I. Government CreditRaymond J. Saulnier
II. Agricultural CreditHarold G. Halcrow
Programs under which public credit is extended to individuals, private businesses, cooperatives, and public agencies have grown in most countries in such variety and to such size that they must now be regarded as a major activity of government. Their variety in the United States is such that virtually every type of program may be found. Because of this fact and because information on U.S. programs is more extensive than that on programs in other countries, government credit programs may best be illustrated by arrangements found in the United States.
Classification. U.S. credit programs may be classified on several bases, of which the first is according to the sector of the economy served. These are (i) agriculture, which is perhaps the progenitor of most government credit programs; (ii) housing; and (iii) business, including foreign trade and regional or area development.
Second, government credit agencies and programs may be grouped according to the methods they employ to achieve their purposes. There is, first, the direct extension of credit, in which funds are made available directly to the borrower. Along with other agencies, the Small Business Administration and the Farmers Home Administration have such programs, the former extending intermediate-term credit directly to qualifying small businesses, the latter extending long-term mortgage loans to help farmers acquire farm ownership or improve farms already owned. Next are the methods of loan insurance and loan guarantees, in which credit is extended by a private lender under full or partial government protection against loss. Loan insurance is illustrated by the Federal Housing Administration programs under which private financing institutions may, at a fee which is intended to underwrite losses and to make the program self-supporting, obtain full insurance on qualifying residential mortgage loans (on single or multiunit structures) in which they have invested their own funds. Loan guarantees are illustrated by the Veterans Administration program under which qualifying loans made by private lending institutions to veterans to help them buy homes or acquire small businesses are guaranteed against loss up to a stated maximum amount without fee and without the use of a reserve for meeting losses. Under both of these programs the lenders are closely limited as to the interest rates and other contract terms on which loans may be made. A variant of loan insurance is the deferred participation arrangement under which a credit agency agrees at the option of an original, private lender to take up all or part of a loan. Because the option can be exercised when a loan is approaching or is in default, it is in effect a guarantee against loss.
A third type of public credit program is the secondary market operation, which is illustrated in the United States by the Federal National Mortgage Association. In this case, the agency stands ready to purchase specified types of financial assets (in the case of FNMA, only mortgages) from lending agencies or other investors who wish to sell them. The purpose is to provide a liquid and orderly market, which at times can be a function of crucial importance.
A fourth method, which has a supporting effect resembling the secondary market approach, is illustrated by functions served by the Federal Home Loan Bank System through its 11 regional banks and by the Federal Reserve System through its 12 regional banks. The former supplies short-term credit to member institutions, mainly member savings and loan associations in the Home Loan Bank System, to meet temporarily heavy mortgage loan demands; the latter lends exclusively to member commercial banks in the Federal Reserve System to meet temporary reserve deficiencies that arise as a result of their lending and investing operations. [For other functions of the Federal Reserve System, seeBanking, Central.]
Fifth and finally, there are programs under which direct subsidies are made in lieu of the extension of credit, although these cannot perhaps be regarded strictly as credit programs. An illustration in the United States is the program under which the Public Housing Administration commits itself to make annual payments over periods up to forty years to local public housing authorities to make up any deficiency there may be between the cost of servicing obligations issued at the local level to finance public housing and the amount of cash available for this purpose that remains from rental income after meeting other operating costs. This has the legal standing of a guarantee by the federal government of local public housing authority bonds.
There is one respect in which U.S. government credit programs differ from those found in a number of other countries: apart from the now virtually abandoned postal savings system and the essentially war-emergency-type government savings bonds, there never has been any determined effort in the United States to collect savings through a public agency, and there never has been any mechanism at all for channeling such funds as were collected to nongovernment users through a government credit agency. In many other countries, on the other hand, the collection of savings is a major activity of government, and savings so collected are in many cases channeled, at least in part, directly to nongovernment purposes, most often to the financing of home purchases. This difference reflects the fact that the United States is amply supplied with mutual or stock savings institutions, whereas nongovernment savings-assembling facilities are inadequate in many countries or absent altogether.
Government credit agencies may be grouped also according to their form of organization and financing, that is, whether they are (i) wholly public; (ii) quasi-public joint ventures using a combination of public and private funds; or (iii) agencies having a relationship with government, such as tax exemption or guaranteed access to financial help if needed, that justifies their being regarded as federally sponsored. The Federal Intermediate Credit Banks, which still utilize some federal funds along with funds obtained in the open market by sale of Intermediate Credit Bank obligations and funds that must be subscribed by its borrowers as a condition of obtaining credit, are an example of the quasi-public type. The Intermediate Credit Banks operate through local “production credit associations” to provide medium-term financing for farmers. The Federal Land Banks, on the other hand, which provide long-term farm financing through local “national farm loan associations,” used federal capital at their inception and for many years thereafter but now have retired all of this and rely exclusively on open-market borrowings and obligatory borrower subscriptions of capital. However, because Federal Land Banks are still supervised by the Farm Credit Administration which is an integral part of the Department of Agriculture, and because they enjoy certain cost-reducing privileges not available to private lending institutions, they still must be considered as federally sponsored agencies.
A fourth basis for classifying government credit programs is found in the reasons that have led to their establishment. In the United States, many programs have been launched because it was felt that private financial institutions were not providing credit in adequate amounts or at rates of inter-
|Table 1 — U.S. government credit programs in fiscal year 1966 (millions of dollars)|
|AMOUNT OF LOANS ESTIMATES TO BE OUTSTANDING, END OF FISCAL YEAR 1966||LOAN FUNDS ESTIMATES TO BE DISBURSED DURING FISCAL YEAR 1966|
|Direct loans||Guaranteed or insured loans|
|* Not available.Source: Taken from U.S. Bureau of the Budget 1965, pp. 408, 410.|
|Office of Economic Opportunity||52||—||37|
|Department of Agriculture:|
|Commodity Credit Corporation||1,524||835||2,297|
|Rural Electrification Administration||4,270||—||365|
|Farmers Home Administration||2,019||1,343||1,036|
|Department of Commerce:|
|Area Development Administration||202||5||73|
|Department of Defense:|
|Defense production guarantees||21||55||7|
|Military assistance credits||132||126||94|
|Department of Health, Education and Welfare :|
|Office of Education||772||100||221|
|Public Health Service||43||10||25|
|Department of Interior: Reclamation loans||108||—||18|
|Department of State:|
|Loans to United Nations||119||—||0|
|Agency for International Development||10,650||565||1,816|
|Loans to District of Columbia||192||—||42|
|Housing and Home Finance Agency:|
|Community Facilities Administration||2,673||—||434|
|Urban Renewal Administration||231||1,856||266|
|Federal National Mortgage Association||1,574||1,555||283|
|Federal Housing Administration||555||52,762||194|
|Public Housing Administration||47||5,641||394|
|Export—Import Bank of Washington||1,826||3,642||601|
|Interstate Commerce Commission||15||208||*|
|Small Business Administration||923||122||366|
|Total (including small amounts and agencies not listed)||32,743||99,123||9,035|
est and other contract conditions thought to be “reasonable.” It perhaps goes without saying that what is adequate and reasonable are debatable questions. In any case, a “gap” theory has been basic to the establishment of financing agencies for agriculture, for which private credit is often more costly than for industrial and commercial borrowers. It is typical also that credit facilities are less available to small business than to large companies, and a “gap” theory has been important here also. Where credit programs are set up on this basis, it is frequently required that the borrower, in order to qualify for assistance, show he has tried and failed to obtain credit from private sources.
A related reason for setting up a public credit program is that the government wishes to provide assistance to what it regards as an especially important activity and one which it believes cannot obtain credit in the open market at sufficiently low interest cost. This is illustrated in the United States by the Rural Electrification Administration, which was set up to make low-interest long-term loans to cooperatively owned light and power companies. Further examples are found in FNMA’s “special assistance” programs, under which the agency purchases at par mortgages which would sell at a discount in the open market because of the relatively low contractual interest rates they typically carry. Among types of mortgages so favored are those issued to finance college housing, nursing homes, housing projects for older people, cooperatively owned housing projects, housing for medium-income groups (especially when located in urban-renewal areas), and the like. The now inactive V-loan program, under which U.S.-guaranteed loans were made during World War ii to defense con-tractors, is a further illustration.
In some cases, however, the special assistance feature is such a prominent element in the program that the activity lacks what may be regarded as a true credit quality. Thus, loans made to farmers by the Commodity Credit Corporation against price-supported commodities are used only as a substitute for a price or income support that could be supplied by other methods. In this case, the price-support purpose is so prominent that the activity hardly qualifies as a credit program. [SeeAgriculture, article onprice and income policies.]
Two other purposes for founding government credit agencies may be mentioned: (i) to offset recessionary tendencies in the economy and (ii) to upgrade standards of private lending practices. The Federal Housing Administration illustrates both of these. FHA was established in the early 1930s to promote home construction and home improvement, primarily as an anti-recession measure. But it has also sought to upgrade lending practices by offering insurance only on mortgages that meet certain standards of credit quality and only on properties constructed to meet specified physical standards.
As would be expected, there has usually been a mixture of reasons behind the establishment of specific programs, and credit agencies frequently follow more than one general approach (that is, direct loans or loan insurance) in seeking to achieve their purpose. Thus, it is difficult to classify them by either of these criteria. Broadly speaking, however, they limit their activities to a particular sector of the economy—agriculture, housing, or business —and accordingly are most often classified in this manner.
Scope and size of U.S. programs. The scope and size of U.S. credit programs may be seen in Table 1. In addition there are the “quasi-public” credit programs presented in Table 2.
Relative importance of U.S. programs. The relative importance of government credit programs in the financial system of the United States is not easy to measure, but it may be noted that it was estimated by the federal government that as of the end of June 1964 its outstanding direct loans to domestic private borrowers amounted to 2 per cent of the then estimated U.S. private debt of $778,000 million. At the same time, private loans wholly or partly guaranteed by federal agencies constituted close to 10 per cent of total private debt. The percentages would be much higher, of course, if comparisons were made with privately supplied credit
|Table 2 — Quasi-public U.S. credit programs in fiscal year 1966 (in millions of dollars)|
|AMOUNT OF LOANS ESTIMATED TO BE OUTSTANDING, END OF FISCAL YEAR 1966|
|Source: U.S. Bureau of the Budget 1965, p. 414.|
|Farm Credit Administration:|
|Banks for Cooperatives||887|
|Federal Intermediate Credit Banks||2,990|
|Federal Land Banks||4,371|
|Federal Home Loan Bank Board:|
|Federal Home Loan Banks||4,600|
|Housing and Home Finance Administration:|
|Federal National Mortgage Association (Secondary market operations trust fund)||2,233|
|National Service life insurance fund||573|
|U.S. government life insurance fund||84|
of a type comparing closely with credits supplied or insured by the several federal programs.
The importance of government credit programs is suggested also by their relative weight in the federal budget, although this is not readily seen in the United States because of the way credit programs appear in budget accounts. In the U.S. budget, repayments of loans are netted against disbursements of loan funds, with only the difference, which can be a minus quantity, counted as an administrative budget expenditure. However, in the fiscal year 1965 disbursements under direct loan programs (thus excluding loan insurance and guarantee programs) were close to 10 per cent of net administrative budget expenditures.
Sales by government agencies of accumulated loans and investments further complicate measurement of the budgetary and economic impact of federal credit programs. As indicated in Table 1, the federal government estimated it would hold something over $30,000 million of loans at the end of fiscal year 1966. At the same time, it planned to sell something over $3,000 million of loans during that fiscal year. Since sales of loans are counted as a repayment, they tend to shrink budgetary deficits or expand budgetary surpluses. And if there is a deficit in the budget, by shrinking this below what it would otherwise be, the credit programs appear to reduce the direct burden which federal finances place on capital markets. But the sale of loans is also a burden on the capital market, so that the total market effect must be regarded as the amount of reported deficit plus sales of loan assets.
Credit programs in other countries than U.S. Government credit institutions similar in point of function and method of operation to those found in the United States are present in virtually all countries of the world. Major reliance tends to be placed, however, on direct lending programs. To cite examples in the field of agriculture: Britain has its Agricultural Mortgage Corporation; Ireland has its Agricultural Corporation of Eire (for general agricultural financing and for financing cooperatives) and has departments for rural credits and for mortgage banking in the Commonwealth Bank of Ireland; South Africa supplies similar services through the Land and Agricultural Bank of South Africa, established in 1912; Egypt has its Credit Agricole d’Egypte, established in 1930; and India has its government-sponsored financing cooperatives.
It would be a mistake, however, to conclude that public institutions are in all cases the major or even a principal source of rural and agricultural credits. Thus, the All-India Rural Credits Survey showed that in 1960 only 7 per cent of all borrowings came from government cooperatives and commercial banks, whereas 70 per cent came from local lenders (mainly individuals) and 23 per cent from relatives, traders, and other private agencies. In Denmark, to cite the case of a capital-intensive agriculture in a developed economy, only about 8 per cent of funds used in agriculture in 1954 came directly from government sources. In the more developed economies, greater emphasis is usually placed on loan insurance or guarantees than on direct extension of credit.
The picture is somewhat different with regard to the financing of residential construction. It has been estimated that more than half of new residential construction carried out in recent years in western Europe received some form of government assistance, ranging to as much as 98 per cent in the Netherlands. At least the nucleus of a national home and construction finance corporation exists in practically every Asian country (for example, Pakistan has its Building Finance Corporation; Ceylon its House Loan Board; Burma its Town and Country Development Board; Japan its House Loan Corporation, etc.). In some cases these are allied to, or are departments of, government agencies that collect savings through a widespread system of branches. Naturally, the use of such agencies is especially extensive where interest rates and equity requirements in home financing are high and credit availability is limited, reflecting a shortage of savings.
Finally, there has been an extensive development recently of government agencies devoted primarily to financing production facilities and infrastructure under national development plans. In industrialized countries these agencies are designed primarily to assist small business or business in areas affected by abnormally high levels of unemployment. In less developed countries, “development companies,” as these agencies are frequently termed, have a broader function, reflecting a more general lack of credit facilities. Among these are the Istituto Mobiliere Italiano (IMI); ETIBANK in Turkey; the Corporacion de Fomento de la Production in Chile; and the Pakistan Industrial Credit and Investment Corporation (PICIC), to name a few. Private capital plays a role in many of these, but some represent entirely public efforts to channel resources into development projects. [SeeCapital, social overhead; Development banks.]
Policy questions. There are a number of important policy questions involved in government credit programs which cannot be examined here. Among these are the following:
What are the relative advantages of direct lending, insurance, and guarantee of privately extended credits as ways of achieving program purposes?
On what interest rate and other loan contract terms should government credit programs be extended? On what terms should private credits be insured or guaranteed?
What standards and policies should be followed in the relationship between private and public credit programs?
Under what conditions should government credit programs be self-supporting?
How should these programs be coordinated with general monetary and fiscal policies for promoting the economy’s growth and stability?
Raymond J. Saulnier
Diamond, William 1965 Development Finance Companies. Fund and Bank Review: Finance and Development 2:97–102.
Federal Credit Agencies: A Series of Research Studies Prepared for the Commission on Money and Credit. Prepared by F. Break et al. 1963 Englewood Cliffs, N.J.: Prentice-Hall.
Federal Credit Programs: A Series of Research Studies Prepared for the Commission on Money and Credit. Prepared by Stewart Johnson et al. 1963 Englewood Cliffs, N.J.: Prentice-Hall.
Food and Agriculture Organization 1964 New Approach to Agricultural Credit. Rome: The Organization.
Saulnier, Raymond J.; Halcrow, Harold G.; and Jacoby, Neil H. 1958 Federal Lending and Loan Insurance. A study by the National Bureau of Economic Research, New York. Princeton Univ. Press.
United Nations, Economic Commission for Europe 1961 European Housing Trends and Policies, in 1960. Geneva: United Nations.
United Nations, Economic Commission for Europe 1962 Report of the Seminar on Housing Surveys and Programmes, With Particular Reference to Problems in the Developing Countries … Geneva: United Nations.
U.S. Bureau of the Budget 1965 Budget of United States Government, Fiscal Year 1966. Washington: Government Printing Office. → Includes an appendix on federal credit programs.
Agricultural credit is the term applied to funds borrowed by individuals, farm businesses, and others for use in producing, storing, processing, and marketing crops and livestock products. Modern farming requires increasingly large amounts of capital, and credit is one way of supplying this capital. Usually the borrowers are farmers, but they can also be other agricultural producers, such as ranchers in the western United States, graziers in Australia, cooperative farming associations, farm partnerships, and corporations. Sometimes the term includes funds extended to agricultural marketing firms and to those supplying services to agriculture, such as machinery, equipment, feed, fertilizer, and seed companies.
Those supplying agricultural credit include individuals, commercial and savings banks, cooperative lending associations, government and government-sponsored credit agencies, life insurance companies, mortgage and loan associations, farm service companies, and agricultural marketing associations, including cooperatives. In general, both commercial credit institutions and government-sponsored programs are most active where industrial economies are advanced and agriculture is highly commercialized. Direct government aid programs usually originate for specific purposes, such as aid to low-income groups, reclamation and development, permanent improvements, or help in case of disaster.
In contrast, where economies are not highly developed, a noninstitutionalized type of lending by merchants, local moneylenders, and landlords tends to predominate. Although in recent years governments have sometimes assisted by lending directly for specific purposes, in most underdeveloped economies agricultural credit is not efficiently organized, resulting in an almost static condition in agriculture. As a consequence, during the past quarter century the gap in per capita food production between the highly commercialized and the underdeveloped nations has widened considerably. In many instances, there has been no net increase in land productivity, income, or net assets. Under most conditions soil productivity remains low, risks are great, interest rates are excessive, income is low, and farmers remain poor indefinitely. Either the farmer is deeply in debt or he works for others as a tenant or hired hand.
In most underdeveloped countries, where the problem is broad, the solution may require land reform and other drastic changes in the social and economic order. Nevertheless, agricultural credit can help provide conditions under which crop yields can be increased and farmers can get a larger net return from the sale of farm products. The small size of many farms adds to the per unit cost of obtaining credit and creates a problem for farmer and banker alike. Agricultural credit is not the sole means of providing needed increases in food production, but it is an important element.
The importance of credit cannot be judged in isolation or by its amount. Land may be leased or rented as an alternative to ownership financed through credit. In commercialized agriculture the total debt may be only a small fraction of the resources used in agriculture. In the mid-1960s in the United States, for example, agricultural debt, or the aggregate of agricultural credit outstanding, was only one-seventh of total assets. Yet the fact is that agriculture has made great progress through expanded use of credit, which has served as a catalyst in resource development.
Types and sources of credit. If use of credit in agriculture is to be effective, it must be adapted to the peculiar needs of farming. In commercial enterprises, some loans must be made for longer periods than usual, and the repayment schedule must be flexible enough to allow for variations and uncertainties in farm income. Generally three types of credit are required: short-term financing to cover operating and family living costs between cropping seasons; intermediate-term credit to finance machinery, livestock, and improvements; and long-term credit for land and major improvements.
The need for short-term credit arises from the fact that, except on well-diversified farms that sell crops or livestock throughout the year, farm income fluctuates from season to season, and swings in prices or crop conditions sometimes cause additional variation in income. This uncertainty, combined with the typically small amount of reserve or working capital held by farmers, creates a demand for short-term credit. Such credit is used to pay family living expenses and to buy goods and materials used in production, such as feed, fertilizer, seed, and tractor fuel.
The demand for intermediate-term credit, covering one to five years, arises from the need to finance farm improvements and to buy equipment. Modern farming requires substantial amounts of capital for these purposes, often running into tens of thousands of dollars for a single family-type farm.
Long-term credit, extending over six years or more, is used to finance or refinance the purchase of farm real-estate, to construct farm buildings, and to make major improvements. Long-term credit often extends over 20 or 25 years and, in some countries, 50 to 75 years. Mortgage security is usually required. In recent years amortization systems have permitted repayment of loans in regular annual, semiannual, quarterly, or monthly installments.
In almost every country the first steps in developing an agricultural credit system have been taken by individuals and other private lenders. In many countries, cooperatives and credit unions designed to provide credit on more favorable terms have followed. Government has entered the field, either as a direct lender or as a sponsor of cooperative credit agencies, to provide more adequate sources of credit and to standardize the terms under which credit is extended. In many advanced economies, credit cooperatives and government-sponsored agencies provide more varied and complete services to agriculture than are available to any other sector. Government-sponsored agencies have played a more significant role in agriculture than in any other major segment of the economy. Thus, credit systems range from private through completely cooperative forms to government lending and loan insurance, with several systems often operating concurrently.
Government-sponsored cooperative systems. Credit cooperatives are usually sponsored by government through laws and administrations established for their operation. Usually government funds are appropriated to purchase capital stock and to cover some of the costs of administration. Once established, the government-sponsored agency tends to become self-supporting, and at least part, if not all, of the funds advanced by the government are usually repaid. Management may be directed in part by government officials. Boards of directors for cooperatively organized banks and loan associations are usually named by member borrowers and stock-holders.
In most countries of western Europe, local co-operative societies belong to regional and state organizations that are part of a national system. Extension of credit is subject to national regulation, but management decisions are in the hands of local officers responsible to the members. Usually the local societies are small, serving a village or a single community. Credit operations are sometimes combined with such cooperative activities as purchasing, processing, marketing, and other services.
Other sources of credit supplement the government-sponsored cooperative agencies. For example, Belgium, Sweden, Italy, the Netherlands, Switzerland, Denmark, and West Germany each have a system of savings banks that loan to farmers. In some instances obligations are guaranteed by local government units.
Government-managed systems. In a number of countries agricultural credit agencies are associated with the government through a system of central management. Sometimes the agency depends on the government for financing; in other cases a co-operative program is maintained and the government role is restricted to management. France, Italy, Japan, and Turkey provide examples of government-managed credit systems.
In France, the Caisses de Crédit Agricole Mutuel are government-managed cooperative societies that lend about three-fifths of the credit extended to agriculture. The organization includes La Caisse Nationale de Crédit Agricole, which enjoys financial autonomy and is administered by a plenary commission or board; the Caisses Régionales, which are private lending organizations serving a region; and the Caisses Locales, which are subordinate to the Caisses Régionales and lend to local areas or communities. La Caisse Nationale is a public body that coordinates and controls the Caisses Régionales and helps them by making advances on loans that they cannot provide from their own resources. The Caisses Régionales in turn help the Caisses Locales and serve as correspondent banks on large loans. Both the regional and the local banks are cooperatives with generally limited liability.
Italy has a central farm-credit organization run by the state. There are also local lending institutions—savings banks, credit banks, people’s cooperative banks, rural and artisan banks, and agricultural syndicates. Special regional or interregional institutes (sometimes with local correspondents), under control of the state, coordinate and direct agricultural credit in each region. Above the regional institutes is the national central authority, the Consorzio Nationale per il Credito Agraria, which, along with the regional institutes, operates throughout Italy, making farm improvement loans that are subsidized in part by the Ministry of Agriculture and Forestry. Farm operating loans, usually short-term, are made by the local banks and rural cooperative banks.
Japan has a cooperative agricultural credit structure and an agricultural, forestry, and fisheries finance corporation. The corporation is an independent government institution entirely capitalized by the government, existing for the purpose of extending longterm, low-interest loans to farmers, forestry men, and fishermen and their associations, where other credit is difficult to obtain. The corporation has no local representatives but operates through the branches of the Central Cooperative Bank for Agriculture and Forestry, the prefectural credit federations, and local commercial banks. The Japanese cooperative system includes village cooperative unions, a federation grouping by districts, and the Central Cooperative Bank. This bank is organized as a cooperative society with limited liability and with an administrative council, largely responsible to the government, which appoints the president, vice-president, 19 governors, and three monitors. The affiliated cooperatives have a council of delegates elected by holders of the bank stock.
Turkey finances about three-fourths of the loans made to farmers through an agricultural bank, a government-owned institution with branches and agencies serving all rural areas. Cooperatives, the second most important source of credit, borrow from the bank to finance their operations.
Direct government systems. In many underdeveloped countries and in some countries where commercial banks or cooperative lending associations have been slow to develop, the government has established a direct system of lending to farmers and others in agriculture. Direct lending through state-controlled credit agencies is also sometimes undertaken for special purposes, such as development of new lands, promotion of a particular kind of agriculture, expansion of output of certain commodities, aid to farmers suffering from adverse weather or low prices, and help to particular classes of the farm population who are unable to obtain credit from other sources. Although some financing may be available from private sources, government has provided credit in many of these cases to supplement these sources and to provide a larger aggregate supply, generally at reduced cost, to borrowers. Many nations with highly developed economies and well-developed cooperative credit systems, such as the United States and some of the western European countries, have also created government agencies for direct lending for one or more of these purposes. More illustrations are found throughout Latin America, Canada, and the Near East.
The United States example. The United States offers the best example of an agricultural credit system in which nearly every known method of credit is utilized. Although both government-sponsored agencies and direct lending are important, major reliance is on credit supplied by private sources. Of the total farm mortgage debt of $21,213 million reported and estimated to be outstanding on January 1, 1966, about 40 per cent was held by individuals and private businesses, 23 per cent by life insurance companies, 20 per cent by federal land banks, 14 per cent by commercial and savings banks, and 3 per cent by the Farmers Home Administration. On the same date non-real-estate credit, including both short-term and intermediate-term, totaled $18,913 million. Of this amount, about 41 per cent was held by commercial banks and about 14 per cent by production-credit associations and federal intermediate credit banks. Farmers Home Administration direct loans were about 4 per cent of the total. The balance, or 41 per cent, was an estimate of loans and credits extended by dealers, merchants, finance companies, individuals, and others. Not included in the above were loans of the banks for cooperatives ($1,055 million) and of the Rural Electrification Administration ($3,044 million).
Federal credit services to agriculture, which compete directly with commercial banks, insurance companies, and other private lenders, including individuals, are more varied and complete than in any other sector of the economy. Mortgage loans and short-term production credit for farmers are supplied through two separate systems of cooperatively organized district banks and local lending associations. These are grouped with the banks for cooperatives under the Farm Credit Administration to form a complete system of farm credit in which the government-sponsored agencies help to coordinate activities of local cooperative lending associations.
The cooperative farm-credit system. For many years prior to the close of the nineteenth century and in the early part of the twentieth, United States farmers had agitated for a system that would provide agricultural credit on more favorable terms and more reliably than was then provided by private lenders. In many parts of the country interest rates were high, varying from 6 or 7 per cent up to 11 or 12 per cent per year. Also, long-term loans were unusual, and farmers had to depend on the willingness and ability of lenders to renew their notes. Uncertainties in the banking system in respect to renewal added to their difficulty.
In 1916, after several years of study, the U.S. Congress passed the Federal Farm Loan Act, creating two kinds of banks: a system of joint-stock land banks, which were privately incorporated and financed, and federal land banks, whose original capital was furnished mostly by the federal government and which were made subject to close government direction and supervision. The joint-stock land banks flourished for a short time, but wide-spread defaults on their loans caused them to be placed in liquidation in 1933. Twelve federal land banks, one in each of the Federal Reserve districts of the United States, became the foundation for the cooperative long-term farm-mortgage system.
In the postwar agricultural depression of the 1920s, it became evident that farmers also desired a more uniform system of short-term credit. The Agricultural Credits Act of 1923 established 12 intermediate credit banks. The $60 million of original capital, $5 million for each bank, was subscribed by the government and is still in use. The initial purpose was to liberalize short-term farm-production credit by making loans to commercial banks, agricultural credit corporations, and other agencies lending to farmers. This purpose was largely unfulfilled until 1933, when Congress provided for a nationwide system of cooperative production-credit associations to make loans directly to farmers.
The third major part of the cooperative farm-credit system is the banks for cooperatives. There are 13 banks, one in each of the Federal Reserve districts and a Central Bank for Cooperatives in Washington.
The service and experience of the farm credit system can be grouped roughly into three periods, 1917 to 1932, 1932 to 1940, and 1941 to date. During the first period the activity of the federal land banks was limited to serving a minor part of the total farm-mortgage market. By the end of 1932 farm-mortgage holdings of the federal land banks totaled only $1,147 million, scarcely more than one-eighth of the total farm mortgages outstanding, and the joint-stock land banks, already in financial trouble, held less than half as much. The intermediate credit banks were not a significant factor, with less than $80 million loans outstanding. Neither of these banking systems was playing a major role in agricultural credit. As they were then capitalized and organized, they were not strong enough to do so.
As a means of combating depression and aiding agriculture, Congress in 1932 appropriated $125 million capital for the federal land banks and in 1933 about $189 million as a subscription to paid-in surplus to enable the land banks to make extensions and deferments of defaulted farm loans. Appraisal and lending standards were made more liberal and flexible. The federal land banks, lending through local cooperative associations, greatly increased their activities, especially from 1933 through 1936. By the end of 1940 the federal land banks and the Federal Farm Mortgage Corporation, which was affiliated with the banks, held more than 40 per cent of the total farm mortgages out-standing.
The importance of federal farm credit during the 1930s can scarcely be overemphasized. In deep depression it was used to stabilize the farm real-estate market and to liquidate loans of lenders, who were often in distress. It provided financing for farmers who otherwise could not have survived financially. Interest rates on land-bank loans were kept relatively low, about 4 to 4½ per cent per year.
From 1941 onward the federal land banks played a more passive role in the farm-mortgage market, dropping by the end of World War ii to about one-fourth of total farm-mortgage debt outstanding and by 1954 to less than one-fifth, at which point the shares of the market tended to stabilize.
The experience of major groups of farm-mortgage lenders is remarkably similar, on the average, over the years since the beginning of the farm credit system. During the 1920s life insurance companies and commercial banks suffered heavy defaults and delinquencies. Until the end of the 1920s the land banks had a very small number of their mortgages delinquent, but by 1932 about half of them were delinquent or extended. The 1930s were a time of heavy delinquency for all bankers. Foreclosures and bankruptcies would have been much more numerous had not the federal government expanded farm-mortgage lending. Since 1940 almost all lenders have had very low losses on farm-mortgage loans, as rising real-estate values have consistently allowed those who were in financial difficulty to liquidate through sale of their property.
Non-real-estate lending of the farm credit system grew slowly during the 1930s but has shown a strong and steady growth since that time. Production-credit associations (PCA’s) make production loans for periods of thirty days to five years, with interest rates generally around 5 to 6½ per cent. The system is a government-sponsored cooperative, with stock in local associations held by member-borrowers, who are required to invest 5 per cent of a loan in capital stock. The PCA’s provide services comparable to those of commercial banks, and their rates and loss experience have been about the same over similar periods as those of commercial banks.
Banks for cooperatives, created in 1933, make loans to eligible farmer cooperatives engaged in marketing agricultural products, purchasing farm supplies, and furnishing farm business services. Facility loans for constructing and acquiring buildings and equipment are secured by first mortgages and are limited to 60 per cent of the value of the property and a twenty-year term. Commodity loans are secured by first liens on storable commodities, warehouse receipts, and other title documents representing agricultural products and supplies. Operating loans are made for short periods and may or may not be secured. The banks for cooperatives, like other agricultural lenders, suffered losses during the 1930s; since then, however, they have had few losses, and cumulative profit has easily covered the cost of government capital originally invested.
Farmers Home Administration. Direct government lending to agriculture in the United States has in recent years been confined largely to the Farmers Home Administration. In 1918 and for many years afterward, the Congress appropriated money to aid financially distressed farmers who had experienced drought or other natural disaster and who were too poor to obtain credit from other sources. In 1935 establishment of the Resettlement Administration combined in one agency various loan and aid programs for relief of low-income farm families. In 1937 this program was transferred, under the name of the Farm Security Administration, to the Department of Agriculture. In 1946 the Farmers Home Administration was established to combine all programs of emergency loans for operation and production, loans to disaster areas, and crop, drought relief, and seed loans.
Real-estate loans made by the Farmers Home Administration include farm ownership loans, rural housing loans, and small amounts in soil and water conservation loans. The organization also insures loans made by other bankers for farm ownership. A new rural housing program was begun in 1949. Since about 1961 the amount of loans made for rural housing has greatly exceeded the amount made for farm ownership and about equals the amount of farm ownership loans insured.
Non-real-estate loans are made chiefly for operating purposes, are generally shorter in term than the others, and tend to be concentrated in areas where economic conditions are unfavorable.
The experience of the U.S. government in direct lending varies from high losses on emergency disaster-type loans to results in real-estate lending much the same as those of commercial lenders. At present the major net expense is administrative costs, which have in recent years run $15 to $20 million a year. Losses during the 1930s were much higher. Results indicate that even the direct government farm-mortgage lending that involves some degree of emergency can be successful if loans are based on the potential earning capacity of the farm property.
Rural Electrification Administration. The Rural Electrification Administration (REA) was established in 1935 to provide credit to cooperative associations and others engaged in the generation and distribution of electric power. The policy of the federal government has been to provide loan funds to the REA at relatively low cost. From 1935 to 1944 the REA borrowed from the Reconstruction Finance Corporation (RFC) at an interest rate of 3 per cent. The REA relationship with the RFC was discontinued in 1947, and loan funds were thereafter borrowed from the U.S. Treasury. By memorandum of agreement the interest rate was set at the average rate paid on all marketable securities, with a maximum of 2 per cent. The rate of interest paid by REA borrowers thus has been generally lower than rates paid by other public utility firms.
Loan funds advanced by the REA from its inception in 1935 to 1963 were about $4,800 million. Total outstanding on January 1, 1963, was $3,800 million. Losses have been negligible, and the main cost to government is money appropriated for administration, which totaled $154.8 million from 1935 to 1963, and a somewhat smaller amount to subsidize the low-interest-rate borrowing.
The effect of the REA program is far-reaching. When the program began in 1935, about 11 per cent of the farms in the United States were served with central-station electricity; by 1953 about nine out of ten farms were being so served; and by 1963 an estimated 97.6 per cent of all farms in the United States were included. About one-half of these were customers of REA borrowers. The REA policy has been to provide “area coverage,” that is, to extend electrical facilities into fringe areas and to supply all customers in a given area. Consequently, a large part of the clientele served by the REA is nonfarm, and this is a major source of recent and potential growth. Other power companies have probably developed more rapidly as a result of REA competition, and rural electrification has proceeded much more rapidly than would have been the case without this government program. Additional investment as the result of power availability is probably on the order of $5,000 to $10,000 million in the farm sector and possibly as much as $3,000 million elsewhere.
Agricultural credit covers a wide variety of situations and needs. It is provided by three general types of lenders: individuals and commercial agencies, government-sponsored cooperatives, and government agencies which make direct loans. How much credit is needed or should be provided and which system is best are matters of social objectives and judgment. Certainly, however, agricultural credit will continue to play a crucial role in agricultural and economic development.
Harold G. Halcrow
Belshaw, Horace 1959 Agricultural Credit in Economically Underdeveloped Countries. Rome: Food and Agriculture Organization of the United Nations.
Commission on Money and Credit 1961 Money and Credit: Their Influence on Jobs, Prices, and Growth: Report. Englewood Cliffs, N.J.: Prentice-Hall.
Land Economics Institute, University of Illinois 1960 Modern Land Policy: Papers. Urbana: Univ. of Illinois Press.
Saulnier, Raymond J.; Halcrow, Harold G.; and Jacoby, Neil H. 1958 Federal Lending and Loan Insurance. A Study by the National Bureau of Economic Research. Princeton Univ. Press.
Credit is a transaction between two parties in which one, acting as creditor or lender, supplies the other, the debtor or borrower, with money, goods, services, or securities in return for the promise of future payment. As a financial transaction, credit is the purchase of the present use of money with the promise to pay in the future according to a pre-arranged schedule and at a specified cost defined by the interest rate. In modern economies, the use of credit is pervasive and the volume enormous. Electronic transfer technology moves vast amounts of capital instantaneously around the globe irrespective of geopolitical demarcations.
In a production economy, credit bridges the time gap between the commencement of production and the final sale of goods in the marketplace. In order to pay labor and secure materials from vendors, the producer secures a constant source of credit to fund production expenses, i.e., working capital. The promise or expectation of continued economic growth motivates the producer to expand production facilities, increase labor, and purchase additional materials. These create a need for long-term financing.
To accumulate adequate reserves from which to lend large sums of money, banks and insurance companies act as intermediaries between those with excess reserves and those in need of financing. These institutions collect excess money (short-term assets) through deposits and redirect it through loans into capital (long-term) assets.
REASONS FOR PURCHASING CREDIT
In a production economy, credit is widely available and extensively used. Because credit includes a promise to pay, the credit purchaser accepts a certain amount of financial and personal risk. Three strategies summarize the reasons for purchasing credit:
- The lack of liquidity prevents profitable investments at advantageous times.
- Favorable borrowing costs make it less expensive to borrow in the present than in the future. Borrowers may have expectations of rising rates, tight credit supplies, growing inflation, and decreasing economic activity. Conversely, profit expectations may be sufficiently favorable to justify present investments that require financing.
- Tax incentives, which expense or deduct some interest costs, decrease the cost of borrowing and assist in capital formation.
USES FOR CREDIT
There are three major reasons why businesses borrow. The first and most common reason to borrow is to purchase assets. A loan to acquire assets may be for buying short-term, or current, assets such as inventory. This sort of loan will be repaid once the new inventory is sold to customers. The purchase of long-term or fixed assets also falls into this first category.
The second reason to borrow is to replace other types of credit. For example, if your business is already up and running, it may be time to take out a bank loan to repay the money borrowed from a relative.
The third business reason for acquiring credit is to replace equity. The desire to buy out a partner who no longer wishes to be involved with a business may be a good reason to consider borrowing.
PROMISE TO PAY
The credit contract defines the terms of the agreement between lender and borrower. The terms of the contract delineate the borrower's obligation to repay the principal according to a schedule and at a specified cost or interest rate. The lender reserves the right to require collateral to secure a loan and to enforce payment through the courts.
The lender may levy a small charge for originating or participating in a loan placement. This charge, measured in percentage points, covers administrative costs. This immediate cash infusion decreases the costs of the loan to the lender, thereby reducing the risk. The lender may also require the borrower to provide protection against nonpayment or default by securing insurance, by establishing a repayment fund, or by assigning collateral assets.
A promissory note is an unconditional written promise to pay money at a specified time or on demand. The maker of the note is primarily liable for settlement. No collateral is required. A lien agreement, however, holds property as security for payment of debt. A specific lien identifies a specific property, as in a mortgage. A general lien has no specific assignment.
The terms of the credit contract deal with the repayment schedule, interest rate, necessity of collateral, and debt retirement.
Credit contracts vary in maturity. Short-term debt is from overnight to less than one year. Long-term debt is more than one year, up to 30 or 40 years. Payments may be required at the end of the contract or at set intervals, usually on a monthly basis. The payment is generally comprised of two parts: a portion of the outstanding principal and the interest costs. With the passage of time, the principal amount of the loan is amortized, or repaid little by little, until completely retired. As the principal balance diminishes, the interest on the remaining balance also declines. Interest on loans do not pay down the principal.
Revolving credit has no fixed date for retirement. The lender provides a maximum line of credit and expects monthly payment according to an amortization schedule. The borrower decides the degree to which to use the line of credit. The borrower may increase debt anytime the outstanding amount is below the maximum credit line. The borrower may retire the debt at will, or may continue a cycle of paying down and increasing the debt.
Interest is the cost of purchasing the use of money, i.e., borrowing. The interest rate charged by lending institutions must be sufficient to cover the lender's operating costs, administrative costs, and an acceptable rate of return. Interest rates may be fixed for the term of the loan, or adjusted to reflect changing market conditions. A credit contract may adjust rates daily, annually, or at intervals of three, five, and ten years.
Assets pledged as security against a failure to repay a loan are known as collateral. Credit backed by collateral is secured. The asset purchased by the loan often serves as the only collateral. In other cases the borrower puts other assets, including cash, aside as collateral. Real estate or land serve as the collateral for securing mortgages.
Unsecured debt relies on the earning power of the borrower. A debenture is a written acknowledgment of a debt similar to a promissory note in that it is unsecured, relying only on the full faith and credit of the issuer. Corporations often issue debentures as bonds. With no collateral, these debentures are subordinate to mortgages.
A bond is a contract held in trust obligating a borrower to repay a sum of money. A debenture bond is unsecured, while a mortgage bond holds specific property in lien. A bond may contain safety measures to provide for repayment. An indenture is a legal document specifying the terms of a bond issue, including the principal, maturity date, interest rates, any qualifications and duties of the trustees, and the rights and obligations of the issuers and holders. Corporations and government entities issue bonds in a form attractive to both public and private investors.
Debt Retirement & Types of Credit
Debt retirement is the term used for the paying off of a debt. The credit contract defines the terms under which credit is issued and usually this contract also outlines how debt is to be retired or paid off. Different types of debt have different means of debt retirement.
Overnight funds are lent among banks to temporarily lift their reserves to mandated levels. A special commitment is a single purpose loan with a maturity of less than one year. Its purpose is to cover cash shortages resulting from a one-time increase in current assets, such as a special inventory purchase, an unexpected increase in accounts receivable, or a need for interim financing.
Trade credit is extended by a vendor who allows the purchaser up to three months to settle a bill. In the past it was common practice for vendors to discount trade bills by one or two percentage points as an incentive for quick payment. A seasonal line of credit of less than one year is used to finance inventory purchases or production. The successful sale of inventory repays the line of credit. A permanent working capital loan provides a business with financing from one to five years during times when cash flow from earnings does not coincide with the timing or volume of expenditures. Creditors expect future earnings to be sufficient to retire the loan.
Commercial papers are short-term, unsecured notes issued by corporations in a form that can be traded in the public money market. Commercial paper finances inventory and production needs. A letter of credit ("l/c") is a financing instrument that acts more like credit money than a loan. An l/c is used to facilitate a transaction, especially in trade, by guaranteeing payment at a future date. Unlike a loan, which invokes two primary parties, an l/c involves three parties: the bank, the customer, and the beneficiary. The bank issues, based on its own credibility, an l/c on behalf of its customer, promising to pay the beneficiary upon satisfactory completion of some predetermined conditions. A bank's acceptance is another short-term trade financing vehicle. A bank issues a time draft promising to pay on or after a future date on behalf of its customer. The bank rests its guarantee on the expectation that its customer will collect payment for goods previously sold.
Term loans finance the purchase of furniture, fixtures, vehicles, and plant and office equipment. Maturity generally runs more than one year and less than five. A large equipment purchase may have longer terms, matched to its useful production life. Mortgage loans are used to purchase real estate and are secured by the asset itself. Mortgages generally run 10 to 40 years. When creditors provide a mortgage to finance the purchase of a property without retiring an existing mortgage, they wrap the new mortgage around the existing debt. The interest payment of the wraparound mortgage pays the debt service of the underlying mortgage.
Treasury bills are short-term debt instruments of the U.S. government issued weekly and on a discounted basis with the full face value due on maturity. T-bill maturities range from 91 to 359 days and are issued in denominations of $10,000. Treasury notes are intermediate-term debt instruments ranging in maturity from one to ten years. Issued at par, full-face value, in denominations of $5,000 and $10,000, T-notes pay interest semiannually. Treasury bonds are long-term debt instruments. Issued at par values of $1,000 and up, T-bonds pay interest semi-annually, and may have call dates (retirement) prior to maturity.
The granting of credit depends on the confidence the lender has in the borrower's credit worthiness. Generally defined as a debtor's ability to pay, credit worthiness is one of many factors defining a lender's credit policies. Creditors and lenders utilize a number of financial tools to evaluate the credit worthiness of a potential borrower. Much of the evaluation relies on analyzing the borrower's balance sheet, cash flow statements, inventory turnover rates, debt structure, management performance, and market conditions. Creditors favor borrowers who generate net earnings in excess of debt obligations and contingencies that may arise. Following are some of the factors lenders consider when evaluating an individual or business that is seeking credit:
Credit worthiness A history of trustworthiness, a moral character, and expectations of continued performance demonstrate a debtor's ability to pay. Creditors give more favorable terms to those with high credit ratings via lower point structures and interest costs.
Size of debt burden Creditors seek borrowers whose earning power exceeds the demands of the payment schedule. The size of the debt is necessarily limited by the available resources. Creditors prefer to maintain a safe ratio of debt to capital.
Loan size Creditors prefer large loans because the administrative costs decrease proportionately to the size of the loan. However, legal and practical limitations recognize the need to spread the risk either by making a larger number of loans, or by having other lenders participate. Participating lenders must have adequate resources to entertain large loan applications. In addition, the borrower must have the capacity to ingest a large sum of money.
Frequency of borrowing Customers who are frequent borrowers establish a reputation which directly impacts on their ability to secure debt at advantageous terms. A history of timely loan payments creates a positive credit picture whereas a history of slow payments will work against a borrower on later credit applications.
Length of commitment Lenders accept additional risk as the time horizon increases. To cover some of the risk, lenders charge higher interest rates for longer term loans.
Social community considerations Lenders may accept an unusual level of risk because of the social good resulting from the use of the loan. Examples might include banks participating in low income housing projects or business incubator programs.
INTEREST RATES AND RISK
Lenders use both subjective and objective guidelines to evaluate risk and to establish a) a general rate structure reflective of market conditions, and b) borrower-specific terms based on individual credit analysis. To be profitable, lenders charge interest rates that cover perceived risks as well as the costs of doing business. The risks calculated into the interest rate include the following:
Opportunity cost risk. The lender fixes interest costs at a level sufficient to justify making a loan in the present rather than waiting for more advantageous terms in the future. The lender focuses on a desired rate of return rather than the credit worthiness of the borrower.
Credit risk or repayment risk. The borrower may not be able to make scheduled payments nor repay the debt at all. The greater the credit risk, the higher the interest rate. Creditors charge lower interest rates to those with the highest credit ratings, and those who are the most able to pay. In other words, those least able to pay find themselves paying the highest rates.
Interest rate risk and prepayment risk. These risks arise when the payment or prepayment of outstanding debt does not match the terms and pricing of current debt, thus exposing the lender to a "mismatch" in the costs of doing business and the terms of lending.
Inflation risk. Inflation decreases the purchasing power of money. Lenders anticipate these losses with higher interest rates.
Currency risk. International trade and money markets may devalue the currency, decreasing its purchasing power abroad even during times of low inflationary expectations at home. Since currency devaluation heightens inflationary expectations in a global economy, interest rates rise.
Financial intermediation is the process of channeling funds from financial sectors with excesses to those with deficiencies. The primary suppliers of funds are households, businesses, and governments. They are also the primary borrowers. Financial intermediaries, such as banks, finance companies, and insurance companies, collect excess funds from these sectors and redistribute them in the form of credit. Financial intermediaries accumulate reserves of funds through investment and savings instruments.
Banks provide savings and checking accounts, certificates of deposit, and other time accounts for customers willing to loan the bank their funds for the payment of interest. Insurance companies gather funds through various investments and through the collecting of premiums. Banks, finance, and insurance companies also raise cash by selling equity positions or borrowing money from private or public investors. Pension funds utilize available funds from participant contributions and from investment earnings. Federally sponsored credit intermediaries capitalize themselves in a manner similar to banks.
Financial intermediation provides an efficient and practical method of redistributing purchasing power to qualified borrowers. Banks aggregate many small deposits to finance a single family home mortgage, for example. Finance companies break large pools of cash down to sizes appropriate for the purchase of an automobile. The pooling of funds from many sources and the distribution of credit to a large number of creditors spreads the risks.
In essence, financial intermediaries are reducing risk by qualifying borrowers and directing funds into creditworthy situations. Furthermore, financial intermediation increases liquidity in the system, acting as a buffer against cash shortages resulting from unexpected increases in deposit withdrawals.
Credit securitization is one of the most recent and important developments in financing and capital formation. Securitization is, very basically, the process of pooling various categories of assets and creating securities that derive their value from the asset pool and income streams derived therefrom. "Securitization is a complex series of financial transactions designed to maximize the cash flow and cash out options for loan originators," explains the American Bar Association in a report entitled Mortgage Securitization, Servicing, and Consumer Bankruptcy. "To securitize an asset, the loan originator creates a pool of financial assets … It then uses one or more [special purpose vehicle] SPV corporations to convert the large pools of these mortgages into complex investment certificates, backed or securitized by valid liens on the transferred collateral. These certificates are then rated and offered for sale to asset capital investors, foreign investors and life insurance companies to name a few. The certificates are normally split into various types, each of which has predetermined cash flow or equity positions in the underlying collateral."
In many instances the underlying debt is mortgages, secured by real estate, and guaranteed by an agency or insurance company. For example, an underwriter may place into securitization only mortgages guaranteed by the Veterans Administration of maturities no less than 20 years, with interest rates of not less than 9 percent, and with a cumulative principal (face) value of $10 million. The underwriter sells shares in this pool of mortgages to the public. In addition to mortgages, credit instruments securitized in this way include auto loans, credit card receivables, and trade receivables.
Credit securitization supports the viability of financial intermediaries by a) spreading the risk over a broader range of investors who purchase the securities, and b) increasing liquidity through an immediate cash infusion for the securitized debt. This process is helpful to investors and borrowers alike. The large volume and efficiency of the system puts downward pressure on interest rates. The pooling of loans into large, homogeneous securities facilitates the actuarial and financial analyses of their risks.
Investors may participate in a portion of the cash flow generated by the interest and/or principal payments made by borrowers of the underlying debt. Investor participation may be limited to the cash flow of a set number of years, or to a portion of the principal when the underlying debt is retired. Investors also choose to participate at a point suitable to their risk/reward ratio.
see also Cash Management; Collateral; Equity Financing; Loans
Allen, Steve L. Financial Risk Management. John Wiley & Sons, 2003.
de Servigny, Arnaud, and Olivier Renault. Measuring and Managing Credit Risk. McGraw-Hill Professional, 2004.
Gardner III, O. Max. "Mortgage Securitization, Servicing, and Consumer Bankruptcy." GP Solo Law Trends & News. American Bar Association, September 2005.
"New Technology Makes Small Business Credit More Available." Financial Update. July-September 2005.
U.S. Federal Reserve Bank of New York. "The Credit Process: A Guide for Small Business Owners." Available from http://www.newyorkfed.org/education/addpub/credit.html. Retrieved on 3 February 2006.
Hillstrom, Northern Lights
updated by Magee, ECDI
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.
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 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 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.
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 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.
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.
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.
cred·it / ˈkredit/ • n. 1. the ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future. ∎ the money lent or made available under such an arrangement: the bank refused to extend their credit | [as adj.] exceeding his credit limit. 2. an entry recording a sum received, listed on the right-hand side or column of an account.The opposite of debit. ∎ a payment received.3. public acknowledgment or praise, typically that given or received when a person's responsibility for an action or idea becomes or is made apparent: the president claims credit for each accomplishment. ∎ [in sing.] a source of pride, typically someone or something that reflects well on another person or organization: he's a credit to his mother. ∎ (usu. credits) an acknowledgment of a contributor's services to a movie or a television program, typically one of a list that is scrolled down the screen at the beginning or end of a movie or program.4. the acknowledgment of a student's completion of a course that counts toward a degree or diploma as maintained in a school's records: a student can earn one unit of academic credit. ∎ a unit of study counting toward a degree or diploma: in his first semester he earned 17 credits. ∎ acknowledgment of merit in an examination which is reflected in the grades awarded: students will receive credit for accuracy.5. archaic the quality of being believed or credited: the philosophy of Cicero has lost its credit. ∎ favorable estimation; good reputation.• v. (cred·it·ed, cred·it·ing) [tr.] (often be credited) 1. publicly acknowledge someone as a participant in the production of (something published or broadcast). ∎ (credit someone with) ascribe (an achievement or good quality) to someone.2. add (an amount of money) to an account.3. believe (something surprising or unlikely).PHRASES: do someone credit (or do credit to someone) make someone worthy of praise or respect: your concern does you credit.give someone credit for commend someone for (a quality or achievement), esp. with reluctance or surprise: please give me credit for some sense.have something to one's credit have achieved something notable: he has 65 tournament wins to his credit.on credit with an arrangement to pay later.to one's credit used to indicate that something praiseworthy has been achieved, esp. despite difficulties: to her credit, she had never betrayed a confidence.ORIGIN: mid 16th cent. (originally in the senses ‘belief,’ ‘credibility’): from French crédit, probably via Italian credito from Latin creditum, neuter past participle of credere ‘believe, trust.’
A term used in accounting to describe either an entry on the righthand side of an account or the process of making such an entry. A credit records the increases in liabilities, owners'equity, and revenues as well as the decreases in assets and expenses.
A sum in taxation that is subtracted from the computed tax, as opposed to a deduction that is ordinarily subtracted from gross income to determine adjusted gross income or taxable income. A claim for a particular sum of money.
The ability of an individual or a company to borrow money or procure goods on time, as a result of a positive opinion by the particular lender concerning such borrower's solvency and reliability. The right granted by a creditor to a debtor to delay satisfaction of a debt, or to incur a debt and defer the payment thereof.
consumer credit consists of short-term loans made to people so that they can purchase consumer goods and services for personal or household purposes.
The term credit has various applications to transactions that involve borrowing. Credit can be used in reference to the ability to postpone payment, as in the case of an individual who has credit with a local store that allows purchase of items on a weekly basis and settlement of account due once a month. An individual might also be extended a credit line, the maximum amount of money that a lender will put at a borrower's disposal. In such case, an individual enters into an agreement for the taking out of a series of loans. Since there is a fixed limitation on the amount to be borrowed, payments must be made to reduce the debt incurred when the maximum is reached.
A letter of credit, sometimes called a creditor's bill, is a written instrument from a bank or merchant in one location requesting that anyone, or some specifically named individual, advance money or items on credit to the individual holding, or named in, the letter. Repayment of the debt is guaranteed by the bank or merchant issuing the letter. Letters of credit are popular in international commercial transactions because they enable parties to transact business without the need to exchange large amounts of cash. This type of instrument was also popular prior to the common usage of credit cards and travelers' checks.
Personal credit is granted based upon an individual's character, reputation, and business standing regarding his or her financial reliability.
Development of the Law of Credit
Traditionally, the law has sought to protect borrowers since they are easily exploitable by lenders. Often the two parties do not have equal bargaining opportunities to negotiate all the terms of the agreement, and, therefore, the stronger is able to take advantage of the more vulnerable. The established legal viewpoint is that a lender can properly charge a fee for use of the funds he or she lends, but the rate of interest should be neither unfair nor unconscionable.
usury traditionally meant charging interest or a fee in exchange for a loan, but it has come to mean charging an illegal rate of interest. Certain credit transactions, such as the loan of money pursuant to a mortgage, are exempt from the provisions of usury statutes.
Amortization Amortization—a system that allows a borrower to discharge a debt in regular, equal installments—was developed in the nineteenth century by savings and loan associations. To amortize a loan, the lender must calculate the total interest due over the term of repayment, add that figure to the total sum borrowed, and divide the total by the number of payments to determine the size of regular, periodically scheduled payments to be made by a debtor.
Morris Plans The establishment of Morris plan companies, still found in some states, was a significant development in the consumer credit business. These industrial banks accept deposits from the general public and issue investment certificates in the amount of each deposit. The certificates entitle the holder to obtain interest on a deposit at regularly scheduled intervals. The bank utilizes the funds primarily to make small loans to wage earners who are steadily employed. It is necessary for borrowers to secure two other salaried individuals to endorse the agreement. The loan is repaid in installments during the course of a one-year period.
State Consumer Laws Originally the fact that consumer loans were difficult to obtain created loan sharking—the practice of lending money at usurious interest rates—coupled with the threat or use of extortionate methods of enforcing repayment. The Russell Sage Foundation analyzed the loan shark problem in 1916 and suggested that credit should be made available to consumers. It proposed a Uniform Small Loan Law for enactment by the states that defined small loans as those under $300. A maximum interest rate of three and one-half percent monthly on small loans was suggested. The interest rate was stated as a per-month charge in order to encourage legislators to adopt the act and to prevent consumers from going to loan sharks who make a practice of concealing their true rates of interest.
The Uniform Small Loan Law was subsequently revised but was important since it made way for legal lending to consumers. It was created as an exception to state usury laws and furnished the pattern for the subsequent creation of consumer credit legislation.
Legal Rate of Interest
Interest can be computed in a number of ways, and creditors generally attempt to use the most profitable way that is within legal limits. In figuring the legal rate of interest, it is essential to determine which expenses are a part of the finance or interest charges. Not customarily considered components of finance charges are fees for filing or recording a document, for payment of an individual who does an appraisal, and for the expense of preparing documents; closing costs; and prepayment penalties.
Credit allowed consumers and borrowers the power to buy something or receive money in exchange for future repayment with added interest. Credit card companies extended credit to consumers that allowed them to be in possession of goods and services before they were paid for. Businesses often purchased their raw materials from other businesses in advance through "trade credit," the most common form of short-term credit.
Credit was extended by individuals, businesses, and governments to pay for a variety of projects or purchases. The provision of credit generated debt that had to be repaid within a specified period of time. To protect themselves from the risk that a borrower might never repay, credit lenders charged the borrower interest. Commercial banks were the most important source of credit in the United States; they had the power to expand the amount of credit available in the economy through their willingness to assume the risk of extending credit to individuals and businesses.
In 1913 the Federal Reserve System was given the power to raise or lower the interests rate that determined how "expensive" it was for banks to extend credit. When interest rates were low, banks were more willing to borrow money from the Federal Reserve, which increased the amount of credit they could extend to consumers and businesses.
The amount of credit extended to consumers and businesses grew enormously in the twentieth century. Credit growth was fueled by the introduction of the credit card and the adoption of sophisticated "credit scoring" techniques that helped lenders analyze the creditworthiness of borrowers. To help fund World War II (1939–1945) and the Korean War (1950–1953), the Federal Reserve imposed "selective controls" on the amount of credit that could be offered to consumers. However by the 1990s the willingness of U.S. lenders to extend credit and of consumers to take on credit debt created a credit crisis. In 1996 a record 1.35 million U.S. citizens filed for bankruptcy, and by mid-1996 U.S. credit card balances had reached $444 billion.
See also: Federal Reserve System