Panic Of 1907: The Stock Market Crash That Brought Us The Fed

Panic Of 1907: The Stock Market Crash That Brought Us The Fed

Catherine Brock  October 23, 2024   Yahoo Personal Finance

Crises have a way of ushering in change, especially in the realm of personal finance. Some of the worst stock market crashes in U.S. history have been followed by regulatory reform efforts to protect investors.

For example, legislators established the Securities and Exchange Commission after the crash of 1929 and passed the Dodd-Frank Act after the 2008 financial crisis.

The banking and stock market breakdown that preceded the creation of the Federal Reserve System is less well known. Called the “Panic of 1907” or the “Bankers Panic of 1907,” the crash had far-reaching consequences that influence how banks operate today. The details of the story also highlight key takeaways that can help investors manage risk.

Bankers Panic of 1907

Greed underpins many stock market scandals, and the Bankers Panic of 1907 was no exception. Under the pressures of the 1907 recession, a group of businessmen attempted to manipulate the stock price of mining company United Copper. The group consisted of three brothers — Augustus Heinze, Arthur Heinze, Otto Heinze — and an associate named Charles Morse. The four of them were majority shareholders in the copper company prior to their price manipulation scheme.

Margin Buying Gone Wrong

The Heinze brothers and Morse had financed many of their United Copper shares in a practice called buying on margin.

Buying on margin is still common today. Brokers loan money for the stock buy and then hold shares as collateral. If the shares' collective value dips too low, the broker can ask the investor to provide more funding. If the investor does not, the broker can sell the shares to pay down the loan balance. The sale creates a loss for the investor.

The Heinze brothers and Morse were facing this scenario. United Copper's share price had fallen, and they were under pressure to provide more collateral.

Failed Short Squeeze

While reviewing the United Copper holdings, Arthur Heinze determined that investors were shorting the company's stock. A short position is a bet the stock price will decline. It involves borrowing shares and selling them to someone else. The Heinze brothers believed their United Copper shares were being lent without their knowledge.

Otto Heinze formulated a plan. He would buy up available shares of United Copper to drive the price higher. The higher price would force short sellers to close their positions — which they could only do by purchasing shares on the open market. Heinze would sell them the shares and use the proceeds to repay the margin loans.

Unfortunately for the U.S. economy, Heinze was wrong. He drove up the price of United Copper with excessive purchases, but the expected demand from short sellers did not materialize. With no buyers for his shares, Otto refused to pay his broker for the trades.

The broker, Gross & Kleeberg, sold the shares at a loss, and the price of United Copper crashed. Gross & Kleeberg subsequently shut down and Otto Heinze was banned from trading.

A Complex Web Of Influence And The Financial Aftermath

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