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T h e Fir s t B o s t o n C o r p o r a t io n io o B roadw ay y^fewTork February 29. 19*+0 Mr. Marriner S. Eccles, Chairman of the Board Federal Reserve System Washington, D. C. Dear Marriner: It was a pleasure to see you at the Savings Bank Journal dinner even though you have gone "high ’ net" on me and dislike government dealers because they're so superfluous. I am glad that at the meeting the question of par loans on government securities came up. We do not, in this organization, just sit here and buy and sell government securities to anyone who wants to buy them and for whatever we can make on the transaction. We have for some tine been spending considerable sums of money on studies of the investment characteristics of the government market in order that we may be as in telligent and constructive as possible when we are asked by investors what portfolio policies they should adopt. As a matter of fact, I believe you would find in checking around the country, that this organization has done more in creating an intelligent investment attitude toward the government market than possibly any other organization, and I, as far as the develop ment of the studies go, will take some measure of credit for it myself. An investment purchase of securities involves the purchase of a coupon at a premium or a discount to the optional or maturity date of the issue. In other words, the investor buys an amortized yield. An investor, for example, has practically no business whatsoever in buying Treasury 2 l/2s of September 19^-8 to yield I.5U when he can buy 2 3/*+s of March 19^8/51 to yield .lU$ more per annum for the next eight years, as at the end of that time he has received fully 1$ more in income and he has a three year 2 3 /^$ optional obligation at the theoretical equivalent of 99» Yet the par provisions for advances by the Federal Reserve System actually tells the bankers that if they have any price consciousness in their systems at all, they should always buy the issue which is closest to par and dis regard the real investment merits of the higher yield issue of comparable term. For example, if a man buys U l/Us optional October 19^7 and due October 1952, don't you think (from your analysis of the probable trend of interest rates) that he is making a b°tt,er selection on a 1.U6 yield to optional date than if he bought a fifteen point lower premium 2$ to yield 1.37 to December, 19^7 — two months longer? Mr. Marriner S. Eccles - 2 - February 29» 19^0 Yet the Federal Reserve, under its current par loan provisions, is telling the investor who ’ouys the U l/bs that he is foolish because on an advance by the Federal he will be able to borrow 15 points per bond less on the l/Us than in the case of the 2 s 19^7 1 as the price of the H l/Hs is approximately 120 and that of the 2s approximately 105» Similarly, the par loaning provisions of the Board's regulations today underwrite loans to a bank who buys 3/^ 8 Jim© I9UU within 7/8 of a point of the prevailing market, whereas if the same bank buys 3 l/^s of October 19^3/% or 19^V^6* he can not borrow within 10 points of what h6 pays for the security in the market although for these two comparable maturities the 3A $ note yields about 1/2 of 1$ and the other securities have an average yield of .60, an increase in amortized income of 20$. A man may borrow within 1 1 / 2 points of the market on HOLC 1 l/2s 19^5/^7 a M yet only be able to borrow within lH points of the market on 3 3/^s ^6/56 which are a direct obligation and yield more. Should the Treasury bring out a 1 l/2$ issue due in 19^6 » a bank could borrow on it at par or not far from what would be its prevailing market and yet if the sarae bank owned th* 3s 19^-6/^S, he couldn't borrow within 10 points of the market. In fact, therefore, the Federal is telling the banks to ignore the investment characteristics of the market in which they are d^Ling and to consider all government bonds as currency substitutes worth 100$ of the par value. I think that is all wrong and I think you would find that the greater proportion of banks in the country feel the same way. Wouldn't it be much better (since on this basis you are underwriting God knows what interest rate as it all depends on the coupon of the security) to say that on maturities of up to one year you will lend at a price equal to 1/2 of 1$ return, and on securities from 1 to 5 years you will lend at a price equivalent of 1$. Or, you could say that in the case of maturities up to 5 years you would lend at a price equal to 1 1/2$ and in the case of maturities of 5 to 10 years you would lend at a price equal to 2$, and in the case of securities of 10 years you would lend at a price equivalent to 2 1/2$. In other words, by establishing your loan provisions along these lines you would make the banks investment conscious and not price conscious. Incidentally, you ¿jestingly made the remark the other night that all government dealers want to see you only to get something from you or to ask some questions that you don't want to answer. I was sorry that you put me in that class because I have felt that through our short acquaintanceship at the Treasury, I had obteined a better grasp than the average person of how your mind worked on numerous financial and monetary problems. I naturally do not agree with you on every thing but I have had a great deal of sympathy for many of the things that you have been trying to do and much more sympathy than many bankers and others with whom I have talked. I have felt that the opinions of too many of these people are based on a loose knowledge of what you are driving at and trying to accomplish as Chairman of the Federal Reserve System. I have felt that when such things come up in discussions of which I was a part, that I have been of assistance to you indirectly in trying to point out that the premises of the criticisms were in some cases faulty. Of course this attitude of mine has been entirely unsolicited on your part but it certainly has not classified me as one wanting something that might be of interest only to a government dealer. With kind regards, larch 22, 1940: Mr* The 100 Hew Aubrey G* Laaston, First Boston Corporation, Broadway, York, New York. Dear Aubrey: This is to acknowledge receipt of your letter of February 29» 1940* I trust that you are not taking my comments on your profession too much to heart* I recognize what your problems are and that you are discharging a re sponsibility in striving to give constructive advice to in vestors. To that end, I hope you will give some thought to factors that I think you overlook regarding loans by Federal Reserve banks on government securities at pir* In place of the present simple rule you would substitute a comparatively complicated one based upon niaturity and yield. You say that you think it would sake the investor more investment con scious and less price conscious. I think its effect would be just the opposite. The purpose of the annoxmcement, that the Reserve banks stood ready to lend at par, was to assure the banks that if they felt they had any need for funds they did not have to sell their governments but could borrow on them at par at the current discount rate. Today, when excess re serves are above billions and are on the increase, and when the demand for credit cannot conceivably drain down these reserves for the banking system as a whole, there is no reason why the banks should sell their governments for the purpose of getting fmds. There is no other reason for selling them if they have been purchased for investment. Manifestly if they are held to maturity they will be paid at par. Mr* Aubrey G. Lanston ■2- Not only is it the System*s policy to encourage banks to treat their bond portfolios as investments, but examination and investment regulations adopted by the several examining agencies have the same purpose* Thus, if a bank purchases governments at a premium it is called up on to amortise the premium down to per at maturity* Also, examiners do not charge off depreciation against net capital* Every encouragement, accordingly, is given to the banks to treat the bond portfolio from the standpoint of a long-time investment and not from that of current market quotations on which your proposal is based* You should bear in mind also that Reserve bs&nk loans on governments are limited to four Months* They can be reviewed at frequent intervals if renewals are sought and there is nothing to prevent the raising of the discount rate if that appears desirable to discourage borrowing* I can see no reason why the Reserve banks should adopt any different policy on loans on governments fro® that followed in discounting ninety-day commercial paper or nine-aonths agricultural paper on which loans are made on intrinsic values and regardless of the rate that the commercial bank may be charging to its customer. The Reserve banks must lend on governments, either at par or at market* If governments are selling at a premium and a bank is not in need of funds, the only reason for selling is to take a profit* And, as I have in dicated, that is gearing the bond portfolio to the ticker* If, on the other hand, bonds are under par, the only reason for selling would be to obtain funds and unless the Reserve System were available, the dumping of bonds on a panicky market would have a devastating deflationary effect, as we have witnessed on occasion in the past. Certainly it is not in the public interest to let the bond market break to say, 83, any more than it is to deny the lending facilities of the System on other assets and allow distress selling to create a ruinous deflation* A basic purpose of the Systea, as recognized in the Banking Act of 1935, i*hen authority was broadened and made permanent for Reserve banks to lend on any sound assets, is to do all it can to prevent such a calamity* Gearing the lending facilities to the market in stead of to sound values would be wholly inconsistent with this fundamental purpose. Mr# Aubrey G. Lanston -3- If you will look at the problem with these con siderations in mind, I think you will agree with my con clusion that your proposal would not be in accordance with the public policy that should be followed. Sincerely yours, H. S. Iccles, Chairman. T h e Fi r s t B o s t o n C o r p o r a t i o n io o B roadway Tork April g, I9U0 Ur. Marrlner S. Eccles, Chairman of the Board Federal Reserve System Washington, D. C. Bear Harrlner: Thank you for your letter of March 22nd which greeted me upon my return from Bermuda last Friday. I appreciate the consideration which you gave to my letter regarding changes in the loans by Federal Reserve Banks, secured by U.S.Government securities. Since 1 agree with you on several of the points which you outline in your letter, and because we have a similar point of view on many questions, I am taking the liberty of farther discussing this matter, as our conclusions as to the best public interest are different. We both agree that all institutions should be encouraged to treat their bond portfolios as investments, and through the firm I represent, 1 have been actively engaged in fostering this point of view. It has been assumed in some quarters that dealers "live" by encouraging speculative activity. I honestly do not believe that the best dealer profits come from a speculative market. Personally, 1 prefer to deal in a market which is predominantly subject to investment activity rather than speculative activity. The market is large enough. Certainly I agree that the Federal Reserve has been most active in encouraging the investment viewpoint through its handling of the examination procedure and that this is true of other examining agencies in general. How ever, the effectiveness of current examination procedure is greatest in times of market stress and when the privilege of borrowing might, under certain circumstances, be exercised. I believe, however, that by expressing the borrowing privilege in terms of price, the importance of this single item is over-emphasised. A banker who has to be helped out at the first gust of wind is not really a private banker - he is, in some respects, a quasi public official. Investment, to me, is the purchase of an annual income and a credit risk. In governments credit risk is lacking and the annual income is de termined by yield, which is a composite of coupon, term and price. The cur rent examination procedure emphasises these three elements of investment Ur. Uarriner S. Eccles April g, 19^0 purchases, yet incongruously, the Federal Reserve Bank regulations governing government securities loans say, in effect, as an after-thought - "By the way, we ignore the investment character of your portfolio in making loans as in such instances we consider only price and pay no attention to coupon and term." The non-investing hank, or the one Inclined to he market conscious, is the one who takes greatest cognizance of the emphasis the loan regulations place on price. This hank is the one that makes most sure that it has the best "out" in case something happens to market prices. The loan regulations encourage this bank to further ignore the basic investment consideration which is yield. Such a bank prefers the lower premium 2 1/Us 51/53 to the higher premium, greater yielding 3® 5^/55 or 2 3/^8 51/5*+» It prefers them purely because of the lower premium - less price depreciation to 100. The fact that the lower premium issue is less attractive as an investment for income, is considered by such a bank to be of lesser importance. Tour letter conveys the impression that by loaning at par, the Federal is ignoring market levels. Treasury securities, however, are generally sold at par, and the coupon is adjusted to the market, so when you lend at par, you are really underwriting, in a way, the market level at which that particular security was offered. Furthermore, loaning at par on all governments, regard less of their real investment merit to a buyer, seems to be a splendid argument, if someone wishes to use it, for issuing currency instead of government securi ties. In effect, the Board's regulations say coupon and term are of no importance when compared to the currency equivalent. Tou draw a similarity between the Re serve Bank's policy of dis counting 90 day commercial paper or 9 months agricultural paper and government securities. Apparently you feel that they are about the same thing and I think they are highly different. First, they are different in their term. The commercial and agricultural paper is definitely short term and presumably self-liquidating. Governments may be short, intermediate or really long term and not necessarily self-liquidating in the same sense. There is a second difference. The commercial and agricultural paper contains a definite credit risk of varying degree. Government securities leave no credit risk in terms of dollar payment. This credit factor in the commercial and agricultural paper causes some variation in the interest rate the paper bears, aside from geographical differences in interest rates throughout the country. While super ficially each different piece of paper is treated the same in terms of face value, it is not considered the same for loan value, as you may require in individual cases more or less face value as collateral for the same dollar amount loaned. Furthermore, thec&fferent rediscount rates of the individual Reserve Banks around the country serve to partially level out the difference in the sectional interest rates. Incidentally, since government securities bear the same rate of interest wherever held, why should not the discount rate for loans versus governments, be the same for each district? Tou mention the complications of the loan provisions based on a price equal to an interest rate. The formula for figuring the interest rates which would be equitable might be a little complicated. I believe, should you ever be interested in working such a formula out, that we might be helpful. Once worked out, the interest rate provisions would not be more difficult, in Ur* Marriner S. Eccles - 3 - April 8, 19^0 my opinion« to handle than the current price provisions. Today a bank having an eye to the loaning rate of the Federal buys at 10M-, knowing it may borrow at 100. It thinks, therefore, in terms of price. By using this suggestion, the bank would look at the security as one purchased at a price equivalent to a 2.25$ basis, and on which it might borrow at a price equivalent to a 2.75$ basis* Incidentally, right there the banks start to think in terms of yield, which is their real Investment, and to think less in terms of price. I feel strongly that a change of this character in the loaning pro visions of the Federal Beserve Banks would go fturther, as a single step, in encouraging an investment attitude in bank portfolio management, than has been accomplished by any other single step yet taken. Therefore, I do believe it is a suggestion which is definitely in the best public interest. With kind regards, April 1$, 1940 M r . A u b r e y Q. Lanston, The First Boston Corporation, 100 Broadway, New York City. Dear A u b r e y : Your letter of April 8 came to the office while I was temporarily absent or I would have acknowledge its receipt before. I doubt whether we could argue this matter out to any conclusion by letter. The question of having the Reserve banks lend at par on governments was exhaustively considered for some months before the policy was announced. The presi dents of the twelve Reserve banks and their respective staffs, as well as the directors of each of the banks, and, of course, the Board and the staff here all gave the subject careful con sideration from all aspects, and so far as I know nobody shared your view that some formula should be adopted geared to the market and yield— a formula that you agree would be complicated. Even if you could persuade me to your view, as a practical matter it could not be put into effect without having the Board and each of the banks retrace the steps they have taken and publicly announced, and substitute an admittedly com plicated formula that would be hard to explain and justify, especially since the present program appears to meet the situation today adequately. 1 need not add that I am always glad to have the frank expression of your views, and recognize that you are animated, as we are here, by what appears to be in the best public interest. Sincerely yours, U. ¿>. Eccles, Chairman. ET:b
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