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The Panic of 1907 and the Birth of the Federal Reserve

Updated: Mar 21, 2023

The Federal Reserve is the Central Bank of the United States, and operates under a mandate from Congress to achieve three objectives when determining policy. Maximizing employment, stabilizing prices, and moderating long-term interest rates [1]. With these goals in mind, the Federal Reserve performs supervision and maintenance over banks, researches and publishes findings about the economy, provides services to the U.S. Government and other entities, and broadly endeavors to maintain a stable economy [2].

A central bank has been, in some parts of America's history, thought to be an extreme vulnerability. Andrew Jackson led the charge against the previous central bank, the Second Bank, in 1832 [3], and America was without a central bank for almost a century until the Federal Reserve was born.

The main incident was the Panic of 1907, and before taking a deeper look at the conditions that led to that panic, let's examine the key players and set the scene.

F. Augustus Heinze - one of the "Copper Kings" from Butte, Montana. Made a fortune through ownership of the United Copper Company. President of Mercantile National Bank, and friend of Charles W. Morse.

Charles W. Morse - member of the Consolidated Stock Exchange of New York (NYSE competitor), large owner of Mercantile National Bank. Cornered the marked on ice and became known as the "Ice King", and friend of F. Augustus Heinze.

Otto & Arthur Heinze - brothers of F. Augustus Heinze. Run a brokerage firm who attempted to squeeze shorts against them

Charles T. Barney - President of the Knickerbocker Trust Company. Frequent financier for Charles W. Morse schemes.

100 share certificate from the United Copper Company

F. Augustus Heinze was a wealthy copper magnate who made a fortune off of lucrative copper mines in Montana. He wanted to be a major financial player, so he based his company on 42 Broadway (just around the corner from Wall Street). He entered the banking business, and met Charles W. Morse - the "Ice King" of New York. Together, these two served on the boards of at least six national banks, ten state banks, five trust companies, and four insurance companies.

F. Augustus Heinze also has two brothers: Otto and Arthur. They ran a brokerage firm right across the corridor. One day, Otto devised a plan to corner the market for United Copper. He believed that his family owned and controlled the majority of the company, and thought that the stake his family had would be enough to squeeze shorts against United Copper (had Heinze had the majority stake, short sellers would have had no choice but to buy their shares at high prices). Charles W. Morse helped the Heinze brothers create a pool of money to make this possible. Together, Otto, Augustus, and Charles met with Charles T. Barney in an attempt to fund the hostile maneuver. Morse warned Otto that Barney couldn't cover the full cost of the scheme, but Otto proceeded onward regardless. They ended up securing financing (but not enough), from the Knickerbocker Trust Company (Charles T. Barney's trust company) to start the squeeze.

On October 14 1907, United Copper opened at $39 ⅞ . By 10:50 AM, the stock quickly rose to $60 before falling to $50. The next day, share prices opened even lower than $50. At that point, Otto began Phase 2. He started calling brokers and stated for shares to be delivered by 2:00 PM that day. In his mind, the brokers would fail to find available shares and they would default on their obligations. Therefore, they would have no choice but to purchase Heinze's over-valued shares. Unfortunately for Otto, this did not actually occur. All 20 brokers found enough shares from other sources, and not a single broker defaulted.

United Copper Short Squeeze, before and after

The attempted short squeeze flooded the market with shares of United Copper, and shortly afterward crumbled the share price. From the $60 high, it closed at $38, with no bid. The next day, it opened at $36 and closed at $10. At this point, Otto is bankrupt, as is his brokerage firm Gross & Kleeberg. United Copper's bank (the State Savings Bank of Montana), also became insolvent in the process. They had used shares of United Copper as collateral against some of its lending, and was a correspondent bank for the Mercantile National Bank (of which F. Augustus Heinze was president). Before noontime, the board voted to oust Heinze, but by then it was already too late. A run had already begun at the Mercantile National Bank. They had enough capital to handle a few days' worth of withdrawals, but runs also began at banks operated by Charles W. Morse as well. The panic was not yet widespread however, and was contained to banks/trusts run by Heinze or Morse. Both were barred from banking by the New York Clearing House (a collective of New York City's banks). A week later, regional stock exchanges across the country began limiting or closing trading.

Due to association with the failed squeeze attempt, the National Bank of Commerce announced that they would no longer serve as a clearing house for the Knickerbocker Trust Company (after Charles T. Barney unsuccessfully attempted to procure funding from J.P. Morgan, a prominent factor at the National Bank of Commerce). On October 22nd 1907, depositors rushed to pull their funds from the failed bank. In three hours, $8 million was withdrawn from the bank, and operations were suspended shortly before noon.

Wall Street during the Panic of 1907

When the panic was originally setting in, J.P. Morgan was out of town. At the time, J.P. Morgan was New York's wealthiest and most well-connected financier, who had rescued the Treasury during the Panic of 1893. Upon the panic, he swiftly returned to New York, and promptly began examining Knickerbocker's books. He and his associates deemed Knickerbocker to be insolvent, and thus abstained from providing aid. However, the panic did not just affect weak trust companies, but also healthy ones as well. This prompted J.P. Morgan to step in and begin rescuing the system while it was in such chaos. He conferred with several bank presidents and the Secretary of the Treasury to deposit money into a multitude of New York banks. John D. Rockefeller deposited $10 million into National City Bank to raise confidence and ease the panic. This ultimately gave National City Bank the deepest reserves of any bank in New York City at the time. Rockefeller even went as far as calling the manager of the Associated Press to publicly pledge half of his wealth to maintain U.S. credit.

Despite the massive cash infusions, the New York banks were reluctant to make short-term loans needed to facilitate daily stock trades. The interest rates on loans to brokers rose to an astounding 70%. Brokers found themselves unable to procure funding, and stock prices fell to lows unseen since December 1900. The panic had fully set in. At 1:30 PM on October 24th, the president of the NYSE rushed to J.P. Morgan's office to inform him that the exchange would have to close early. Morgan believed that if the exchange were to close early, the chaos would amplify.

J.P. Morgan called a meeting with all of New York City's bank presidents. He informed them that as many as 50 stock exchange houses would fail unless they managed to raise $25 million in 10 minutes. 14 bank presidents managed to pledge $23.6 million, and the money reached the market in less than 15 minutes. Within the 30 minutes until market close, $19 million had been lent out. They had managed to survive the day.

The next day, the markets continued to exhibit volatility, and once again, J.P. Morgan attempted to seek money from New York City's bank presidents. This time, they could only collectively pledge $9.7 million. To keep the NYSE from closing, Morgan decided that this money couldn't be used for margin sales. The daily volume was 2/3 that of the prior day, but once again, the market managed to survive until closing.

The bank presidents were aware that they could not continue to infuse money into the system. Even the Treasury was low on funds. They knew that if the public stopped panicking, the chaos would end. Together, they formed two committees: one to convince clergy to calm their congregations that Sunday, and one to talk to the press and explain their financial rescue package. To ease the panic even further, the Secretary of the Treasury agreed to return to Washington, hoping it would be a signal to Wall Street that the panic was over. Before the market opened on Monday, the New York Clearing House issued $100 million in loan certificates for banks to trade between each other. This influx in cash, combined with the actions of the two committees, ultimately did the trick and a sense of order returned to Wall Street that Monday.

Panics such as this, if allowed to begin, were costly and difficult to control. What would be done to limit the conditions which created such a problem?

The Secret Meeting at the Jekyll Island Club

The old clubhouse on Jekyll Island, GA

Key People:

Senator Nelson Aldrich - chairman of the National Monetary Commission. Studied the European banking systems for almost two years. Drafted the Aldrich Plan, which was partially implemented in the Federal Reserve Act.

Paul Warburg - Key architect of the future Federal Reserve. An advocate for banking reform prior to the Panic of 1907. Future Vice Chairman of the Federal Reserve.

Paul Warburg

Paul Warburg was a German-born banker who was born into the Warburg Family, a prominent banking dynasty with origins in Venice. He began his life in the banking industry in 1891, when he entered his family's firm of M.M. Warburg & Co. (founded in 1798, it is still functional to this day). In 1895 he married Nina Loeb, the daughter of Solomon Loeb, who later founded Kuhn, Loeb & Co. (where Warburg would later work) in New York City.

In 1902, he decided to take up residence in New York and became a partner at Kuhn, Loeb & Co. He would become a director of Wells Fargo, and later became the second Vice Chairman of the Federal Reserve.

He believed in centralized banking, and he was very passionate about advocating his views. Shortly after moving to New York in 1902, he drafted his critique of the current decentralized banking system, but inevitably didn't publish it (due to being self-conscious of his rusty English, and having recently emigrated). He let his critique sit for 4 years before he was finally persuaded to publish his writing by a Columbia University professor who shared his views on centralized banking. Soon, his writing was published in the New York Times, titled "Defects and Needs of our Banking System".

After the Panic of 1907, his arguments toward banking reform began to garner a wider reception. He later published two more articles, titled "A Plan for a Modified Central Bank" and "A United Reserve Bank of the United States".

Also shortly after the Panic of 1907, Senator Nelson Aldrich (R-RI) helped spearhead the Aldrich-Vreeland Act (co-sponsored by Senator Edward Vreeland, which established the National Monetary Commission). Its goal was to study the banking laws in the United States, and those of a multitude of European countries. Aldrich (now chairman of the Commission) and his team travel to Europe to study the features of their banks. They are stunned to see the stability, the flexibility with international trade, and the stark difference in value between their dollar and the pound/franc. Aldrich was inspired by the central banking systems in Europe and wished to implement this in the United States.

When Aldrich and his team return to the United States, he called a meeting with all of the nation's leading financiers at the Jekyll Island Club, GA - referred to in 1904 as "the richest, the most exclusive, the most inaccessible" club in the world. They planned to discuss monetary policy and the current banking system.

On the night of November 22, 1910, Senator Aldrich and the collective of influential bankers (together comprising about **25% of the world's total wealth at the time**), along with Paul Warburg (an early advocate for banking reform, whose ideas gained much more traction after the Panic of 1907) left Hoboken, NJ on a train in complete secrecy, dropping their surnames in favor of first names, even using code names, to maintain the secrecy of their meeting and their identities. They built and implemented the alibi of going duck hunting.

The exact details of the meeting on Jekyll Island are to this day still kept a secret. However, the founder of Forbes Magazine, Bertie Charles Forbes, wrote the following about the secret meeting:

"Picture a party of the nation's greatest bankers stealing out of New York on a private railroad car under cover of darkness, stealthily riding hundreds of miles South, embarking on a mysterious launch, sneaking onto an island deserted by all but a few servants, living there a full week under such rigid secrecy that the names of not one of them was once mentioned, lest the servants learn the identity and disclose to the world this strangest, most secret expedition in the history of American finance. I am not romancing; I am giving to the world, for the first time, the real story of how the famous Aldrich currency report, the foundation of our new currency system, was written ... The utmost secrecy was enjoined upon all. The public must not glean a hint of what was to be done. Senator Aldrich notified each one to go quietly into a private car of which the railroad had received orders to draw up on an unfrequented platform. Off the party set. New York's ubiquitous reporters had been foiled ... Nelson (Aldrich) had confided to Henry, Frank, Paul and Piatt that he was to keep them locked up at Jekyll Island, out of the rest of the world, until they had evolved and compiled a scientific currency system for the United States, the real birth of the present Federal Reserve System, the plan done on Jekyll Island in the conference with Paul, Frank and Henry ... Warburg is the link that binds the Aldrich system and the present system together. He more than any one man has made the system possible as a working reality" - B.C. Forbes

During this meeting, they drafted the Aldrich Plan, which ultimately failed against the Owen-Glass Bill (the Federal Reserve Act). However, some elements from the Aldrich Plan were incorporated into the Federal Reserve Act (namely, the concept of a decentralized centralized bank, much to the chagrin of President Woodrow Wilson). This bill was signed into law on December 23, 1913, thereby creating the Federal Reserve System.

A collection of Essays Including Paul Warburg's cited works can be located here.



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