How The Panic of 1907 Ushered in The Federal Reserve

Coming to you live from The Panic of 1907.

“The market is like a large movie theater with a small door. And the best way to detect a sucker is to see if his focus is on the size of the theater rather than that of the door.” — Nassim Taleb

The Panic of 1907 was a three-week financial nightmare that took place in the United States. Starting in mid-October, the NYSE dropped nearly 50% from the highs one year earlier. At the time, this would prove to be the final blow to the already bedeviled National Banking Era beginning in 1873, then continued in 1884, 1890, and 1893. “Bank panics” are distinguished by the attempts by clients who all concurrently pull their cash from the system, often in mass hysteria, because banks don’t keep a 100% reserve against deposits. Therefore, it paid to be near the front of the line of when the sh*t hit the fan. 1907 differs from previous market crises because the attention was so hyper-focused on the NYC trust companies.

Once the public ethos tuned into the uneasiness surrounding potential illiquidity or insolvency of their banks, frenzy ensued and consumer confidence plummeted as hoarding cash was the only option left. On October 16, 1907, F. Augustus Heinze devised a coup to juice the United Copper Company stock, only to foozle miserably. Despite the fact that United Copper was an insignificant firm in comparison to its competitors, the crumbling of Heinze’s ploy revealed a dark web of Wall Street banks, brokerage houses, and trust companies, and their alleged commingling. It’s believed that the unearthing of close ties betwixt bankers and brokers severely exacerbated the public angst.

Under more favorable economic circumstances, a plot like Heinze’s might not have had the power to put a pin in the bubble, but conditions were unusually atypical in 1907. The economy would hit the breaks, the stock market was dragging down toward bear market territory, credit supply was shriveling causing interest rates to go up, and there wasn’t a trustworthy central bank or lender left to turn to. Thus, there was no well-grounded way to expand the U.S. money supply.

Monday, October 21st, is when the real panic started. That afternoon, the National Bank of Commerce declared it would no longer clear checks for the Knickerbocker Trust Company, the third largest trust in NYC. Vincent Carosso said the run on Knickerbocker was put into motion as early as Friday, October 18, when Knickerbocker president, Charles Barney, was purportedly an accomplice in Heinze’s copper conspiracy. Using both public and confidential business records of J.P. Morgan, Carosso notes that the National Bank of Commerce had been handing down loans to the Knickerbocker to ward off future bank runs. What’s more, the National Bank of Commerce’s refused to continue acting as a secure clearing agent for Knickerbocker— when there’s smoke there’s fire, and this agitated Knickerbocker clients.

On October 21, J.P. Morgan sought out a top secret meeting of trust executives to brainstorm measures to resolve the widespread panic. Morgan, along with James Stillman of National City Bank and George Baker of First National Bank, assembled a team of several young financial experts in charge of evaluating assets of troubled institutions and decided the ones who would qualify for aid. Among these junior market wizards was Benjamin Strong of Banker’s Trust Company. [who later became president of the Federal Reserve Bank of New York] Strong told Morgan he was unable to assess Knickerbocker’s financial state before funds would have to be pledged. Morgan was hesitant, as time was of the essence, and decided against aiding the trust, a decisive move that steered other institutions away from stepping up to plate.

A cartoon on the cover of a 1910 Puck Magazine, titled: ‘The Central Bank – Why should Uncle Sam establish one, when Uncle Pierpont is already on the job?’.

Tuesday, October 22nd, Knickerbocker underwent a savage bank run for three hours before suspending all transactions at noon, having shelled out $8 million in cash. Withdrawals from Trust Company of America came to $1.5 million, and following a New York Times article which spurred further distress, depositors withdrew another $13 million of the nearly $60 million total reserve. During this brief stint of economic uncertainty, the Trust Company of America paid out $47.5 million in deposits.

The collapse of the Trust Company of America and Lincoln Trust (another bystander that could no longer mask its’ downfall) resembles the fall of Bear Sterns and Lehman Brothers in 2008. 1907 was preceded by the Gilded Age during which mammoths like Standard Oil ran the economy and astronomical growth catered to the upper-class in a concentration of wealth. Roosevelt referred to the “predatory man of wealth” in one of his speeches, which rings true in the period before the 2008 Recession, which was characterized by loose monetary policy and an inflated stock market. Similarly in 1908 in order to revive financial markets, the five leading trust company presidents teamed up to assist cash-poor trusts. But to make matters worse cooperation from the trust committee’s was nil, so they had no choice to but to page Mr. Morgan for assistance.

Wednesday, October 23rd rolls around, and J.P. had accepted the likelihood of getting the trusts to concede, but also foresaw the economic ramifications of insolvent trusts. After a meeting late into the night, Morgan concluded that Trust Company was worthy of a bailout and handed over about $3 million just before the days end, allowing the Trust Company to open up the following day— business as usual. Even John D. Rockefeller threw his $10 million dollar care package into the Union Trust and, much to his chagrin, announced his support for rival J.P. Morgan. [Rockefeller v.s. Carnegie & Morgan] After top New York financiers met with the Treasury Secretary on October 23 to discuss a plan of action, the Treasury deposited a cool $37.6 million in New York national banks and provided $36 million in small notes to meet bank run demand. By November, the U.S. Treasury’s working capital had already capitulated to a meager $5 million and could no longer contribute financial assistance. While the top financiers were working out the crises with the trusts and the call loan market, the bank’s cash reserves were running low.

On October 26, the Clearinghouse issued loan certificates to the public, a strategy used in past financial downfalls in 1873 and 1893. In doing so, Clearinghouse loan certificates gave banks the option to convert their noncash assets into cash during a crisis: e.g. banks would sub out loan certificates for cash, thus releasing the funds to pay off clients who came to the doorstep with pitchforks demanding cash.

At first, trusts were dubbed conservative institutions. They were managing estates, holding securities, and taking in deposits. By 1907, it was a whole new ball game; trusts were performing the same functions as banks, except issuing bank notes. Many of the big-whig trusts specialized in underwriting security issues, while the others wrote mortgages or invested directly in real estate activities that were off-limits for national banks. NYC trusts had a higher proportion of collateralized loans than the NYC national banks.

The Clearinghouse acted as a force field to its members from bank runs in 1907, where there were virtually no runs on deposits. Shoutout to Mr. Morgan and his cronies, as they were the last resort lenders we required to stabilize to the system, and even though they made a considerable chunk, the increased default risk made the possibility of future recession lending less attractive. Ultimately, this forward outlook is what resonated with the bankers; it forced them to cast aside their title as de facto shylocks of last resort lending and set the groundwork for the integration of the Federal Reserve System.

Following the catastrophic year of 1907, the movement for banking reform picked up momentum across all parties, including Wall Street bankers, Republicans and Democrats. A yuge portion of the country was skeptical of bankers, and after two decades of minority status the Dem’s regained control of Congress in 1910 and were able to block a multitude of attempts at Righty reform, even though they knew there was a need for change. As always, it was more important to further political power than to do the right thing.

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