About the current credit market turmoil, Former Federal Reserve Chairman Alan Greenspan said in early September, “The behavior in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987, what I suspect we saw in the land-boom collapse of 1837, and certainly the bank panic of 1907.”
Registered Rep.'s Editor-In-Chief David A. Geracioti phoned Sean Carr, one of the coauthors of The Panic of 1907: Lessons Learned from the Market's Perfect Storm, to learn about the 100-year-old crisis to which Greenspan referred. Carr, a former journalist who worked as a producer for CNN, and for ABC's World News Tonight with Peter Jennings, is director of Corporate Innovation Programs at the Batten Institute, University of Virginia. The other coauthor, Robert F. Bruner, the dean of the Darden Graduate School of Business, was out of the country, and unavailable to participate.
Registered Rep: Your new book, The Panic of 1907, seems to have been published at a fortuitous time. In your book, you and Robert Bruner describe the run on banks in 1907 after a trust company failed. How relevant is the Panic of 1907 to today's credit crisis? Countrywide is still kicking, thanks to a cash injection, and there haven't been any bank runs — well, not in the U.S. anyway. But investors seem afraid and uncertain that the sub-prime mess may spread into the larger economy — or even cause a good, old-fashioned bank run of the type that hit the fifth-largest mortgage lender in Britain. Also, the politics of 1907 sound similar to our own. The political fear mongering about the power of trust companies then sounds similar to the concern over private equity firms and hedge funds now.
Carr: Bingo, that's exactly right. Certainly when we started researching this book, we had a sense that there might be some analogies there, but I think it's become quite apparent that there are striking similarities — particularly when we looked at the emergence of the trust companies in 1907 that at the time were still considered a financial innovation. Basically, trust companies operated as banks, but until 1906 they were not required to hold any reserves against the profits whatsoever. Not only that, unlike the national and state banks at the time, they were permitted to invest directly in equities. So they could be putting money directly into the stock market.
Thus the era was marked by a lack of protection, risk-seeking and a highly unregulated market. We certainly see much of that today. And, again, there are definitely lessons to be learned from how the trust companies were managed then.
RR: But hedge funds and private equity firms of today — the so-called fat cats that politicians rail about — aren't anything like bank institutions were in 1906 or 1907.
Carr: To the extent that trust companies served as an investment vehicle, they are: their size, their growth — trust company deposits were growing at several times the rate of banks. So in terms of capital flows, I think there's a strong argument to be made for how they are analogous to hedge funds today.
RR: What triggered the incredibly bad economic situation back then? I mean, it sounded horrible: Economic output dropped, and unemployment spiked. What caused all this stuff? What was the trigger?
Carr: There were multiple triggers, as there always are. Like lots of panics, there is some external shock. At the turn of the last century, that external shock took the form of an earthquake in San Francisco in 1906. It destroyed the city. We tend to think of the economic financial system 100 years ago as being somewhat more quaint and simple. And yet it was highly sophisticated and global. And as a complex system, like the complex system we have today, trouble can travel quickly. And so when the earthquake occurred, money was pulled from all the United States money centers, but also from London, and it created strains in the global market.
RR: A seizing of credit like we're having now?
Carr: Exactly, a progressive tightening of liquidity, which had been accelerated by the massive capital demands of San Francisco's earthquake.
RR: So that's what's happening today: People get risk averse when they see institutions, such as a hedge fund or two, go belly up.
Carr: Yeah, that's right. Now, as I said, there were multiple triggers. The other trigger to the crisis that occurred in October of 1907, was the attempt of a group of unscrupulous speculators led by Augustus Heinze and Charles Morse, to corner the market on a copper mining company. The bid failed.
RR: And that implicated others, right, including the head of a trust company? People got scared?
Carr: Yes, it was because Charles Barney, the head of the Knickerbocker Trust, along with other trust companies, funded the mining company venture. Barney's mere association with Augustus Heinze had panicked the trust company's thousands of depositors. It created a run, and the Knickerbocker Trust failed. Two weeks after the crisis was resolved, Barney killed himself.
So the larger trigger for the series of events, I think, was the earthquake in San Francisco; that was the external shock that broke an already stressed economic and financial system.
RR: And it was stressed because they'd absorbed too much risk?
Carr: That's right. And the cost of the earthquake was the equivalent to 1.2 or 1.3 percent of the nation's GDP at the time.
Carr: Massive. It's still really hard for us to comprehend the scale. In order to rebuild the city, the populace made claims on insurance companies. And the draw upon insurance companies was pulling cash out of the system across the country, and in turn, out of London, which was the world financial center. Now that creates an environment in which we also identify another factor that leads to a crisis, which is a lack of a safety buffer. So with the earthquake, money is pulled out, liquidity is tight, there's not much more room or give if something else should happen. So then there are a few bumps along the road in March, and later in the spring of 1907. The stock market takes a dip of about 7 percent, people are starting to get nervous, but investment is still happening at a rapid pace.
The economy continues to grow — it had been growing more than 7 percent over the past several years annually. We then get into August and October, and then there's this attempt to corner the stock of this copper company that failed. And that was the trigger that made people really anxious. Because people knew that the individuals behind that corner attempt were associated with a number of other institutions: the Knickerbocker Trust Company, other national banks at the time. And through various board connections, people became very afraid that by virtue of a failure in the stock market, their individual investments and deposits at banks would be affected.
So we begin to get a sense of the pre-linkages in this complex system that are affected by an earthquake that occurred in 1906, and then made worse by a tight monetary system at the time.
RR: And in the end, Morgan gets those bankers together …
Carr: Yes, but he didn't react immediately. The banks were not providing leadership or sufficient collective action. There was no buyer of last resort, or Central Bank at the time. It is only because J. P. Morgan finally inserted himself into [the crisis] and, through his personal contacts and with his influence, could, on an as-needed basis, exercise the art of a central banker, which is to intervene as needed with capital.
RR: Weren't we still in the gold standard at the time?
Carr: We were. So he was also instrumental in requesting gold to be brought over from London to support the system here. Because there simply wasn't enough gold available here.
RR: So people were bringing in their dollar notes saying, “I want gold?”
Carr: Yes, exactly. And, in fact, some of the banks would actually take piles of gold, and put it in the windows of their banks to show people that they had sufficient assets to honor their claims — even if they didn't. Under Morgan's leadership, the crisis was finally stopped.
RR: And so out of this was born the Federal Reserve system?
Carr: That's right.
RR: Is there anything you see wrong with the way things are going now?
Carr: Ben Bernanke is in a tough spot, and this is his moment to exercise astute leadership. In 1907, J.P. Morgan played that role. J.P. Morgan was not everywhere at once, and he did not intervene everywhere. J.P. Morgan let the Knickerbocker Trust — the third largest trust company — falter. He explicitly refused — and we don't have documentary evidence to know exactly why he didn't intervene there. But the next trust company that came along that was on the precipice of failure, the Trust Company of America, he did. And there's a famous moment in the book, and in the archives, in which he looks around to the bankers assembled in the room after having received the report on that particular bank, and it appeared that there were enough assets. He said to them, “This is where the trouble stops,” and made it very explicit to them.
And then it was reported to the public that the trouble would stop right then, and that was the beginning of the end of the crisis. So leadership today will need to draw some lessons from that — and it is. Part of the art form of being a Central Banker is knowing when and where to play a hand, and finding the right balance between being aggressive, and performing a more moderate role if there's going to be a challenge.