Lessons from an old crisis

There were several scams in the early 1900s but the most fascinating tale is of how Otto Heinze, a stockbroker on the NYSE, made a wrong call that resulted in a crash in the shares of United Copper Company(UCC) and had a devastating impact on the rest of the market as also some banks. The company belonged to his brother FA Heinze, a copper mining magnate, known to be shrewd and unscrupulous, who had an interest in the Mercantile National Bank (MNB). The Heinze brothers had purchased large quantities of UCC stock through 20 brokerages "on margin" or without paying up the full amount. Believing that some brokerages had loaned out these shares hoping to buy them back at a lower price, Otto Heinze, who had already run up a bill of $2 billion, holding on to the shares in a weak market, decided to corner the short sellers by "calling in the shares". The MNB aided him in this attempt only to discover that there had been no short sellers in the first place. Hundreds of shares came pouring in and the stock crashed, taking down with it a reputed stock broking firm and resulting in losses for MNB.

The Panic of 1907 is an interesting read because of the colourful personalities such as Charles W Morse, one of Wall Street's most notorious figures who controlled a couple of banks and pursued a "chain-banking" strategy, buying a controlling interest in one bank and using that bank's equity as collateral to borrow money for purchasing shares in other financial institutions. Or "Jupiter" J P Morgan, the undisputed leader of the financial community , "a mighty for decent finance" who took it upon himself to inspire confidence and organise collective action in a time of instability. The books begins on a dramatic note with the suicide of Charles Barney, part of the financial elite and head of the Knickerbocker Trust Company, which ultimately saw a run on its deposits and failed.

The financial crisis itself began in 1906, when a severe earthquake and a rash of fires destroyed San Fransisco, then the financial centre of the West. Very soon the ripples were felt in the global financial system since several British insurers had underwritten fire policies and were forced to liquidate stocks to pay up the huge claims. Large sums of gold were exported from England to America. Concurrently a bull market, fuelled by a brisk 7 per cent plus growth rate of the US economy, was beginning to run its course. A buoyant economy, the authors say, makes the financial system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent. That's exactly as it happened and in a period of 15 months, from its peak in September 1906 to its trough in November 1907, the markets lost 37 per cent. What was worse was the panic in the banking system that brought down at least 25 banks and 17 trust companies as hundreds of depositors tried in vain to get back their money. In a ripple effect, commodity prices fell 21 per cent, wiping out virtually the entire increase of the three previous years. The immediate effects of this crisis were an "extremely severe" and "extraordinarily violent" economic contraction, leading to an "intense" depression in 1908.

At a time when the sub-prime loan crisis in the United States seems to be getting bigger than what was originally thought, a recounting of the 1907 financial collapse in the United States may not seem out of place, even though it happened 100 years back. Of course, there are some major differences, the most important being the presence of a far more influential central bank that can inject liquidity into the market at a time of crisis. But like before, the stock, debt, currency, gold and commodity markets are integrated and so a severe fall in prices in any one market could have repercussions on another. The authors believe that a complex financial system makes it difficult for anyone to know what might be going wrong; by definition the multiple parts of the financial system are linked, which means that trouble in one institution can result in a chain reaction. In other words, trouble can travel. They say that while history is unlikely to repeat itself, the drivers of the crisis can and do recur; they point out that about 9,000 unregulated hedge funds control $1 trillion in investment capital directly. The seven "lessons" that the authors believe can be learnt from the episode may not really contain any new insights but do raise some relevant questions of adequate safeguards to prevent the spread of potential shocks.

THE PANIC OF 1907
LESSONS LEARNED FROM THE MARKET'S PERFECT STORM

Robert F Bruner & Sean D Carr
John Wiley & Sons Inc
258 pages