CREDIT

CREDIT. There are two primary types of credit: producer credit and consumer credit. Producer credit is extended to businesses; consumer credit is extended to individuals. Credit can be extended long term or short term. Long-term credit generally has a maturity of one year or more.

Businesses seek credit to finance operations or to purchase long-lived assets such as machinery or real estate. A strict accounting may not precede the credit contract, yet businesses are presumed to take profit maximization concerns into account when deciding to borrow.

Individuals seek credit for parallel reasons, although the terminology differs. Businesses finance operations; individuals finance household expenses. Businesses purchase long-lived assets such as machinery or real estate; individuals purchase durable goods or homes. Whereas businesses consider the bottom line, individuals borrow for more complex reasons.

The most important distinction between producer credit and consumer credit is the role of credit in generating the funds with which the debt is repaid. Businesses borrow to produce and sell a product, and thus generate the revenue with which the loan is repaid. Families borrow in order to buy products, not to generate family in-come. This distinction mattered to lenders, especially in the nineteenth and early twentieth centuries. Lenders, particularly bankers, were unwilling to extend credit to individuals to buy consumer goods unless the product would "pay for itself": pianos could be used to give piano lessons and sewing machines could be used to take in sewing, and credit was readily available for families buying these products.

Credit extended to producers or consumers is typically—but not always—a loan. What is and is not a loan is primarily a legal distinction. Most credit—but not all—is secured by a real or financial asset. If the debtor breaches the contract that is secured by property, the creditor (lender) can claim or repossess the property.

Producer Credit

In the United States, the demand for producer credit probably dates back to the day of first settlement. Because the economy had little transportation or manufacturing, demand for producer credit was largely mercantile and agricultural. There were, however, few institutional arrangements that extended credit. What credit existed was usually extended directly by individuals or by merchants.

Borrowers were frequently located long distances from creditors, and often planned to use their borrowings for activities about which the potential creditors had little knowledge. The long physical distances tended to preclude many transactions. The difficulty in evaluating a project's creditworthiness limited credit availability even more. Search, information gathering, and administration are, however, all subject to increasing returns to scale, so that average costs can be substantially reduced if these activities are centralized; moreover, risk is reduced if the benefits of insurance are obtained By the introduction of some institution between lender and borrower.

In 1781, the Bank of North America was chartered in Philadelphia. Commercial banks were soon opened in the other Northeast cities. By 1810 there were 88 banks, and By 1930, 30,000. Early Banks were largely devoted to supplying the credit needs of the mercantile community. They Lent the savings of stockholders and a few depositors, and also issued bank notes in exchange for commercial IOUs (commercial paper). Banks continue to function in much the same way today. After 1865, however, the creation of demand deposits (checking accounts) largely replaced bank note issue as the means of extending credit.

In the nineteenth century, local banks dominated the short-term credit market in the North and West. In the South, credit was provided by a combination of merchants and people in the cotton industry (supported at times by northern banks). Legal restrictions prevented the establishment of national banks. Local banks mobilized credit within regions, but there were few mechanisms to move credit between regions. Demand for finance was high in the South and West but supply was greatest in the East. Commercial paper houses such as Goldman Sachs emerged to facilitate interregional flow of funds. These institutions began operating in the East in the 1840s. They Moved into the Midwest in the early 1870s and to the Pacific coast By the turn of the century. Commercial paper houses bought commercial paper from banks in high-interest regions and sold it to banks in lower-interest areas.

Demand for long-term credit increased in the 1820s, 1830s, and 1840s as canal building dominated transportation firms, factory production emerged in manufacturing firms, and new technology transformed agriculture. Existing commercial banks and new industrial banks such as the Morris Canal and Banking Company were initially able to meet the increased demand for credit. But the loan defaults during the panic of 1837 and depression of 1839–1842 convinced some bankers that long-term loans were unsafe, and commercial banks began to shy away from extending long-term producer credit.

Other institutions emerged as major suppliers of long-term credit. The first savings bank had opened its doors in 1816. The idea spread rapidly; by 1825, most Northeast cities had at least one savings bank. Savings banks were the most important suppliers of long-term credit from the late 1830s until the end of the century. The Bank for Savings of New York City, established in the early 1800s to serve the working poor, made a substantial contribution to the financing of the Erie Canal. The Provident Institution for Savings in Boston was instrumental in financing the New England textile industry. Savings banks, however, held primarily the meager savings of the poor and were never important outside the Northeast.

In the East, Midwest, and South, life insurance companies provided long-term producer credit. Life insurance business first grew substantially in the 1840s, but its fastest growth came after 1870 with the establishment of tontine and industrial insurance. Life insurance companies passed savings banks in importance in the early years of the twentieth century.

As transportation, manufacturing, and government demand for credit increased in the nineteenth century, formal capital markets developed to facilitate the extension of producer credit. The New York Stock Exchange was formally organized in 1817. Local markets soon emerged in eastern seaboard cities such as Boston and Philadelphia. By the 1830s, there were local markets as far inland as St. Louis. Improvements in communication and the financial advantages enjoyed by New York led to centralization of securities exchanges in New York City. The exchanges initially dealt only in public issues but began dealing in transportation securities in the early nineteenth century and in public utilities shortly thereafter. By the end of the nineteenth century, they were handling a substantial volume of manufacturing securities. By 1914, the market was mobilizing credit for all branches of American activity except agriculture. Although the system suffered a temporary setback after the crash of 1929, it rebounded during World War II (1939–1945) and remains an important route for the extension of long-term producer credit.

Consumer Credit

Consumer credit allows individuals to buy goods and services they may not otherwise be able to pay for. The use of credit by individuals is as old as commerce itself. The forms of consumer credit have evolved over time.

Until the late nineteenth century, most consumer credit was extended directly by merchants and service providers, or by pawnbrokers. Store credit, also known as merchant or service credit, was extended by doctors, funeral parlors, grocers, dry-goods merchants, and others. Unexpected expenses, unexpected declines in income, a seasonal pattern to income, or a lack of currency in the community led individuals to use store credit. There was usually no collateral; only the family's promise to repay typically secured the credit.

Pawnbrokers, known colloquially as "loan sharks," extended money loans particularly to working-class families. This "small lending" was also extended by small loan institutes, usually known as industrial banks or industrial societies. Small loans were often secured by a pledge of household goods or personal property. Some working-class families, for instance, would regularly "pawn" the husband's good Sunday suit on Monday, only to redeem it after Saturday's payday. The loans were typically at very high interest rates for a short term, as much as 200 to 300 percent annually in Northeast and Midwest cities, and as much as 1,700 percent in Southern cities. The collateral would be forfeited if the repayment terms were not met. Pawnbrokers continue to do a great deal of business in twenty-first-century America, located primarily in low-income areas or near gaming centers, and often advertising themselves as "jewelry" stores.

Individuals who sought credit from pawnbrokers at the beginning of the twentieth century were typically perceived as being "down on their luck." The high interest rates they faced led reformers of the Progressive Era to advocate for regulation of "small lending." With the aid and sponsorship of the Russell Sage Foundation, reformers crafted a Uniform Small Loan Law in 1916, which was subsequently used as the basis of many states' legislation. By 1931, twenty-two states had enacted small loan acts conforming to the Uniform Small Loan Law. The legislation set maximum interest rates (usually 3 percent per month) and required that all charges be considered "interest."

Installment Credit

Installment credit is extended for the purchase of a specific product, repaid in regular monthly payments, and governed by a legally enforceable signed contract between buyer (debtor) and seller (creditor) that grants possession but not ownership of the good to the buyer. In the mid-1800s, installment credit was available primarily for furniture and for consumer goods that could be used to generate family income, such as pianos and sewing machines. Furniture credit was extended By the retailer. Other credit was offered By the manufacturer: Singer Sewing Machines began extending installment credit in 1856; piano manufacturers followed suit in the late 1800s.

During the 1920s, installment credit use exploded. Both greater supply and greater demand fueled the rapid increase. Automobile manufacturers used installment credit to sell more automobiles. Some manufacturers established legally separate corporations whose function was to finance dealer wholesale inventory and retail installment contracts. Prominent auto manufacturer John Willys founded Guaranty Securities Corporation in 1915; General Motors Acceptance Corporation was established in 1919; Ford Motor Company established Universal Credit Corporation in 1928. Other sales finance companies were independently established but subsequently signed contracts with auto manufacturers to be the exclusive source of retail installment credit for the manufacturer's franchised dealers: Commercial Credit Corporation was established in 1912 in Baltimore and in 1920 entered into a contractual relationship with Chrysler Corporation.

Demand for installment credit increased in the 1920s in part because the way in which the public viewed installment credit underwent an almost complete reversal during the 1920s. Before World War I, families that used installment credit did so with a bit of shame and secrecy. But By 1929, families that used installment credit were viewed as good financial managers, recognizing that they could "buy now and pay later" at what they believed were low monthly costs.

Installment contracts were not considered "loans" under the law; they were contractual agreements to pay for a good over time. The distinction matters because loans were subject to usury laws that set maximum interest rates, but contractual agreements to pay over time were not subject to such laws. The installment contract specified a down payment, a term, and the amount of the regular, usually monthly, payments. In the interwar period, the monthly payments were typically computed by taking the amount financed, multiplying it by an interest rate, adding in various fees and charges, and then spreading the total amount evenly over the term of the contract. The effective interest rate on the installment contract was therefore much greater than the stated interest rate on the contract. The fees and charges were hidden interest costs and the contract interest rate was assessed on the total amount financed at the beginning of the contract, but the amount financed was repaid over time. The contract interest rates ranged from 6 to 11 percent; the effective interest rates reached almost 100 percent.

Beginning in the 1920s, most installment contracts were purchased by sales finance companies. The buyer provided the down payment and signed the contract in the presence of the retailer. The retailer then sold the installment contract to a sales finance company, which had often extended a wholesale inventory loan to the retailer. The sales finance company received its operating funds by bundling together several hundred installment sales contracts and selling shares in the securitized bundle. The buyer typically then made payments directly to the sales finance company. The installment contract transferred possession but not ownership of the good to the buyer. Missed payments or other breach of contract resulted in swift repossession. Down payments were large—one-third down was not unusual for car installment sales—and terms were typically twelve months or less. Repos-session early in the installment term therefore resulted in a financial gain for the finance company.

Society's attitude toward installment buying switched from scolding to applauding in the 1920s, but bankers' attitudes did not change. Bankers retained their conservative, if circular, views: families that bought goods "on time" were bad credit risks; good credit risks would be able to manage their family finances so that they did not need credit. Finance companies had the last laugh, however. When the Great Depression hit in the 1930s, consumer credit was the only financial asset that showed a positive rate of return during the episode. Because of the threat of swift repossession, American families made good on their installment contracts despite the wage cuts and layoffs that permeated the depression economy.

Mortgage Lending

Home mortgage loans enable individuals to buy a house. Legal distinctions again matter. A mortgage is a loan; an installment contract is not. Under a mortgage, both possession and ownership of the house transfer to the buyer; with an installment contract, only possession transfers to the buyer. If a borrower defaults on or otherwise breaches a mortgage contract, the lender can place a lien on the house. This may necessitate sale of the house, but the lender does not take possession or ownership. Mortgage loans are subject to usury laws that set maximum interest rates; installment contracts are not.

Until the 1930s, many home mortgages were three-to five-year contracts. Monthly or quarterly payments often covered only accumulated interest and included little or no principal repayments. At the end of the mortgage, a "balloon" payment equal to all or most of the principal was due. Homeowners typically refinanced the mortgage, sometimes paying off some of the principal due but just as often refinancing the entire balloon. This arrangement implies that homeowners gained little equity in their homes as a result of their payments; equity was acquired only as housing prices rose.

The absence of principal payments became a crisis in the 1930s. Housing construction flourished in the 1920s following two decades of rapid population growth through immigration. But the post–World War I immigration restrictions of 1921 and 1924 had slowed the growth of housing demand just as housing supply was growing rapidly, and the combination of these two factors lowered housing prices. When balloon payments now became due, the new, lower price of the house could be insufficient to justify refinancing the balloon payment. Home mortgage foreclosures soared in the 1930s.

The New Deal reforms of President Franklin D. Roosevelt's administration sought to correct this feature of home mortgages. The Home Owners Loan Corporation was created by Congress in 1933 to refinance home mortgages. Principal payments were required to be fully amortized, spread out over the life of the loan.

Credit Cards

Credit cards began in the 1920s as charge cards offered to loyal customers of department stores, to identify the customers to retail clerks. Gas companies, in an effort to gain customers in the 1920s new environment of automobiling, distributed hundreds of thousands of unsolicited courtesy cards. These cards, by and large, did not feature credit but were simply a means of creating customer loyalty.

Diners Club was established in New York City in 1950 by theater producer Alfred Bloomingdale, his friend and head of Hamilton Credit Corporation, Frank McNamara, and McNamara's attorney, Ralph Snyder. Diners Club was a universal travel and entertainment (T&E) card: it could be used at many different businesses. Competitors Carte Blanche and American Express were introduced in 1958.

Revolving credit is the key feature of credit cards. Cardholders can charge items, pay off only part of the balance, but still charge more. William Gorman introduced revolving credit to department store cards in the 1940s, first at the L. Bamberger & Company department store in Newark, New Jersey, and in 1947 at Gimbel Bros. of New York.

Bank universal cards were established in the 1950s. Bank of America, of San Francisco, introduced Bank-Americard in 1959 and took it national in 1966. The Interbank Card Association, later the provider of Master Charge, was formed in response in the late 1960s. Bank Americard changed its name to Visa in 1976; Master Charge became Master Card in 1980.

Debit cards look the same as credit cards, but they do not extend credit. When a buyer uses a debit card, the amount charged is deducted directly and in full from the buyer's associated checking or savings account.

BIBLIOGRAPHY

Baskin, Jonathan Barron, and Paul J. Miranti Jr. A History of Corporate Finance. Cambridge, U.K.: Cambridge University Press, 1997. An excellent recent history of corporate finance.

Board of Governors of the Federal Reserve System. Consumer Installment Credit. Washington, D.C.: Board of Governors, 1957. Three-volume report of government study of consumer credit with extensive bibliographic footnotes.

Calder, Lendol. Financing the American Dream: A Cultural History of Consumer Credit. Princeton, N.J.: Princeton University Press, 1999. Argues that the rise of consumer credit in America created worker discipline.

Lamoreaux, Naomi R. Insider Lending: Banks, Personal Connections, and Economic Development in Industrial New England. New York: Cambridge University Press, 1994. Important contribution to the history of antebellum banking and finance.

Mandell, Lewis. The Credit Card Industry: A History. Boston: Twayne Publishers, 1990. A thorough history of the credit card industry in the United States, but the absence of any footnotes or bibliography limits its usefulness.

Olney, Martha L. Buy Now, Pay Later: Advertising, Credit, and Consumer Durables in the 1920s. Chapel Hill: University of North Carolina Press, 1991. Chapter 4 contains history of consumer credit.

Phelps, Clyde William. The Role of the Sales Finance Companies in the American Economy. Baltimore: Commercial Credit Company, 1952. Published by a sales finance company, contains thorough history of the sales finance industry in the United States.

Robinson, Louis N., and Rolf Nugent. Regulation of the Small Loan Business. New York: Russell Sage Foundation, 1935. A perspective on small lending from the architects of United States small lending regulation.

Seligman, Edwin R. A. The Economics of Installment Selling: A Study in Consumers' Credit, with Special Reference to the Automobile. New York: Harper and Brothers, 1927. An epic study of installment credit, solicited by General Motors but widely regarded as objective and thorough.

Martha L.Olney

See alsoFinancial Services Industry .

To convey the general attitude of society toward consumer credit, Clyde Phelps wove together several quotes from articles published in popular and professional journals between 1926 and 1928.

The use of credit, and particularly the installment type, by consumers was characterized as "an economic sin," as "enervating to character because it leads straight to serfdom," as setting "utterly false standards of living," causing judgment to become "hopelessly distorted," and tending to "break down credit morale." It was attacked as "marking the breakdown of traditional habits of thrift," as tending to "weaken the moral fiber of the Nation," and as dangerous to the economy of the United States. It was accused of "breaking down character and resistance to temptations, to extravagance, and to living beyond one's means, breeding dishonesty," causing "many young people to get their first experience of being deadbeats through yielding to temptations that are placed before them," and "creating a new type of criminal or causing professional deadbeats to shift to this new and highly lucrative opportunity."

SOURCE: Clyde William Phelps, The Role of the Sales Finance Companies in the American Economy. Baltimore: Commercial Credit Company, 1952, pp. 39–40.