The Break in the Credit Chain

"It is all very well to say that the customers were foolish. But when a system prevails which caters to the folly of too large a proportion of a population, a proportion so large that the destruction of its purchasing power is of concern to every business in the land, then it deserves serious attention."
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Three paragraphs in an agreement too often signed without thought have played a devastating role in recent stock-market history. They relate to customer’s borrowings from his stockbroker, pleasantly referred to as ‘debit balances.’

The sum total of these debit balances furnished the flimsy scaffolding upon which stock quotations were lifted so far above rational investment values they could only fall on any change in speculative sentiment. And it is on account of them, and the lack of real it behind them, that the fall in stock prices, once commenced, was precipitate and could not be stopped until thousands of financial tragedies had occurred—tragedies affecting the life prospects of hundreds of thousands of individuals. These loans by brokers to their customers, made without regard to the customers’ credit rating and without pretense of credit investigation, form the weakest link in our credit structure.

On the stage, the Mortgage on the Old Homestead played a familiar part in the melodramas and tragedies of a former day. In the tragedies of real life to-day, the mortgage has been replaced by the much more highly efficient debit balance—efficient in its power to wipe out a man’s financial standing without affording him recourse to any of the protections and safeguards against hasty action which are thrown about the borrower on mortgage.

Moreover, formalities of law, evidenced by documents and red seals, have firmly planted in our minds the idea that the condition of being a mortgagor is not one to be entered into lightly. It is understood by a majority who mortgage their homes that interest and payments to reduce the principal of the mortgage must be calculated ahead and made a part of the family budget, along with life insurance, clothing, groceries, meat, fish, and music lessons. A mortgage is solemnly contracted and plans for its repayment out of income are made in family council, for it is understood that if the mortgage is not paid the home is in jeopardy.

 Likewise, when a man wishes to borrow from a bank, although the lending of money is the bank’s largest source of profit, he will not find himself urged to borrow. In the well-conducted bank he will meet a counselor who will investigate the whole question of whether the loan is advisable, and if so, within what limits it should be kept, in order that it may be as happy a transaction in its termination as in its inception. In other words, the man’s credit is appraised and a loan is made proportionate to his credit standing.

Banks rarely, if ever, make loans to people with whose affairs they are not reasonably familiar. And even in the case of a well-known customer, if the loan exceeds what would normally be expected to satisfy the ordinary requirements of his business, the bank will call for a special investigation, perhaps an engineer’s or an auditor’s report, before making advances. And further, when a loan is made the bank will insist that a direct promise to pay a definite sum of money be signed by the borrower, so there can be no question in the borrower’s mind with regard to the amount and terms of his debt. This again is a sober business transaction, soberly entered into.

Not so with the debit balance and the agreement concerning it which is signed when an account is opened with a stock brokerage firm. A new customer enters the brokerage office with $25,000. He may or may not be known to a member of the firm. Perhaps he knows a ‘customers’ man’ who is eager to report a new customer and to swell his record of commissions earned for the firm. The customers’ man is delighted to see some real money. No question is raised even as to whether or not the money actually belongs to the customer. It may belong to his wife, his child, or, in a few unfortunate cases, to the bank where he is employed—situations that would come to light under credit investigation. But to the customers’ man it is too often sufficient that the money is present and that it is the material out of which margins are made.

The discussion proceeds at once as to what may be a ‘good buy.’ In ordinary times, this may involve discussion of earning ratios and dividend records, but in the last year or so generalities and golden future prospects have been substituted, because the earning ratios did not account for the current quotations. The customer’s own enthusiasm to participate in some of the ‘easy money’ which his friends have made and the youthful assurance of the customers’ man are enough to result in an order involving $50,000 or perhaps $75,000, of which from $25,000 to $50,000 must be borrowed by the customer. Is he asked to sign a note for $25,000 or $50,000, with a promise to repay it? Hardly, for in many cases the full realization of what he is doing would bring him part way back to his senses, and he would be unwilling to sign such a definite obligation. Commission business would suffer. Instead, ‘as a matter of mere form,’ the standard agreement relating to debit balances is presented for his signature.

Many who have suffered a tragic change of prospect as the result of having incurred a debit balance at their brokers’ may not even now remember just what it was that they signed that put them in such jeopardy. So it is well to print below the three paragraphs in the standard form of the agreement which has brought so much trouble upon so many people. No lawyers were present when this agreement was signed, no red seals attached; no drama had forewarned them of the seriousness of their act, when they affixed their names; nor had any disagreeable questions been raised as to their capacity to protect themselves against the full force of the third paragraph, in case of need. The three fatal paragraphs run in part as follows:

                                            AGREEMENT OF........... Richard Roe

                                                                          WITH
X, Y, Z & Company

In consideration of X, Y, Z & Company consenting to act as my brokers, and to carry for me securities on a debit balance, giving me credit service and/or affording me facilities for the transacting of business in securities, I hereby agree with them, as follows:

FIRST: [unimportant]

SECOND: I agree that X, Y, Z & Company may at any time, without prior notice to me, pledge any securities deposited by me with them, or purchased by them for me, or any part or portion of such securities, for the debit balance due thereon, or may pledge any or all of my said securities with other securities in a loan or loans for an amount greater than the debit balance due on my said securities…

THIRD: X, Y, Z & Company may, at any time, if my indebtedness or my obligations are not secured to their satisfaction, without notice or demand, sell at public or private sale, without advertising the securities or any portion thereof that they hold in my account…

How many have signed this agreement to their own and their family’s irreparable harm?

The debt they incur, represented by an ever-growing debit balance on their brokers’ books, has rarely any relation to their power to repay it. The hope of extricating themselves from debt, if in fact they fully realize that they are in debt, is founded upon the hope of selling the securities in their account upon a constantly rising stock market.

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