Panic of 1907

Based on Wikipedia: Panic of 1907

In the autumn of 1907, one man's hubris brought the American financial system to its knees. His name was Otto Heinze, and his scheme was elegant in its simplicity: corner the market on copper stock, squeeze the short sellers, and walk away fabulously wealthy. Instead, he triggered a cascade of bank failures that would reshape how America manages its money forever.

But we're getting ahead of ourselves.

A Country Without a Central Bank

To understand the Panic of 1907, you need to understand something strange about America at the time: it had no central bank. President Andrew Jackson had let the charter of the Second Bank of the United States expire in 1836, and for the next seven decades, the nation stumbled along without any institution capable of managing the money supply or injecting cash into the system during emergencies.

This created a peculiar rhythm to American finance. Every autumn, money drained out of New York City like water through a sieve. The reason was prosaic: farmers needed to be paid for their harvests, and that meant cash flowed from the financial capital to the agricultural heartland. To lure money back, New York banks raised interest rates, which attracted foreign investors seeking better returns. The system worked, more or less, in normal times.

The year 1906 was not normal times.

In April, an earthquake devastated San Francisco. The physical destruction was catastrophic, but there was a financial earthquake too: money flooded out of New York to fund reconstruction on the West Coast. Then the Bank of England raised its interest rates, partly because British insurance companies were paying out enormous sums to American policyholders. Money that would normally have flowed to New York stayed in London instead.

The stock market began to slide. From its January 1906 peak, prices fell eighteen percent by July. They recovered partway, then fell again. A new law called the Hepburn Act gave federal regulators power to cap railroad rates, which crushed the value of railroad securities—a cornerstone of the market. Standard Oil was slapped with a twenty-nine million dollar antitrust fine, equivalent to nearly a billion dollars today. The copper market collapsed.

By October 1907, American stocks had lost nearly a quarter of their value since January. The financial press noted the market's instability with growing alarm. "No sooner are these signs of new life in evidence," observed The Commercial and Financial Chronicle in July, "than something like a suggestion of a new outflow of gold to Paris sends a tremble all through the list, and the gain in values and hope is gone."

Bank runs had already struck Egypt, Japan, Germany, and Chile that year. America was a powder keg waiting for a spark.

The Copper King's Gamble

Frederick Augustus Heinze had made his fortune in the copper mines of Butte, Montana. He was brilliant, ruthless, and spectacularly litigious—he'd once tied up rival mining companies in over a hundred lawsuits simultaneously. In 1906, he moved to New York, where he fell in with Charles Morse, a financier of equally flexible ethics who had once cornered the market on ice.

Together, Heinze and Morse assembled a web of financial institutions. Between them, they sat on the boards of six national banks, ten state banks, five trust companies, and four insurance firms. They were, in the parlance of the era, "big men."

Augustus's brother Otto had an idea. The Heinze family already controlled a majority stake in their company, United Copper. Otto believed that speculators had borrowed many of these shares and sold them short—betting the price would fall, at which point they'd buy the shares back cheaply, return them to the lender, and pocket the difference.

A short squeeze is the nightmare of every short seller. If you've borrowed shares and sold them, you eventually need to buy them back. If the price rises instead of falling, you lose money. If the price rises dramatically and you can't find shares to buy anywhere, you're at the mercy of whoever holds them. They can name their price.

Otto proposed that the Heinzes buy up every remaining United Copper share, then demand that the short sellers return their borrowed stock immediately. Unable to find shares elsewhere, the shorts would have to come crawling to the Heinzes. It would be a license to print money.

There was just one problem: the scheme required enormous capital. Otto approached Charles Barney, president of the Knickerbocker Trust Company, New York's third-largest trust. Barney had bankrolled Morse schemes before, but even he blanched at the scale of this one. He declined.

Otto decided to try anyway.

The Corner That Wasn't

On Monday, October 14, 1907, Otto Heinze began buying United Copper stock aggressively. The share price jumped from thirty-nine dollars to fifty-two in a single day. On Tuesday, he issued his call: short sellers must return their borrowed shares.

The price climbed toward sixty dollars. Otto must have felt like a genius.

Then the shorts started returning shares. They found them everywhere—from sources Otto hadn't accounted for, from shareholders he didn't know existed. He had fundamentally misread the market. He didn't control nearly as much United Copper as he thought.

The share price collapsed. It closed at thirty dollars on Tuesday, fell to ten dollars by Wednesday. Otto Heinze was wiped out. His brokerage firm declared bankruptcy. The New York Stock Exchange suspended his trading privileges.

United Copper traded not inside the stock exchange but literally on the curb outside—an informal market that would eventually become the American Stock Exchange. The Wall Street Journal reported scenes of unprecedented chaos: "Never has there been such wild scenes on the Curb, so say the oldest veterans of the outside market."

But the real damage was just beginning.

The Dominoes Fall

Augustus Heinze owned a bank in Butte, Montana—the State Savings Bank—which had accepted United Copper stock as collateral for loans. When the stock became worthless, so did that collateral. The bank announced its insolvency.

The Montana bank was connected to the Mercantile National Bank in New York, where Augustus served as president. The board of Mercantile, horrified by his association with the failed corner, forced him to resign before lunch on Thursday. But word travels fast on Wall Street. By the time Augustus cleaned out his desk, depositors were already lining up to withdraw their money.

A bank run is a peculiar form of collective action problem. Any individual depositor is rational to withdraw their money if they believe others will do the same—a bank holds only a fraction of deposits in cash and cannot pay everyone at once. But if enough people act on this rational fear, they create the very insolvency they feared. It becomes a self-fulfilling prophecy.

The run spread to Charles Morse's banks: the National Bank of North America, the New Amsterdam National. The New York Clearing House, a consortium of the city's banks, forced both Heinze and Morse to resign from all their banking positions, hoping to contain the damage.

By the weekend, the immediate crisis seemed to have passed. Money withdrawn from Heinze-associated banks simply moved to other New York institutions. There was no systemic panic.

Yet.

The Knickerbocker Collapses

Trust companies were the hot financial innovation of the early twentieth century. They operated like banks but faced lighter regulation, allowing them to invest more aggressively and offer higher returns. In the decade before 1907, trust company assets had grown by two hundred forty-four percent, compared to just ninety-seven percent for national banks.

The Knickerbocker Trust Company was the third-largest trust in New York, run by Charles Barney—the same man who had refused to fund Otto Heinze's copper scheme. But Barney had financed other Morse ventures in the past, and that association now proved fatal. On Monday, October 21, the Knickerbocker's board asked him to resign.

That same day, the National Bank of Commerce announced it would no longer serve as the Knickerbocker's clearing house—essentially cutting off the trust from the financial system. The message was unmistakable: the Knickerbocker was tainted.

On Tuesday, October 22, the Knickerbocker faced a classic bank run. The scene outside its headquarters was pandemonium. As the New York Times reported, "as fast as a depositor went out of the place ten people and more came asking for their money." Police were called to keep order. Two vanloads of cash were rushed in, but even this failed to calm the panic. Directors pushed through the crowds, promising that everyone would be paid.

In less than three hours, eight million dollars walked out the door—equivalent to roughly two hundred seventy million dollars today. Shortly after noon, the Knickerbocker suspended operations.

The dominoes began falling faster now. Interest rates on stock exchange loans spiked to seventy percent. Stock prices crashed to levels not seen in seven years. The Trust Company of America and Lincoln Trust Company faced runs of their own. Within days, a litany of institutions had failed: the Twelfth Ward Bank, Empire City Savings Bank, Hamilton Bank of New York, First National Bank of Brooklyn, and half a dozen more.

The Most Powerful Man in America

When the crisis broke, John Pierpont Morgan was in Richmond, Virginia, attending an Episcopal church convention. At seventy years old, Morgan was not merely wealthy—he was the gravitational center of American finance. His bank, J.P. Morgan and Company, sat at the hub of the nation's financial system. He had helped rescue the Treasury during the Panic of 1893. When serious men needed serious money, they went to Morgan.

He rushed back to New York on Saturday night, October 19. By Sunday morning, his library had become the de facto crisis management center of American capitalism. Bank presidents and trust company executives streamed through, seeking information, seeking help, seeking salvation.

Morgan and his lieutenants examined the Knickerbocker's books and concluded it was genuinely insolvent—there was nothing to save. They let it fail. But when the Trust Company of America came calling, the calculus was different. An overnight audit showed the institution was fundamentally sound. It was facing a crisis of confidence, not a crisis of solvency.

"This is the place to stop the trouble, then," Morgan declared.

What followed was essentially one man coordinating the response to a financial crisis because no institution existed to do so. Morgan worked with George Baker of First National Bank and James Stillman of National City Bank—the ancestor of what would become Citibank—to liquidate assets and keep the Trust Company of America solvent through the day.

That night, Morgan summoned the presidents of the city's other trust companies to his library and held them there until midnight. They agreed to provide eight and a quarter million dollars in emergency loans.

Treasury Secretary George Cortelyou deposited twenty-five million dollars of federal money into New York banks. John D. Rockefeller, the richest man in America, deposited ten million into Stillman's National City Bank and called the Associated Press to announce he would pledge half his fortune to maintain American credit.

The infusion of cash helped, but it wasn't enough. Banks remained reluctant to make the short-term loans that kept the stock market functioning. On Thursday, October 24, the president of the New York Stock Exchange rushed to Morgan's office at one-thirty in the afternoon with dire news: without emergency funds, dozens of brokerage firms would fail before the three o'clock close. He would have to shut down the exchange.

Morgan refused to let that happen. He summoned the presidents of the major banks to his office and, in a remarkable display of personal authority, extracted commitments for twenty-five million dollars in loans within fifteen minutes. A clerk was dispatched to the exchange floor to announce that money was available. The market rallied.

One More Crisis

By early November, the immediate panic had subsided. But Morgan faced one final challenge. A major brokerage firm, Moore and Schley, had borrowed heavily using stock in the Tennessee Coal, Iron and Railroad Company as collateral. If Moore and Schley failed, it could trigger another cascade of failures.

Morgan saw a solution: his own company, United States Steel, could acquire Tennessee Coal, Iron and Railroad. This would make the collateral valuable again and save Moore and Schley. But there was a problem. President Theodore Roosevelt had built his political brand on trust-busting—breaking up the very kind of industrial consolidation this deal represented.

On the morning of November 4, two of Morgan's partners took a train to Washington and met with Roosevelt before breakfast. They explained the situation: without the merger, the financial system might collapse again. Roosevelt, who had no legal authority to pre-approve a merger, gave them a verbal assurance that he would not oppose it.

The deal went through. The crisis ended.

The Lesson America Finally Learned

The Panic of 1907 exposed a fundamental vulnerability in the American financial system. The country had no lender of last resort, no institution capable of injecting liquidity during a crisis, no mechanism for coordinating a response except the personal authority of one very old, very rich man.

What if Morgan had been less capable? What if he had been too sick to act, or simply refused? The terrifying answer was that the entire system might have collapsed.

Senator Nelson Aldrich of Rhode Island established a commission to investigate the crisis and propose reforms. The result, after years of debate and political maneuvering, was the Federal Reserve Act of 1913. The United States finally got a central bank—one designed to do systematically what Morgan had done through sheer force of personality.

The Federal Reserve would face its own tests in the century to come: the Great Depression, the stagflation of the 1970s, the 2008 financial crisis. Its responses have been debated and criticized. But the fundamental insight of 1907 has never been seriously challenged: modern economies need an institution capable of acting as lender of last resort, capable of injecting liquidity when panic freezes the system.

Otto Heinze's failed copper scheme cost him everything. But it also gave America something invaluable: proof that leaving financial stability to chance—or to the whims of individual titans—was a gamble the country could no longer afford to take.

Charles Barney, the Knickerbocker president who had refused to fund the scheme that destroyed him anyway, shot himself on November 14, 1907. He died a few weeks later. His association with Morse and Heinze had been distant and historical, but in a panic, guilt by association is guilt enough.

Morgan lived until 1913, long enough to testify before Congress about the "money trust" he was accused of controlling. Asked whether commercial credit was based primarily on money or property, he gave an answer that captures something essential about financial systems: "No sir. The first thing is character."

He was right, of course. Financial systems run on trust—trust that promises will be kept, that debts will be honored, that the money in your account will be there when you need it. The Panic of 1907 showed what happens when that trust evaporates. And it showed that in a complex, interconnected economy, restoring trust requires more than the character of any individual, no matter how formidable.

It requires institutions.