage bank in that their bor- rowers and investors are distributed over a wide territory. Loans are secured by chattel mortgages on cattle, while the farm mortgage banker's loans are secured by real estate. The cattle loan company is a type of banking institution which has been developed to serve a special branch of the farming industry. Loans are made largely for operating purposes, but they are better adapted in size and length of term than coumercial banks are able to supply. The rapid development. of cattle loan companies seems to indicate that they aro moagting a distinet need. nhe Federal Intermediate Credit System Although the Federal Reserve Act and the Federal Farm Loan Act greatly facilitated the movement of the loanable funds of the country into the farming industry, many students of the agricultural financing problem pointed out the necessity of still another nationswide system of banks. This system of banks, they held, should be adapted to the particular purpose of extending farm loans for a period of time longer than was desirable for deposit banks and yet not as long as the term of farm mortgage banks. After the great fall in the prices of agricultural products in 1920 and 1921, numerous so-called "farm relief" measures were presented in Congress. Among these measures, the various proposals for 7. ds F. Ebersole, "Cattle Loan Banks", Journal of Political Economy, June, 1914. pee ys >205 improvement in the farmer's credit facilities seemed to be the most persistent, In 1921 the War Finance Corporation, which had been organized by the Government _ in 1918 to aid industry in meeting the increasing demands brought about by the war became predominantly an agricultural financing organization. Through this organi- zation the Government loaned approximately $300,000,000 for agricultural purposes from August, 1921, to November, 1923.8 Loans were made for a term of one year with a possible extension and renewal to three years. Although the War Finance Corporation was an emergency organization, its ex- cellent service to farmers' marketing organizations, small banks, and livestock loan companies gave impetus to the demand for a permanent banking system to supply what had come to be called middle-term or intermediate-term credit. In the first place, it was argued that livestock loan companies9 were operating with an entire- ly inadequate market for their securities, inasmuch as many livestock loans were undesirable for commercial banks because the term was too long. Many livestock producers desired loans running from one to three years, which term made the paper ineligible for rediscount with the reserve banks. Hence much of the livestock security was left out of the regular credit channels of the commercial banking system. In the second place, there was strong pressure during the period of agricultural depression for better facilities for financing the cooperative marketing associations. The War Finance Corporation had given liberal assistance, but commercial bankers were on the whole rather conservative in financing these "“mush-room" organizations. Many agricultural leaders fett that in the cooperative movement lay the farmer's greatest hope, and that one of the greatest needs of the cooperative associction was ample credit facilities. In the third place, certain legislators and agricultural leaders maintained that the six-months period S6r Fediscounts with the federal reserve banks was too short even for operating credit for the regular crop farmer. Such arguments as the aboy@, with the general clamor for some sort of "farm relief” legislation, induced Congress to pass the Agricultural Credits Act of 1923, creating the federal intermediate credit system. The purposes of this legislation may be summarized as follows: 1) to establish a banking system particularly de- signed to make loans for a term adapted to the turnover period of the farmer and stock raiser and, 2) to relieve the federal reserve system and depositebanks in general of at least some of the burden of carrying notes of the longer maturities. 8. War Finance Corporation, Annual Reports. 9, The old term "cattle loan" company is being replaced by the broader term "livestock loan company".206 The Act provided for two main types of banks: 1) twelve regional banks known as federal intermediate credit banks to be established with Government capital under the supervision of the Federal Farm Loan Board; and, 2) banks known as national agricultural eredit corporations and rediscount corporations to be established with private capital under the supervision of the Comptroller of the Currency. 1° The federal intermediate ¢redit bank obtains its loanable funds, aside from its capital and surplus, by the issue and sale of bonds and by redis- counting notes with federal reserve banks and other intermediate credit banks. The intermediate credit bank makes no loans directly to farmers, but discounts agri- cultural paper for commercial banks, livestock loan companies, agricultural credit corporations, cooperative marketing associations, other intermediate credit banks, cooperative banks, savings banks, and farmerst cooperative credit associations. Direct loans or advances are made to farmers’ cooperative marketing associations. National agricultural credit corporations may obtain loanable funds, in addition to their capital and surplus, by the sale of bonds and by rediscounting paper with the rediscount corporations and intermediate credit banks. They make loans directly to farmers. The rediscount corporations are designed to supply a ready discount market for national agricultural credit corporations. Their supply of loanable funds may be replentshed at any time by the sale of any paper which they may have discounted. OTHER SQURCES OF FARM CREDIT Besides the ordinary commercial banks and the distinctly agricultural banks, there are several sources of greater of less importance in supplying farm credit. These sources include individuals and certain types of business concerns and banks which are attracted by farm investments. Loans made by these agencies arise chiefly under one or more of the following circwnstances or situations: 1) the sale of farms; 2) the landlord-tenant relationship; 3) individuals of the come munity attracted by farm securities as investments; 4) the desire for safe invest- ments by concerns which by the nature of their business have large sursluses to invest; and 5) inability of the farmer to get sufficient credit from the local bank. The first three of these five situations give rise to loans by individuals; the fourth situation accounts for the loans of insurance and trust companies, savings banks, and buildingsand loan associations; and the last named circumstance largely explains the practice of obtaining credit from the merchant. 10, At the end of 1926 no rediscount corporations had been organized, while only three-national agricultural credit corporations had been organizes and twe of these had been liquidated.207 Individuals The total of farm loans obtained from individuals undoubtedly exceeds those from any other one source, even the local banks. This is accounted for largely in the partial-payment method of selling farms, whereby the seller accepts part payment and a mortgage to cover the remainder of the sale price. This practice is particularly common in the sale of farms by farmers who are retiring. Also, the practice is common in the newer sections where large ranching or lumbering concerns are selling land for farming purposes. Farm mortgage loans are often made by individual farmers and local merchants who are seeking a long-term investment for their surplus funds. They choose the farm mortgage because of a lack of knowledge of other investments, or because of a special preference for the farm mortgage. Farm mortgages were formerly very attractive investments because of the high interest yield, but with the establish- ment of the federal farm loan system and the increased competition of insurance companies and the old private mortgage companies this particular attrattion is not so great. The safety element, however, will continue to attract individual lenders. The land-lord tenant relationship is the basis for many individual credit transactions, particularly, in the South where share-tenancy and the "cropper" system are prevalent. The tenant is often unable to offer security which is satisfactory to the banker or the merchant. Sometimes the landlord indorses his note at the bank or "stands good" for an account with the merchant, but he often makes direct advances in the form of supplies or cash. Merchants Farmers obtain atlarge amount of credit from local merchantsés Their exten- sive practice of running credit accounts, rather than borrowing money from the bank and paying cash for supplies, is explained largely by the following condi- tions: 1) inability to obtain loans from the bank because of poor credit rating; 29 convenience of running a credit account, together with ignorance or indiffer- ence as to credit costs; and, 3) custom. In the early days before banking facilities were extended to the small farm- ing communities the local merchant, or factor, assumed the function of supplying his farmer-customers with credit. Merchant credit was particularly prevalent in the cotton and tobacco producing regions. Banking facilities have now become available to all farmers, but the force of customehas helped to maintain the merchant credit system. Many farmers run accounts with merchants because of the convenience of the service, or because of a lack of understanding of the costs. But probably a more fundamental explanation ef the practice is the inability to obtain bank credit. rane oe ee Pe i lace eae Te a ee ae208 As a rule the banker is more careful than the merchant in accepting credit risks, In the first place, the merchant's primary business is to sell merchandise and the extension of credit often increases his list of customers. Credit acts as a special inducement to a certain class of farmers. Incidentally, in the process the merchant gets many poor accounts. On the other hand, the extension of credit is the primary business of the country banker, and there is no particular ad- vantage to be gained by obtaining more loans by accepting poorer security, In: the second place, the banker's business is closely supervised by government of- ficials. Even if he desires to take poorer credit risks, government supervision 18 conducive to care and conservatism. Hence the banker is likely to require a mortgage, or an indorsement, unless the borrower is well recognized as a good risk. Rather than mortgage his teams and crop, or secure the indorsement of a frienc, the farmer gocs to his merchant and obtains credit on easior terms. In order to be able to extend credit, most local merchants find it necessary to borrow from the banker or to obtain goods on credit account with the whole- saler. The extension of credit by the wholesaler in turn increases the amount ov credit which he must seek from the banker. The result is that the farmer who trades on account is largely borrowing indirectly from the benker. The more progressive farmers are realizing that such a round-a-bout syster of obtaining credit is very expensive. The merchant credit system is obviously becoming less prevalent, and the local banker is supplying a larger and larger portion of the short-tern credit needs of the community. Historically, the merchant has performed a valuabse service in extending credit to farmers, but the economy of specialization is slowly. directing the credit business to the banker, Savings Banks, Insurance and TrustsCompanies, etc. Savings Banks - The numerous savings banks and savings departments of come mercial banks collect an enormous amount of losnable funds. The smaller ine vestors find the savings bank both safe and convenient. Such advertising as, "a dollar opens a savings account with us", attracts funds which might never be saved to invest in bonds of $100 te $500 denominations. Also, the savings banks are conveniently located for a large percentage of the people ~ they are home institutions. Moreover, the savings banks are rather strictly supervised by the state governments and, therefore, are widely recognized as being excellent de- positories for the funds of those who do not care to make their own investments. Savings banks usueliy pay three or four per cent interest on deposits and must in turn find some profitable and safe investment. The farn mortgage has long been recognized as one of the best long-term investments aveilable and, until recently, has paid a relatively high rate of interest. Concurrently with209 the general reduction of interest rates, the marketability of the farm mortgage has improved and it remains one of the best investments for savings banks. It is so recognized by the state supervising officials. Insurance Companies - The contingencies of the insurance company are such + that surplus funds must be accumulated. The premiums of a policyholder in a life insurance company, for instance, may accumulate for a long period of years before the company is called upon to pay the policy. Since the current needs of the com- pany to pay policies is only a small portion of the total funds collected, there is always a surplus to invest, In fact the investment of this: surplus is one of the most important sources of profits of the insurance company. The long-term insurance periods of the life insurance company adapts it to long-term investments. At the same time, safety is of paramount importance in the investment of the funds of policyholders. As is the case with savings banks, the state governments supervise the investment policies of life insurance com- panies. The farm mortgage not only meets the safety and long-term requirements of the life insurance company investments, but it pays a satisfactory rate of in- terest. As a result, insurance companies are estimated!! to have held about fifteen per cent of the total farm mortgages of the country in 1921.14 According to the report of the Association of Life Insurance Presidents for October 31, 1921, insurance companies had $1,247,300,000 outstanding in first mortgages on farms. Life insurance companies are developing very rapidly and will in all probability remain one of the most important sources of investment credit for farmers. Trust Companies and Estates - The trust company, or trustee, holds property or funds "in trust" for its wards. Property or estates are often turned over to trust companies, either by preference of the owner or by order of the courts because of the ovmer's inability to manage his affairs. Formerly the business of the trustee was almost wholly restricted to hahdling the business affairs of minors and persons who were physically or mehbally incapacitated, but in recent years it has become common for normal and capable individuals to place their financial affairs in the hands of the trust company. In most of the states trust companies are rather strictly supervised, park- ticularly in the matter of selection of investments for trust funds. Many of the states specify the types of investments which must be made with trust funds. Farm mortgages are almost universally placed second only to government bonds in the preferred lists of investments. While no estimates are available as to the total amount of farm mortgages held by trust companies, they are in the aggregate an important source of farm investment credit. ll. See Chicago Journal of Commerce, February 27, 1922; and United States Depart. itant of Agriculture, Bulletin No. 1047. 12. Some of these farm mortgages are held hy other insurance companies, but a very large percentage of the total are held by life insurance companies. De Cer eee coy : Be RRS meee ante eee TE ee tr ooSaeed - eT = 216 Building and Loan Associations = While the rapid growth of building and loan associations in America during recent decades has made them a primary sourde of credit for urban development, they are of importance in farm mortgage financing only in a few of the northern states. Ohio and Pennsylvania building and loan associations seem to be the leaders in extending their business to farm financing. State Funds and Endowed Institutions - A large percentage of the state governments invest a large share of their permanent funds, particularly their school funds, in farm mortgages. One state, South Dakota, not only supplies farmers with her permanent educational funds, but has established a system of rural dredits by which bonds are igsued on the State's credit and the funds lent to farmers. A great number of endowed institutions, such as sohools, hospitals, libraries, and research foundations, find the farm mortgage an attractive investment. THE AGRICULTURAL CREDIT SYSTEM Figure 3 shows roughly the direct and indirect connections between the e original owners of loanable funds and farm borrowers. A close study of this diagram should give a fairly accurate mental picture of the relationship of financial institutions to borrowers and investors and of each institution to the others of the whole financial system. The more important immediate sources of farm credit are indicated on the diagram by heavy lines. At present, come mercial banks and merchants are by far the most important sources of operating and consumption credit, while insurance companies, farm mortgage companies, joint stock land banks, and federal land banks are the chief sources of invests ment credit. In the future the relative importance of the merchant as a source of credit is likely to decrcase, while the importance of the cooperative marketing associations, livestock loan companies, and agricultural credit corporations xis likely to increase. The new federal farm loan system, including the inter- mediate credit institutions, is developing rapidly anc will absorb a very son- siderable percentage of the farm credit business within the next few decades. The diagram has certain important limitations. In the first place, it should be emphasized that no finoncial institution limits its loans strictly to any one purpose. Professor H. G. Moulton has well described the recent tendency toward “department-store banking",S whereby commercial banks, for instance, maintain bond and savings departments and render various other services not formerly rendered by commercial banks. Yet there are a group of banks which 13. He Ge Moulton, The Financial Organization of Society, che 29.Sy RTA eR eT PRENATAL RE TEEN TOP A RI ERIE DEE BALI AMIRI TT RRO ene Oa. lent funds primarily for investment purposes and another group which lent primaril. for operating purposes. Thus, farm mortgage banks lent primarily for the purpose of buying investment capital, while commercial banks serving farmers are primarily interested in supplying their operating credit needs. Certain credit merchants, such as grocery and dry goods merchants, supply consumption credit, while others, such as hardware and implement merchants, supply investment credit. In the second place, certain sources of credit, such as credit unions, cooperative banks, and manufacturing concerns, are not included in the diagram. In certain communities of North Carolina and New York credit unions are an important source of credit for farmers. Fertilizer manufacturing concerns supply a consider- able volume of farm credit in some sections of the country, particularly in the South Atlantic States, But these are relatively insignificant sources of farm credit when the whole country is considered. ‘i ine PT ee edl. 3e 8. 96 10. 12. QUESTIONS AND PROBLEMS Explain briefly how bankers establish connections with investors on the one hand and borrowers on the other. Why were the earlier banking systems adapted primarily to the needs of merchants and manufacturers rather than farmers? Explain the agitation during the last few decades for more adequate banking facilities for farmers. ‘Summarize the chief weaknesses of the old national banking system in supply- ing the short-term credit needs of farmers. Show how the Federal Reserve Act, with its amendments, has improved the efficiency of commercial banks in supplying credit to farmers 1) by reduc- ing reserves, 2) by increasing the flexibility of the currency supply, and 3) by improving the discount market. Should state benks be compelled to joingthe federal reserve system? Trace the development of the farm mortgage companies up to 1916. What are the chief purposes for which the federal farm loan system was es- tablished? What are the essential differences between the cattle loan company and the commercial bank? Describe the basic causes for the establishment of the federal intermediate credit system? How do you account for the fact that banks are gradually supplanting mer- chants in supplying farm credit? Figure 5 indicates that farmers obtain a large share of their credit through indirect means. In some cases credit passes through three or four financial institutions before it reaches the farmer. Since each bank must have its commission or margin of profit, it seems that the system is top-heavy with banks and banking systems. Discuss.213 Chapter 13 THE COMMERCIAL BANK AND FARM LOANS The purpose of this chapter is to explain some of the more important policies of commercial bankers who serve farming communities. Why, for instance, does the local banker prefer to extend a loan for only a few months, while insurance com- panies and farm mortgage banks prefer to lend for several years? Why does the local banker insist on promptness on the part of borrowers? Why are loans some- times refused in spite of the fact that the applicant has excellent credit stand- ing? What determines the lending power of the local bank? What determines the interest rates charged? These and many other questions often arise in the minds of borrowers who are not familiar with the principles governing the banking busi- nesS.e Banking is indeed much more difficult to understand than are most other types of business. The banker deals in intangibles. To laymen who are thoroughly ig- norant on banking practice, banking appears to be merely a matter of money-changing to the slightly informed, who realize that the handling of actual paper money and coin is only a small part of the banker's business, banking is a mystery; and even to those considered well-informed, banking is often puzzling. The fact that bank- ing has not been understood more generally seems to be due in part to the complex- ity of the business and in part to the complicated explanations made by writers on the subject. Space here permits only a brief descripbion of the factors controlling the country banker in the extension of loans. Bankers have other functions, such as providing a safe depository, facilitating exchange,-and issuing bank notes, but the lending functions is of primary importance here. If the factors controlling the banker's decisions in making loans can be clearly understood, the questions suggested above can be answered with little difficulty. LENDING POWER OF COMMERCIAL BANKS It should be remembered at the outset that a large percentage of the loanable purchasing power of all banking anstitutions is obtained from outside sources: depositors, or investors. Herein lies the fundamental explanation of the lending policies of bankers. The conditions under which the bank gets its lending power largely determines the conditions under which it can make loans. On the basis of the source of lending power, all banks may be classified broadly as deposit banks and non-deposit banks. The former type of bank accepts deposits and adjustssxits loans to the requirements of depositors, while the latter type of bank finds pros- pective borrowers and locates investors who are willing to comply with their re- quirements. Sh be Sea Bee a a ae it neh ae ae ae214 1. Sources of Lending Power ‘The lending power of the commercial bank is derived from two main sources, Coke, 1) the permanent investment of the owmers or proprietors of the business in the form of capital, surplus, and mdivided provits, and 2) funds obtained from depositors and other creditors.! The permanent investment, or "proprietary in- terest", arises when capital is paid in and when earnings are accumulated and left in the business as surplus® and undivided profits. The larger portion of the total lending power of the typical commercial bank is, however, supplied from the outside, in the form of deposits and funds borrowed from correspondent banks and from the reserve bank. Proprietary Interest The capital, surplus, and undivided profits of the’ bank are the great bul- wark of safety to depositors, since by law the bank is liable to depositors for the full amount of its capital (usually double), surplus, and undivided profits. But the proprietary interest represents only a small percentage of the bank's _iending power. The financial statement of the typical small-town bank will or- -dinarily reveal loans and discounts equal to four to eight times as much as the amount of its total capital, surplus, and undivided profits. Thus the total loans and discounts of the Spur National Bank, Spur, Texas, on September 28, 1925 amounted to approximately 9600,000 while the total proprietary interest of the bank was only about $140,000. It cannot be assumed that the full $140,000 can be lent, or used as a4 basis for loans. A considerable share of this.must be investe- ed in the bank building, furniture, and fixtures. In the case of this particular bank, approximately $24,000, or more than fifteen per cent of the total was so invested.5 This leaves only $116,000 which can. be used as a basis for loans. 1. The note issues of the bank are not included as a source of lending power for the simple reason that in obtaining the privilege to issue notes the bank is compelled to invest on amount in government bonds which is approximately equal to the note issue. The net result is that the note issue gives the bank power to lend to the government. The lending power of the bank in its community is not greatly affected one way or the other. 2 Surplus is sometimes created by the owners of the bank by actually subscribing to a surplus fund, but it arises more commonly from the accumulated earnings of the bank. 5. Members of the federal reserve system which are designated as "country banks" invest an average of approximately fifteen per cent of their capital, surplus, and undivided profits in the banking house, furniture, and fixtures. See Federal Reserve Board, Annual Reports, 1923 and 1924, p. 187 and 127, respec- tively. ‘eertentemndieeal Gt a OLLI ace Lea esas A Sea aa iene Dea eL5 Outside Funds 4 Borrowed Funds ~ It is obvious that $116,000 is an inadequate amount from which to make loans of $600,000. The Spur National Bank not only had loans of this amount on the date referred to above, but it had about $54,000 in cash. The financial statement shows that $145,000 had been obtained from other banks: $45,000 in "notes and bills" rediscounted with the federal reserve bank, and $100,000 in "bills payable". Thus this bank had borrowed an amount greater than its total proprietary interest.4. But the total of the borrowed funds and the proprietary interest of the bank was only $261,000. A large share of this bank's lending power had been obtained from’ depositors. Deposits - The total deposits of.the Spur National Bank on September 28, 1925 amounted to approximately $420,000. Then the total of deposits, borréwed funds, and proprietary interest, less the investment in the banking house and equipment, is.well above the total amount of loans. But not all of the $420,000 of deposits supply lending power to the bank, since certain of these deposits were derived directly from the loans of the bank. From the standpoint of the lending. power of the bank, the "deposits" item in the ordinary bank statement includes two distinct types of deposits: 1) primary deposits, and 2) deposits which are created directly by the extension of loans. Deposits from extemnal sources, or. so-rcalled primary deposits,° increase the lend- ing power of the bank, while deposits resulting directly from loans made by the . bank in question actually decrease its lending power. - When the banker extends a loan, the borrower ordinarily leaves a part, or all, of the loan with the bank in the form of a deposit. As time passes, checks . are drawn to take up all or most. of the deposit. Among farmers! banks there is probably an average of three to ten per cent of the loan which is left on deposit 4, This figure is considerably higher than the average borrowings of the country banks of the federal reserve system. Thus the two items, "bills payable" and "notes and bills rediscounted", for all of the country member banks averaged $335,124,000 for the nine reports from December 29, 1922, to December 31, 1924, while the total proprietary interest of these banks was $1,851,645,000. See Federal Reserve Board, Annual Reports, 1923,and 1924. 5- See C. A. Phillips, Bank Credit, Chapter 3. eas I Or re eee ee ee cas dee ee NS a an a216 throughout the period of the loan.& This deposit simply increases the bank's total deposit liabilities without adding a dollar to its supply of cash. Since the bank must keep a cash reserve of a certain minimum percentage of its deposits, the increase of deposits arising from the extension of loans results in an actual decrease of the bank's lending power. On the other hand, deposits of cash obviously increase the lending power of the banker, The deposit of checks, or other credit instruments which can readily be reduced to cash,? likewise add to the bank's lending power, provided they are drawn on other banks.®8 Such deposits are the basis for the great bulk of the commercial banker's lending power. 2. Measuring the Lending Power of the Bank Suppose that in the case-of the Spur National Bank, borrowers leave an average of five per cent, or $30,000 of their loans of $600,000, on déposit with the bank. If the. $30,000 is subtracted from the total deposits of $420,000, there remains $390,000 of primary deposits. Then the lending power of the bank is based on the $390,000 of primary deposits, plus $116,000 of proprietary in- terest, plus the $145,000 borrowed. This makes a total of $651,000. Subtract- ing the $54,000 of cash and cash items on hand, there remains $597,000 which is almost exactly the amount of the total loans of the bank. Approximate Measure The total proprietary interest (less the permanent investment in the bank- ing house and equipment), borrowed funds, and primary deposits are an approximate measure of the lending power of the commercial bank. This is a fundamental fact 6. Professor C. A. Phillips had collected estimates from a number of bankers which indicate that deposits arising as the result of loans amount to an average of five to twenty per cent of the loans. He designates such depos- ' its as "derivative deposits", In his derivative deposits, however, are in- cluded not only that part of the loan which is left with the bank, but also the deposits which are.made by the borrower just prior to the maturity of the loan for the purpose of liquidating the loan. The estimate here of three to ten per cent does not include deposits accwnulated for the liquidation of loans. Moreover, Professor Phillips! estimate of five to twenty per cent applies to commercial banks as a whole; whereas, farm borrowers commonly withdraw a larger percentage of their loans than do merchants, manufacturers, etc. See C. Ae Phillips, Bank Credit, Ch. 3d. 7. Checks and other instruments readily reducible to cash are for all practical pprposes of the bank considered as cash, 8. It should be observed that the deposit of checks or other credit instruments drawn on-the bank in question would have no effect on the total aépogits of the bank.CLF in commercial banking. Commonly, commercial banks are able to lend slightly more than the total of these three items, and still have sufficient cash reserve. On the other hand, conditions are conceivable under which banks would be unable to lend as much as the total of these items. The variation in either direction cannot be very great. | The Spur National Bank was able to lend an amount approximately equal to the total of these three items and still have about $45,000 invested in stocks, bonds? and real estate. The variation of lending power above or below the total of these three depends upon three factors: 1) the cash-reserve policy of the bank, 2) the average percentage of loans which is actually withdrawn from the bank, and 3) the portion of the total of the three items which is comprised of proprietary interest and borrowed funds. The Reserve-Deposit Ratio Commercial banks are required by law to maintain ea certain minimum cash re-- serve to protect their depositors. Thus the member banks of the federal reserve system which are designated as country banks are required to maintain a deposit reserve of seven per cent of their demand deposits and three per cent of their time deposits. Since this reserve must be kept in the federal reserve bank, the local bank must necessarily keep some cash in its own vaults to meet the daily demands of depositors, 19 For these banks the total of the reserve kept in federal reserve banks and cash-kept in vaults ordinarily ranges from ten to fifteen per cent of their deposits, depending chiefly on the policy of the individual bank. In the case of state banks which are not members of the federal reserve systen, a minimum cash reserve is sét by the banking laws of the various states. There is some variation among the different states, but the indications are that the ratio of cash te deposits is about the same in non-member country state banks as in country banks who are members of the federal reserve system. The higher the cash reserve required, the lower will be the lending power of a given amount of primary deposits. Suppose, 1) that a particular bank maintains a reserve of ten per cent of its deposits, 2) that all its lending power is derived from deposits, and 3) that borrowers withdrew all the loans from the bank at the time they are obtained. Then with deposits of $100,000 the bank could lend $90,000. If the reserve-~deposit ratio were reduced to five per cent, the 9." This does not include government bonds used to secure note circulation, since the bank's note circulation is approximately equal to the total amount of such bonds. , 10. In 1920.national banks held cash amounting to approximately five per cent of their deposits, See Comptroller of the Currency, Annual Report, 1920, Vol. oy pe Lio218 bank could lend $95,000, or if it were increased to twenty per cent the bank could lend only $80,000. Thus, a decrease in the reserve-deposits ratio increases the lending power of the bank, and vice versa. Loan-Deposit Ratio The lending power of a bank is also affected by the practice of borrowers in withdrawing the proceeds of the loan. If borrowers leave an average of ten per cent of their loans with the bank and if the reserveedeposit ratio is ten per cent, the bank could lend almost the full amount of its outside deposits. That is, for each $100,000 received from outside sources (not a direct result of its loans) the bank would be able to make loans amounting to approximately $99, 000,13 The borrower would withdraw about $89,000 and would increase the bank!s deposits by $10,000.32 Thus by the triple transaction of deposit, loan, and deposit tha bank's total deposits are increased by about $110,000 and its cash holdings are increased by $11,000. But if borrowers leave only five per cent of their loans with the bank, lending power is reduced accordingly. Thus, in the above example the banker could lend about $94,000, the borrower would withdraw about $89,300, leaving $10,700 as cash reserve back of $104,700 of deposits. Proprietary Interest and Borrowed Funds It was observed above that if the reserve-deposit ratio is ten per cent and the borrowers leave ten per cent of their loans with the bank, lending power ig increased about $99,000 for each $100,000-of primary deposits received. But if $100,000 is added to proprietary interest, the lending power of the bank in ques= tion is increased by about $109,000, since no cash reservo is required for capi- tal, surplus, and undividéd profits. Likewise, if the bank borrows $100,000 from other banks it may be able to make additional loans of morc than $100,000. But in this latter case the average amount which can be kept in loans ‘will ordinar{ly be less than $109,000, since the banker finds it necessary to accumulate funds with which to pay his creditor~bank at the maturity of the loan. 11. Of course some of this $99,000 will come back to the bank and furnish the basis for additional loans, but the indications are that a very large shére of it will go to deposit accounts of other banks, and to the payment of loans of other customers of the bank in question. If it goestto pay off other loans, the bank's total lending power is not increased, since one loan simply replaces another. If it goes to deposit accounts in’ other banks, lending power is not increased. The portion of the loan which comes back in the form of primary deposits is estimated bo be very small. See C. A. Phelps. Bank Credit, ch. 3.3e Summary. The lending power of a commercial bank depends, in the first place, on the amount of its capital, surplus, and undivided profits, after deducting the nec- essary outlay for buildings and equipment; second, on the ability of the banker to acquire cash deposits; third, on the ability of the banker to obtain loans from cther banks; fourth, on the reserveedeposits ratio; and fifth, on the per- centage of loans lcft on deposit.or returned to the bank. Lending power is measur- ed.roughly by the total of primary deposits, proprietary interest, and borrowed fundse LENDING POLICIESSOF COMMERCIAL BANKS From the foregoing it is evident that the conditions under which depositors leave. funds with the bank determine largely the loan policies which the banker is compébled to pursue. The responsibility to derositors is effective in determining the term for which loans can be made, the Gistribution of loan maturities, the conservatism which the banker must use in placing loans, and the interest rate charged on loans. 1. The Term and Maturity of Loans Short-Term Loans Since deposits are left with the bank for only a short period of bime, the loans arising from deposits must be made for short terms. In the case of "demand" deposits the depositor retains the privilege of writing cheeks or withdrawing cash at any time, while in the case of "time" deposits the funds may be withdrawn at the end of a specified period, or upon due notice as the case may be. By far the most common form of deposit is thatecalling for payment "on demand". Whether "demand" or "time" deposits, they may be. withdrawn within a relatively short period of time. The exact period of time for which deposits are left with the 5« bank or, more accurately, the rate-of withdrawal of deposits, depends upon the circwnstances of individual depositors and cannot be determined in advance. Bank- ing experience, hovever, has supplied the basis for a fairly accurate estimate of he average rate of withdrawal. On the basis of this experience, commercial bank- . ‘rs have long held that 20, 60, and 90 cays are the most desirable periods for QO m— Suppose a commercial banker who has demand deposits amounting to $100,000 decides to invest $50,000 in ten-year farm mortgages. Although the mortgage may be "as good as gold", the banker is following a dangerous policy. Undoubtedly,Seen . ie = 22 the depositors will wish to withdraw their funds before the mortgages mature. Many bankers have become insolvent with their vaults well supplied with notes or : If the depositor had desired to invest his funds Ss mortgages "as good as gold". for ten vears, he could have purchased a mortgage in the beginning. But the purpose of the demand deposit is to maintain a supply of purchasing power which can be used:on 2 moment's notice. The banker must be prepared at all times to Supply this purchasing power. Yet as a matter of fact commercial bankers do invest in farm mortgages and other long-term securities. The commercial banks of the United States had con- siderably more than one billion dollars outstanding in farm mortgages in 1920, according to an estimate made by the Department of Agriculture. 12 Almost with- out exception the financial statements of commercial banks indicate some investe ment real estate mortgages, or other long-term securities, such as industrial end government bonds. How can the bank meet its deposit liabilities under such conditions: Presumably investments in long-term securities are made from the capital, surplus, and individual prefits of the bank. Such investments serve as a kind of permanent safety fund fep depositors to be liquidated and used to pay depositors only in great emergencies. When comacrcial banks invest in long-term securities, sound banking policy requires than investments be selected which are readily marketable, so that they may be reduced to cash on short notice. It was for this reason, in part at least, that national banks ‘vere originally prohibited from investing in farm mortgagese Since the passage of the Federal Reserve Act, however, national banks are permitted to make loans on farm mortgages amounting to a maximum total of one-fourth of thoir capital and surplus or one-third of their time deposits. Stace banks in most states have long been permitted to make farm mortgage loans in limited amounts. Both state and national banks can make 2 limited amount of farm mortgage loans with greater safety than they could before the passage of ~ the Federal Reserve Act for two reasons: 1) commercial banks can more easily replenish their vaults with. ready cash now because of the discount market created vy the federal reserve banks, and 2) there is a better market for farm mortgages. Whether commercial banks invest in farm mortgages, government bonds, real estate, or any other long-term investments, good banking policy requires that such investments be made for funds permanently supplied by the owners of the bank and not from deposits. Such investments are incidental to the main functions of the commercial banker. His business is essentially thet of accepting deposits and making short-term loans. 12, United States Department of Agriculture, Bulletin No. 1047.Ze It was indicated above that the most desirable terms’ for loans’ of commercial banks have been placed by commercial bankers at 30, 60, and 90 days. The history of deposit banking shows, however, that the thirty-,sixty- and ninety-cay periods are more or less arbitrary. The banker has probably arrived at the conclusion that these periods are most desirable partly because merchants and manufacturers normally require operating credit for only one, two, or three months. Since a large percentage of the operating loans to fermers are needed for four, five, and six months, ow longer, it may be concluded that devosit banks are not well adapted to supplying operating credit to farmers. No convincing analysis has been made, however, which shows that four-, five- and six-month loans are not well adapted to deposit banking. It has been demonstrated that deposit banks were not well adapt-~- ea to supplying farm loans prior to the creation of the féderal reserve system. But it does not follow that the lack of adjustments was due to the longer term of farm-loans. Indeed « study of the local banker's problems seems to indicate that the chief difficulty was the poor adjustment of loan maturities to the require~ ments of the bank's depositors, due to the seasonal nature of farm loans. Thus farmers borrow heavily during the planting and producing period of the year and liguidate their loans during the harvest season. Unfortunately for the country banker the demands of depositors are ordinarily greatest just when loans are heaviest, and least during the fall when notes are being paid off. Thus, the banker cxperiences a dearth of ready funds during the season following heavy loans and a surplus of funds following the farmer's liquidation season. This situation has been particularly acute in the one-crop farming sections, as would be expected. What the banker really desires is greater regularity of loan maturitics throughout the year, or in other werds, a better adjustment of loan maturities to deposit withdrawals. The Distribution of Loan Maturities The distribution of loan maturities is quite as significant as the term of loanse Thus if the banker should go so far as to restrict all loans to thirty-day terms and yet make all loans to mature on the same date, the problem of meeting the daily demands of depositors, would be unsolved. Moreover, an equal distribu- tion of maturities does not suffice. The banker must anticipate a season of heavy deposit withdrawals end scanty inflow of new deposits and adjust his loans to mature accordingly. Bankers use three methods of maintaining the desired volume and regularity of flow of loan maturities: 1) by regulating the amount of loans made in any one day or any month; 2) by varying the length of the term of loans; and 3) by restricting the size of individual loans. Thus if all loans are made for three-month terms{F if } i i. 222 and the amount of loans made each day..or each month:is regulated, thé result.will evidently be a similar return flow of loan maturities. The same result may be obtained, however, without maintaining inflexible rules for the amount of loans made in any day or any month by varying the length of the term of loans. Thus, any banker usually prefers to have a part of his loans in thirty-day paper, a part in sixty-day paper, etc. The third method of obtaining a desirable adjust- ment of loan maturities is that of restricting the size of individual loans. An extreme example will illustrate this point. Suppose the banker were to place ail his lending power in three big loans to mature in three months. The best possible maturity distribution would be one loan each month, which obviously would not be adapted to the daily requirements of depositors. The proper degree of regularity of maturities can be achieved only by having a large number of smaller loans, . It is often said that commercial banks are adapted only to making short-term loans. The above discussion indicates that with a proper distribution of the maturities of his loans the banker is prepared at all times to meet his deposit liabilities. What then is the relation between short-term loans and the proper distribution of loan maturities? Would it not .be possible for the banker to make his loans for ten-year periods, provided they were made to mature at regular “intervals? The difficulty here is that the inflow of loan maturities would be entirely too slow to supply the needs of depositors. For illustration, suppose o11 loans are made to mature at equal intervals duringsa ten-year period. Less . than one per cent of the total loans of the bank would mature each month. OQ the other hand, if all loans are made to mature at equal intervals during a thirty-day period, more than three per cent of the total loans mature each day. The term of loans must be made sufficiently short to permit the desired daily or weekly volume of loan maturities, Whether the six-;-or nine-month loans required by farmers can properly be supplied by. deposit banks depends, in the first place, on the rate of withdrawal of deposits. The banker who has a large portion of his deposits in time deposits and savings accounts is in posstion to make loans for longer periods than-is the banker whose lending power is based largely on demand deposits. Likewise, the banker whose depositors are in businesses that require a slow withdrawal of .. deposits can make loans for longer periods. In the second place, the ability of the deposit banker to make six- and nine-month loans needed by farmers depends on the percentage of the bank's total loans which are made for these longer terms. It was observed &bove that practically every commercial bank has some funds invested in long-term mortgages or bonds, but that no commercial bank can safely invest a very large percentage of its total lending power in long-term securities. The same principle applies to farmeoperating loans which are neededRent a Ee eee ee ae eased Bee ee ee ee CNC aia EE eR aL a ae ae dae Nh eo 223 for periods longer than the standard terms of 30, 60, and 90 days. If all the banker's loans are made for six=- and nine-month periods, he will in all probabil- ity find some difficulty in paying depositors; whereas, if a large percentage of his loans are made for shorter periods, he will experience little difficulty. Thus the banker who deals exclusively with farmers may often findehis vaults over- loaded with so-called "frozen" security, or “slow" loans. This situation is particularly noticeable among the banks in the cattle-ranze sections of the coun- try where operating loans are often required for a year or more. Although the commercial banker may have some difficulty in supplying operat- ing credit to farmers because of the periods for which loans are nequired, by far the greater difficulty is that of collecting loans through the yeare In all pro- bability the length of, the term would be little cause for worry if the farmer's income could be distributed through the year and loan imaturities could be more accurately adjusted to deposit withdrawals. Ze Interest Rates on Loans What determinessthe commercial banker's policy with regard to interest charges? . Why are large merchants and speculators in the cities able to obtain short-term loans at four or five per cent, while the farmers of Texas, Georgia, and Montana commonly pay eight to ten per cent, or even more? Is the difference due to the lack of competition among country bankers, the greater risks involved in farm loans, or the inefficiency of country bankers? While these and other fundamental factors must be considered in an adequate analysis of interest rates, the purpose here is to point out cértain characteristics which are common in the banking business in a farming community as contrasted to the banking business of the large city. Small Scale Business - In the first place, the typical bank of the farming community is a very small-scale business as compared with the city bank. Deposit and loan accounts are small. When it is considered that the expense of adminis~ tering small deposit accounts is about the same as that of large accounts, it is obvious that the banker realizes less net return on small deposit accounts. The spme principle applies in making small loans. The process of making and collect- ing a $100 loan is the small es that for a $10,000 loan. The total deposit and loan business of the bank is in8ufficient to justify specialization in performing the different functionse . The cashier is ordinarily the credit man, the teller, the chief executive and, sometimes, the bookkeeper of the bank. The size of the business does not. justify the employment of high-salaried officiahs.224 . Deposit Practices of Customers - Farmers are proverbially poor depositors and liberal borrowers. "Fhe deposit accounts are commonly small in proportion to their loan.accounts. Farmers as a class have never become as thproughly con- vinced of the advantages of maintaining a checking account as have merchants and other classes of business men. Their purchases are less frequent and they often prefer to make payments in cash. ‘Moreover, the fact that most of the farmer's income is commonly received during one season of the year often results in the withdrawal of his deposits long before the harvest season. This applies partio- ularly to the-so-called "one-crop" farmers. Likewise, the farmer-borrower often withdraws the full amount of his loan imnediately, whereas it is common for the city borrower to maintain about twenty per cent of his loans on deposit with the bank. The merchant finds it to his advantage to maintain a good sized checking account from which to make the daily payments required in his operations. The farmer makes payments less frequently and usually waits until the payment is to be made before borrowing. As a matter of fact most city bankers require the borrower to maintain a minimum of twenty per. cent of his loans on deposit at all times.+3 some country bankers attempt to establish such policy by permitting the farmer~-borrower to withdraw only a certain percentage of loans each month, but this policy is usually considered a form of discrimination against the borrower and has not been adopted very ex- tensively. In this nonnection it should be observed that customers who maintain good aeposit accounts commonly receive better accommodations from the bank. While interest rates are usually the same for ail borrowers, the banker will make a special effort to supply loans in the desired amounts and for the desired length of term for the customer who keeps &&good balance on deposit with the bank. Since the banker obtains most of his lending power from depositors, it is only normal that borrowers should be served somewhat in proportion to their contribu- tion to deposits. One banker has summed up the situation in the brief advertise ment: "Bank with us and you can bank on us". Seasonal Loans - The fact that farm loans are well concentrated in one season of the year tends to increase the cost of banking, In the first place, the concentration of loans during the producing season often compels the banker to rediscount paper or to obtain direct loans from other banks. Secondly, the concentration of loan maturities during the harvesting season often leaves the bank with surplus funds which must remain idi@ or which must be placed outside of the community at a considerable sacrifice in interest rates. The small town bankers are at a disadvantage as compared with city bankers not only because of the greater seasonal fluctuation of the volume of their loans, but also because 13. See Glenn G. Munn, Bank Credit, ch. 15.Re ree ee Le ae a Re ce Ne oe aR ee ae aa ” 225 of their poorer connections with the great money markets of the country. This latter difficulty is now being rapidly overcome, however, by the wide use of the trade acceptance which supplies a ready investment for the country banker. Farm Loans Slow - Farmers have often been accused of being unbusinesslike. While such accusation is not true to the extent that it was formerly, and while it does net apply to.all farmers, they are comparatively slow in meeting their bank obligations. This is the case partly becausc they are not as conveniently located as are merchants, but a far more important cause of delay in paying notes is the uncertainty of timely income from which to pay the loan. This does not mean that the risk in farm loans is greater - rather the uncertainty of payment at a given time is greater. Whether the farmer will be able to pay his loan Septem- ber lst depends largely on the weather and other uncontrollable conditions. Like- wise, such uncontrollable conditions may prevent payment for another year. Hence, farmers? notes are frequently renewed and extended. Renewals and extensions make additional work for the bank. liore important is the fact that the necessity for renewals often places the bank in an embarrassing position in its relation to depositorse Inadequate Discount Market - The great majority of small towvm banks are not members of the federal reserve system and, therefore, do not have as ready access to the country's loanable funds as do their city neighbor banks. This usually means that such bankers suffer the disadvantage of paying.a higher rate S6r bor- rowed funds. They reach the great discount markets of the country by the indirect route of a correspondent bank. 5. Conservative Loan Policy The deposit banker is 2 sort of trustee. He uses the funds of others. He must guarantee not only the return of funds left in his care by depositors, but a timely return. His business would be a failure if depositors did not have Pal confidence in his ability to pay demand deposits in full at any time and time deposits according to specified agreement. The whole deposit banking business is founded on this confidence. Of course the; depositors will not demand all their funds ab one time, yet they must be assured beyond doubt that they could do so if they cesired. In order to guarentee the payment of depositors the national banking law and most state banking laws make the banker jiable to the exsent ox dovble the amount of his capital. Thét is, if the banker places his loans in such manner that he cannot meet the demands of depositors, he may become insolvent and be called.upon to pay depositors from the proprietary interest of the bank ane an additional amount equal to his capital stock. Banks may become insolvent with226 . @ list of well secured and safe loans on hand, which are uncollectable at the time they are needed. Thus, many bankers go out of business because of the con- gestion of "frozen credit", although they may be able at some later date to pay all depositors without loss. To prevent such coriditions the Federal and State Governments provide for a periodical inspection of the banker's business by banking experts known as bank examiners. The conditions under which the deposit banker obtains his lending power thus forces him to follow a conservative policy, 1) as to the security back of loans and, 2) as to the » certainty of the timely collection of loans. Farmers often feel that the banker is over-cautious in requiring 1 mortgage on property, a lien on thesorop, or the indorsement of:a neighbor. But when the banker's responsi- bility to depositors is considered, such precaution is not surprising. 14 By taking a mortgage the banker obtains a specific guarantee that the loan will be paid and he has the right by law to sell the property to recovor the loan at its maturity. To the casual observer it may seem that the banker requires a morte gage on too much property as compared with the amount of the loan. It should be remembered though that property sold at auction or by foreed sale ordinarily sells for much less than its normal selling price. The banker desires 2 guarantee that the mortgaged property can be reduced readily to an amount of cash equal to the loan. SOME GENERAL POLICIES OF COMMERCIAL BANKS The foregoing discussions of the sources of the commercial banker's lending power and some of his loan policies leads to 2 consideration of certain other of his practices. What methods are used in securing deposits? Under what condi- tions does the banker borrow additional funds or rediscount notes with the feder- al reserve bank? What®part does the banker take in programs for improving the methods of farming and the general prosperity of the community? Why is the bank- er so vitally interested in the farmer's business welfare? Methods of Obtaining Deposits In general the banker appeals to the depositor on the basis of the safety offered in the form of a large capital and surplus and a conservative loan policye Although a statement of the amount of capital and surplus in relation to the total deposits of the bank means very little to the average depositor, this relation is an important indication of the safety of the bank. A conservative loan policy is even more significant, since deposits are the chief basis for loans. 14, In this connection the advisability of a credit record sheet for cach éus- tomer should be considered. See Chapter 9.eo ee a ae ce ee a aay el Another inducement to depositors is offered in the form of services and accommodations. Bankers offer their services as advisers on.investments and other business transactions, They make collections and deposit them te the account of the customer, and make an effort to supply loans when needed. £ special inducement which is becoming more and more common is that of paying interest on time deposits or savings accounts. The degree.of competition for deposits and the possibility of increasing them determine largely whether the banker will offer interest on time deposits. Interest on deposits is seldom paid by banks which have little or no competition. Thus, a very large percentage of the one-bank farming communities of the country have no savings banks, Yet in the eastern and northern sections of the country many farmers! banks in one-bank communities pay interest on deposits. This seems to be due largely to the. fact that the banker is forced into the policy by the competition of bankers of the adjoining communities. The maintenance of suall savings accounts is an added expense to the bank,’ and, unless there is a possibility of a considerable increase in total deposits, the payment of interest is unprofitable. Certainly the banker who can get the deposits without paying interest will not assume the added expense of running savings accounts. The surplus funds to be found in some communities are entirely inadequate to make 2 savings department profitable. Hence, the banks who main- tain savings departments are found largely in the older and richer sections of the country. Bank Borrowing and Rediscounting The ability to borrow from correspondent banks, or to rediscount notes with the federal reserve bank, supplies an element of flexibility which is indispensa- ble to the local banker. Without such inter-bank borrowing it would be practi- cally impossible for the farmer's bank to meet the seasonal demands of borrowers end depositors. The funds of depositors often prove inadequate during the spring when farmers borrow heavily to finance production, and again in the fall when buyers are financing the marketing of farm products. Likewise, the local banker is often compelled to borrow during the months following the heavy borrowing season in order to maintain an adequate supply of ready runds for his depositors. But borrowing is profitable to the banker only when the funds supplied by depositors are inadequate. A large percentage, if not all, of the small town banker's deposits are obtained without interest; whereas, interest must be paid for borrowed moneye Hence, the banker borrows sparingly. Presumably, little or no profit is made by restending funds obtained from other bankers. This depends of course upon the margin between the rate paid and the rate received, and the cost of making loans. In those sections of the country where farmers pay six nent228 per cent, or less, there is obviously little direct advantage to be gained by the banker in borrowing from other banks at four and one-half to five per cent to lend to farmers. On the other hand, bankers in certain sections of the coun- try are able to obtain a margin of five or six per cent between the borrowing and lending rates. But regardless of the margin received the banker restricts his borrowing largely to emergencies. A crop failure or a series of crop fail- ures forces. him to borrow. Similarly, the desire to maintain a maximum of loans through all seasons of the year compels him to borrow occasionally to replenish ‘ his supply of cash. Most inter-bank borrowing is done on the general credit of the borrower or by pledging collateral security. There is little connection between the process of lending to customers and borrowing from a correspondent bank, except that the credit of the borrowing bank is based largely on the conservatism of its general loan policy, But in the case of rediscounting, the federal reserve bank of course actually takes over the notes of the farmers and other customers of the- member bank. Being located at great distances from the member banks and knowing nothing of the personal credit of borrowers, the federal reserve banks maintain the policy of requiring 2 detailed financial statement of the business of all borrowers whose notes are rediscounted,15 Although this policy is interpreted by many farmers as an unnecessary amount of red-tape, it is esséntial af the re- discounting functions of the reserve banks are to be performed on a sound busi- ness basis. As a matter of fact, the local banks are often handicapped in their use of the federal reserve banks because of the inability of farmer borrowers to supply adequate statements of their business. Although the federal reserve banks are permitted by special provisions of the Federal Reserve Act and its amendments to rediscount "agricultural paper" for a maximum period of nine months, the local banker is often limited to the use of commercial paper because of the farmer's inability to supply the required financial statement. Improving Farming methods. The country banker is proverbially looked upon by the community as a leader and adviser in all lines of business. He urges diversification in the one=crop farming community, the substitution of pure-bred livestock for scrubs, the proper care of soils, and the proper upkeep of the farm. He is usually the leader in programs for better farming methods in general. Is his position as leader and adviser due to his special fitness for leadership because of his superior business training and his intimate knowledge of the business affairs of the community? His business training and his personal knowledge of the 15. See Chapter 9,oon a “ os a x i adi i hail Se i a seh ee ee 229 financial affairs of the community are doubtless important bases for his leader- ship, but a more accurate explanation of his policy in improving business condi- tions is the direct dependence of his business upon the prosperity of his custom- erSe Prosperous Customers = The time-worn statement that "orosperous customers male P Pp a prosperous business" is peculiarly applicable to the banking business. To say . the least, bankers are usually the first to realize the significance of this fact. In general, depositors supply lending power in direct proportion to their pros- perity and hence any program which tends to stabilize and maintain the income of farmers usually has the active support of the banker. In fact he commonly initi- ates programs for better cropping systems, better quality of crops and livestock, and better business methods in general. Contrary to popular opinion, an increase in the prosperity of a community tends to increase the loans of the bank. It would seem on first thought that prosperity would tend to eliminate the necessity for borrowing. But the prosperity of certain farmers induces others to follow a liberal borrowing policy. A good return on the farm investment naturally leads to a policy of increasing the invest- ment; and this is commonly done in part, or wholly, by borrowinge For illustra- tion, suppdee Farmer A demonstrates the profitableness of substituting pure bred cattle for scrubs. Farmer B observes the results and calls on the banker to assis’ him in obtaining-a purebred herd. Again Farmer § becomes convinced that "quality production" pays, and immediately begins to apply the same principle in crop pro- duction, in the type of machinery used, in the+type of farm buildings, etc. Far- mer B concludes that such policies are good and borrowséfunds from his banker to buy better seed and to improve his farm. Likewise, when the profitableness of the use of commercial fertilizer is demonstrated in a given community, farmers feel safe in borrowing funds to invest in fertilizer. Diversification of Farm Production - Why do the more progressive bankers in the one-crop sections of the country urge diversified production among their farmer customers? The arguments used to induce farmers to diversify may be summe up as follows: 1) diversification minimizes the risk of failure and tends to stabilize the farmer's income from year to year; and, 2) diversification helps to maintain soil fertility’ and, therefore, to prolong the prosperity of the communit From the specific point of view of the banking business, diversification is urged in order to reduce the risk of loans. It is interesting to note here that in } 1916 when the boundaries of twelve federal land bank districts were determined, special effort was made to include a diversified farming area in each district. The reason given for this policy was thet such division would increase the sala~ bility of federal land bank bonds.230 Another factor which has an important bearing on the attitude of the wise banker toward diversified farming is the better adjustment of loan maturities to deposit withdrawals. The necessity of more or less regular loan maturities in deposit banking was discussed above. Diversification tends to distribute-the farmer's income more equally through the year and hence to make possiblé the col- lection of loans during the spring and summer months, as well as the regular crop marketing seasonl | Other examples and illustrations could be given to show why the progressive country banker is vitally interested in improving the farming methods of his come munity, but these should be adequate. It is not surprising that the nation-wide organization of commercial bankers, known as the American Bankers! Association, has. established agricultural committees in all sections of the country for the purpose of studying the farmer's problems and making suggestions for improvement. The essence of successful comnercial banking is the maintenance of a maximum ‘flow of deposits and the placing of safe loans whose terms and maturities are adjusted to the demands of depositors. Hence the wise banker recognizes that the profits of his business depend directly upon the proper economic development of the community. Sound farming practices increase the volume and safety of his business.9. 10. ll. nl OO EE EEo——ee_V_V_00O Pel 3 , c fale . pa idisdeiincainn i ia A ae Be a a as TERED nes apie 231 QUESTIONS AND PROBLEMS Do commercial banks create lending power? What are the functions of the proprietary interest in a commercial bank? If commercial banks would increase their capital, they could probably dis- pense with the inter-bank borrowing privilege. Discuss. Distinguish between primary deposits and deposits created through the exten- sion of loans, and show how the latter decrease the lending power of the bank. Assuming the following figures, estimate the bank's approximate lending power without borrowing: Country bank, member federal reserve system Capital and undivided profits $120,000 Buildings, fixtures, etc. 50,000 Primary deposits 1,000,000 Loan-deposit ratio:. TO) igual Bank notes in circulation 25,000 Maintains cash items (including cash in vault and accounts due from other banks) amounting to 10 per cent of all deposits. About how much would this bank's lending power be increased if borrowers left an average of 20 per cent instead of 10 per cent of their loans on deposit? Criticize the statement that the deposit bank is not adapted to making loans for terms of six months to one or two yearse Is there any relation between diversified farming and the length of term the deposit banker can safely make loans? Discuss the more important factors which tend to make interest rates higher in farming communities than in the large cities. Explain the low percentage of savings departments among farmerS! banks. Why are progressive country bankers particularly interested in improving farming methods? Tn TT gel232 Chapter 14 FARM MORTGAGE BANKS Farm mortgage banks include the federal and joint stock land banks and the so-called farm mortgage companies. They supply farmers with long-term loans. Their lending power is obtained from ovmers of surplus funds who desire to make investments rather than deposits. The fact that these banks make loans for the longer periods, and consequently seek funds from more permanent investors, dis- tinguishes them from the ordinary commertial bank. Mortgage Security - As their name indicates, mortgage banks ‘invariably require a mortgage on specific property of the borrower, whereas, commercial banks are satisfied with a personal note in most cases. The universal practice of taking a mortgage is due, in the first place, to the fact that loans are made for 2 long period of time, The personal note is obviously inadequate for a ten- or twenty-year loan. The risk is too great. The earning ability of the borrower over a period of ten or twenty years is subject to too many uncertain- ties. The banker must have more tangible security if he is to be able to meet the inevitable payments due to investors. In the second place, personal security 1s impracticable because the banker is seldom acquainted with the borrower, Farm mortgage banks usually operate over a territory covering one, two, or more states and personal connections with individual borrowers are impossible. The local commercial banker may well afford to accept personal notes on the basis of his knowledge of the character and earning ability of borrowers, but the mortgage banker knows little of the character and history of his customers. In the third place, long-term loans are used to buy property which auto- matically becomes available as security. If the borrower buys land, buildings, equipment, or livestock, the common practice is to mortgage the property to secure the loan. But if the borrower buys seed and feed, or uses the funds to hire labor, no tangible security is created. Determining Credit Risks - The farm mortgage banker spends a large part of his time and energy in analyzing the credit risks of applicants for loans. This - problem is complicated by the fact that, 1) applicants are located at great dis- tances from the bank, 2) the loan runs for a long-period of time and earnings must be estimated for a period of years, 3) analysis of property values must be made, 4) the title to mortgaged property must be investigated and approved. The commercial banker, on the other hand, lives among his borrowers and knows them personally, ‘He makes loans for short-terms based on estimates of earnings for the current year only. Moreover, he has little to do with appraising property values or clearing titles to land.1 a ee i —— Face es De Ee Ge i (Svat fea ee Zot RBar ahead ae Sa ies ta ale ra Mae dat ae rae oe ine Tiak 1 “ , PA. 233 Maintaining Security - The mortgage banker not only has a difficult problem of determining the value of his security, but he must prevent serious deteriora- tion of the mortgaged property during the period of the mortgage. It is not suf- ficient to take the mortgage and await the payment of the loan. The property may fall into the hands of the state because of back taxes, the soil may be ruined by a poor cropping system, and the buildings may be lost.by fire or tornado. The banker must keep close watch on his security throughout the period of the loan. The wide distribution of his customers makes the periodical property inspection a considerable task for the banker or his agents. Absence of Checking Accounts - A large share of the time of the clerical force of a commercial bank is occupied in keeping checking-account records, where- as, the mortgage banker runs no checking accounts. He handles investments instead of deposits. Payments are made and received in relatively large sums and only at considerable intervals of time. The accounting system ig4 therefore, relatively simple and inexpensive. Certainty of Liabilities ~ The mortgage banker knows definitely the amount of the interest andzprincipal which must be paid to investors at any date. He experiences none of the uncertainties of deposit withdrawals. His business is no so directly affected by the temporary financial strains of commercial banking. There is, for instance, no such thing as a “run on the bank". His is a stolid plodding type of business as compared with the "hair-trigger" business of the deposit banxer. There are of course other differences between commercial and farm mortgage banking, but those outlined above are sufficient to distinguish mortgage banking practices from the more familiar practices of the ordinary local banker. To summarize, mortgage benking is characterized chiefly by 1) the requirement of mortgage security, 2) the wide territorial distribution of customers, 3) the pecu- liar problem of measuring credit risks for many years in advance, 4) the problem of maintaining the value of mortgaged property, 5) the absence of checking acaru counts, and 6) the definiteness of liabilities at all times. The Business of the Mortgage Bank So much for the distinguishing characteristics of the farm mortgage banking ‘business. The actual day-to-day business of the mortgage bank may be divided intc the following functions: 1) making loans; 2) selling bonds or mortgages; 3) main- taining security; 4) collecting payments of interest and principal; and 5) making payments of interest and principal to investors. Incidentally these functions, i the order named, indicate roughly the chronological process of any particular loz “from the time it is made to the time it is paid off. This does not mean of cours . that the borrower must wait until the banker sells his mortgage to get his loan, aes a Seow esis or” pipe ea akan tata gst 2 out Mean ie234 or that an inspection of the mortgaged property is made before interest and prine cipal payments are received. It does not even mean’ that interest and principal are always collected from the borrower before the investor is paid. As @ matter of fact, the banker often advances payments to investors and collects from bor- rowers at some later date. Instead of thinking of these functions being perform- ed one after the other in connection with an individual loan, a more realistic picture of farm mortgage banking can be obtained by thinking of all of these #°, functions being performed by the banker on any given day as a kind of cross-sec- tion picture of the business. On most any business day the farm mortgage banker will be found performing some of the processes of each of these general functions. The work of the larger banks is often divided among two or three distinct depart- mants, such as 1) loan department, 2) bond or investment department, and 3) filing, Collecting, and disbursing department. MAKING LOANS To the uninitiated the process of making farm mortgage loans may seem a Simple matter. Loans are madé for a long term, and they are secured by farm lands the value of which seems to be determined with little difficulty by asking a few questions. But how does the banker establish connections with borrowers located hundreds of miles from his place of business? Does he maintain an agent in every farming community? Does he make loans directly to the farmer, or through some other financial agency? What is the process of determining whether a loan shall be made and, if a loan is to be made, on what basis does the banker _ determine the amount to be extended? How is the term of the loan determined, and what are the methods of repayment? Finally, what are the limitations on the total lending power of the bank? The answers to these questions are somewhat different for different mortgage banks. In fact, there are certain rather wide differences in the loan practices of the regular farm mortgage companies and the banks of the federal farm loan system. Yet the general principles regulating the extension of loans are the same for all farm mortgage banks. Loan Machinery The federal and joint stock land banks ana the farm mortgage companies maintain different types of loan organizations, or machinery through which loans are made, The Federal Land Banks ~ The twélve federal land banks make loans through national farm loan associations.! No loans are made directly to farmers. The 1. Provision is made in the Federal Farm Loan Act for making loans through cer- tain designated agencies, such as local banks, in case no association is available to the borrower. But since associations have been organized exe tensively, few loans are made through agencies,i = : on : 4 a Si = aad, ~ m, aN ERE ea AR ea Ss ey cena eT Oa ae ee Sy Ree Te ae Ge a a a ae ca boo ree 235 associations are organized by a minimum of ten borrowers who desire total loans of at least $20,000. Every borrower automatically becomes a member of the associ- ation and is compelled to buy stock in the organization amounting to five per cent of his loan. In turn, the association buys an equal amount of stock of the federal land bank of the district in which the association is located. When a farmer of the community applies for a loan, the loan committee, or the secretary, of the association makes an appraisal of his security and forwards recommendation to the bank. The bank looks over the application and the recommendation of the local committee and details one of :its special appraisers to make a personal analysis of the applicant's case. With the facts at hand concerning the reputation and earning ability of the borrower and the value of the land to be mortgaged, the executive committee of the bank finally approves, or disapproves, the application. If the application is approved, the loan is extended to the local loan association whose secretary-treasurer pays the borrower. Thus the federal land bank supplies mortgage loans through numerous Locel organizations of farmers. On December 31, 1925, there were 4,657 associations in operation in the United States, or an average of about 400 for each of the twelve land banksdistricts.© Besides the loan machinery supplied by local associations of farmers, each federal land bank maintains a corps of appraisers which are appointed by the Federal Earm Loan Board and designated to the bank. The Joint Stock Land Banks® - The joint stock land banks make loans directly to farmers, but since each bank may make loans over two states, it is necessary to maintain agents at certain central points over the territory. Usually commercial bankers,tinsurance agents, or lawyers are selected as local loan agents. The bank's territory is commonly divided into a few larger districts, each of which is placed under the supervision of a special agent. A preliminary appraisal of the credit risk of the prospective borrower is nanally made by the local agent, while final appraisal must be made by an appraiser selected by the Federal Farm Loan Board. Final decision on the application is made by the executive committee of the bank. Farm Mortgage Companies ~- The farm mortgage companies have loan organizations very similar to those of the joint stock land banks; local agents, district agents. and the loan department of the bank. These banks sometimes operate over several states. Several mortgage companies located in such agricultural centers as Ghic:.c c 2. Federal Farm Loan Board, Annual Report, 1925. 3. On December 31, 1925, there were 53 joint stock land banks.in operation in the United States. At the same date in 1923 there were 70. The decrease was due in part to the consolidation of two or more banks into one organi- zation and in part to premature organization and lack of business. ws See nee lene ee ee236 Chicago, St. Louis, and Kansas City make loans throughout most of the Middle West, the Missouri Valley States, and the Southwest. Such territorial expansion makes necessary an extensive staff of local and district agents. The farm mortgage companies supply their own appraising force which consists largely of the local and district agents. The common process is as follows: 1) the local agent passes on an application for.a loan; 2) the district agent approves or disapproves it; and 3) if it is approved, the loan department or loan officials of the bank accept or reject it. Attracting Borrowers | Farm mortgage banks establish connections with borrowers. by advertisements, the personal solicitation of agents, and the recommendation of the local banker. Frequently the local banker acts as agent for some farm mortgage bank. He has the advantage of a wide acquaintance in the community and an established business with the prospective farm mortgage borrowers. Whether or not he acts as an agent, mortgage bankers find his recommendation one of the most effective means of plac- ing loans. Local newspaper and poster advertisements serve as a supplement to agents in attracting the loan business of the community. The attention of prospective borrowers is called to an attractively low interest rate, a convenient method of repayment of loans, or the liberal ratio of loans to the value of the property mortgaged. Another favorite inducement offered by farm mortgage agencies is the "easy terms" upon which loans may be obtained. That is, the loan is granted for a long period of years and payments may be made on the installment plan. Determining Credit Risks The loan business centers in the analysis of credit risks. The skill with which the mortgage banker can estimate real estate values and the earning power anc character of the individual borrower very largely determines the success or failure of his business. An inaccurate estimate of the moral character and earning ability of the borrower results in endless trouble with the loan and, probably, forecldsure of the mortgage. An over-estimate of the value of the property mortgaged may result ultimately in the loas of part of the loan. The banker who can place loans in such manner that interest and principal payments will be met promptly, is well on the road to success in the mortgage banking business. Formal Application - The first step in the process of obtaining a loan is the formal epplication of the borrower. Blanks are supplied by the bank. While che application baanks of farm morcgage companies and federal and joint stock land banks differ somewhat in form and the amount of information called for, theee aR oa an ae ca AES Teme he 2o7 . essential content of all may be outlined as fellows: 1) description of the pro- perty to be mortgaged; 2) the purpose of the loan; 3) statement of value of the lend and improvements to be mortgaged; 4) statement of financial status of appli- cant; 5) amount and value of products of the farm for one or more years; and S$) certain general information, such as the age and farming experience of the ap- plicant and the general condition of ‘the farm. The application blanks of the federal and joint stock land banks call for several hundred separate items of information, covering three large sheets of paper. Confidential Report of the Local Agency - In addition to the information supplied by the borrower, the local agency sends in a confidential report in which estimates of property velues, earning power, and the personal character of the borrower are summarized and a loan is recommended for | stated amount. The loan committee or the secretery* of the local loan association makes this report for the federal land bank, while designated local agents make such revorts. for joint stock lend banks and farm mortgage companies. The confidential report of the Iccal agency serves as a check against the report of the applicant. The district agents of the joint stock land banks and farm mortgage companies usually pass on applications and the reports of local agents before they are turned over to the bank for final decision. Report of Special Appraisers - A third report is make by a special appraiser on the basis of a personal investigation. This report is invariably required by federal and joint stock land banks and ordinarily carries more weight with the bank than do the other two reports combined. The appraiser is a specialist and he is familiar with the generel conditions of the territory in which he is operat- inge Presumably at least he is above the bias which méy enter into the report of a local agency. In those communities in which no local agent is mainteined the appraiser's report is substituted. On the other hand, the farm mortgage companies often accept the report of the iocal agent and avoid the extra expense of a specia. appraisal. Final Decision’ by the Bank - Final decision on all loans rests with the loan officials-of the bank. On the Basis of all the available facts concerning the applicant, the lending experiences of the past, and a general knowledge of the economic conditions of the territory, the banker decides on the amount and condi- tions of the loan or rejects the application. 4. J order to reduce the cost of the prelininary apjraisal,«Congress passed an amendment bo the Federal Farm Loan Act in 1920 permitting the loan committee to designate the sectretary-treasurer as the appraiser for the local associa- tionse238 In determining credit risks of a particular loan the banker depends on two distinct types of knowledge, e.g-, 1) his knowledge of the general economic conditions of his territory, and 2) the facts supplied by agents and appraisers concerning the specific applicant under consideration. A liberal or a conserva- tive loan policy is already established when the individual application is pre- sented to the banker. He knows from his own past experience whether farming in the section from which the application comes is a stable or uncertain business. From his general knowledge of land values in this section, he realizes whether Jand is valued rather accurately on the basis of average earnings or whether current prices contain a considerable degree of the speculative element. If land is over-valued, the banker normally discounts the recomendations of ape praisers and local agents. Thus the banker mey follow the general policy of lending 60 per cent of the value of mortgaged property in one section, while he will lend only 40 per cent in another. Likewise, the conditions under which the loan is made are likely to be different as between a stable farming community and one in which crops are uncertain. Similarly, the banker is likely to be more consérvative at one time than he is at another. His knowledge of the general economic conditions of the country, the general trends of prices of farm products, and the general ovtlook for agri- culture will help to determine his general policy. He must consider whether the prices of the agricultural products of his territory are likely to increase or . decrease during the period of his loan, and whether land values are likely to rise or fall. The final decision of the loan officials upon a particular loan rests upon the analysis of the character, earning ability, and the value of the property mortgaged. That is, it must be determined whether this particular applicant will be able and willing to mect the obligations of the loan. Then as a final guarantee of the full repayment of the loan, an estimate must be made of the probable emergency sale value of the mortgaged property.° Investigation of Title The farm mortgage banker required a demonstration of clear title to the property offered as security for a loan. Ordinarily the applicant must send an abstract of title elbong with his application. Abstracting of the title consists of tracing the history of transfers of the property and writing it up in brief form. The abstract is simply proof of a clear title. The evidence upon which it is based is found in the records of the county in which the property is located. Abstracting #s usually done by a local professional ebstractor, an OV « For a more complete discussion of the detérminstion of the credit risk of a specific loan see Chapter 10,lk renee eet 259 attorney, or a guaranty title company. Due to the inefficient system of record- ing title and title transfers in most of the American States, abstracting is very expensive to borrowers. An investigation in North Carolina indicates that costs vary from $31.60 to $230.00 per farm,6 Before a loan is advanced, the bank requires that its own lawyer make 2 careful examination of the abstract. This is sometimes called the "determination of title”, and a fee is charged for the service. While there are no legal limita~ tions to the charges made by local abstractors, federal and joint stock land banks are prohibited by law from charging more than the actual cost of the service of examining the abstract. The Term of Loans The maximuin term of federal and joint stock land bank loans is forty years, but any borrower has the privilege of paying off his loan at any interest payment date after five years.’ Loans are commonly made for periods of thirty-two to thirty-six years. The regular farm mortgage companies, as well as insurance and trust companies, make loans for considerably shorter periods. The most common terms seems to be five and ten years, although there has been a tendency during recent years to make more loans for twenty years.8 The length of the term of farm mortgage loans is determined by the needs of the borrower, the wishes of investors, custom, and law. From the point of view of the borrower, the term should be sufficiently long to permit repayment from his earnings.? The excessive renewals and extension of loans of mortgage com- panies in the past indicate that the term has been too short. In spite of the fact that the average term of their loans has orobably doubled since 1900, there is still evidence of lack of proper adjustment. Custom has been effective in retaining the five- and tensyear terms, which in the earlier days of low-priced 6. Je Be Morman, Farm-Credits in the United States and Canada, De Ue 7. The Federal Farm Loan Board has rulad that under certain special circumstances borrowers shall be permitted to pay off the loan before the end of five years. See Federal Farm Loan Board, Circular No. 10. 8. A recent investigation made in Texas indicates that about 47 per cent of the loans of farm mortgage companies are made for ten years, 52 per cent for five years, 9 per cent for twenty years, 7 per cent for seven years, and most of the remaining 6 per cent for less than five years. The terms of loans of insurance companies were distributed as follows: 49 per cent for five years, 41 per cent for ten years, 4 per cent for twenty years, and the remaining 6 per cent for less than five years. See Texas Agricultural Experiment Station, Bulletin No. 3350. 9, See Chapter 5 for a discussion of the purposes of investment loans. , ee : 3 nk “a aveebalDuIN oS oes hie alee240 land and equipment were very satisfactory to borrowers. The ease of selling mortgages of shorter terms has been another important factor in delaying the adjustment to the needs of borrowers. The average investor clearly preferred the shorter term investments, due largely to the lack of a ready market for farm mortgages, A better adjustment of the term of loans to the needs of borrowers was one of the chief purposes of the Federal Farm Loan Act in creating the federal and joint stock land banks. The long term of thirty to forty years was arbitrarily set by the law as a maximum. The privilege of either distributing the payments over this long period, or paying off the entire loan at any time after five years, Simply guarantees the desired flexibility of the term. Few borrowers are able to pay off a mortgage in less than five years and certainly the maximum term is sufficiently long for any borrower. The disadvantage which the farm mortgage companies have experienced in selling long-term mortgages to investors is negligible in the case of the feder- al and joint stock banks, since the securities of these banks have a wide market, They are standardized and well known. The investor is not very particular about whether they run for five, ten, twenty, or thirty years, since he can sell them with little difficulty at any time. -Increased marketability of the securities of farm mortgage companies, likewise, will tend to eliminate any objections which their investors may have to longeterm loans. Methods of Repayment Farmers prefer to pay off loans by installments, while investors commonly prefer payment in lump sum at the end of the term. The banker's problem is to satisfy both. In the earlier stages of the development of farm mortgage banking in this country the borrowing:farmer was compelled to meet the terms of the investors to whom the banks sold the mortgages. That is, loans were usually repaid in lump sum. Since it was considerably easier to place loans than it was to sell mortgages, investors were favored at the expense of borrowers. Since 1900, however, there has developed a considerable amount of competi- tion for farm mortgages. More bankers and insurance companies have entered the field, and the farm mortgage is more favorably knowm as an investment. With this development there has been quite naturally a noticeable adjustment in the mortgage banking business to the needs of borrowers. An important phase of this adjustment is that of adapting loan repayments to the income periods of the borrowers, i.e., permitting annual payments. But tho regular farm mortgage companies still make rather extensive use of the lump-sum method of repayment. This method seems to be even more prevalent among insurance companies. A recent investigation indicates, for instance, that about 40 per cent of the loans ofa Me ge Ca ane ee aD ec ae Le eae a re eee La Av) i i eu 241 farm mortgage companies in Texas are repaid in lump sum, while about 45 per cent of the loans of insurance companies are repaid in this manner. 10 The reguiar annual or semi-annual payment method, however, is coming to be used very extensively. All federal and joint stock land banks require annual or semi-annual payments, and the farm mortgage companies are gradually adopting the plan. There are two rather distinct methods of making payments under the annual payment plan, e.g., 1)‘the proportional method, and 2) the amortization method. Under the proportional method of annual payments the borrower pays an equal amount of the principal each year. For instance, suppose 2 $10,000 loan is made for a ten-year term. The borrower pays $1,000 on the principal each year. If the interest rate is 5 per cent, his interest bill for the first year is $500, for the second year, $450, for the third year, $400, etc. Thus his total payment of principal and interest for the first year is $1500, second year, $1,450, third year, $1,400, etc. Under the amortization method the total of the interest and principal payment is the same cach year. Interest payments decrease with each year, while payments on the principal of the loan increase each year until the loan is finally liquidated. The essential difference between the proportional payment method and the amortization method is that under the former method the total payments gradually decrease from year to year, while under the latter method the total.annual payments remain the same. Tables 1 and 2 illustrate the proportional and amortization methods of pay- ment of a $10,000 loan for ten years at 5 per cent interest. fable 1. Annual Payments of Principal and Interest on the Proportional Plan. 3 Year Total Payment Interest | Principal Unpaid Principal theo eye. ‘api steds .oospeoat LOpeOGaQE a 1,500.00 500.00 1,000.00 9,000.00 a 1,460.00 450,00 1,000.00 8 ,000,00 3 1,400.00 400.00 1,000.00 7,000.00 4 1,350.00 380.00 1,000.00 6,000.00 5 1,300.00 300.00 1,000.00 5,000.00 & 1,250.00 250.00 1,000, 00 4,000.00 % 1,200.00 200.00 1,000.00 3,000.00 8 1,150.00 150.00 1,000.00 2,000.00 9 1,200,00 100.00 1,000.00 1,000.00 10 1,050.00 50.00 RROOOSOO" ah “S Mise. « ay Total 12,750.00 1 2,750.00 |} 10,000.00 10. Texes Agricultural Experiment Station, Bulletin No. 3350. eae ea2a2 Table 2. Annual Payments of Principal and Interest on the Amortization Plan. Year Total Payment Interest Principal Unpaid Principal 10,000.00 1 1,295.05 500.00 795-05 9,204.95 é 1,295.05 460.25 834. 80 8,570.15 3 1,295.05 418.51 876.54 7,493.61 4 1,295.05 374.68 920.37 6,573.24 5 1,295.05 328.66 966.39 5,606.85 6 1,295.05 280.34 1,014.71 4,592.14 7 1,295.05 229.61 1,065.44 3,526.70 8 1,295.05 176.33 1,118;72 2,407.98 9 1,295.05 120.40 1,174.65 1,233.33 10 1,295.05 61,67 1,233.33 ceeesebe Total 12,950.50 2,950.45 10,000.00 All federal and joint stock land banks use the amortization method. mortgage companies use both methods but the proportional payment method seems to be more common, 1 There are of course certain variations of these methods. The federal and joint stock banks, for instance, permit payment in lump sum after five years. Some farm mortgage companies permit full repayment at any time, while others permit full repayment at any time after a designated period, usually three or five years. Another variation of repayment methods among farm mortgage companies is the privilege of paying any amount at any time. Several difficulties have been experienced by farm mortgage bankers in ad- justing loan repayments to the income periods of borrowers. In the first place, installmentspayments increase the clerical expenses of the bank. Accounts must be kept on principal payments as well as interest payments. In the second place, installment payments make frequent re-investment necessary. On the one hand, if the banker insists on passing the payments on to the investor, the investment is less attractive. On the other hand, if the banker attempts to maintain the full amount of the investment throughout the period, he must be busy continually in placing new. loans to avoid the accumulation of idle funds on which he is peying interest. This means double duty for the banker. Suppose the banker makes a loan of $10,000 to be repaid in lump sum at the end of a ten-year period, and 1i,- ‘An investigation of loans of farm mortgage companies in Texas in 1924 indi- cates that about 23 per cent of the loans are repaid under the regular + annual payment method, while 15 per cent are repaid under the amortization method.a a eee — . ~ TEE Ae LO 8 ae Eee, big EE a Se te g Be ds ord Wie aie Sew Ce. 7 ca Ba 8 Be a ae TRO 243 in turn sells the mortgage to an investor. During the full ten-year period the benkerts function in regard to the payments consists only in collecting interest and passing it on to the investor. But if the borrower is permitted to make principal payments of $1,000 each year, the average size of the loan for the ten years is only $5,000. For the banker's business as a whole, this results in the necessity of making just twice as many loans as would be necessary if he required lump sum payments. Nevertheless, it is the business of the banker to supply the borrower with the most attractive loans and to sell the most attractive securities to the inves- tore Increased competition both in the investment market and in the borrowing market is gradually compelling the banker 1) to adjust loan repayments to the convenience of the borrower and 2) to maintain the investment for the investor by re+lending the installment payments. From the point of view of the borrower, the annual payment method is much more desirable than the lump-swn method. In the first place, payment under the latter plan involves the difficult process of accwaulating savings over a long period of time. Obviously the borrower is more likely to manage to make a $1,000 payment each year than he is to save $1,000 to pay off a loan which is not due for several years in the future. The annual payment method serves as @ sort of compulsory savings plan. In the second place, even if the borrower does take his obligation of several years hence seriously enough to save a sufficient amount each year, he has the problem of investing his savings. If he uses his savings to reduce the principal of the loan, he reduces his interest bill. This is equiv- alent to making 2 safe investment at the rate which he is paving for the mortgage loan. If he does not use his savings to pay off the loan, he will fail ailmost invariably to find an investment as attractive as that of "killing off" his own mortgage; 1) he may deposit it with his banker at three or four per cent interest; 2) he may buy government bonds at four or five per cent; 3) he may invest in speculative securities and lose «ll or a part of his savings; and 4) in exception- 41 cases only he may find a safe investment which pays an interest rate equal to the rate he is paying on the mortgage. It has been assumed above that equal annual payments are adapted to the bor- rower under all circumstances, but as a matter of fact they are not perfectly adapted to the farmer's paying ability. Farming is proverbially a business of occasional partial or complete failures, and occasional years of great prosperity. To be perfectly adapted to the fermer then, the repayment method should permit the borrower to make advance payments during a period of prosperity. On the basis of the advanced payments made, he will be better prepared to survive an occasional failure. Federal and joint stock land banks permit such advance payments after five years. Also, some farm mortgage companies permit advance payments after a period of three or five years; a few companies permit such payments at. any time after the loan is made.244 Interest and Other Charges The maximum interest rate on loans of the federal and joint stock land banks is set by law at 6 per cent. The actual rate depends chiefly upon the rate these banks must offer on their bonds. The most common rate of interest on federal land bank bonds hes been 4.5 per cent, and the most common rate of interest charged on loans has been 5.5 per cent. Of course bond interest rates vary with the conditions of the investment market and the rate charged on loans must vary somewhat accordingly. The margin taken by the federal land bank varies from one- half to one per cent. The most common rate of interest paid on joint stock bank bonds has been 5 per cent, although a large volume of bonds has been sold at 4.5 and 4,75 per cent, Their most common rate on loans has been 6 per cent. In the case of either type of banks, the law requires that the rate charged on loans at &@ given date must not be in excess of one per cent above the rate of the last bond issue of the lending bank. Certain charges are made by federal and joint stock land banks to cover the expenses of appraisal, determination of title, and recording of papers, The law requires:in all cases that such charges be limited to the actual cost of these services, The charge is strictly limited to two per cent of the amount of the loan in the case of federal land bank loans: one per cent each for the local association and the bank. The joint stock land banks may not charge more than enough: to cover the actual expenses of appraisal, determination of title, and recording of papers; and it is presumed that thése expenses are less, on the average, for joint stock banks than they are for the federal land banks, since the services of the local association tend to increase the cost of the latter, 12 The interest rates charged by the farm mortgage companies are commonly from one to two per cent higher than those of the federal and joint stock banks. That is, the rates of the latter range from 6 to 6 per cent, whereas, the rates for the great majority of the loans of the farm mortgage companies fall within the limits of 6 to 8 per cent. The explanation of the lower rates of the federal and joint stock banks is based chiefly on the following factors: 1) their large: scale of operation; 2) their conservative loan policy; 3) the greater marketa- bility of their securities because of government supervision and standard methods of appraisal of credit risks; and 4) the exemption of their securities from taxa- tion. The interest rates of farm mortgage companies vary considerably from one section of the country to another. Thus in certain of the more stable farming communities of the North and Northeast, where there is less difficulty of finding investors’ and where loans are considered more secure, the rate is often below 6 per. cent, while in the less stable farming communities of the South and West the rate is frequently above 8 per cent. 12. See Je B. Morman, Farm=Credits in the United States and Canada, pe l22.= q - _ ee - ee ae eR MEE TS ek ee ae eM ee a tN 245 Little information is available on the charges made by farm mortgage com- panies for appraisal, determination of title, ete. In the early days of farm mortgage banking these charges were often exorbitant, but the indications now are that they are being reduced to a minimum. In fact, there are some indications that charges are less among the mortgage companies than they are among the federal land banks, since the land banks permit the local associations to make a charge for their services.15 It should be remembered that the above charges made by the federal and joint stock land banks and by the farm mortgage companies do not include the cost of abstracting the title. The borrower makes a separate payment for this service to a local abstractor, or attorney. The amount of this expense varies chiefly according to the difficulty of the service and the conscience of the abstractor. Lending Power of Mortgage Banks Like commercial banks, farm mortgage banks obtain their lending power largely from outside: sources. Indéed capital and surplus supply a sinaller percentage of the total lending power of mortgage banks than of commercial panks.14 Moreover, loans made by mortgage banks are immediately withdrawn, while a part of commerci-1 al bank loans is usually left on deposit, Mortgage banks, therefore, can make loans just to the extent that they are able to attract the funds of investors. The ebility of the mortgage banker to attract investors depends largely upon the economic conditions of agriculture, the reputation of the banker, and the interest rate he is willing to pay on mortgages or bonds. But the interest rate. he can pay depends upon his efficiency and the rate he obtains from the borrower. Then if the farm mortgage banking system is as efficient in reaching the investors of the country as are the investment bahks, or bond houses, it is assured that agriculture will be adequately supplied with investment funds. If farming is prosperous, the safety of farm loans will attract investors. Also, if agriculture is prosperous, farmers will be able to attract their share of the investment funds cf the country by offering an attractive interest rate. It would seem than that the economic condition of agricu'ture would largely determine the lending power of 13. See J. B. Morman, Op. Cit., che 8. 14. Federal land banks are permitted by law to issue bonds equal to twenty times the amount of capital stock and joint stock banks may issue bonds equal to fifteen times the amount of their capital stock. Reports from seven of the larger mortgage companies operating in Texas in 1924 indicate that their total ¢apital and surplus is equal to only 2.36 per cent of their total loans. See Texas Agricultural Experiment Station, Bulletin No. 3350.246 the mortgage banks; but this is true only to the extent that farm mortgage bank- ers are efficient and able to compete on an equal basis with investment bankers representing the other industries, such as manufacturing, mining, and merchan- dising. The establishment of the federal farm loan system in 1916 was. prompted by the recognition that the farm mortgage companies had been unable to open up the Credit channels of the country to agricultural borrowers. In the first place, the investment banks or bond houses had the advantage of an earlier start,15 secondly, the. business practices of corporations served by these banks were fairly well standardized and their securities were well known to investors; whereas, the business practices of individual farmers were varied and uncertain, and the great majority of the investors of the country knew little or nothing of he farm mortgage as an investment. Thirdly, the farm mortgage banker had an uphill business in that his loans were made in small amounts over 2 wide terri- tory, Placing loans of a million dollars might involve five-hundred individual loans of an average of two-thousand dollars each, distributed over atterritory of several states, while it was not at all uncommon for the investment banker to place a million dollars with one corporation. Congress attempted to. overcome these handicaps to the free flow of invest- ments to agriculture by creating the federal farm loan systom. In the first place, the banks of the system, particularly the federal land banks, were to be operated on a large scale. Secondly, the farm mortgage was to be made a stands ard, marketable security by a uniform system of appraising credit risks. Third- ly, the difficulty inherent in the sale of small individual mortgages was to be overcome by collecting e large volume of mortgages and using them as a basis for large bond issues which would appeal to large investors. Fourthly, in order to be sure that investors would be attracted, Congress exempted the securities of the banks of the new system from taxation. The farm mortgage companies are rapidly falling in line by operating on a large scale, by standardizing their appraisal methods, and by establishing more effective connections with the investment markets of the country. Some of these companies are reorganizing as joint stock land banks in order to obtain the ad- vantages of tax-cxemption and other benefits of the government-supervised bank- ing system. With the establishment of the federal farm loan system and the im- provement in the methods of the farm mortgage companies, agriculture is rapidly being placed on an equal basis with the other industries in competing for the loanable investment funds of the country. The efficiency of the banking system should be such that the farmer can attract loans in proportion to the prosperity of his business. 15. See Chapter 12.247 SELLING BONDS OR MORTGAGES The second phase of the business of farm inortgage banks is that of selling securities to investors. This work commonly occupies the time of a separate de- partment of the bank called the investment or bond department. This department takes the mortgages supplied by the loan department and either sells the mort- gages outright, or sells bonds or certificates based on the mortgage. Organization and Methods The sale of all federal land bank bonds is vnder the supervision of a fiscal agent located in Washington, 16 The issuing banks sell only about 5 per cent of their bonds, while the fiscal agent disposes of the remainder as follows: 1) about 35 per cent is sold through a syndicate of investment bankers or bond houses; 2) about 50 per cent is sold to the United States Government Lifle Insurance Division of the Treasury Department; and 3) about 10 per cent is sold directly to smaller investors. 1? Ordinarily group offerings are made by several of the banks of the ystem. The total amount issued at any one time depends of course upon the needs of the various issuing years has been about $20,000,000. Bond or mortgage seles of joint stock land banks and the farm mortgage com- banks. The average size of the issues during the past few panies are under the direct supervision of the issuing bank or company. Three methods are used 1) direct sale to investor, 2) sale through regular agents of the bank, and 3} sale through investment banks. The first two methods are probably more common with farm mortgage companies, while the third method seems to prevail among the joint stock banks.18 A very large volume of the mortgages handled by mortgage companies are sold directly to insurance companies. Also, mortgage com- panies sell a large volume of their securities directly to a regular clientele of individual investors. Sales are made through agents of two general types - travel- ing agents and agents who maintain residence in the great investment centers or in farming communities. Thus, many of the larger companies maintain regular offices in the eastern cities, through which to market their mortgages. The loan agents located in farming communities frequently find investors in the locality 16. The fiscal agency was established by the Federal Farm Loan Board in 1923. Prior to this time the Board supervised the sale of land bank bonds. 17. Letter from Mr. Charles E. Lobdell, Fiscal Agent of the Federal Farm Loan Board, December, 1926. These percentages vary of course from time to time. They are given only to indicate current methods of disposing of bonds. 18. Letters received from joint stock banks indicate that about 95 per cent of them sell their securities through investment bankers, vhile the indications are that only about 15 per cent of the farm mortgage companies sell through investment bankers.248 in which the loan is made. Joint stock land banks rely to a great extent upon investment bankers in selling their bonds. A smAll commission is paid and the banker places the bonds through his regular investment channels. In addition to the personal solicitations of agents and officials, the farm mortgage banks promote the sale of their securities by advertising in the periodical and daily press and by mailing circulars to prospective investors. Process of Bond and Mortgage Issue There are two main forms in which farm mortgage securities are sold by bankers;' 1) the mortgage itself, and 2) bonds representing individual mortgages or @ collection of mortgages. The farm mortgage companies commonly pass the mortgage on to the investor. The borrower supplies the banker with his promis- sory note and a mortgage on the farm, and these in turn are sold to the inves~ tor, This is the simplest method of selling securitics and it involves very little trouble to the banker, But the amount of the mortgage is not always adapted to the requirements of the investor. To overcome this disadvantage a few mortgage companies issue serial bonds or participation certificates repre- senting the mortgage. The bonds or certificates are issued in denominations convenient to investors, such as $100, $500, and $1,000. The mortgage itself may or may not be placed in the custody of a third party, or trustee, who guarantees its safekeeping. \Thus, each purchaser of a serial bond or certifi-e cate becomes a part owner of a specific mortgage.) Another method, now almost defunct, is that of issuing bonds on the general credit of the company. These so-called "debenture" bonds were issued in large quantities during the "farm mortgage craza", 19 The total outstanding bonds of the bompany were presumably backed by an equal amount of farm mortgages. The $1,000 bond, for instance, represented $1,000 in farm mortgages in general. In the absence of sufficient legal restrictions and supervision, this system was greatly abused hy the recke less management of the companies. In some cases bonds were issued greatly in excess of the amount of mortgages held. After the collapse of a large percent- age of the farm mortgage companies in the ‘'eighties and early ‘nineties, the debenture bond system was almost entirely discarded. Very few} if any, of the farm mortgage companies use this system at present. Of the three methods des scribed here the practice of sélling the mortgage outright to the investor is by far the most common. Federal and joint stock lard banks sell debenture bonds exclusively. Their ‘bonds simply represent e@ collection of mortgages. The law requires that the banks maintain at all times an amount of farm mortgages equal to the total outstanding bonds. Every bond issue must be approved by the Federal Farm Loan 19. See Chapter 12,TTL AOREE EE iy OER OED ELE ATLA AT OE HEIN Baa MR ee ae ee nN Se ho a a FREE PROOR ATES : . 7 Vit dl 249 Board, and the mortgages offered as security for the bond issue must be deposited with the farm loan registrar of the district in which the issuing bank is located. The Federal Farm Loan Board appoints a farm loan registrar for each of the twelve districts, It is his duty to act as trustee for investors. When -certein mort~ gages in his keeping mature, he requires the bank to replace them with other mort= gages; or when a new bond issue is made, he requires the deposit of an equal amount. of additional mortgages. The registrar receives all applications for bond issues and passes them on to the Federal Farm Loan Board. When the Board approves such application, the Secretary of the Treasury of the United States has the bonds printed and delivered to the Board, which in turn delivers them to the issuing bank through the farm loan registrar, Collecting the "Banker's Margin" In addition to fees for such specific services as appraising, determining title, end negotiating the loan, the banker collects a "margin" from which to pay the general costs of operating the bank end from which to pay dividends to share- holders. Thus, the banker is compensated for the trouble and cost of caring for the investment and collecting interest and principal payments. Presumably the margin alse covers the risk of puaranteeing the security in cases in which the banker guarantees the payment of the lean, The general expenses of maintaining the banking house and salaries for the officials and the clerical force, as well as many incidental expenses, must be paid from the margin. Also, the banker sometimes finds it necossary to supplement appraisal and other interest fees with the general ecarnings of the bank.20 The portion of the margin which remains after all expenses ere paid is available for surplus or dividends. Federal and joint stock lond banks obtain their margin by charging a higher rate on loans than they pay on bonds. The margin varies from one-half to one per cent. This margin is of course collected each year on the unpaid principal of the loan. Farm mortgage companies have no uniform method of collecting the "banker's margin", Probably the most common method is that of collecting a cash commission at the time the loan is made.°! Under this plan the banker simply deducts the anount of his commission when the loan is made. The amount of this commission is 20. See A. C. Wiprud, The Federal Farm Loan System in Operation, Pe 70. 21. According to letters received from 59 farm mortgage companies distributed over the country, 54 receive a part or all of their margin in the form of a cash commission, In some of these cases, however, 2 part of the com- mission is collected at interest payment detes,250 commonly 5 to 10 per cent of the loan, depending to some extent on the length of term for which the loan is made. The flat-commission plan is particularly common among so~called farm mortgage brokers, whose functions cease when the loan is negotiated and a buyer is found. A variation of the cash commission plan is that of requiring part cash payment, the remainder being paid as payments are made ‘on> the loan. For instance, the company may call for half of the conmission at the time the loan is made, and the other half in equal annual installments during the succeeding five years. The second most common method used by mortgage companies in collecting the margin is probably that of sel?ing the mortgage at a lower rate of interest than the borrower pays, There is of course little difficulty in this plan when the banker sells bonds or certificates representing the mortgages; but since most mortgage companies pass the actual mortgage on to the investor, certain devices have been adopted by which to collect the margin. In the first place, many companies take a "commission note” secured by a second mortgage on the borrowerts property. Under this method the borrower simply has two notes to pay. If the first mortgage note calls for payment of six per cent interest, the second mort- gage note held by the bank will probably call for an annual payment of an amount equal to one per cent of the principal of the loan. In the second place, some few mortgage companies simply withhold their margin when remitting interest pay~ ments to the investor. If the banker sells a seven per cant mortgage, for ine stance, by agreement with the investor he retains one per cent and remits six per cent at each interest payment date through the term of the loan, Bond Maturities Under the system used by most mortgage companies of passing the mortgage on to the investor, or of issuing serial bonds or certificates representing a specific mortgage, the investor usually recéives payment on principal as the bor- rower makes payment. That is, if the bank sells a $10,000 mortgage which the borrower has contracted to repay in ten equal annual installments, the bank Simply collects $1,000 on the principal cach year and passes it on to the inves- tor. But regardless of the advantage of installment payments from the point of view of the borrower, usually they are not satisfactory to the investor. The trouble and expense of continual re-investment are too greet, Federal and joint stock banks, on the other hand, accept annual or semi- annual payments from borrowers end pay investors in lump sum. There is no direct connection between individual mortgages received froma borrowers and individual bonds sold to investors. Instead of looking to a certain borrower to pay a certain investor, the bank looks to its total receipts during a given year ta pay its totel obligations for that year. Suppose the bank can arrange to have @Oa ot ae mom en re Me ee Ren ek cn a aed 251 group of bonds amounting to $1,000,000 moture during a particular year end collect a total of $1,000,000 in principal payments from borrowers during that year. This group of bondholders could thus be paid in lump sum from the installment payments of all the bank's borrowers, Then in order to pay investors in lump sum and permit borrowers to pay by installments, the federal and joint stock banks have the problem of adjusting the volume of annual bond maturities to the volume of annual principal payments from borrowers. Such adjustment cannot be made with a very high degree of accuracy, since bonds are made to mature twenty to thirty years after they are issued. Ob- viously no banker can cstimate his receipts from borrowers twenty years in advance. Twenty years hence his receipts may be either greater or less than his bond obli- getions for that year. But there are certain banking methods by which thé proper adjustment can be made. If receipts are too great, the banker may invest his surplus in United States Government bonds or federal farm loansbonds, or he may use the surplus to make loans. If the receipts for the year are less than the pond obligations, he may cover the deficit with a new bond issue. The federal and joint stock banks obtain additional flexibility in adjusting bond maturities “ts through the "callable" feature of their bonds. Bonds may be issued with ar’ option providing for calling the bonds after any specified time up to ten years after they are issued. Thus the benker may employ surplus collections for a particular year by calling and cancelling some of its outstanding bonds. Also, he can prepare in advance for a year of heavy bond maturities by calling some of the bonds each year for several years prior to the year of heavy maturities. Of course the callable feature has other purposes, such as the replacement of high-interest bonds with loveinterest bonds, but probably the most important function is that of supplying flexibility to bond maturities. Security Offered by Farm Mortgage Banks Farm mortgage securities are in all cases legally secured by either specific or general mortgages on farm property.©@ If the investor holds e mortgage, serial bonds, or participating certificates, the investment is secured by a mortgage on specific farm property, If the investor nolds a debenture bond, the investment is secured by the general assets of the issuing bank, but the law requires that the “seneral assets" of federal and joint stock banks include an emount of farm mort- gages equal to the outstanding bonds of the bank. Hence, all outstanding bonds are secured as a gponpsby an equal amount in farm mortgages held by the bank. 23 22. There are possibly a few farm morvreage companies which issue debenture bonds and which do not maintain mortgages equal to their ovtstanding bonds, but the amount of business done by such companies is negligible. 0 23, In case of emergency these banks are permitted to substitute cash and Govern- ment bonds for f ‘arm mortgeges.252 Farm mortgages commonly represent only 40 to 50 per cent of the value of the property mortgaged. Federal and joint stock land banks are required by law to restrict their loans to 50 per cent of the appraised value of farm lands and 20 per cent of the value of buildings and improvements. Loans made by these banks during their ten years of operation have been about 40 per cent of the appraised value of all property mortgaged. °4 Likewise, the loans of farm mort~ Gage companies are becoming fairly well standardized at 40 to 50 per cent of the value of the property mortgaged. Although some companies make more liberal loans and other restrict their loans to less thon 40 per cent of the value of the pro= perty, by far the most common ratio is 40 to 50 per cent. This gives the inves- tor a 50 to 60 per cent margin: of safety, In addition to the security of the mortgage itself, the mortgage or bond is sometimes guaranteed by the assets of the bank, Thus; the federal and joint stock banks are liable by law to the extent of their capital stock and an addi- tional amount equal'to the capital stock. Also, in the case of the federal land banks, the twelve banks are jointly liable for the bonds of any one of the banks. Furthermore, the Federal Farm Loan Act restricts the amount of bonds which the federal and joint stock banks may issue. Joint stock banks are not permitted to have bonds outstanding equal to more than fifteen times the amount of their capital and surplus, while federal land banks may have bonds equal to twenty times their capital stock alone. Thus, if the joint stock bank is to be able to issue bonds beyond a certain amount it must increase its capital or surplus. In the case of the federal land bank, each borrower is required to buy stock equal to 5 per cent of his loan, and hence the capital stock of the bank is automatically increased at the ratio of 1 to 20. That is, the power of the federal dand bank to issue bonds is automatically increased as its loans are in- creased. Each $1,000-loan gives the bank a $1,000-mortgage and $50 in capital svock on which to issue & §1,000-=bond,. The surplus and undivided profits of federal and joint stock banks serve also as security for the investor. Each bank is required by law to set aside semi-annually 25 per cent of its net earnings as a reserve or surplus until the reserve is equal to 20 per cent of the capital stock, and 5 per cent of its semi-annual net earnings thereafter. In the case of federal land bank bonds, the surplus and undivided profits of the loan associations serve as further security. The associations are required to set aside semi-annually 10 per cent of their earnings as reserve until the reserve is equal to 20 per cent of their capital stock, ,and 2 per cent thereafter. 24, Federal Farm Loan Board, Annual Reports.ee Reem Mes gad edctk eae Raa eee eee oe nee BT ae cn NE hs ce OT 253 While a few of the farm mortgage companies guarantee their mortgages,25 the great majority seem to follow the practice of bond houses of "recommending but not guaranteeing" their securities. Unlike the federal and joint stock land banks, there are no laws which require that they guarantee their securities, However, in order to maintain a reputation for safe investment they do sometimes compensate investors for losses. Safety in Choice of Credit Risks - In the last analysis, safety lies chiefly in the ability of the banker to appraise credit risks. If the banker carefully selects his borrowing customers and if he follows a conservative policy in apprais- ing property values, there is little question of the safety of the interest and principal of the investment. On the other hand, an inefficient system of apprais~ als may easily lead to delayed. payments, frequent foreclosures, and even the loss of a part of the investments. Government supervision of the federal and joint stock banks is designed to compel efficient appraisal and adequate protection to the investor. Since there is little or no government supervision of the farm mortgage companies, their reputation among investors rests largely upon their past performance and upon the individuals in charge of the companies. MAINTAINING THE SECURITY Placing the loan and selling the mortgage or bond are only the beginning of the mortgage banker's function. He must look after the investment throughout the term of the loan, ieé., 1) maintain the value of the mortgaged property, 2) col». lect interest: and principal payments and 3) make payments of interest and princi- pal to the investor. The farm mortgage banker is unique among investment bankers in that he super- vises the security after the loan is made.. Investment banks, or bond houses 4s _ they are usually called, sell bonds for large corporations which presumably are well Inown to the investing public. The investor commonly buys the bonds of a particular corporation because of its reputation, rather than the reputation of the bond house which happens to be floating the issue. But in the case of the farm mortgage, little or nothing is knovm about the farmer whose mortgage the panker is offering. Moreover, the investor usually has no means of obtaining information on the security, other than through the banker. After the loan is made he has no means of ascertaining whether the property mortgaged is being maintained properly. The investor must depend largely on the reputation of the 25. Letters from more than one-fourth of the total membership of the Farm Mort- gage Bankers! Association of America indicate that only about eight per cent of these banks guarantee their securities.254 bank. Farm mortgage banking experience indicates that supervision by the banker 1s almost imperAtive.to the sale of the security. Of course-the federal and joint stock banks, as well as some of the mortgage companies, which guarantee their securities, have a special interest in maintaining the security back of loans. The Function of Maintaining Security Maintenance of the value of the security involves keeping a close. check on the borrower with regard to 1) the proper care of the land and buildings mort- gaged, 2) payment of taxes, and 3) payment of insurance on buildings. Mortgage agreements almost universally providei that the borrower take "proper" care of the property and pay all taxes promptly. Usually the borrower agrees to maine tain insurance on the buildings. It is the banker's business to see that the provisions of the contract are carried out. If the soil is not maintained by a good system of crop rotation, the use of fertilizer, the maintenance of ter- races, drainage ditches, etc., the farm willcobviously depreciate in value over a period of ten, twenty, or thirty years. If taxes are not pakd promptly, the property may be attached by the state, which in all cases has prior claim even though the banker holds a first mortgage on the property. If insurance against — fire hazards is not maintained, the banker stands a chance of losing a large share of his security over hight. Methods of Maintaining Security A few farm mortgage companies advance funds to pay taxes and insurance premiums in case the borrower is unable to meet these payments. The advance is charged to the account of the borrower and collected at some later date. Feder-~ al land banks hold the members of the local association responsible for any default on the part of the borrower. Each member of the association is liable to double the amount of his stock as a guarantee of the loans made to the mem- bershipe The matter of maintaining the property in proper repair is not forced very strictly by the banks, largely because of the indefiniteoness of the meaning of "proper care". No standardized method of caring for the soil has been evolved. Moreover, it would be rather difficult to bring suit for foreclosure because of the failure of the borrower to terrace the farm, for instance, when no specific reference is made to terracing in the mortgage agreement. While it is only in extreme cases of neglect that the mortgage banker foreclosea, the local agente of mortgage companies and joint stock banks and the officers of the local assor ciations frequently inspect mortgaged farms and make suggestions as to theei eal ded ager aie ie a aca ae ale cent cn a ead De Aine CNEL DL MT Fe — E 255 proper care of the property. Of course the banks attempt in the beginning to select as their customers only those farmers who are good managers and who will use a reasonable amount of diligence in maintaining the oroperty in good condition, COLLECTING AND PAYING INTEREST AND PRINCIPAL Throughout the period of the loan the banker collects and pays annual or semi-annual interest payments. This service involves a considerable amount of clerical work.