[Global Finance History] The 1907 Financial Crisis and JP Morgan

Although the 20th century had begun, the United States did not have a central bank to oversee the bank proposed by Hamilton and to act as the ultimate lender of last resort. Nevertheless, the U.S. economy grew by 5% annually, and the number of banks exploded. In 1907, there was one bank for every 4,000 people in the U.S., totaling 22,000 banks. In major cities, there were trust companies that became the main culprits of financial crises.

Trust companies, which emerged in the early 1890s, engaged in bond and stock investments and also handled deposits. In other words, trust companies became quasi-banks. Compared to regular banks, they invested in riskier assets but operated in regulatory blind spots. Banks were required to hold 25% of their assets in cash, but trust companies had only a minimum 5% requirement. Paying higher interest than banks, trust companies grew nearly 250% over ten years until 1907, becoming almost as large as national banks.

Unregulated trust companies were at the center of the 1907 financial crisis. The main culprit was the Knickerbocker Trust Company. It was a trust company founded by copper miner Augustus Heinze and ice manufacturer Charles Morse as partners. Knickerbocker Trust's deposits surged from $10 million in 1897 to over $60 million in 1907, making it the third-largest trust company in the U.S.

However, Knickerbocker Trust suffered heavy losses after accumulating large amounts of stock in the copper company United Copper, whose stock price plummeted. To purchase the copper company’s stock, they borrowed huge sums from their own bank and embezzled funds. The economy began to slow slightly in 1907, causing commodity prices, including metals, to fall. Consequently, United Copper’s stock price also dropped. As stock prices fell, Heinze and Morse faced huge losses due to massive leverage.

As investors rushed to withdraw funds, the bank run vortex engulfed the trust company. Rumors about the bank’s financial condition spread, and depositors lined up on the streets demanding cash. Knickerbocker paid out $8 million within a day, but it was inevitable. Eventually, some withdrawal requests had to be refused, and the fire spread to other trusts. Bank runs began at other trust companies such as America and Lincoln Trust. Some New Yorkers moved cash from one trust to another. As it became clear that the financial system was unsafe, Americans began hoarding cash at home.

With stock prices plummeting, the New York Stock Exchange halted trading of United Copper. Investors flocked to Knickerbocker Trust, which had invested entirely in United Copper, to withdraw their funds, pushing the trust company to the brink of bankruptcy within two days.

As the panic spread and interest rates soared to 125%, JP Morgan appeared as the rescuer in October 1907. Morgan first secured cash. Until a rescue fund of $25 million was agreed upon, he locked the entire New York banking community in his library. Although he prevented collapse, that amount of cash was insufficient. Despite a robust economy, a nationwide liquidity shortage ensued, and the economy entered a recession. Morgan made it clear that responses had to be limited. Trust company presidents flocked to Morgan’s headquarters to save their companies, but through due diligence, he distinguished between companies that could be saved and those that had to be closed. Based on that criterion, he guaranteed payment on notes demanding cash settlement. Morgan’s ability to act as rescuer was not only due to his financial resources to raise rescue funds but also because of the authority or trust he commanded. Of course, as a businessman, nothing was free. US Steel, controlled by Morgan, acquired the Tennessee Coal, Iron and Railroad Company (TC&I) as a kind of spoils.

Besides the macro rescue plan led by Morgan, ordinary people always find solutions to specific economic situations. An alternative to the shortage of legal tender soon emerged. Bank checks and small promissory notes began to be used on-site like legal tender as substitutes for dollar bills. In principle, this was illegal, but the total value of private sector emergency cash far exceeded Morgan’s rescue funds, amounting to about $500 million. Although a kind of workaround, this allowed the U.S. economy to grow again until 1909.

Eventually, a central bank was established. The initial rescue plan focused on supplying official emergency funds of $500 million to solve the cash shortage. Subsequently, the establishment of a committee (National Monetary Commission) to discuss how the U.S. currency system should operate was discussed. For four years, evidence from around the world was examined to find the best way to restructure the system. Concluding that an appropriate lender of last resort was necessary, the Federal Reserve Act was enacted in December 1913 to establish the third central bank of the United States. Hamilton had ultimately found the way, albeit belatedly.

Baek Youngran, CEO of History Journal

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