Financial History Issue 129 (Spring 2019) | Page 16

By Daniel C. Munson Much has been written about the changes to the American financial sys- tem and the American economy resulting from the establishment of the Federal Reserve Bank in 1913. These writings are interesting, but they often devolve into attempts at second-guessing the actions of the Federal Reserve in response to various economic conditions—depressions, spec- ulative bubbles, etc.—with the convenient perspective of hindsight. Another way to think about the effects of the Federal Reserve System is to ask what changes it has wrought on the behav- ior of the nation’s citizens. Do our busi- ness people behave differently because there is a central bank? This question can be approached any number of ways, but one way is to look at similar sets of economic circumstances occurring with and without the presence of the Federal Reserve and observe the behavior of the market participants. Market panics can throw these behav- iors into stark relief. In the same way that bad weather can expose the skill (or lack of skill) of ship captains and airplane pilots, bank failures and liquidity crises can throw bright light on the actions of a nation’s financiers. The panics of the late summer and early fall of 1907 and 2008 can serve. They were separated not merely by a clean century of time, but by the absence (1907) and the presence (2008) of a powerful central bank. A look back at the chaos and the action during those two panics can per- haps allow us to understand better the effects of central banking. The facts surrounding the panics of 1907 and 2008 were different, but in pre- cipitating features they were the same. Credit conditions were strained in Octo- ber 1907 and suddenly came completely unglued when the Knickerbocker Trust, a prominent New York bank, was rumored to have a big book of business with an over-extended copper mining financier who went bust attempting to force a Previous page: Wall Street during the Panic of 1907. “short squeeze” in the shares of a com- pany he controlled. Troubles in 2008 cul- minated when Lehman Brothers was sunk by a large pile of lousy mortgages and real estate investments. In 1907, J. Pierpont Morgan sent his people to rifle through the books of the Knickerbocker Trust to assess if it was salvageable with an emer- gency loan and, similarly, in 2008 Lehman Brothers was examined by a number of potential buyers (including J.P. Morgan Chase) in the days before its collapse. The suspension of operations at the Knickerbocker Trust and the bankruptcy of Lehman Brothers had similar cascading effects: there was uncertainty concerning exactly which financial institutions held the bad loans and in what amounts, and this uncertainty led to reduced levels of lending. Asset prices declined sharply as the credit necessary to finance asset pur- chases dried up, and banks tried to call in loans and refused to make new loans until they could assess the damage. The difference for investors is that in 2008 the benefit of being liquid was small. Interbank overnight rates increased a few percentage points in the two weeks follow- ing the collapse of Lehman Brothers, then dropped precipitously to near zero. Mar- gin lending rates, strictly limited in scope, barely budged. Long-dated Treasury secu- rities, which while liquid do involve put- ting principal at risk, increased in value some 15–20% in the ensuing months as long-term rates declined. But, in general, those in cash and money market funds simply sat by and contented themselves with the thought that they hadn’t lost any money. In 1907, however, a liquid investor unwilling to tie up money for years in buying depressed common stocks could still have made some real dough. In the wake of the closure of the Knickerbocker Trust, the market that lent short-term against stock market collateral—the “call loan,” now the “margin loan” mar- ket—needed lenders: the prevailing rate of roughly 6% was not high enough to induce sufficient supply. (Recall that a 6% interest rate in 1907 was a “real” rate in that the gold-backed 1907 US dollar held and even tended to increase slightly in value over time.) Trust companies like the 14    FINANCIAL HISTORY  |  Spring 2019  | www.MoAF.org Knickerbocker routinely made unsecured loans to Wall Street brokers, but when the panic began and Trust depositors began queueing up to withdraw money, credit on Wall Street became very tight. J.P. Morgan’s syndicate of banks sent funds, but the demand from the illiquid was insatiable. The nation’s newspapers reported the dramatic events: on October 22—the day the Knickerbocker Trust sus- pended operations—the morning call loan rate of 10% produced insufficient supply, and by mid-afternoon rates had skyrock- eted to 60% and later 70%. On October 24, call money rates peaked at 90%. The following day, call money temporarily reached 100%. Brokers in Philadelphia threw up their hands and simply discon- tinued all trading on margin. One person’s high borrowing rate is another’s payday, of course, and the mar- ket participants holding unencumbered cash in late 1907 might have felt that they were indeed living in “the best of all possible worlds.” Those who could lend funds to the call loan market did so, earning 1% on their money in only a few days. These profitable rates persisted: call loan rates remained well above 20% into early November and averaged around 20% for months afterwards. There was money made by these same liquid folks in cash- ing checks and clearing house certificates, perhaps discounting them significantly from face value. My contemporaries may wish to avert their eyes. The business of charging “usu- rious” rates to the financially distressed, the illiquid, is not a pretty sight. Those solvent souls in 1907 who saw themselves as fulfilling a useful function—providing cash at a time when it was needed—had to know that the country at-large probably thought of them as vultures. The financial trauma of October 1907 did not pass quickly from public conscious- ness. It became known that the leaders of the major Wall Street banks, J.P. Morgan and his colleagues, had decided behind closed doors which banks and trust com- panies could be saved and which ones had to be shuttered. In the days before deposit insurance, this appeared to be incredible power wielded by private citizens account- able only to their shareholders.