November 13, 2007

1907 Crash and Banking Panic: Will History Repeat?

The last paragraph is important because I talk about the present. Also, I highly recommend this book for an extensive history of the panic.
The Panic of 1907: Lessons Learned from the Market's Perfect Storm Financial Turmoil: The Panic of 1907 The banking panic of 1907 brought a crisis to the financial heart of the U.S. The stock market saw a thirty-seven percent fall in price.1 The decline was short lived. In late 1907 the stock market began to rise year over year and by the fall of 1909 had made back the losses.2 There have been different interpretations of the causes and impact over the one hundred years following the crisis. Its effects had significant consequences not only then but as government sought to prevent similar future problems.

It is important to get a sense of the background in the financial economy prior to the panic. There was San Fransisco’s major earthquake and fire in 1906 coupled with strong anti-trust political movement. At that time England was the global center for capital. Half of the San Francisco’s fire insurance was covered in England. The biggest blow was that most people were not covered against earthquakes. England saw trouble. As winter came in 1906 a major credit deficit was in effect in New York as the two countries financial systems were intertwined.3 Coming into 1907 there was already a negative atmosphere. There was a burden on monetary conditions thanks to a recent flood of new companies mostly in railway and industrials.4 In response to the boom of big business and trusts, Standard Oil, American Tobacco and Du Pont were sued in late 1906 and in 1907 prior to the panic.5 There was nervousness among businesses and in all of the U.S. capital markets.

Throughout 1907 F. Augustus Heinze, a new arrival to Wall Street began buying stock in his company at many brokerages. The company was United Copper and he was buying $2 million worth of these stock options on borrowed money to manipulatively boost the stock price.6 The attempt failed and forced Mercantile National Bank, which had given $1 million for the scheme into insolvency and prompted a panic run on the bank.7 The failure spread to national banks and to many trusts like the Knickerbocker Trust and the Trust Company of America. In the end, the most prominent businessman J.P. Morgan saved the trusts and economy with an infusion of money. This was not the first time J. P. Morgan supported the government. In 1893 he came through for then president Grover Cleveland in the mist of a worsening liquidity problem.8

There were many different factors that contributed to the 1907 panic. In The Economic Journal in September of 1908, only about a year after the panic O. M. W. Sprague believed that unlike the 1893 crisis 1907 could have been better contained. Looking at the broad nation-wide picture, he noted that agriculture was strong and farmers were in good financial condition in 1907. There were not any banks going under in agricultural parts of the country. This contrasts to previous crises.9 He says that the government’s control of companies like railways resulted in a drop in stock prices in March and August of 1907. He also notes that people in finance believed the crisis was caused by government involvement in economics.10 Written very close in time to the crisis he focuses a lot on the banks, especially in New York.

Bruner and Carr in The Panic of 1907: Lessons Learned from the Market’s Perfect Storm do a good job of reconstructing the events prior to the fallout with a lot of primary evidence. They highlight that Sprague believed “the most important financial factor in the panic of 1907” was the trouble in the summer of 1907 when the Bank of England blocked U.S. finance bills and brought down gold reserves causing a “national liquidity drought.”11 They see the crisis being caused by a variety of things including poor leadership, lack of transparency, an unsafe system and the end of the business cycle among others.

In The Bank Panic of 1907: The Role of Trust Companies published in The Journal of Economic History, Jon Moen and Ellis W. Tallman find fault with O. M. W. Sprague and others who stressed national banks in their research. Rather, they find trusts at the root of the problem. They believe the problems that took over the country originated in trusts risky portfolios. They say they were “less regulated” than different operations in similar markets. In addition to the risky nature of the trusts “the lack of direct access to the clearinghouse, and lower reserves against deposits must be the main reasons why the Panic of 1907 was concentrated in the trust companies.”12 They say that trust companies had more collateralized loans than national banks. They make the case that trusts suffered greater than national banks due to these loans.13

George Bittlingmayer in The Stock Market and Early Antitrust Enforcement attributes declines in the Dow Jones index to anti-trust legislation. The Dow Jones tracked the major companies stock prices in an index. The Dow gave a good representation of the overall stock market. On March 14, 1907 the day of Roosevelt's ICC directive the Dow dropped 8.65% to recover most of those losses the next day of trading up 6.48%.14 With this volatility a sense of the fear driven trading can be seen leading up to the crash. However, this volatility does not compare with what was scene from 1929 to 1939 during the Great Depression according to William G. Schwert.15 With anti-trust enforcement in full force during Roosevelt’s term it was ironic that it was the reckless business practices of the Knickerbocker Trust Company that set off the panic.

In Bittlingmuyer’s Antitrust and Business Activity: The First Quarter Century he finds correlation with anti- trust initiates and business confidence and the business cycle. He takes the side of those that find fault with Roosevelt’s anti-trust stance. These are the people who thought government had interfered with the economy that Sprague mentions in 1908. He looks at quarterly changes in aggregate output and to gauge investment changes in pig iron productions. He found that in “each case against a large industrial firm or railroad was accompanied by a decline in output of -4.5 percent.”16 He says there is no “decisive proof” to come from his analysis. He says the view is not certain because there is no way to know for sure and that it could just be chance.17 One of the key ideas of Bittlingmayer’s argument is that the uncertainty such anti-trust moves had on the business environment was significant because companies might hold off, wondering who would be the next target of anti-trust regulation.

In 1915, Minnie Throop England in Promotion as the Cause of Crises sees a correlation in the movements of gold between England. She says that reserves go down as gold is shipped.18 This is what Sprague believed was key in leading to the crisis. She shows how psychology is behind the shrinkage of liquidity and looks at data in 1907. The most important idea she relates is that money is readably available“before” the crisis but the shrinkage of credit begins “after” the crisis.19 Moen and Tallman draw fault from the risky portfolios of trust companies. England further substantiates this assertion with the idea that to much optimism during rapidly growing economies sets the stage for the fear driven pessimism that is a crisis. It can also be seen in the stock market as prices are brought down beyond what is reasonable.20 She says,“Crises are the price of progress. The more rapid the progress, the more severe the crises.”21 This has great relevance to 1907 as their had been a rise in big business and trust companies that were getting out of control.

Looking at Jack W. Wilson and Charles P. Jones A Comparison of Annual Common Stock Returns: 1871-1925 with 1926-85, the rise and fall attributed to psychology can be seen in stocks with the annual capital appreciation of –33.3% in 1907. This was the greatest decline from 1871 to 1825.22 It is interesting to put this into perspective though as Bruner and Carr’s chart show that the market had made back the losses in less than 3 years in a steady bull market. This shows the emotional over-reaction as the gains were redeemed quickly. In that sense the long-term economic consequences of the panic on stock prices were not serious. This contrasts to the steady bear and slow bull markets that appeared before, during and after the Great Depression.

Trust companies played a big role in the panic. It is imperative to understand how they came about and what went wrong. Larry Neal in Trust Companies and Financial Innovation, 1897-1914 believes the most important thing to develop in the financial world during the consolidation years of 1898-1902 was the fast appearance of the trust companies.23 This position supports the works of Moen and Tillman among others. Trust companies originally sprung up to offer wealthier clients a savings bank. They got the privilege to get deposits and buy stock in companies. Going back as far as 1874 there were issues taken with how what they did changed and how they competed with the banking structure.24 In Banker’s Magazine in 1874 there was a report that people were concerned with their involvement in stock investors.25 This is exactly what triggered the crisis with Mercantile National and Knickerbocker. Their deal with Heinze and his corner of United Copper was what open pandora’s box.

In Andrew A. Piatt’s The United States Treasury and the Money Market. The Partial Responsibility of Secretaries Gage and Shaw for the Crisis of 1907 he makes the case against Secretary’s Shaw and Gage, holding them responsible for the crisis. He says that Mr. Shaw in face of the rising stock market of 1905 and strong business growth made no intervention.26 When New York bank reserves were negative in 1906 he privately allowed New York banks to import gold for possibly up to months before in making the same deal for other banks. He did the same thing “adding oil to the fire” in the summer as the stock market was over-heated pumping money into New York to take the place of gold.27 These were his final attempts to stop the credit contraction and then after these failed attempts and disappearance “had withdrawn from public life and had been welcomed to other fields of usefulness.”28

Possibly adding to historians seeing negative effects coming from the increase in anti-trust activity while backing the psychological nature of the markets that England asserted, Francis B. Forbes shows the stock quotes of eight railroad and eight industrial stocks from January 1907 through January 1908. The biggest declines were in the industrials.29 Interestingly, the recovery is rather quick. This sudden recovery is also touched on by Alexander D. Noyes in 1909. He has a quote from a city branch president, “Let the people resume business the way they mere doing twelve months ago, start everything with a hurrah, and we will forget all about the panic in a day or two."30 Like others, Noyes notices the speculation that had occurred in the years prior to the crisis and lays blame on it. The cause he says, “was not an imperfect American currency, nor "President Roosevelt," nor even, primarily, unsound banking practices at New York, but the extravagant over-exploiting of capital and credit throughout the industrial world.”31

Following the evidence there is a lot to take away from the panic. The economy and the banking system would have benefited enormously from a Federal Reserve System. A central bank may have been able to stabilize the banks and could have allowed for a soft landing without the widespread depositor panic. By pumping liquidity into the system the government would have been able to take on the role of J.P. Morgan. Moen and Tallman have it right. Understanding the role of the trusts like Knickerbocker is the key to unlocking the mystery around the panic. Trust companies were not as safe as national banks. The trust company and their risky structures were one of the main causes of the panic. There needed to be more regulation in the securities market. Heinze should never have been able to pull such a stunt without transparency. Furthermore, Bruner and Carr having published their book in 2007 have the most comprehensive view taking into account all the pieces of 1907.

As an avid commentator and investor in equity markets I see parallels from 1907 to 2007. The trend of horizontal consolidation is still alive and well in the banking industry today though now flirting with anti-trust law. Big U.S. banks like Bank of America and Citigroup, though limited in their market share are making up for it by diving into speculative areas like mortgage backed securities. This is exactly like what the trusts in the late 19th early 20th century were doing. They were diversified but ended up taking on too much risk. The Banking Act of 1933 sought to limit banks in the scope of services like commercial and investment banking. When key financial institutions are involved in risky investments like in 1907 and the mortgage arena in the years leading up to 2007 there is going to be trouble. With portions of it lifted in 1999 this trend may have serious consequences.Risky, manic speculation driven by greed existed in the years before both. The current U.S. sub-prime loan crisis, which relates to risky loans granted during the recent housing bubble, is having an effect on the large financial institutions. This is strikingly similar to the risky loans issued by trusts in 1907. No one is sure how much the current crisis will spread into the credit markets. Where was the Federal Reserve and government regulation to reign in the capitalist environment? How can all these ridiculously risky loans be approved? Speculative investments fueled by greed will always exist. We cannot forget the Panic of 1907.

1. Robert F. Bruner, Sean D. Carr, The Panic of 1907: Lessons Learned from the Market’s Perfect Storm (John Wiley and Sons Inc., 2007), 2.
2. Bruner, Carr, 144.
3. Bruner, Carr, 14,15.
4. Bruner, Carr, 16.
5. George Bittlingmayer, “Antitrust and Business Activity: The First Quarter Century,” The Business History Review, 70, no. 3 (1996): 364.
6. Bruner, Carr, 44.
7. Bruner, Carr, 54, 55.
8. Bruner, Carr, 11.
9. O. M. W. Sprague, “The American Crisis of 1907,” The Economic Journal 18 no. 37 (1908): 354, 355.
10. O. M.W. Sprague, 356,357.
11. Bruner, Carr, 30.
12. Jon Moen, Ellis W. Tallman, “The Bank Panic of 1907: The Role of Trust Companies,” The Journal of Economic History 52, no. 3 (1992): 628.
13. Ibid., 628.
14. George Bittlingmayer, “The Stock Market and Early Antitrust Enforcement,” The Journal of Law and Economics 36, no. 1 (1993): 5.
15. William G. Schwert, “Indexes of U.S. Stock Prices from 1802 to 1987,” The Journal of Business 63, no. 3 (1990): 424.
16. George Bittlingmayer, “Antitrust and Business Activity: The First Quarter Century,” The Business History Review 70, no. 3 (1996): 365.366.
17. Ibid., 366.
18. Minnie Throop England, “Promotion as the Cause of Crises,” The Quarterly Journal of Economics 29, no. 4 (1915): 762.
19. England, 764,765.
20. England, 766.
21. England, 767.
22. Jack W. Wilson, Charles P. Jones, “A Comparison of Annual Common Stock Returns: 1871-1925 with 1926-85,” The Journal of Business 60, No. 2 (1987): 255.
23. Larry Neal, “Trust Companies and Financial Innovation, 1897-1914,” The Business History Review 45, No. 1 (1971): 37.
24. Ibid., 37.
25. Ibid., 37.
26. Andrew A. Piatt, “The United States Treasury and the Money Market. The Partial Responsibility of Secretaries Gage and Shaw for the Crisis of 1907,” American Economic Association Quarterly 3rd series, 9, no. 1 (1908): 224.
27. Piatt, 225.
28. Ibid., 225.
29. Francis B. Forbes, “Notes on the Financial Panic of 1907,” Publications of the American Statistical Association 11, no. 81 (1908): 1-5.
30. Alexander D. Noyes, “A Year After the Panic of 1907,” The Quarterly Journal of Economics 23, no. 2 (1909): 211.31. Noyes, 212.