The Short Loan Fund and the Price of Securities.
A certain proportion of the capital which flows into the London
short loan fund is invested in securities by the bill brokers and
the discount houses, and, as the said securities are deposited with
the bankers from time to time against temporary advances, it follows
that their choice is largely restricted to those of and guaranteed by
the British Government, because the margin exacted on the so-called
gilt-edged varieties is considerably less than that demanded upon the
more fluctuating stocks and shares.
The bankers themselves invest largely in the same class, and they also
employ vast sums in the short loan market; so that when the market rate
for bills is higher than the interest received upon, say, Consols,
the bankers are disposed to sell some of their Consols in order to
obtain the higher rates ruling in the outside market. Obviously, then,
any accretion or diminution in the short loan fund at once affects the
prices of gilt-edged securities. If the Bank rate be high, and also
representative, Consols ought to fall, and, conversely, if the Bank
of England's rate be low, trade dull, and the market rate of discount
smaller than the return on Consols, gilt-edged securities should rise.
If this be the case, a low Bank rate must give an immediate incentive
to speculation in securities, and, therefore, the condition of the
short loan fund is intimately connected with the prices of stocks and
shares, but more particularly with those securities in which lenders in
the money market largely invest. The banks--let the condition of the
money market be what it may--must, of course, always invest a certain
proportion of their resources in Consols, but the sum so invested is
not constant.
Again, powerful business firms and companies hold Government stock as
reserves against contingencies. The Government makes large purchases
in the Consol market on account of the Post Office Savings Bank and
the Sinking Fund, while numerous other "bull" points could be given.
However, the fact remains that cheap money provides a strong inducement
to large speculative purchases of Consols.
The large capitalists and those persons whose credit is good can borrow
at, and sometimes even slightly below, Bank rate on Consols from
the banks, which are satisfied with a small margin against possible
depreciation on Government securities. If, therefore, we examine the
period between February, 1894, and September, 1896, when the Bank rate
was stationary at two per cent., it will be possible to illustrate
this tendency. Day-to-day money was then sometimes quoted at one per
cent. and under, and this state of affairs occasionally extended over
protracted periods.
Now, suppose a person invested £20,000 in Consols at 112, and that his
banker agreed to advance £18,000 against them at, say, seven days'
notice at one per cent. per annum. Two-and-three-quarter Consols at
112 return £2 9s. per cent. (about). His annual income, therefore, on
£20,000 would amount to about £490; but he owed his banker one per
cent. on £18,000. Hence £180 must be deducted from £490. Upon a capital
of £2000 he therefore earned £310; and a return of fifteen-and-a-half
per cent. per annum on Consols is surely an excellent reward for his
skill. Of course, we must not forget possible depreciation; but seeing
that the banker's advance released £18,000, which he can use, he can
afford to take some risk.
The following example, however, affords a more practical illustration
of the possibilities of speculation in Consols during the depressed
portion of a cycle, when the prices of commodities are low and
loanable capital is cheap. First, we want to ascertain the movements
in this security from, say, 1894 to 1896, and of these the table given
hereunder supplies a good idea:--
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| 1894. | 1895. | 1896. |
Goschen's +----------+----------+----------+Bank rate from
Two-and-three-quarters | Highest. | Highest. | Highest. |22nd Feb., 1894,
per cent. | 103⅝ | 108⅛ | 114 | to 9th Sept.,
(Two-and-a-half | | | | 1896.
per cent. | Lowest. | Lowest. | Lowest. |
after | 98⅜ | 103½ | 105⅛ | Two per cent.
5th April, 1903) | | | |
=========================================================================
Let us assume that a person invested £20,000 in Consols at parity in
1894, and arranged with his banker for a loan against them at Bank
rate, and that the banker's margin was to be ten per cent. on the
purchase price. He received, then, a loan of £18,000 from his banker,
so the amount of his own capital remaining in the venture was £2000.
Very probably, especially if his credit were beyond doubt, he would
have made a closer bargain with his banker, and thus have reduced the
margin slightly--but this is by the way.
Upon his £20,000 in Consols he obtained two-and-three-quarters per
cent., so that his annual income therefrom was £550. But as he had
to pay his banker two per cent. per annum on £18,000, £360 must be
deducted from £550. His capital in the speculation being £2000, he made
£190 thereupon. This gain works out at nine-and-a-half per cent. per
annum, and nine-and-a-half per cent. on Consols may surely be classed
among the minor forms of temptation. Moreover, as the Bank rate stood
at two per cent. for slightly over two years and a half, he had a long
run for his money.
But we see that he bought at parity, and that in 1896 Consols touched
114. Had he sold at 110 during that year, his £20,000 in Consols would
have realised £22,000. He, however, owed his banker £18,000, so there
remained £4000 to his credit. As his own capital in the speculation was
£2000 he would have exactly doubled it, and nine-and-a-half per cent.
per annum upon £2000 in Consols for close upon two years, with a bonus
of £2000 at the finish, is painfully reminiscent of those financial
dreams which so very seldom materialise; yet huge blocks of Consols
were actually bought during this period of two per cent., and dealt
with in the manner aforesaid.
Of course, the results were not always so satisfactory as those given
in the above illustrations, and no doubt many such ventures ended in
a loss, for prizes of this description are for the lucky few; though
it is usual to dwell upon them to the mortification of the mutable
many. The snatching of profits in this fashion requires skill and
considerable patience, and those persons who receive specious pamphlets
telling them how money is to be made in a marvellously short space of
time by an infallible system may appreciate the plausibility of my
illustrations, but yet should remember that they may find the results
of similar speculations in Consols very disappointing.
The demand for Government securities created by these speculative
operations is one of the causes which drive up the price of Consols
during periods of cheap money, but it is not by any means the only
cause. When the Bank rate advances, and capital can be employed more
advantageously in the London short loan market, this period soon comes
to an end, and consequent sales depress the Consol market.
Very many of the better class securities such as Colonial Government
stocks, Foreign Government securities, and so on, yield from three to
five per cent., and when the Bank of England rate is at from two to
two and a half, though the margin demanded upon such stocks is wider
than that required upon Consols, the difference between the interest
received in the shape of dividends and that paid as the price of a loan
often makes speculative dealings in them decidedly profitable. As the
Bank rate increases, and the speculator's profit margin consequently
narrows, the tendency is for stocks and shares so "carried" to fall in
value. The holders or gamblers then begin to sell, and as the increased
supply of such securities is certain not to be met by an enhanced
demand on the part of investors, prices must fall. Seeing the better
class securities declining in value, those investors who had previously
held aloof are tempted to come in, and the greater the reaction, the
stronger is the inducement to buy; consequently, the lower prices
recede the larger becomes the number of purchasers, until demand
overtakes supply and prices again begin to move upwards.
Broadly speaking, it is evident that, unless the markets are
disorganised by panic or by some disquieting political occurrence, the
prices of the so-called gilt-edged securities are influenced by the
conditions prevailing in the London short loan money market.