John Thain got a phone call one Friday evening, demanding his presence at the New York Federal Reserve building within the hour.
The chairman of Merrill Lynch ditched his normal contingent of assistants and employees and went alone.
As he was shown into the meeting room, he saw a collection of the most powerful CEOs from the largest investment and commercial banks.
As the room quieted, the host had one thing to say: “There will be no bailout for Lehman… the only possible way out is a private-sector solution.”
At 3 a.m. early one Saturday morning, 120 bank and trust company officials assembled to hear a full report on the status of failing companies. After filing into the library, they realized their host had locked the doors behind them.
If the men wanted to go free, they would have to strike a private sector deal to contain a domino effect of failing credit and cash reserves from destroying Wall Street.
There are only three miles between the Fed building and the library… but the events were over a century apart.
What ties them together are two key conclusions and an important lesson to learn.
J.P. Morgan and the Panic of 1907
The Panic of 1907 was underway well before J.P. Morgan summoned the heads of prominent companies, banks, and trusts to his library.
It all started with a failed scheme to corner the copper market by Augustus and Otto Heinze, majority owners of United Copper.
In spite of concerns that they didn’t have the cash to pull it off, the brothers pushed ahead with a bold scheme to force investors with short positions to sell their shares to them for pennies on the dollar.
On October 14, shares of United Copper rose from $39 to $52 per share as the brothers bought up all the shares they could.
But too many others sold their shares. They couldn’t set their own price.
The next day, the share price fell to $10, and they were ruined.
The State Savings Bank of Butte, Montana, owned by Otto Heinze, failed because it held United Copper shares as collateral for many deals.
Contagion and loss of faith spread to the Mercantile National Bank, of which Augustus was president, and then on to any bank with business or personal ties to the brothers.
Not knowing who would survive, banks and trust companies froze short-term lending. Overnight rates hit 70%. The credit crunch hit brokers in need of cash and led to stock prices falling to seven-year lows.
Dozens of smaller banks subsequently failed, and New York’s largest trusts were poised to collapse.
By the time J.P. Morgan locked 120 bankers in a room, he had already bought $30 million of bonds to save New York City and strong-armed bankers into pooling over $40 million for loans to struggling banks.
$100 million in loan certificates was issued by the New York Clearing House. Secretary of the Treasury George Cortelyou was convinced to inject $25 million of taxpayer money into New York banks.
John D. Rockefeller put in $10 million and pledged half his wealth to maintain America’s credit.
Yet banks in New York still were reluctant to make short-term loans, even after over $200 million in orchestrated interventions flowed into banks and trusts desperate for any reprieve.
Morgan entered the talks demanding another loan of $25 million to save weaker institutions — otherwise a complete collapse of the banking system was inevitable. Cowed by Morgan’s legendary prominence and influence, the bankers emerged at 4:45 a.m. with a forced solution.
Morgan had his deal, but one last obstacle stood in his path…
President Theodore Roosevelt had made breaking up monopolies a central focus, and he would have to suspend enforcement of the Sherman Anti-Trust Law to allow the deal to go forward.
One of the largest brokerage firms was heavily in debt and used massive amounts of Tennessee Coal, Iron and Railroad Company (TC&I) stock as collateral.
To prevent the brokerage and TC&I from failing and causing more panic, Roosevelt was convinced to allow Andrew Carnegie’s U.S. Steel to buy its competitor.
“The relief furnished by this transaction was instant and far-reaching,” according to Commercial & Financial Chronicle, and the panic subsided. Yet the U.S. economy and markets continued to languish.
Paulson’s Failed Attempt
Henry Paulson, then Secretary of Treasury, had already struggled to contain the panic and fallout from the subprime mortgage fiasco for months before summoning the CEOs of the most powerful banks to the Federal Reserve building in New York City late Friday, September 12, 2008.
A run on investment banks and hedge funds in the shadow banking sector was rapidly accelerating out of control, although it wasn’t apparent because of overly complex trading and off-the-balance-sheet positions.
Bear Stearns had already imploded and been sold for a pittance to J.P. Morgan Chase on the condition that the Fed provide $30 billion in funds to cover losses.
IndyMac Bank had already failed, marking the fourth-largest bank failure in U.S. history. Fannie Mae and Freddie Mac, with their $6 trillion exposure to the tanking mortgage market, had been nationalized already as well.
The next bank to fail was going to be Lehman Brothers. Paulson, determined to avoid another government bailout that could set a precedent for others, was the point man for finding a private buyer.
Unfortunately, it wouldn’t work. Paulson didn’t have the clout or leverage of J.P. Morgan. That Friday evening, none of the CEOs would commit. There was no safety net, and it was time to panic.
By the time the Troubled Asset Relief Program bill was signed into law on October 13, 2008, Lehman Brothers failed, Merrill Lynch was swallowed by Bank of America, AIG had received $85 billion in Fed loans, investigations into dozens of banks had begun, and the Dow had shed 3,000 points.
Between Paulson and Bernanke meeting with key members of Congress to propose the bailout, the Fed had to lend nearly $1 trillion to banks and $1.3 trillion to non-financial U.S. companies.
By the time the dust settled and the Dow hit a bottom on March 6, 2009, it had shed nearly 5,000 points and 54% of its value from an October 9, 2007 high. The Fed already held $1.75 trillion of bank debt, mortgage-backed securities, and Treasury notes by then.
History Repeats Itself
There are plenty of differences between the Great Panic of 1907 and the Great Recession in 2008.
However, there are two key themes that tie them together.
First, it doesn’t matter if the money used to shore up banks comes from the private or public sector because the only thing it can stop is irrational panic.
After confidence was restored in 1907 through (virtually all) private money, unemployment continued to spike and production continued to lag for a year. That year saw unemployment rise to 8% from under 3%. Industrial production fell 11%.
From the beginning of 2008 until late 2009, unemployment jumped up 5% to top 10%. Between the start of the recession and the end, industrial production fell 16%.
As the Great Recession loomed, the Fed provided unilateral bailouts and wielded influence like J.P. Morgan while pooling money like the beleaguered bankers and waiving policies like Teddy Roosevelt.
It absorbed an unprecedented $3.5 trillion expansion of quasi-governmental debt without hesitation, guaranteed $16 trillion of debt worldwide, and dictated the terms of the government’s TARP bailout.
The market has more than recovered, yet wages are down, a vast majority of Americans have no exposure to stocks, and the economy has yet to return to previous growth rates.
Second, whenever there are credit squeezes, bank runs, or market turmoil, the temptation to let the end justify the means is too great. Ultimately, this compromises sound policy and erodes the free market.
Roosevelt compromised his adamant anti-trust efforts, the Fed was created to provide control over monetary policy without electoral influence, and J.P. Morgan whipped bankers with no good reason to loan each other money into a cabal of financiers for their weakest competitors.
We can see that recessions approach depressions in Japan and around Europe. Deflation is all but unavoidable as oil price drops push economic stagnation into contraction.
Bond markets are severely distorted, with bond yields in Japan under 0.5%, and German bonds at negative rates.
Things are so messed up that people are willing to lose money buying bonds that lock their money in for five years.
U.S. markets and bonds may be benefiting from mass belief that they are the only safe harbor, but interest rates remain jammed close to 0% and it will take many years to wind down the Fed’s balance sheet.
Ultimately, we have no reason to abdicate more power to centralized institutions who will use taxpayer leverage to disproportionately reward their peers.
