Introduction

On the morning of October 22, 1907, the third-largest trust company in New York City ran out of cash. Pandemonium ensued, as the Knickerbocker Trust paid out $8 million to panicked depositors in a little over three hours before having to close its doors at noon to remain solvent. By the next morning, lines had formed at trust companies across Manhattan and within days, the contagion had spread to Providence, Philadelphia, and Pittsburgh. The New York Stock Exchange was in freefall as call options, the overnight loans that financed daily stock trading, had climbed to 100 percent annualized and then disappeared entirely, with no offers at any price. The US economy was seizing near the brink of collapse.

At this point the United States had no central bank to mediate the panic. It had no Federal Reserve, no Federal Deposit Insurance Corporation (FDIC), and no Securities and Exchange Commission (SEC). The government had no established mechanism to inject liquidity into a seizing financial system. However, it did have in the autumn of 1907, one 70-year-old private banker sitting in a brownstone library on Madison Avenue. Known as Jupiter due to his colossal power and dominance, and the Sphinx for his elusive nature, J.P. Morgan was America’s lifeline.

J.P. Morgan had not asked for the role, but it was bestowed upon him. At a Friday service on October 18 at the Triennial Episcopal Convention in Richmond, Virginia, news of the impending crisis reached him. He contemplated what it was he needed to do; his role in America’s financial markets is unique in that his every move inspired confidence or panic in the economy, a self-fulfilling prophecy by a market that placed so much stock on his word. Aware of this constant surveillance, he waited before rushing back in order to avoid spooking the markets. He was in New York by the next night, walked into his library, and began doing what no government institution could do; because no government institution existed to do it. Only he could save the US economy, but would he succeed?

A System Built to Fail

The structural vulnerability of the American financial system that made this economic panic possible, had been visible for decades. Back in 1836, President Andrew Jackson destroyed the Second Bank of the United States by allowing its charter to expire, vetoing Congress’s wishes. In his eyes, he believed it was an unconstitutional monopoly that corruptly favored wealthy elites over ordinary citizens. He didn’t believe in paper currency, having lost a significant portion of his personal funds due to speculation, and wanted to push the US to hard currency like silver and gold. The Bank held all federal tax revenues interest-free using public tax dollars to fund its own private loans, allowing wealthy bankers to profit from this advantage at the expense of the taxpayer, the common man. Jackson hated that much of the Bank’s stock was owned by wealthy foreign investors and argued that the Bank trampled on state sovereignty by operating branches wherever it pleased without paying state taxes.

71 years without a central bank left the US money supply fluctuating wildly over the years with the agricultural cycle: supply would expand each autumn as harvests were purchased and capital flowed out of New York, but then contract in the spring. Over the years European central banks could extend money supply during these periods of economic stress while the US could not; a vulnerability in national economic sovereignty.

To fill this gap in the US’s home turf, trust companies became the shadow banking system of the Gilded Age. Unlike national banks, they faced minimal regulation, held cash reserves of only around 5 percent of deposits compared to 25 percent for national banks, and were excluded from the New York Clearing House, the private consortium that served as a de facto central bank for regulated institutions. The downside however was that because their deposits were demandable in cash, they were massively exposed to any bank runs, when customers demand more withdrawals all at once than the bank can provide with liquid cash on hand.

Trust companies would loan large sums directly to stock market brokers so they trade on margin, leveraging their potential profits. These margins had to be repaid by the end of business each day, else there would be interest charged on that loan. However, when trust companies came under pressure, they called those loans, a process known as “margin call”, where they can force brokers to liquidate their stock in order to repay their loan. Liquidated stock would then crash prices, lowering the value of other stocks and triggering more margin calls. This becomes a dangerous, self-reinforcing feedback loop that gains speed when the average stockholder panics over the market’s nosedive.

The cracks in this flawed system began to show in early 1907 when Jacob Schiff of the respected Kuhn, Loeb & Co. delivered a speech to the New York Chamber of Commerce warning that without a central bank, "this country is going to undergo the most severe and far reaching money panic in its history." The massive 7.9 magnitude San Francisco earthquake of 1906 had drained gold reserves as British insurers made massive payments, prompting the Bank of England to raise its discount rate to stanch the outflow, tightening credit globally and adding pressure to the global economy.

A Failed Copper Corner

It took one massive speculation to be the straw that broke the camel’s back. F. Augustus Heinze was an aggressive copper magnate from Butte, Montana. After selling his mining interests for millions, he moved to New York City and bought a major stake in the Mercantile National Bank, becoming its president. Along with his brother Otto who ran a brokerage firm, and speculative financier Charles W. Morse, Heinze controlled a web of interconnected banks and trust companies. Their flagship asset was the United Copper Company.

In October 1907, Otto Heinze noticed that investors were heavily short-selling United Copper stock, meaning they were borrowing shares, selling them, and then returning the shares. This is essentially a bet that the stock price would drop; a way to make money off the fall in a share price. The brothers assumed their family owned the majority of shares, so they devised a plan to short squeeze the stock. If shareholders are betting the price will drop, then if a massive volume of shares are suddenly bought, the price naturally goes up. This strategy would then apply pressure to those who are short selling, causing them to sell at a price higher than they borrowed at, resulting in a loss, while the Heinze brothers would walk away with a profit.

On October 14, 1907, the brothers began aggressively, but quietly buying up every remaining share of United Copper stock on the market, using borrowed money from their own banks. They successfully drove the price up sky-high, from $39 to $60 a share in a matter of hours. Where they would trap the short sellers is when the brothers owned all the shares and they could then demand that the short-sellers return the stock they had borrowed. Where this traps the short-sellers, is that because the brothers own all remaining stock, there is none remaining in the open market for them to sell, forcing them to go to the Heinze brothers, hat in hand, and buy the stock from them at whatever astronomical price the Heinzes demanded.

The next day they executed the trap by calling in the borrowed stock. But there was one problem: the Heinze family were not majority shareholders in the company. They grossly overestimated their equity in the company and because of their ploy, the rising price was attractive to many other outside investors. When the borrowed stocks were called in, the short-sellers had no problem finding other buyers on the market, avoiding the extortion rates they would have faced had this oversight not happened.

Without any desperate buyers to sustain the artificially high prices, the market realized the corner had failed and began to panic sell. The next day on Wednesday October 16, the price of United Copper stock collapsed from $60 down to $10.

Once word spread that Heinze and Morse were connected to various trust companies through their banking relationships, depositors freaked out and began withdrawing their accounts from every institution that had ever touched either man. When the Knickerbocker Trust Company,  the third-largest trust in New York began its run on Friday October 18, there was no direct affiliation with Henize or Morse. The contagion had spread far beyond any institutions that had direct exposure to the copper corner, inciting an economic bedlam driven by the strongest economic driver: fear.

Morgan's Return

Morgan’s private library on 225 Madison Avenue was adjacent to his home. Completed in 1906, Morgan spent much of his time here being mostly retired. However, this location would famously become the command center of the American financial system during the panic.

If anyone can save the economy, it’s J.P. Morgan, but even he can’t save everyone. He would need to employ an articulate triage to save only those that can withstand the windfall with sufficient cash injection. Not every institution could or should be saved. Morgan assembled a team led by Benjamin Strong, the secretary of Bankers Trust and later the first governor of the Federal Reserve Bank of New York, to investigate which companies are solvent and which ones aren’t. Morgan would rely on this information to determine who would receive lifelines and who would not.

After an anxiety-filled weekend, on Monday October 21, Knickerbocker Trust appealed to Morgan for financial aid. Morgan sent Strong to examine its books, but he could not determine solvency in the time available. Without bulletproof data to guide his decision, instead Morgan refused to act on this request by declining to provide support. This decision carried a lot of weight within the finance world, causing the National Bank of Commerce to simultaneously announce it would no longer act as Knickerbocker's clearing agent. Both announcements publicly put the nail in the coffin, securing Knickerbocker’s fate and accelerating the run. A few weeks later, Knickerbocker’s president, Charles Barney, personally asked Morgan for help, but Morgan knowing he wouldn’t alter his decision, refused to see him. The financial ruin was too much for Barney to bear, and on November 14, 1907 at his home in Manhattan, Barney shot himself.

With Knickerbocker being the third-largest trust, the decision was controversial then as it is today. But there are differences between good decisions and good outcomes. Morgan’s reasoning was analytically sound: he would not commit capital to an institution of unknown solvency. However, solvency was apparent with the second-largest trust in New York, the Trust Company of America, and with Strong’s clearance the following day, Morgan deployed his financial aid. The operating principles used in deciding the fates between the two institutions is what a functioning central bank would do – in the absence of a federally established one.

The Stock Exchange Crisis

By the morning of Thursday, October 24, the market for short-term loans, which stockbrokers rely on daily to fund their businesses, had completely frozen. The morning started with an interest rate of 6% to borrow cash, but as panic spread throughout the day that number spiked 10x to 60% as desperate brokers were willing to spend anything for the lifeblood of trade: liquidity. Even at that massive rate, one that would make a bank drool at the thought of, no banks were willing to lend them a single dime with such an uncertain financial outlook. By the end of the morning, the interest rate spiked to 100% with still no willing banks. Because cash had vanished from the market and could not be borrowed at any price, stockbrokers could no longer clear their trades, essentially putting the entire New York Stock Exchange on halt and only minutes away from being forced to shut down entirely.

At 1:30 p.m., president of the NYSE, Ransom Thomas, rushed to Morgan's office to report that he would have to close the exchange. Having to do so would fuel the public’s passions even further, as early closures were mostly used during presidential assassinations or national catastrophes. After making a number of calls, within minutes Morgan had assembled the presidents of the major New York banks in his office and extracted $18.95 million in commitments for call loans at interest rates as low as 10% from institutions that had just been offering nothing at 100 percent thirty minutes earlier. The traders on the exchange floor received their sought-after loans and by the end of the trading day, the exchange remained open.

To further bolster confidence in the economy, the following day on October 25, Morgan’s group injected additional funds: $10 million came from the Morgan group, $2 million from First National, and $500,000 from Kuhn, Loeb & Company. These funds came with strict conditions to prevent any opportunistic speculations: no margin sales allowed, only cash purchases for investments. He released funds only in the afternoon, deliberately preventing morning speculation, and he made it known to the financial markets that this wasn’t just injecting liquidity to the markets, he was intentionally shaping the behavior to stabilize it.

US Treasury Secretary George Cortelyou deposited $25 million of government funds in national banks on the morning of Thursday October 24, a meaningful but inadequate contribution. It took additional industry tycoons like John D. Rockefeller, to deposit additional funds; he deposited a further $10 million in Stillman's National City Bank and telephoned Melville Stone of the Associated Press to announce he would pledge half his wealth to maintain American credit as a show of confidence.

Just as Morgan could sigh a breath of relief, a few days later on Sunday, October 27, his associate George Perkins informed Morgan of another crisis that needed to be addressed. Perkins was informed that New York City itself was on the verge of insolvency, needing $20 to $30 million by November 1 or it would default on its obligations. The city had attempted a standard bond issue and failed. Morgan contracted to purchase $30 million in New York City bonds. But to further instill confidence among the public, Morgan deployed his teams of bankers to various churches across Manhattan to provide ministers with talking points for their congregations, calming the public psychology of the crisis from the pulpit.

Locking The Door

By Sunday, November 3, two weeks into the crisis, the trust companies were still in a fragile state. The Trust Company of America and Lincoln Trust had consumed emergency funds but still needed more. Morgan required a $25 million consortium loan from the trust company presidents, but they didn’t want to commit to this voluntarily. Ever the father of America’s financial economy, Morgan summoned all the trust company presidents to his library. He quietly locked the front doors and told the presidents no one was leaving until a resolution was agreed upon. And Morgan was serious, as negotiations ran through the night, he was playing solitaire in the next room while his associates applied their rhetoric and personal loyalty to advance towards an agreement.

Morgan’s associates, Perkins and Strong presented Morgan with an agreement they felt would be well-received, and so at 4:45 a.m. Morgan walked back into the room, approached the unofficial leader of the trust company presidents, and presented the agreement. The man signed and the others followed. The $25 million consortium loan was committed before dawn, and Morgan allowed the bankers to go back home.

The Final Crisis

As calm was restored in New York by early November, a new crisis surfaced. Moore & Schley, one of the largest brokerage firms on Wall Street, was $25 million in debt. They had used large blocks of Tennessee Coal, Iron and Railroad Company (TC&I) stock as collateral for loans, but TC&I’s stock was in freefall. TC&I was the nation's next-largest steel producer with an estimated 700 million tons of iron ore in reserves and 2 billion tons of coal. If the firm collapsed, the forced liquidation of its TC&I shares would trigger another cascade through every institution that held similar collateral. The financial system was intricately woven with trusts, creating a house of cards that was ready to fall at the next speculation blunder.

Morgan’s solution was using his massive $1.5B US Steel trust to acquire TC&I, assuming its debts and removing the distressed collateral from the system entirely. US Steel would issue $30 million in 5% bonds in exchange for TC&I stock at 84 cents on the dollar, a price below market, but enough to absolve Moore & Schley's obligations and prevent the liquidation cascade. But with US Steel already controlling 60% of American steel production, they were ripe for an antitrust violation under the Sherman Act.  Acquiring, would be a direct and obvious antitrust violation under the Sherman Act.

To avoid the ire of anti-trust’s biggest proponent, President Theodore Roosevelt, Morgan sent Henry Clay Frick and Elbert Gary on the overnight train to Washington. They arrived at the White House before the market opened and implored Roosevelt to grant antitrust immunity before trading began. Roosevelt made trust-busting his flagship cause in his campaign, and even broke up Morgan's own Northern Securities railroad merger in 1904. But he had enough foresight to understand the implications of breaking this trust, so after roughly ten minutes of thinking, Roosevelt granted immunity.

The acquisition was announced before the opening bell and the Panic of 1907 was effectively over. Over a stressful three week period, the crisis had been averted with Morgan personally losing $21 million, but with the US and global economy remaining intact. For context, by the middle of November the US Treasury's working capital had been reduced to a measly $5 million.

Outcome

The US economy continued to feel the impact from the panic, as by 1908 real GDP fell 12% and industrial output declined 17%. The NYSE’s decline from prior year peak was almost 50%, wiping out many years of gains for investors large and small. The only impact worse than this was the Great Depression of 1929. Morgan was often vilified in the media and caricatured as your prototypical Robber Baron, but his efforts to step in and save the global economy was admired and respected through the financial world.

In 1908, the most powerful Republican in the Senate, Nelson Aldrich, pushed through the Aldrich-Vreeland Act in 1908, establishing the National Monetary Commission to study the crisis and propose legislative remedies. A secret conference took place off the Georgia coast in November 1910 attended by Morgan's key men, including Strong and Davison, to draft the framework for a national reserve bank. On December 23, 1913, Congress passed the Federal Reserve Act. What Morgan had embodied during those three weeks in 1907 – lender of last resort, coordinator, crisis manager, and provider of liquidity – was transformed into a permanent institution. Unfortunately Morgan would not live to see its fruition as he died on March 31, 1913.

The panic was efficiently resolved through the orchestration of a single colossus. To convince executives of the most powerful banks in the country requires unprecedented influence. In 1912 the Pujo Committee investigation, found that Morgan and his associates had representation on the boards of institutions with a combined market value constituting more than four-fifths of the entire New York Stock Exchange.

A joke circulated in the aftermath: a schoolboy, asked who created the world, replied that God made it in 4004 B.C. "and it was reorganized by J.P. Morgan in 1901." Morgan reorganized it one final time in 1907 answering the beckoning call of fiduciary duty when he didn’t have to and nobody could.

Key Insights

1. Before systems become institutions, they often exist in the form of exceptional individuals: The Federal Reserve is not an abstract economic innovation, but an institutionalization reaction to a crisis, embodying the functions that one man was forced to perform manually. The Federal Reserve is "Morgan made permanent." Morgan had no choice but to become the lender of last resort, coordinator, liquidity provider, investigator of solvency, and generator of confidence – all at the cost of his own personal fortune.
2. Real power is not resources, but coordination through influence: The biggest impact felt in the resolution to the crisis was the speed of execution. The necessary funds were effectively allocated only because Morgan’s influence allowed him to quickly assemble bankers, extract commitments, evaluate institutions, broker agreements, and persuade government officials. No one else other than the President of the United States could get away with locking executives in a room until a resolution was reached. He forced cooperation among those actors who would otherwise be reluctant.
3. Markets run on stories as much as balance sheets: Financial markets are driven by two emotions – fear and greed. The Efficient Market Hypothesis argues that financial markets are so competitive and information travels so quickly that stock prices already incorporate everything investors know. If true, consistently outperforming the market becomes nearly impossible because any obvious opportunity has already been discovered and priced in by someone else. This is patently false, as all financial panics show that actors in the financial market are anything but rational. Emotions are the largest catalyst in dictating the markets. The Panic of 1907 spread to firms that had no direct exposure. Morgan’s directive to the clergy in an effort to calm congregations shows that confidence is a true financial asset.
4. Leadership involves tough decisions like who not to save: While Morgan saved the global economy and many essential institutions, we cannot overlook the difficulty behind the decision to not save Knickerbocker Trust, one that impacted thousands of people and their families. Leadership is not merely helping, but deciding where limited resources should and should not go.
5. Complex systems seem “too big to fail” but that’s a myth: Civilization runs on the trust required to run a global economy. For the fact that it has run for thousands of years, we assume it is infallible, but the Panic of 1907 shows how much the economy is hanging on by a thread. This was not an example of a self-correcting system as efficient capitalists would believe – it required much duct taping from Morgan and his associates. A single, failed copper speculation destroyed massive trust companies, brought the stock exchange to its knees, nearly bankrupted New York City, and threatened the national and global economy. There’s no better example of the butterfly effect.