The Panic of 1907

The Panic of 1907

The panic of 1907 was a short-lived financial crisis that saw the New York Stock Exchange (NYSE) tank over 50% off its previous year’s highs. An ambitious speculative bid to corner the lucrative copper market failed, triggering a collapse of two major brokerage firms. The ensuing panic saw runs made on New York banks and the then-popular trust companies as depositors rushed to make withdrawals. It took the intervention of JP Morgan and other major financiers to stem a full-blown crisis. The impact of the 1907 panic on the monetary system is still felt to date because it highlighted the importance of a central banking system and laid the foundations of the establishment of the US Federal Reserve.

The Background

The 20th century started with the US not having any form of a central bank. The money supply in the economy was very much influenced by agricultural cycles. Money flowed out of New York during the harvest period, and to attract funds, the government raised interest rates. This had the effect of also attracting European investors who were keen to take advantage of the higher rates. In January 1906, the markets that had been in a prolonged period of steady upward drift started retracing. The market correction was then accelerated by a contraction of the money supply throughout the year. First, an earthquake hit San Francisco in April 1906 and money flowed from New York to aid in rebuilding efforts. Over in London, interest rates were hiked and European investors now had the incentive of investing closer to home. Furthermore, a maximum return was set for railroad securities – a regulatory intervention that obviously diminished their appeal.

The volatility spilt over into 1907 when other notable events continued to pile negative pressure on the economy. A major stock, Union Pacific, tanked significantly in June, during the same month that New York bonds were floated unsuccessfully. But it was the spectacular failure of two brokerage firms to corner the copper industry that inspired public panic, which eventually led to runs made on banks and trust companies.

The Collapse of Brokerage Firms

Augustus Heinze and Charles Morse were the reputable brokerage firms that attempted to take control of United Copper Company, one of the biggest players in the lucrative copper industry. The proponents of the idea believed that most shares of the company had been borrowed by short-sellers who were betting on lower prices. It was planned that artificial demand for the stock would be created, and the short sellers would have no option other than to sell their holdings to the broker duo, at a loss of course. The plan was set in motion on October 14th, with shares of the company trading at circa $39. By the next day, after aggressively purchasing shares of United Copper, the stock was trading at more than $60, and the two brokers issued a call for short sellers to return their stocks. But what seemed like a brilliant plan backfired as short sellers were able to find other sources of obtaining the stock. That day, the stock closed below $30, and the next day it tanked to circa $10. The brokers were ruined, and because the scheme was financed by leverage, the impact spread further out.

The Impact on Trust Companies

Trust companies were a mainstream feature in the 1900s, and they operated as shadow banks that accepted deposits. They were state-chartered banking intermediaries, but they were only required to maintain a 5% cash reserve to deposit ratio. National banks were required to maintain a 25% ratio. The lax rules for trust companies were a potential cause for worry, but they were not considered a central part of the payments system and still commanded very low volumes compared to national banks.

One of the biggest trust companies at the time was Knickerbocker Trust Company.  It was backed by influential figures in the New York financial scene and was one of the financiers of the failed copper cornering scheme. These links saw investors make a run on the company. On one particular day, cash withdrawals of over $8 million were made, and eventually, the broker declared bankruptcy. It did not help that JP Morgan announced that it would not work as a clearinghouse for the trust company.

Panic Continues

Knickerbocker Trust Company was not the only financial company associated with the directors of the collapsed brokerage companies. As elite financiers, they held directorships on numerous banks. Depositors rushed to make withdrawals out of every other bank associated with them. Initially, there was not much of a systemic collapse because funds withdrawn from one bank would be deposited into other ‘reputable’ banks. But the panic only increased, and neither banks nor trust companies were willing to continue lending money. Brokerage firms, in particular, saw their borrowing rates soar to over 70%, leading to the collapse of several of them. By the end of October, stocks were trading at lows only witnessed in December 1900. Trust companies and a couple of other national banks failed to survive during this crisis. Low public confidence in financial institutions meant that the financial system was staring down a black hole in desperate need of immediate help.

JP Morgan Intervention

JP Morgan was the president of the bank named after him, JP Morgan & Co. He was one of the leading and most influential bankers at the time, and he sought to provide a solution when he got news of the crisis going on. He convened a meeting of other top financiers that included the then wealthiest man in the US, John Rockefeller. The team looked into the books of several trust companies and banks and decided which ones were insolvent and which ones should be saved. All firms that were supposed to be saved all managed to survive the crisis. The collective action saw major banks raise funds periodically and on short notice to inject capital into the economy. This action was combined with press messages intended to inspire public confidence.

But the public contempt towards the financial community would take a while to reverse. Despite the numerous interventions, many banks, brokerage companies, and even New York City were still vulnerable and needed special financing to avert different complex financial problems. In addition to press messages and capital injections, the financiers also sought the help of clergy in calming their congregations.

The Formation of the Federal Reserve

Even before the 1907 panic, there was always debate on the difference between the European and US banking systems. Unlike in the US, Europe had central banks and in times of crisis, the government was able to intervene proactively to solve any issue. On their part, top banks and financiers were not able to sustain periodic capital injections to salvage a financial system that had made them so rich and powerful. This inevitably led to the debate of a central banking system in the US.

In the aftermath of the 1907 panic, there was a meeting convened by legislator Nelson Aldrich to discuss the US monetary and banking system. The meeting tabled its design for a central banking system in January 1911. It was debated by legislators for almost two years, and on December 23rd, 1913, Congress passed the Federal Reserve Act. The Federal Reserve System was created, and Charles Hamlin became the first chair of the bank.

Lessons Learnt

The panic of 1907 is a clear illustration of the importance of a central banking system. The US was facing liquidity or money supply problems before the panic, but even during the crisis, runs were made on healthy trust companies and banks. Central banks play important roles in ensuring the stability of financial systems, and they can also formulate and implement monetary policies that boost or limit liquidity as demanded by the economy. Central banks also regulate banks and other financial institutions to ensure that they are not exposed in a manner that may damage the economy.

The value of a central bank is even more important nowadays compared to over 100 years ago. The financial system today is enormous and highly complex, while technology has also ensured that both transactions and information spreads much faster than before. Any vulnerability now can be very devastating if not resolved efficiently.

The 1907 panic also gave a blueprint on how best to save companies during a crisis. While every company deserves a second chance when things fall apart, the priority must always be healthy and fundamentally sound companies. If necessary, insolvent companies with negative fundamentals can be let go so that they do not drown others.

Final Word

The panic of 1907 is a tale of how a recession degenerated into a contraction due to limited money supply and runs made on banks and trust companies. The excesses of market participants who attempted to corner  the market are also highlighted. But it is in the eventual formation of the Federal Reserve that ensures the panic of 1907 will forever be etched in our memories of the US.