The sum total, then, of the debt against stocks is no longer self-liquidating, and the amount of debt owed by each individual borrower bears no relation to his competence, character, and earning power. The quality of a great volume of credit is then found to bear no relation to sound banking standards. It is based solely upon fictitious stock quotations, themselves the result of the abnormal volume of debt created. The credit structure breaks at its weakest link, and thousands who suddenly find that they are in debt beyond their means to repay are sold out.
It is all very well to say that the customers were foolish. As we suggested earlier, if only a small part of the population were affected, the matter might be passed over lightly. 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.
Particularly is this true if stock quotations are to be used, not only as a basis of credit, but also as a basis upon which major financial transactions are undertaken. It will be well for the banking community, who are vitally interested in the maintenance of stable credit, thoroughly to investigate how valid stock quotations are, either as a basis of credit or as a basis for major intercorporate transactions. If they do this they will soon find that, under the present indiscriminate method of extending credit to brokers’ customers, such quotations are without validity, and the principal reason that they are without validity is that the credit upon which they finally rest has never been really appraised. It has not been based either (1) upon the competence, character, and earning power of the ultimate borrower, or (2) upon documents representing genuinely self-liquidating transactions.
The collapse of the stock market in 1907 was attributed in large part to an inelastic currency and banking system, which resulted in an inadequate volume of credit and a shortage of actual cash. The lesson learned inspired the formation of the Federal Reserve System, which cured these particular weaknesses.
The fall in stock prices in 1920 and 1921 was attributed largely to the inflated inventories which had been accumulated during 1919, accompanied by a spectacular rise in commodity prices. Attention then was focused upon the use of credit in its relation to commodity prices and inventories. From this episode, business has learned a lesson, and in 1928 and 1929, as stock prices reached ever higher levels, great comfort was taken in the fact that corporate inventories were low, and that therefore there could be no danger in the situation.
Let us not forget the lessons learned from these two former experiences. But let us face the fact that, while in 1929 we had apparently no inflation in commodity prices, no accumulation of inventories, and, through the operation of the Federal Reserve System, abundant credit and currency, yet a fall in stock prices has occurred, exceeding in rapidity anything we have previously experienced. Let us focus our attention upon one of the causes, perhaps the principal cause of this unprecedented break: namely, a weak link in our credit structure—the fact that no proper credit investigations are made when stockbrokers make loans to their customers by means of the debit balance. These debit balances, to be a valid part of the security price structure which they support, should bear some relation to the borrower’s power to repay the debt, whether or not stock quotations move in the direction he hopes they will. Let us find the means of applying to this form of credit standards which have been tested through centuries of banking practice.