The doors of the library were locked from the inside. No one was allowed to leave.
It was the first week of November, 1907. Outside, a crisp autumn breeze brushed through the streets of Manhattan… and a silent fear permeated the air. The financial system was coming apart, and New Yorkers could “feel” it more acutely than most.
Perhaps absurdly, the trouble had started with a failed scheme to corner the stock of a copper company. It was a bet so bad that it took down an entire brokerage and triggered bank runs throughout the Big Apple.
Now the contagion was spreading through the whole of the New York financial system. Depositors stood in lines that wrapped around city blocks, weathering the sharp autumn air to pull their savings out of trust companies that might not last the afternoon.
At the same time, the stock market was crashing. And there was genuine panic that the entire financial system would lock up.
That is, until a seventy-year-old banker named J.P. Morgan decided it was in his best interest to act.
So it was that a group of bankers sat in J.P. Morgan’s private library on Madison Avenue that crisp November day. Renaissance paintings adorned the walls and the world’s finest collection of medieval manuscripts rested on the shelves.
Morgan moved between rooms as the long night wore on—trust company presidents gathered in the West Room, other bankers in the East. He made it clear that no man would leave until a plan was in place to rescue the American financial system.
Morgan had his associates physically lock the doors to emphasize the point. And while he didn’t say it outright, it was understood that any such plan would be on his terms.
What was discussed in the room laid the foundation for the financial architecture that we still have in place today. But to understand the other forces at work, we must go back five years — to a steamship pulling into New York Harbor, carrying a man who already knew exactly what he intended to do in America.
The Plot Begins
In 1902, a thirty-five-year-old German banker named Paul Warburg stepped off a steamship and onto the streets of New York City. His mission was to study the American banking system from the inside, as if he were a surgeon assessing his patient.
Now, Warburg was not an ordinary immigrant. He was born into the Hamburg banking dynasty of M.M. Warburg & Co. It was a powerful old-money house that had been financing European trade since 1798.
As such, Warburg had trained in the money markets of London and Paris. He understood, in intimate mechanical detail, how the Bank of England operated — how it expanded and contracted credit, how it served as a lender of last resort, and how it sought to manage the rhythm of an entire economy from a single building on Threadneedle Street.
What’s more, Warburg had married Nina Loeb, daughter of Solomon Loeb, who happened to be the founding partner of Kuhn, Loeb & Co. That’s the marriage that put him inside one of the most powerful investment banking houses in America.
So when he looked at the American banking system, Warburg was not looking at it the way an American would. He was comparing it to the European central banking model he had grown up inside. And by that standard, the American financial system looked rigid and unyielding. There was no central institution in place with the power to bend it.
Within two years of his arrival, Warburg was writing essays and circulating private memoranda arguing that the United States needed a European-style central bank. He kept writing them and then refining them for the better part of a decade.
However, this was a foreign concept in America. No Americans walked around thinking that their country should adopt a central bank… most had no idea what such a thing even was.
So Warburg was agitating for a solution to a problem that did not exist upon his arrival in 1902. We’ll come back to that thought in a few minutes.
The Nature of the National Banking System
As we’ve discussed in our earlier entries to this essay series, Alexander Hamilton instituted a national banking system as one of his key pillars to what became known as the American System.
While it was a centralized system compared to the laissez-faire free banking model, the national banking system did not resemble the banking system we have today.
To the contrary, it featured sound money because the dollar was backed by gold. And the amount of dollars in circulation was tied explicitly to the amount of US Treasury bonds that banks held as collateral.
Thus, the US dollar was an “inelastic currency” from the perspective of people like Warburg who advocated for a European-style central bank. The supply of national banknotes could not easily expand or contract with the fluctuation of trade or crisis periods. And no one could simply create dollars at will.
So when Warburg wrote in his essays about how the American banking system was rigid and panic-prone, he wasn’t wrong. When rumors of trouble within a particular bank arose, depositors would wisely rush to the bank to pull out their deposits. Because if the bank was in fact short on its reserves, they knew that whoever was slowest to withdraw would be left holding the bag.
One could argue that this wasn’t such a bad thing – because the possibility of a bank run serves as a strong incentive for banks to engage in sound lending practices with good, thorough underwriting. If a particular bank went bust, it would go out of business.
Now, there were clearing houses that could provide banks with emergency liquidity in times of trouble. But that liquidity was limited to the reserves held by the clearing house. There was no lender of last resort with unlimited bailout capacity.
To Warburg, however, this was a problem. And it was a problem that he intended to solve. That brings us back to that locked library on Madison Avenue in 1907…
The Panic of 1907 Made the Case
As we noted earlier, J.P. Morgan and his assortment of bankers were responding to a banking crisis that had stemmed from a failed scheme to corner a copper stock.
The corner attempt was the work of two brothers – F. Augustus Heinze and Otto Heinze.
Augustus had made his fortune in the copper mountains of Butte, Montana, and he had parlayed that fortune into control of Mercantile National Bank in New York. His brother Otto ran a brokerage firm called Gross & Kleeberg.
Together, along with their associate Charles Morse — himself a banker with his own web of New York financial institutions — they believed they had spotted an opportunity in the stock of United Copper Company.
At the time, United Copper Company’s stock was heavily “shorted” because a contingent of investors expected it to go down in price.
When investors short a stock, they borrow shares, sell them, and plan to buy them back later at a lower price — pocketing the difference. So if you can accumulate enough of the available shares such that short sellers can’t find stock to buy back anywhere else, you control the price. The shorts have to come to you to cover their positions, at whatever price you name.
That’s what it means to corner the market for a given stock. And the Heinze brothers believed they had bought up enough shares in United Copper to spring exactly that trap.
They were wrong.
When Otto moved to force the short sellers to cover their positions, he discovered that United Copper shares were available elsewhere in the market. There were available shares that his syndicate hadn’t accounted for.
So instead of being able to force the stock price higher, United Copper collapsed. The stock fell from roughly $60 per share to under $10 in two days. Given how many shares he had acquired, that move bankrupted Otto’s brokerage Gross & Kleeberg. Then the New York Stock Exchange (NYSE) suspended his trading privileges.
News of Otto’s bankruptcy spread fast throughout the city. Not taking any chances, customers of Augustus’ Mercantile National Bank rushed to withdraw their deposits.
This prompted the New York Clearing House to move quickly. It forced Augustus to resign his position, and then the Clearing House agreed to backstop Mercantile National Bank by providing liquidity to stop the bank run.
But if we remember, the Heinze brothers partnered with Charles Morse, who himself controlled a web of interlocking financial institutions. When word got out that he was also involved, contagion ripped through the system.
To appreciate what happened, we have to understand the trust company model.
Trust companies in 1907 occupied a peculiar position in New York’s financial world. They functioned like banks in that they took deposits, made loans, and managed assets for wealthy clients.
But trusts operated under lighter regulation, which in ordinary times made them profitable and competitive. The critical difference was that they were not members of the New York Clearing House. Thus, they had no access to the emergency liquidity network that had saved Mercantile National.
So when word spread that Charles T. Barney, the president of Knickerbocker Trust, had social and financial ties to the Heinze-Morse crowd, another panic ensued.
The connection to Knickerbocker Trust, the third-largest bank in New York, was indirect. There was no solid evidence that Knickerbocker was involved in the United Copper scheme. But it didn’t matter.
Depositors didn’t wait for investigations. They formed lines outside Knickerbocker’s doors and began withdrawing their money.
On October 22nd, 1907, the National Bank of Commerce announced that it would no longer clear checks for Knickerbocker Trust. That’s when the run became a rout… and Knickerbocker had to close its doors forever.
The panic then spread.
Trust Company of America… Lincoln Trust… institution after institution faced the same impossible situation as depositors demanded all their money at once. With no Clearing House to backstop them, and no way to demonstrate solvency faster than the lines were growing, the trusts had no solution.
The stock market fell hard. And people worried if the heart of America’s financial system would stop beating.
That’s what prompted Morgan to gather a group of bankers in his library and lock them in until they had formed a rescue plan. But Morgan was not the only man watching the crisis unfold with a plan in mind.
This was the moment Paul Warburg had been waiting for. He had spent five years circulating essays and private memoranda arguing that the United States needed a European-style central bank.
To Warburg, the Panic of 1907 made his case plainly. So he, along with the interests aligned with the European banking model, made their move.
They already had their solution to the crisis ready – dismantle the American System and install a European-style central bank. The panic ripping through New York in 1907 is what gave them the cover they needed to push it…
But before we move forward, we need to take a step back.
Cracks had already been chipping away at the American System for years prior. We’ll assess what had happened in the preceding decades in our next essay. Doing so will put the silent takeover of 1913 in context.
Stay tuned…
-Joe Withrow
P.S. Episode 8 of the Phoenician League podcast is now online. In it, we explore what may be the most important number in modern finance, and we examine how the modern financial architecture is shifting right before our eyes.
You can find the podcast at: https://phoenicianleague.com/podcast-episode-8-the-number-nobody-changed-gold-remonetization-and-the-new-financial-architecture/
And if you would like to tune in via other means, the podcast is available on all the major platforms. This includes Apple Podcasts, Spotify, and all the others. The video version is available on our YouTube channel as well.
Alternatively, you can catch every episode after it has published at: https://phoenicianleague.com/podcast