This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
There is a fundamental difference - as will be emphasized from time to time in this volume - between short-term borrowing and long-term borrowing. While they tend in certain isolated cases to merge into each other, the distinction, as has already been pointed out, is for practical purposes clearly marked.
The simplest form of long-term or "funded" borrowing is the ordinary mortgage on real estate or, as it is more correctly called, the bond and mortgage. The form of this instrument is almost as ancient as law itself. It purports to be a transfer of the title to a piece of real estate from the former owner to a new owner, with the proviso, however, that the title may be redeemed by the former owner by his repayment, at maturity, of an acknowledged debt which he obligates or. "bonds" himself to repay. Although this is the immemorial form, the instrument does not, as a matter of practice and of legal interpretation, actually convey ownership of the property cited; its effect, in spite of the wording of the mortgage, is merely to pledge the property as security for the repayment of the loan. There are varying forms of the bond and mortgage in the different states which may not be covered in all their details by the description given above, but the essential characteristics of these bonds and mortgages are the same in all cases.
The bond and mortgage is used ordinarily for relatively small amounts. It is the favorite form under which individuals who own farms, city real estate, and other property, raise long-term loans secured by this property. It is frequently used also by smaller partnerships and corporations. But there are, of course, some obvious drawbacks to this form. In the first place, it is necessary for the mortgagor to find some one who is willing to invest the whole amount named in the bond in a lump sum. This may not be difficult so long as the sum is small. Mortgages are very commonly taken by savings banks and other institutions as well as by individuals who reside in the neighborhood of the property mortgaged and therefore are acquainted with it and at the same time are able and willing to advance the sum of money that is required. Within recent years there has been a concerted and successful effort to extend the market for farm mortgages, and a number of brokers operating in the agricultural states west of the Mississippi have built up successful businesses in selling mortgages direct to investors in the eastern states. Nevertheless the limitations make this a relatively inefficient and uneconomical method of raising funds.*
The mortgagor of a piece of property may wish to borrow, let us say, $20,000. He finds three men, one of whom could lend $10,000, one $8,000, and the third, $2,000, but no one who is in position to lend $20,000. All insist on being protected by a first mortgage. How is the difficulty to be solved? The answer is to be found in separating the bond and the mortgage. Let the mortgage be drawn in favor of some disinterested party who will hold it, as trustee, for the lenders of the money. Let a bond, or promise to repay the sum advanced, be given to each lender, the bond to be secured by the claim on the property which has been given to the trustee. By separating the bond and mortgage we have made it possible to secure the money that is needed from any number of different sources and yet have given the same protection to each lender that would be obtained by an individual who might advance the whole sum in a lump.
* In most other countries where agriculture is highly developed there are "mortgage banks" which make it their business to receive and hold in trust mortgages of farm land and to issue their own bonds based upon these mortgages. It is thus possible to secure for farmers the same advantages that are treated in the next paragraph and that are now secured in the United States almost solely by large corporations.
Several years ago, for example, John Wanamaker, who was at that time individually the owner of his Philadelphia store, wished to borrow $10,000,000. It would have been a difficult thing to find one man or one institution that was willing to lend $10,000,000, but it was not especially difficult to give one mortgage for this sum, to issue 10,000 bonds each for $1,000, all equally secured by the mortgage, and to sell the bonds to investors. It is in this manner that the mortgage bond issues of corporations are created.