SECURITY OF PRINCIPAL

1. Responsibility of Borrower: Of the factors entering into the security of principal, the foremost is the financial responsibility of the borrower or user of the funds advanced. Both present and potential financial responsibilities are important considerations. The amount of the borrower's wealth and its availability to meet the principal sum when due are the gauges for determining the degree of the security of the principal. Proper use of borrowed funds is another factor the lender must consider. If a person goes to a bank to borrow money, the banker usually inquires as to the use to which the money is to be put. If the banker is told that the money is desired to play the races or for other illegitimate purposes he is very likely to refuse the request unless he is given a pledge or collateral on which he can realize the value of the sum advanced, independently of the borrower's capacity to pay. Without collateral, the banker must have full confidence that when the proposed loan comes due the borrower will have sufficient wealth on hand to pay the indebtedness. The use to be made of the wealth furnished the borrower is, therefore, frequently an important factor in determining the security of principal.

It is not sufficient for the borrower merely to have resources with which to pay the loan. There should be some means of enforcing or compelling him to pay. Hence, many investment securities have what is known as a "mortgage/' or a pledge of property, back of them. The purpose of a mortgage is to insure performance of the borrower's obligations. In case of default or bankruptcy of the borrower, the mortgage, or pledge, gives the lender, i.e., the investor, a preferred claim on property as against other creditors. In other words, he has authority to make a legal seizure of property and dispose of it to satisfy the loan. The conditions of the mortgage are scrutinized very carefully in studying the merits of various classes of investments. Most American railroad bonds are mortgage bonds. Bonds which have no mortgage security are known as "debentures," or plain bonds in the United States. The distinguishing characteristics of these two classes of securities are discussed in detail in a later chapter.

2. Durability of Assets

A further element in the security of principal is the permanence or durability of the assets which secure the investment. If a person is loaned $1.000 with the agreement that he pay it back in twenty-five years, and the only security he gives is a pledge of a frame building with no provision requiring that it be kept in repair and in as good condition as when the money was loaned, the lender may find no value at all to the security at the end of the twenty-five years. Hence his principal may be lost.

A careful investor demands that provisions be included in the mortgage to guard against future losses of value. For this reason most loan agreements secured by a pledge of property contain a provision requiring maintenance and repairs, as well as insurance against accidents, fires, floods, and other contingencies. In this way the investor, though not always having the right to take possession and control of the pledged property, is given some indirect means of protecting the principal of his investment. This matter will be discussed in more detail in Chapter III.

3. Market Value or Earning Power

Another element in the security of the principal is the character of the property safeguarding the repayment of the investment. The property should have what is known as "market value," or marketability. In other words, the property or assets should be readily transferable. This does not mean that pledged assets should always be of a nature to command ready purchasers and be instantly disposed of. In some cases it may be desirable that the loan be secured by a pledge of, or the title to, quickly salable commodities and goods. Frequently, however, the property may have no fixed or definite market value that may be determined from day to day by reference to current price quotations. Yet it has an investment value, particularly if the assets are capable of profitable employment. A railroad, for example, cannot be said to have market value, because if it fails to repay the principal on its secured indebtedness it cannot be carried off, or broken up and sold.

But if the property has good earning power and is in good physical condition there is likely to be some person or group of persons who will assume the loan and become responsible for the repayment of the principal.

A security which is regularly quoted and sold on a stock exchange, and can be disposed of at any time, has much of the character of a demand loan, the maturity of which is determined by the will or discretion of the lender as well as the borrower. A holder of United States Steel Corporation 5 per cent Sinking Fund Bonds can sell them at any time during the market hours and get back a sum representing the principal, though not necessarily the amount of his original investment, in much the same way as he could demand payment of a "call loan" secured by collateral. There is, however, one important point of distinction. The holder of a demand obligation, or call loan, has the right to receive back at any time the principal amount or face value of the obligation. On the other hand, the holder of an unmatured obligation if he wishes to realize cash for his investment may receive back more or less than his original outlay, depending upon the position of the market price.