The CHAIRMAN. All right, Mr. Presley, we are very much obliged to you.

Is Mr. Thomas in the room?

STATEMENT OF WOODLIEF THOMAS, OF THE RESEARCH STAFF OF THE FEDERAL RESERVE BOARD

The CHAIRMAN. Mr. Thomas, will you qualify by telling us what your full name is, what you have been, and what you are?

Mr. THOMAS. My name is Woodlief Thomas. I am on the research staff of the Federal Reserve Board at the present time, having been here since September on leave of absence from the Federal Reserve Bank of New York. I was there for 3 years, and in that time, among other things, I attempted to make a careful study of the question of brokers' loans, and the use of credit in stock-market speculation.

In connection with that study, while I happened to be in Europe for another purpose, I also made a short and more or less superficial inquiry into the ways in which stock market speculation is financed abroad-in London, Paris, Berlin, and Amsterdam.

Before being with the Federal Reserve Bank in New York, I was for a year and a half in Berlin with the economic service of the transfer committee, connected with the Office of the Agent General for Reparations Payments. Before that I was for 6 years in Washington with the Division of Research and Statistics of the Federal Reserve Board. I should like to limit my statement here to a description of the credit aspect of the stock markets; how speculation, or stock trading, if you prefer, is financed; what credit is obtained; how it is obtained; through what sources, and where the money comes from.

All stock speculation, or practically all, is financed by the use of credit. It is, of course, entirely possible for someone to buy stock and pay for it in full, with the idea of selling it a short time later at a profit. If that were done, however, the amount of speculation would be relatively small, because it would be limited to supply of savings and would not incur the expansion of speculative activities on the basis of credit.

Now, the types of credit that are used in the stock market can be roughly classified, very roughly, in three general forms or stages. (1) An individual trader can go to his bank and arrange to purchase securities and borrow on them part of the purchase price.

(2) An individual trader can open an account with a brokerage commission house. By that process he has an open account and he can readily buy or sell, as the case may be, and the broker will arrange the necessary financing, except for a certain margin which the trader will put up.

(3) The third form of stock market credit, represented by the socalled "broker's loans", involves the relationship between a broker on the one hand and a banker or some other lender on the other hand. A broker, in order to finance transactions for his customers must go out and borrow from other lenders, generally from banks.

In regard to the first two types of credit, which involve the relations of the individual trader to a borrower, there are certain differences that might be pointed out between a stock trader, operating on the basis of bank loans and one operating on the basis of an account with a brokerage commission house.

In the case of a bank loan, the trader gives a note for certain specified amount. He signs the note. It is turned over to the bank. If he increases his commitments, he signs another note. As he makes payments on these loans, his note is credited by corresponding amounts and the debt is reduced. In the case of a trader operating through the brokerage house, all debits and credits are made on an open book account, under certain agreed upon provisions, or rather certain requirements by the brokerage house as to what the customer shall do.

The customer may sign a slip covering these requirements but he signs nothing showing the size of monetary obligation.

There is also a difference between a bank loan and a brokerage account in respect to title of the securities. In the case of a bank loan, the individual borrower generally retains title in the security and simply pledges it as collateral for the note. In the case of a brokerage account, the broker generally holds title to the security and has the right to hypothecate it in turn as security for his own loans at a bank. Generally, that right is given expressly by a little statement, which the customer must sign and which also appears in the broker's monthly statement, to the effect that the broker retains that right to hypothecate securities held on margin.

There is another distinction between bank loans and brokerage accounts, one which is rather important. In general, it may be stated that banks are a little more particular about whom they make loans to than a brokerage house. A bank will ordinarily make some credit investigation and find out about the credit standing of the individual. As a matter of fact, a bank will generally not make a loan to anyone who is not a customer of the bank, maintaining a deposit.

In the past, certainly in case of some brokerage houses and perhaps to a certain extent at present, it has been relatively simple to open up an account with a broker. The chief requirement was that the account should be adequately margined. If a man came in with $10,000 worth of securities and an order to buy, or to sell, he generally found it relatively easy to open up an account. That is not the case in the market in London, for example. One has to be a gentleman to have an account with a broker in London. He has to have a credit reference from his bank. He has to show ability to meet his obligations in case there should be any difficulty. Altogether it is a difficult process to open such an account. Partly for that reason they do not

have much margin trading in London.

I understand that many of the more reputable brokerage houses in this country recently have made it more difficult to open up accounts; they require credit references and make some sort of an investigation.

Another difference between banks and brokerage houses in respect to credit for stock-market purposes, is the matter of margin requirements. I think it is customary for a bank to require a little larger margin than would be true with a broker. But, also, the banker has an additional margin which a broker does not have in that the borrower maintains a deposit balance with the bank against which the bank has always a claim in case of difficulty.

A very important difference from the standpoint of the stability of the stock market is that the broker feels a little freer about selling out his clients in case of an under-margined loan, although a bank

has, and often exercises the right to sell collateral behind a loan that is insufficiently margined. In case prices of stocks, that are given as collateral for the loan, decline and the loan becomes under margined, the broker may sell, mostly without notice or with a very short notice. The banker generally feels that he has a more responsible relationship to his customer and will carry him along a little further. That may or may not be an advantage. Sometimes it proves to be a disadvantage. It means, however, that the market is less subject to erratic fluctuations because sell of under margined accounts actually intensifies the decline in prices and thus other margins are affected.

The banker can afford to take a little more risk because of the additional security he possesses. He has a note, a little more margin, and the customer's deposit and he has made a more careful credit investigation, so he is generally surer of his ground.

It is true that there have been times in the past when the banks have gotten into difficulty by not selling out their borrowers more promptly, but I might say that those times have been partially due to the very practice of the brokers selling out their clients. The broker will claim that stock-market credit is the safest sort of credit and, as a matter of fact, there are very few records of any losses, simply because the broker is always careful about selling his client out before losses are reached. But that throws the burden on others who do not happen to sell out, especially on the banks that hold collateral behind loans. If the bankers and the brokers and everybody else attempted to sell at the same time, the broker would not always be so fortunate. These differences, in general, describe the nature of the relationship between a customer and the broker. I think I might explain a little more fully the matter of margins.

When an account is opened with a broker, the trader may deposit a certain amount of cash or he may deposit securities. If he wants to buy, say, $10,000 worth of securities, he may give the broker $2,000 in cash, and establish an account. The broker then buys the securities for him at $10,000, and establishes a debit balance on his books against the customer for the remaining $8,000.

On the other hand, the customer may buy the $10,000 worth of securities, and create a debit balance to the full amount of $10,000, but add an additional $2,500 of securities as a margin, giving him what may be called a 20 percent margin in both cases.

There are apparently two ways of figuring percentages of margin. One is to compute the percentage in relation to the total value of securities held. The other is to compute the percentage of margin in relation to the debit balance or amount of loan that the customer may have obtained from his broker. For example, if a customer has a debit balance of $8,000 on a $10,000 commitment, he might be said to have a 20 percent margin, $2,000 in relation to the $10,000, or he may be said to have a 25 percent margin, relating the $2,000 to the $8,000 loan.

In this bill, there is a requirement that under certain conditions the lender cannot advance over 40 percent of the market value of the security. The margin in that case may be called 60 percent, or it may be called, as I noticed in the papers Mr. Whitney has called it, 150 percent.

Last August the stock exchange made a ruling that a minimum margin of 30 percent of the debit balance would be required on each

account having a debit balance of more than $3,500. This permits a broker to make loans up to 77 percent of the value of the collateral, maintaining a margin of only 23 percent against the collateral. It is my understanding that it is, however, the practice of some houses to require 30 percent of the value of collateral, which is a margin of 43 percent, according to the stock exchange method of computing margins against debit balances.

In the case of short selling, there have been various practices with respect to margins. A customer who has sold short has a credit balance with the broker on cash account. That is, the broker owes him money, because he has sold securities for the customer and he has obtained cash returns for these securities. On the other hand, the customer owes the broker for the securities, so he has a debit balance on securities account.

The broker generally requires sufficient margin to protect himself against a rise in the prices of those securities, but frequently it happens that a trader may be long on some securities and short on others, and in the past, at any rate in some cases, the brokerage house has considered that one margin was sufficient, because of the likelihood that if stocks went down, they might all go down together, or if they went up, they might all go up together and losses or gains on long account would be offset by gains or losses on short account.

In

The next question is how the broker finances his operations. the course of a day's trading, the broker will buy and sell a great number of securities for a great number of people. The process whereby these transactions are settled is a more or less complicated one, but an exceedingly efficient one. The Stock Clearing Corporation of the New York Stock Exchange receives statements from every broker at the end of the day showing stocks sold and bought, prices at which they were sold and bought, and the dollar value of commitments on both sides. These are all balanced against each other, and each broker obtains or delivers simply the differences. A broker, for example, may sell 500 shares of United States Steel for a number of customers, and may in the course of the day buy 200 shares of Steel for other customers. He will the next day have to deliver only 300 shares.

The brokerage house also has to make other payments in the course of the day. The customer may have a debit balance with the broker

Mr. MAPES. May I interrupt to ask you if that situation will be changed by this bill, the provision which requires the broker to keep the interests of customers separate?

Mr. THOMAS. I should not think it would.

Mr. MAPES. It would have any effect on that feature?

Mr. THOMAS. I should think that might be subject to regulation by the Commission under this bill. The clearing process is largely a bookkeeping transaction, as in clearing houses for banks, etc. I do not believe the bill would involve any change in that respect.

The broker has to make a lot of other payments in the course of the day. For example, he has to pay out taxes, interest, commissions. He may have a loan which is called. Customers may have credit balances with brokers from time to time, and may decide to withdraw them. On the other hand, a broker receives a lot of money in the course of the day. He may get new margin accounts in the form of

cash from customers. He may collect interest and dividends on securities held and he may collect commissions and fees.

These vary from day to day. They vary at month ends, for example, brokers maintain very small cash balances, and they are practically always, until the last few years, indebted to banks or to other interests, so that if they get any more cash in the course of the day than they spend, they use it to reduce their loans. If they have to pay out more than they receive they will increase their borrowings. It would be interesting to examine a broker's balance sheet in order to see the relationship between the different items and to find out why brokers have to borrow, and the various factors that effect borrowings. Unfortunately, the Stock Exchange has never seen fit to publish any composite broker's balance sheet. We do not know exactly what their corditions are, although we know that brokers are always borrowing.

The amount they have to borrow may vary with a number of factors. Generally, the most important of these are the customers' debit balances. That is, the amount of commitments the customers have made; the amounts customers owe the broker for securities the broker has bought for them.

The broker may decide to keep a certain amount of his funds in cash. As I have said that is generally a very small amount.

On the other hand, he may obtain funds from other sources. For example, he has the partners' capital, and he has customers' credit balances. These credit balances are of two sorts. They may be credit balances against short sales or may be so-called "free credit balances", which are practically the same as cash deposits. If a broker can get a lot of deposits from customers, then he does not have to borrow. Deposits are in effect borrowings, but they may be used to reduce bank loans. It is entirely possible to have a situation. where a broker would not have to borrow outright at all. This would be true, for example, if all long accounts were exactly balanced by short accounts. That really is quite a technical point, but is what happens in the case of term settlements, which is the practice on European stock markets. In London, for example, purchases and sales are made to be settled at the end of 2 weeks, so that in reality all sales are short sales for a period of 2 weeks, and all purchases are contracts to purchase and pay at the end of 2 weeks. Thus, for the 2 weeks' period no one has to borrow money; the sellers really give the purchasers credit for that time. At the end of the period they have to settle up and some of them may have to borrow in order to pay.

As I have said, however, brokers generally are borrowing, because the long commitments of their customers are always much larger than the short commitments.

Brokers can obtain funds from a number of sources. They can borrow from a bank, with whom they have a customer relationship, just as any business man can go out and borrow from his own bank. They can borrow at the money desk of the stock exchange from sums offered by banks or other lenders to any member of the exchange, who will take the money at the rate established. They can also go to money brokers that operate in the so-called "outside market", lending to brokers funds obtained from various types of lenders.