179. Long Bills From Loaning Foreign Money

The second class of bankers' bills originates from loaning operations. To appreciate fully the nature and standing of these bills, it is necessary to understand the mechanism of the loaning of foreign money in this market. Take, for instance, the case of a house in London which decides to lend money out here. Its American correspondent is notified, and the question having been settled as to whether the loaning house wants to take the risk of exchange and accept a fixed rate of interest on the money, or whether the loaning house would rather accept a commission and leave the risk of exchange to the borrower, the operation goes forward about as follows:

Suppose the London house to have chosen that the loan shall bear, say, 4 per cent interest, the risk of exchange to be taken by itself, the lender. The first step is the drawing by the American house of an amount of ninety-day exchange exactly equivalent to the amount of American currency to be loaned out. Thus, if the loan is to be for $100,000, and the rate realizable for ninety-day exchange is 485, the American house draws a draft on the lender in London for £20,618. This draft it sells in the open market, realizing thereon exactly $100,000 which, upon deposit of satisfactory collateral, it turns over to the firm here to whom the loan has been made. The latter will then have the use of the $100,000 for ninety days, at the end of which time it must pay it back, plus 4 per cent interest, to the American correspondent of the English lender.

So far as the actual borrower of the $100,000 knows, the loan is a regular loan of American currency - he has no way of knowing that the money he is receiving is a product of bills of foreign exchange, or, indeed, that there is any question of foreign exchange involved. He has borrowed $100,000, and at the end of ninety days he will have to pay it back with 4 per cent interest. Beyond that his concern in the matter does not extend. But with the two banking houses who have lent the money the case is different. With them it is very much of a question of foreign exchange rates. They began the operation by selling £20,618 of ninety-day sight bills, and at the end of ninety days those bills will come back and have to be paid. What rate has to be paid in order to secure demand bills with which to meet the maturity of the "nineties" originally sold will have a good deal to do with what they will make on the transaction. If, during the life of the loan, exchange rates have gone down, they will be able to buy in the necessary demand exchange at a low price and make good profit on the transaction. But if rates in the meantime have risen, a price may have to be paid for the necessary exchange which will wipe out all profit on the transaction. Not infrequently it happens that enough of a rise in exchange takes place to cause the whole operation to show an actual loss to the lender.

In the other kind of a foreign loan where the lending banker does not care to take the risk of exchange, he lends out bills of exchange instead of dollar proceeds of bills of exchange, and charges a commission instead of a fixed rate of interest. The borrower, in this case, instead of receiving a check for $100,000, would receive a ninety-day bill for £20,000. This he would immediately sell for dollars, but when the time for repayment came along three months later, he would have to pay back, not dollars but a demand draft for £20,000 plus the commission (usually % per cent on ninety-day loans). In this case it is evident that it is the borrower who takes all the risk of exchange, the cost of the loan to him depending upon what he has to pay for the £20,000 demand which he must return at the end of ninety days. The banker, of course, makes only the commission, but that is fixed - he knows exactly what his profit is going to be.

Because of the speculative element which attaches to loans of foreign money in this market, they are a favorite form of operation with many houses. Take, for instance, the case of a borrower of money who figures out that the exchange market is bound to decline within a few months. By getting some foreign banker to lend money to him on the basis of his, the borrower, taking the risk of exchange, he can practically get himself short of the exchange market, and if he is right in his forecast he can get the use of the money for nothing, or even make a profit out of the deal. Similarly with the banker. Frequently it happens that foreign money is pressed on the market here on the idea that exchange rates are about to go down and that the lender of the money, by assuming the risk of exchange himself, can make a big return on the money put out.