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Business Environment
Commercial Paper Market
Founding
Early Years


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THE DEVELOPMENT OF THE U.S. COMMERCIAL PAPER MARKET 1800-1900

The Period 1800-1850

In colonial America, and then on into the 1800s, the nation's currency consisted of notes issued by private banks, along with the First and Second Bank of the United States, the notes of private banks purportedly being backed by gold or silver. Over time, and in many cases, such a backstop didn't exist, and banks' assets began to be comprised of various types of loans and securities. As such, the credit standing and value of the notes of different banks varied widely. As such, bank notes were not a very reliable medium of exchange. Gold and silver coins were in circulation but really only useful in small, consumer transactions. Bartering was a known and reliable method of exchange, but in many cases clumsy and impractical.

Most businesses in America even well up into the 19th century were small, single person, or family, owned operations -- "proprietorships" or "partnerships"-- often encompassing family members, with names like "George Smith, Tailor," "Smith & Wesson," "John E. Jones & Bros.," or "Ian MacLachan & Son." The names in the business title followed by a trade description reflected the very personal nature of many businesses. The nature of each business, the character and competence of the owners, and the business' general success, were quite often generally known within the local community, but not outside it. Business-to-business relationships between suppliers and customers were also personal and generally not conducted over long distances. A merchant vendor could feel secure and comfortable selling goods on credit to merchant customer known and evaluated personally, and operating a business with which the vendor was somewhat familiar and even perhaps had physically visited and observed. Such a merchant could have in selling goods to such a customer and take in return a note providing for payment on a specified future date. The note might have expressed a stated interest rate, but usually not, the vendor thus absorbing the "time cost of money" in his gross profit. The vendor would typically then "carry" the note and be paid the face amount by the customer/drawer at maturity, often with acceptable bank notes, all as part of an ongoing business relationship. The merchant vendor would often, in turn, be the customer of another merchant vendor doing business the same way and thus have both trade notes receivable and trade notes payable entries in his book of accounts.

Apparently commencing in the late 1700s and carrying over into the early 1800s --especially in Boston, Philadelphia, and New York, America's then main trade centers -- merchant vendors began to realize that banks, or in some cases non-bank individuals or partnerships who took on the name "bankers" or "capitalists," would purchase customer trade notes, essentially "for investment," at a discount from face value, providing working capital to the vendor and a good return to the note purchaser/investor. In most cases, the investor or "holder" of a note would know very little if anything about the customer ("drawer") of the note and thus would require the vendor to "endorse" the note (by signing his name on the note's back side), thereby guaranteeing payment at maturity. Also, such an endorsement was a guaranty of the note's "authenticity" in the event at maturity the investor had to claim payment directly from the drawer.

It is not surprising that interest of vendors to sell, and the interest of investors to purchase, such "business paper" created the opportunity for "go between" middle men. Thus the business of "note broking" was born. It is also likely that once a few note broking proprietorships or partnerships came into being and showed success, others soon followed. As this intermediary business grew and more vendors and investors availed themselves of the services provided, the more there became a "market for business paper." Comments on the availability of and rates for "business paper" became a regular part of the daily "money market reports" in the major city newspapers. It also appears that some note brokers were already handling in parallel the short dated borrowings ("notes" and "warranties") of cities and towns, and began to broker business paper as an extension and diversification of municipal paper dealing.

Simultaneous with the growth of the short term note brokerage business in the 1800-1850 period there was a significant expansion in the number of state chartered and non-chartered private banks taking deposits in the main cities and in the countryside throughout New England, New York State, Pennsylvania, and in the South. These organizations needed to put their deposit funds to work and as time went on they became the main investors in discounted business paper.

Although the early "note brokers" were often referred to as "bankers" - a title they often used in their advertisements -- they in fact dealt in trade notes on a "consignment" basis. They did not lend funds to a merchant vendor, taking his customers' trade notes as collateral, nor did they purchase and own such notes outright. They were "agents, not "principals. They took no credit or market rate risk in merchandising the trade notes owned by a vendor. Usually the broker would take on consignment all of a notes of a vendor with whom he had established a relationship (usually exclusive), but might even "select" from a vendor's cache of notes those which he believed he could particularly market and provide the vendor with the cash he needed at that time. The note broker would visit the vendor, pick up or otherwise receive the notes to be sold, provide a receipt for them, and then in turn visit local bankers and other investors to complete sales. Some dealers prepared offering sheets mailed or otherwise regularly delivered to investors, listing the notes they held for sale, including maturities, rates of discounts, and the endorser's name, all subject to prior purchase. When a note was sold, the broker would remit to his vendor client the proceeds of sale (face value less the agreed market rate and time discount) and after deducting a small "commission" for broking services, usually also expressed as a percent discount per annum, such as 1/4%. For instance, for a trade note in the face amount $4,567 payable in 4 months at a 10% discount, the discount to be earned by the investor would be $152.23, the commission to the broker would be $3.81, and the proceeds to the vendor would thus be $4,410.96. These numbers seem small today, but were rather typical for transactions around 1850. The practice of buying and selling discounted trade notes as principal/dealer rather than taking them on consignment as agent did not develop generally until in the 1890s, although possibly somewhat earlier in eastern cities.

The Period 1850-1873

Business records clearly suggest that "discounting trade notes" through brokers and their sale primarily to banks, became the principal form of short term working capital financing for many American businesses by the 1850s up into about 1900. This method of financing was especially associated with the textile and leather industries in New York and Boston which industries involved many "tiers" of fabrication and distribution by business entities operating in disparate locations before the finished goods reached ultimate, widely dispersed consumers. Later, the discounting of trade paper spread to most all industries, as the nation's economic development moved westward, and as "multi-level" manufacturing and distribution activities grew substantially and broadly in many industrial sectors. At each layer of business activity, vendors and customers depended on the "discount market" to augment and replenish their working capital. Each merchant had to incorporate in the pricing of his goods the discount he would give up on the trade notes he would consign for sale in order to convert these notes into cash. Also, such a merchant vendor, as guarantor/endorser, would need to take into account the character and apparent business success -- and thus credit -- of each customer and note drawer to whom he sold goods. And, finally, the merchant vendor would need to run his own business successfully and be sensitive to how he and his business were perceived in his local business community, particularly within the local banks. These perceptions, along with hints or reports of financial condition and operating results over time, would influence his credit standing, the weight given his endorsement of his customers' notes, which, in turn, would be a primary factor in the discount he would incur to market his trade paper, and thus determine his "cost of money."

The maturities of early business paper were usually in the three to six month range and quite often were for four months. As time went along, maturities of notes being created in some industries began to conform to the seasonal pattern of a drawer's business and industry. For instance, an original maturity of eight months was established on the notes of certain industries because that amount of time was generally required for end-use customers to convert purchased goods into cash sufficient to meet their trade note obligations. Of course, generally, the longer the maturity date on a note ("long dated notes") the higher the market discount rate, and the deeper the amount of the discount a vendor would have to absorb if the note were sold in the market.

As the banking industry grew and expanded in the last half of the 19th century, and as sectional and regional banking and money markets coalesced, the form of trade notes used by drawers began to include -- on their face, either printed or as a blank to fill in -- the name of a bank (or other specified office) at which payment would be made at maturity, upon presentment. Also, banks in towns and smaller cities in eastern region began to look to larger, central city banks for services, such as the presentment of drafts or notes into their city's clearing house system, or for forwarding to and collection by banks in other cities. These central city bankers also began to handle a wide range of other agency and service functions, and to provide advice, including increasingly an opinion about the endorsers of paper being offered to a country bank by a note broker. In due course, these central city banks became paying agents and custodians of paper purchased and owned by country bank clients and became responsible for collecting such paper at maturity and crediting the country banks' account. This emerging bankers' communication and service network began to be known as "correspondent banking." The emergence of these networks gave a great boost to the widespread marketing, purchase, and sale of what was now commonly called "open market commercial paper" in the later part of 1800s and into the 1900s, especially in the Midwest, southern, and western states.

The Period 1873-1900

For various reasons, the panic of 1873 was a turning point in the national commercial paper market. During mid-1873, business paper discount rates were rising, and in the month of September, reached a rate of 1 1/2% per month for top rated, shorter term paper. Much paper could not therefore be sold at any rate, or certainly not at one which most businesses could afford, even for a short time period. A number of banks and railroads went bankrupt. Many other businesses went bankrupt, or suspended operations, but many survived and paid their trade notes on a timely basis. Overall, trade note payment experience was quite favorable.

Business activity was depressed for some six years through 1879, followed generally by a small boom and then decline in 1880-6, and then more-or-less steady expansion through to the mid-1893 panic. All during this almost 20 year period, commercial paper rates for well established businesses -- but also for businesses which were strong and growing but still young -- were relatively steady in the 6-8% per annum range. On the other hand, loans by banks to a much more select group of businesses carried generally higher rates. For the first time, the banking industry was feeling the competition of lower cost "open market borrowing." At the same time, banks were encouraging the development of the "open commercial paper market" as a source of diversified and liquid short term investment increasingly reflecting in rates and terms the wide spread and objective judgments of many investors as to credit worthiness. By this state, commercial paper became an established and integral part of the nation's money markets.

As illustrated in the offering lists of note brokers at the time, it was apparently during this period that two-name paper began to be created in even denominations. This probably was the result of vendors requesting and obtaining multiple notes from customers, at least for larger sales of goods, with only one of the notes having an odd denomination to reconcile with the total odd amount of an invoice. All such notes might be dated the same, or even perhaps have somewhat different maturity dates, to improve their marketability, perhaps on the advice of the note broker, and as acceptable to the customer. Also, it was during this period, perhaps in the 1880-90s, when the owner of a single proprietorship business might create (draw) obligations in the name of his business, and then endorse the paper with his own signature, such that technically the paper was "two-name," but essentially depended on the creditworthiness of a single person or family.

Until late in the 1890s, but perhaps not even until into the 1900s --with the possible exception of a few very large publicly owned companies -- there were no financial statements readily available for vendors/endorsers, and certainly not for most vendors' customers, the originators and signers of the underlying trade notes. Such documents were just not expected to be available to creditors. In many cases, even owners and managers had poor and delayed financial information about their own business. Word of mouth existed about a business' general operating results and financial condition, but even many bankers did not have such privileged, close-to-the-vest financial information about their customers. Some business historians have suggested that the culture of the times (however irrational it might appear today) was such that the availability, or even the request, of a business' financial statement was a prima facie indicator of that business' weak credit. However, it appears that by the mid-1890s and into the early 1900s, perhaps as a result of the 1893 panic and subsequent poor business conditions, bankruptcies, and large credit losses, the expectation and analysis of financial statements became rapidly prevalent, even for smaller businesses. In this regard, it might be noted that starting in the early 1900s advertisements by business firms offering "accounting service and financial statement preparation" began to appear in the classified sections of major newspapers. This period apparently witnessed the emergence of the American "accounting and auditing firm."

It is not clear when vendors first began to offer discounts to customers for early payment rather than taking payment via a trade note of, say, 3-4 months maturity. Also, it is not clear whether this development took place in connection with selling some or all goods on an "open receivables" basis versus a dated trade note basis. Perhaps these practices began to emerge as early as the 1870s when money was very tight and, if available, only at the prevailing very high discount basis of 1 1/2% per month. Perhaps, too, some vendors realized that such a practice reduced or eliminated the risk of being contingently liable on 3-4 month endorsements of customers' trade notes sold in the open market. A common discount for early payment might have been 2% if paid in 30 days, or perhaps even "2%/10." Here again, some vendors probably began to build into their pricing the cost of offering these early payment discounts.

However or whenever the "discount for early payment" practice emerged, it became very attractive for many businesses to take advantage of the high return on capital realized in taking such discounts, if at all possible, including borrowing money to do so. Such borrowing might be from the business' bank or banks, or perhaps in the "open market." By this time, open market investors were beginning to be accustomed to what was, in fact, single name paper, and were beginning to prefer round amount denominations and maturity dates that fitted into their own cash flow needs as well as those of the issuer. It was thus a "small step" -- as A. G. Becker later said -- for credit worthy issuers -- especially if they were willing to disclose their financial condition -- to issue unsecured short term promissory notes on their own credit, fashioning terms to suit their needs as well as those of purchasers, and generally financing inventories and receivables, particularly short term assets which experienced large seasonal fluctuations.

Commensurate with all these developments was the transition of the "note broker" into a "commercial paper dealer." The practice of a note brokers purchasing some very high quality, short dated trade or simple promissory notes directly from vendors or issuers, using his own and borrowed funds, may have started in New York or Boston sometime before 1893, as suggested in some business history literature. However, it is reasonably clear that A. G. Becker pioneered this practice in Chicago and the western commercial paper market in his first year in the business, 1893-1894.

It is interesting to note that A. G. Becker literally "grew up" in the two name trade note and then commercial paper business as it blossomed, evolved, became institutionalized, and matured after 1873. It will be remembered that A. G. Becker joined the Greenebaum banking businesses in that year at about the same time as Herman Schaffner. As mentioned elsewhere in this chronicle, the Greenebaum business was quite prominent in size and reputation, but still a small organization by modern standards, and in all likelihood handled business paper. Schaffner and Becker must have worked relatively closely together especially at the German National Bank. A. G. Becker must have observed, from the inside, the growth and apparent prosperity of the Greenebaum enterprises, including, however, very loose banking practices, regulatory scrutiny, and then suspension in late 1877. In 1878, while launching the Herman Schaffner bank with his brother-in-law, Mr. Becker must have been dismayed and pained to see Henry Greenebaum, accused of embezzlement. And then during the whole of the 1880s, and into the 1890s, the commercial paper business of the Shaffner bank, presumably under A. G. Becker's management, grew significantly, participating in the expanding national market. By 1893, it was variously reported that the Herman Schaffner bank had become the largest commercial paper broker outside of New York, Boston, and Philadelphia, with a with particularly large market share among bank investors in Chicago, the Midwest, west, and South.

A. G. Becker reminisced about many of these developments in a speech he prepared for a group of Cook County bankers in 1923. We providing this complete paper at this point in our chronicle since it includes a review of developments in the commercial paper market over time. But also, the speech conveys the thinking of A. G. Becker about the commercial paper business as it was being operated in the early 1920s, just a few years before Mr. Becker's death in 1925. In particular, the presentation outlines three closely related policies of A. G. Becker & Co. which endured for the next 80 years: comprehensive, diligent, and sustained credit analysis of client issuers; initiating issuer relationships which would be sound and mutually valuable in the longer term; and accepting a moral responsibility for the indebtedness of any commercial paper handled by the firm.

A. G. Becker Speech (This is a large PDF file. After downloading, the displayed speech needs 90 degree clockwise rotation for easy reading. To do so, save a copy on your computer in a PDF file you name, then retrieve that file, click on "view," and click on "rotate clockwise" for easy reading.)

   



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