With this Weekly, I am finally writing my first book review. The book I now finished, is about the financial panic of 1907. However, it is not just a short-lived event with a simple crash in stock markets, limited to that particular year, as the title might suggest. Furthermore, it is about a sequence of events that caused a chain reaction of significant relevance, laying the foundation for the creation of the Federal Reserve Bank (although not what you know today).
Summary and key takeaways from today’s Weekly
– The book “The Panic of 1907” is a well-written piece, using and citing contemporary sources.
– It is so precious, because human behavior never changes. You can pull much from it. Also, it helps you to better understand the current banking crisis and why people act like they do.
– A clear recommendation!
Although having taken place already more than a century ago, the historical review in this book, based on and proved by contemporary sources and reporting, is an easy to read, timeless piece about human behavior in times of financial stress as well as unnerving uncertainty.
It gives valuable lessons for today – and the current banking crisis.
Yes, although mainstream media and politicians are pretending that nothing big happened, we have seen some of the biggest bank failures ever – measured by deposit sizes – in US history over the last about two months. The most recent one being just this past Monday with the First Republic Bank (ISIN: US33616C1009, Ticker: FRC) being taken over by JPMorgan (ISIN: US46625H1005, Ticker: JPM).
After that story was off the table, the look for the next weakest part of the chain is going on, hammering down several more smaller, often regional banking stocks.
While you learn what happened before, during and after 1907, you certainly will also see psychological patterns that repeat in times of turmoil in the financial sector, especially when banks that depend on the trust and confidence of its depositors are involved.
Human behavior never changes.
This is one of the most important things I ever learned in investing. What changes are the protagonists and the scenery. For those interested in financial and economical history as well as human behavior in times of financial stress, this book is a must.
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This Weekly first gives a brief and abbreviated summary of the book, touching on the main events.
However, in order to not destroy the reading experience, I am only making very brief summaries and simplifications, as the book goes into way more detail, often describing what happened in single days, especially during the crucial months of October and November 1907, naming different actors and their actions as well as relationships to each other. All this on just around 150 pages (the rest is add-on content).
In the second part, I explain the structure of the banking system around 1907 and the following consequences, resulting in the creation of the Federal Reserve Bank.
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Summary of the key events described in the book
Between 1814 and 1914, there have been multiple panics, stock market crashes and economical slow-downs, even depressions. However, what happened around and in 1907 was one of the most significant events – in terms of what happened, the dire situation and the subsequent events that caused a mass panic.
It was more or less a breaking-point between the 19th and early 20th century on one side and the modern day era on the other, if you want to put it this way.
Shortly prior to this period, the US economy – being an emerging market – experienced phases of rapid growth. After the last big crisis which ended in 1893 and the near sovereign default in 1896, the US economy picked up steam – also thanks to the railroad boom – and grew on average (!) with 7.3% per annum.
At the same time, gold imports into the country rose and peaked, while the stock markets were roaring into 1905 / 1906. Also, many mergers and acquisitions cleaned up the playing field, leading to a vast wave of consolidations (from over 1,800 companies to just under 100).
Giants like U.S. Steel (today, by far not of the same importance as back then, ISIN: US9129091081, Ticker: X), American Tobacco or Standard Oil were just some examples of the resulting monopolies and oligopolies – dominating forces of this era.
If you’d like to read more about monopolies, here is my dedicated article about this topic: “The massive power of monopolies – and why Warren Buffett likes them” (see here).
The end of the boom and the beginning of the fatal chain reaction was the San Francisco Earthquake of April 1906. Not only were big parts of the city destroyed by a resulting fire which was dire enough.
Many people were only insured against fire – however, not against earthquakes.
Plus, the destruction was so vast that it put pressure on insurance companies. Some insurers had to sell their portfolio holdings (pressuring stock markets) to pay outstanding claims, others closed their doors for good.
This sent shockwaves through Wall Street in New York. Not only did the stock market tank (–12% on the bad news), but also was there a severe shortage of liquidity and credit. Railroads and insurance companies went into a bear market over the next weeks and months.
Keep in mind that railroads were the FAANG or Dotcom stocks of that time.
On the chart, you can see the yearly performance of the Dow Jones Index. Look at the years 1904 and 1905 with their 30%+ gains, showing the excessive optimism.
A little surprising is that the year 1906 only produced a comparatively minor loss of not even 2%. After the initial shock, stock markets resumed their way up. However, what fell in price were bonds, as interest rates were lifted (sounds familiar?) to attract capital for the overall expanding economy as well as the harvesting season.
Stock markets peaked in September 1906.
People started hoarding their money, taking in out of circulation – this is the liquidity scarcity that is described in the book, as there was no electronic money to be quickly sent to where it was needed urgently. Refinancing became pretty hard to get by, as for example railroads had difficulties to sell bonds during the next twelve months.
What unfolded then, is described as a “silent crash”.
From September until the end of February 1907 markets fell by close to 8%. Then in March alone, another 10% were shed. This was another period of confusion and mysterious angst, shaking confidence. But it was not the height of the panic that was yet to come.
April and May were unspectacular.
Then in June, the amount of transactions on the stock exchange came down and the city of New York was unable to refinance by selling a bond with a 4% interest rate – companies were offering 6% to 7%.
People were hoarding their money due to the looming uncertainty. Uncertainty and insecurity always lead people to act defensively in this regard, pulling money out of circulation, pushing down effective money supply and making financial institutions vulnerable to shocks.
As a side note, the city of New York was then finally able to sell its bond with a 4.5% interest rate under the help of J.P. Morgan – the person (more to come below the next picture).
From June until September, the Dow Jones fell by another 8%, marking a 24% decline for the whole year until then – a real bear market, however, without the final sell-off. as you can see from the chart above, the year 1907 was the second worst year for the Dow Jones during the shown nearly 80 years. It was no child’s birthday.
Then came October of 1907 – the core and main period of the book.
It was the key month that initiated the panic until early November.
And it was the last big spotlight appearance of a certain J. Pierpont Morgan. The gentleman was the informal leader of the finance industry without any question.
Actually retired, having successors in place in the private bank he founded and himself touring through Europe at the age of 70, Morgan was about to be urgently needed to solve a crisis where no other leader was neither ready nor had the personal standing to solve the upcoming panic.
J.P. Morgan at that time was favoring big, concentrated monopolies to achieve efficiencies. He disfavored competition that he saw as disturbing and destructive. He was also involved in many of the big mergers, so he was not only well known and respected, but factually he was the face of finance at that time.
Not even the president of the U.S. – Theodore Roosevelt – was back then even in a position to prevent the panic. When he was not coincidentally on hunting trips in the south, he was rather complaining about too big corporates and initiating several break-ups. It was the era of the so-called “progressives”.
But he was not involved too much in this topic of the financial panic.
Even though the next presidential election was already around the corner in the same year, the book describes the situation that nearly everything circled around and depended on J.P. Morgan. Only at the end of the book and the events, he had an important appearance – I’ll come to that back later in the text.
What led to the reappearance of J.P. Morgan was a chain reaction, caused by credit-funded speculation and the subsequent loss of confidence leading to what we know today as bank runs.
A man called Augustus Heinze, who made 12 mn. USD – a fortune then – by selling his copper smelter company (I spare the details of what happened before as well as the following litigations and buyout by Standard Oil), entered Wall Street and bought a bank where he also became president.
In parallel, Heinze also became director at several other banks and trusts (less regulated financial institutions) where a friend of him – Charles Morse – was involved in a chain banking scheme. Morse was the opposite of J.P. Morgan: not really respected, having a negative image of untrustworthiness.
Chain banking means that (controlling) stakes in a bank were bought on margin. The bank’s equity gets collateralized and with the loans new stakes in other banks get acquired.
This scheme works for so long until something breaks and pulls all involved parties down.
The two men, also pulling in the brother of Heinze, tried to push the stock of United Copper – the company the Heinzes created and were majority shareholders of – by cornering the market. They thought their stock was heavily shorted on loans, even with more shares than were factually outstanding. Thus they tried to buy up as many shares outstanding as possible to then call in the shorted shares.
This move would have bankrupted the alleged short sellers and pushed the stock of United Copper up, due to short covering (being forced to buy a shorted, i.e. borrowed stock at nearly any price to give it back, thus pushing the price up due to too many buyers competing for the stock).
However, the Heinzes themselves used loans to buy those stocks, only to find out after they bought the stocks, that they were the only buyers – the stock crashed. There was no bid, or at least only at much lower prices, as the book describes. The company went bust, the loans stayed.
The gamble didn’t work out as hoped.
United Copper subsequently refused to pay down its loans, taking down brokerage houses and of course also pulling down the Heinzes as well as some banks and trusts.
This caused a public panic and people started to withdraw their physical deposits, as they didn’t want to be left with an illiquid, insolvent bank without access to their money (as there was only physical paper money). What followed was a contagion or chain reaction where several banks and trusts were about to get insolvent.
It started with institutions were the key people were associated to be dealing somehow with Morse. It was not even important whether true or not. But it was not helpful either that Heinze and Morse had director’s seats and stock of several banks and trust.
Only the belief of a possible connection was strong enough to set the chain reaction in motion.
In the end, to not make it too long, it was J.P. Morgan who stepped in and brought the mighty bankers and bosses of the trust companies to the table of his private library and more or less forced them to guarantee loans to the struggling houses in order to restore confidence.
The book even describes a scene where Morgan locked down the door of his library, saying that it will only open up again, as soon as there is an agreement – to his rules and conditions, to be clear. His bank also participated in this move.
Even priests and clerks were used to preach in church on Sundays that everything was under control.
This was a race against the clock, as at the same time, banks were holing their cash back instead of lending it to the economy, causing further contraction. This was understandable, as no one wanted to become insolvent due to the panic.
Depositors were standing in lines, demanding their money back. Several financial institutions were on the verge of a collapse.
Due to the panic, no one was thinking rationally and calmly, but everyone wanted to be on the safe side. However, the banking system is build upon trust and unable to cash out all depositors, as the majority of these funding (deposits) is either lend out via loans or invested, e.g. in bonds.
Deposits are fragile and short-term, while loans and investments have longer durations. This “duration mismatch” is always a risk for banks to get insolvent, if too much deposits are pulled.
If you thought this was it – not quite.
The above was going on until the end of October 1907. After that, there was also a struggling brokerage house that had given loans that were collateralized by shares of a combined coal and steel company. However, the shares fell massively which troubled the broker. Then J.P. Morgan arranged another deal where U.S. Steel bailed out the falling broker.
However, at this point, president Roosevelt was involved, as he had to give his go for this move.
Interestingly, it was exactly against what he was preaching and advocating, because with his approval, he made U.S. Steel even bigger, by sucking up a struggling competitor. But he was more or less forced to allow it, as otherwise the panic around the broker (and falling stock prices) shortly before the presidential election wouldn’t have stopped.
The events are written in a way that you don’t want to lay the book away, as soon as you enter the summer / fall period of 1907.
The structure of the banking system in 1907 and the creation of the Federal Reserve
A big difference to today was that there was no central bank – no Federal Reserve, either. There were also different types of financial institutions and also different types of banks.
Rather problematic were the trust companies, shortly mentioned above, that were more a type of bank, but factually less regulated ones (while reading, I had to think several times about hedge funds, but that’s not accurate, as those trusts operated like retail banks). They could offer higher interest rates and hold less reserves, making them more fragile.
However, as a group, they held a similar amount of assets as all national banks.
Instead of a centralized lender of last resort, financial institutions formed so called “clearing houses” where they guaranteed each other liquidity. These commitments, however, were on a voluntary basis only.
In the end, the currency of the US was called “inelastic”, as liquidity support from one bank to another was carried through by shifting bags of paper money from one house to the other. In times of dire stress, this is indeed rather uncomfortable and inelastic. Even more so, if several institutions are affected by depositors pulling their money.
At the end of the book, it is described that the clearing houses issued certificates for the use among each other and thus freeing up physical money for the general public, this way unofficially increasing the money supply and liquidity somewhat.
In 1908, a first Act was passed by Congress to set up a new structure which would do what J.P. Morgan did – to coordinate pointed liquidity assistance – however, quicker, more efficient and covering all institutions. This emergency scheme should issue repayable money to struggling institutions, making it “elastic” and stopping or at least limiting solvency issues.
This proposition finally led to the creation of the Federal Reserve Banking System.
However, two important differences to today:
- it was neither designed nor intended to be one big central bank, as the several regional branches (from today’s perspective) were able to determine their individual interest rates
- the central bank was not abused to bail out governments or to finance their excessive spending
The final Federal Reserve Act was then passed on 22 December 1913 by Congress.
The title of the act reads as follows:
An Act To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.
Federal Reserve Act of 1913 (see here)
As we are again and still in an uncertain environment, I clearly prefer stocks that have strong balance sheets and especially liquidity on hand. This way, they won’t be pulled into a cascading disaster quickly, if at all. What I want to avoid is indebted and low on cash companies that might be forced to seek financing at the wrong moment.
I regularly present my best investment ideas to my Premium and Premium PLUS Members. The most recent idea (exclusively for Premium PLUS Members) has even the chance to multiply several times.
Conclusion
The book “The Panic of 1907” is a well-written piece, using and citing contemporary sources.
It is so precious, because human behavior never changes. You can pull much from it. Also, it helps you to better understand the current banking crisis and why people act like they do.
A clear recommendation!
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