Too Big To Fail: An analysis of the panic of 1907 and a short comparison to the 2007–08 Great Recession
The United States economy was booming between 1902 and 1907. Driven by brisk growth in coal, iron, and railroads, the prosperity attracted over one million immigrants in 1905 alone. Output was high, and growing, but so was volatility. Americans were demanding less liquid cash — the currency-to-deposit ratio hovered around 20%. At the same time, banks were keeping less currency on hand, with an average reserve-to-deposit ratio of 11%. This left the U.S. financial markets vulnerable to changing liquidity preferences, and it was these changes that catalyzed the panic of 1907.
The U.S. money markets had been strained heading into the year. Between the 1906 San Francisco earthquake that cost 1.7% of the nations GDP, and the Bank of England demanding debt payments in gold, liquidity was increasingly difficult to come by. Since America was on the gold standard, every printed dollar had to be backed by an equivalent amount of gold. The uptick in gold exports contributed to a large decline in the high-powered money stock, and by proxy, the amount of printable currency.
Trust companies (trust co’s) only exacerbated the situation. These were a new form of financial intermediary that functioned as a bank, albeit with a fraction of the regulation. They were able to own stock directly and had lower reserve requirements, both factors that allowed them to pay higher interest rates to their depositors. Depositors, lulled by the potential returns, flocked to these vehicles, leading to the rapid growth of trust companies. One of the largest of these institutions was Knickerbocker Trust Company (Knickerbocker).
On October 22nd, 1907, Knickerbocker was forced to halt payouts to their depositors. Suspensions of convertibility such as this one were technically illegal, though the rule was rarely enforced. In practice, it is argued that these suspensions prevent both bank failures and the money stock from plummeting.
Knickerbockers suspension came on the heels of a Wall Street scandal. The president of the company had been asked to resign because of his ties to a market manipulation attempt. News of the scandal had caused the National Bank Of Commerce, Knickerbocker’s clearinghouse, to refuse to cash any of Knickerbocker’s checks. This led to the October 22nd run on Knickerbocker and its subsequent declaration of insolvency.
Due to their relatively unregulated nature, trust co’s were some of the first institutions that panicked depositors ran on to secure their funds. Because trusts had the ability to own stocks and other risky assets, they could create much riskier portfolios than national or state banks while holding much lower reserves against deposits. All of this contributed to greater investor concern about trust co solvency.
Knickerbocker was not the only trust co that depositors ran on. The same scandal caused runs on both the Mercantile National Bank and the Trust Company of America. The Mercantile National Bank turned to the New York Clearing House (NYCH) for assistance when it began to approach insolvency. Hoping to avoid a full-blown panic, the NYCH rescued the Mercantile Bank time and again over the course of the crisis. While this seemed to help at first, more action was needed — and fast, in order to keep the situation from devolving.
J. Pierpont Morgan
J.P. Morgan, one of the most prolific New York bankers, was the director of the National Bank of Commerce and the founder of JP. Morgan & Co. Morgan, after watching Knickerbocker collapse, became concerned with the futures of other trust co’s and what their demise would mean for the economy. Not to mention, JP. Morgan & Co. alongside a handful of others were responsible for financing every major corporation, and a downturn would hurt his own bottom line as much (if not more) than the average American.
As one of the most respected and well-connected bankers in America, Morgan took the lead in managing the private sector response to the crisis. He first called all the trust co. presidents to his office, forming a committee to assess the situation. Morgan needed a way to restore the public trust, thus he created a clearinghouse comprised of every member of the committee. This clearinghouse would ensure any member at risk of insolvency had a resource to fall back on.
Bankers, Clearinghouses & The Government
While the trusts had an immediate safety net, there were other battles to be fought. The New York Stock Exchange was in a complete currency drought, with the interest on call money reaching 100%. The lack of liquidity caused stock prices to plummet to decade lows. Fear of a stock market crash moved the presidents of the national and state banks to come together. Guided by Morgan, the banks banded together to finance the New York Stock Exchange and other liquidity constrained institutions. The largest party bailed out by the private bankers was the city of New York itself, which had failed to raise funds through the sale of municipal bonds.
In addition to the roundtable of bankers, clearing houses also stepped in, issuing emergency loans to member banks. These loans took the form of certificates, which banks could swap with one another in lieu of cash. This freed up cash to be distributed to the public, easing depositor fears. The certificates had the effect of increasing total money supply, but their biggest drawback was the ad hoc method by which clearinghouses would parcel them out.
The private sector was not the only party involved in these bailouts. The first responder to the crisis had been the U.S. Treasury Secretary, George B. Cortelyou. The United States, at the time, had no formal central bank thus money market operations were largely handled by the treasury. Cortelyou announced that he was ready to deposit government money into any banks requiring liquidity. The Treasury also offered to make advance payments of principal and interest on government bonds. Towards the end of the recession, as the Treasury exhausted it’s cash reserves, it found one last way to boost public confidence. It issued $40 million worth of gold bonds and allowed them to be used as a basis for currency creation instead of actual gold.
The gold standard restricted the Treasury or banks from printing gold without a dollar for dollar backing. Prior to the crisis, there had been a net outflow of gold, due to the Bank of England decision. During the crisis, however, interest rates in the U.S. were higher than those available elsewhere, which resulted in a steady inflow of gold. This would also help ease the panic.
1907 v. 2007–08
There are several parallels between the panic of 1907 and the Great Recession of 2007–2008. Both crisis started in strained economic conditions, and both suffered from a liquidity crunch. Liquidity in the Great Recession dried up due to the decline in housing prices and the collapse of subprime mortgages. Mortgage-backed securities began to fail and banks, seeing their profits at risk and taking on large credit and counterparty risk, stopped lending to each other. This created a shortage of credit and banks found themselves under a tremendous risk of failure.
In 1907, Morgan was fearful that the collapse of Knickerbocker would lead to a downturn in the entire financial system. Similarly, in the Great Recession, lawmakers and the Federal Reserve argued that some of the nation’s largest banks were too big to fail. This resulted in the massive bailout package for Wall Street and increased regulation via the Dodd-Frank act.
One of the key differences between the crisis then and now is that the United States moved off the gold standard in 1971. This allowed for a much more free injection of currency into a liquidity strapped economy. Whereas in 1907, policymakers and financiers had to hope for gold imports from foreign nations, the Federal Reserve can now perform quantitative easing without the need to rely on any external third parties. The other party in the 2007–08 crisis was the Federal Reserve. While the 1907 Treasury attempted to fill this role, they were simply too constrained by the gold standard to correct the situation without considerable help from Morgan and the wealthy elite.