The Tycoon Report

The Stock Market Panic of 1907 vs. the Mortgage Panic of 2007

Wednesday, December 5, 2007 | Dylan Jovine

THE YEAR WAS 1907.

The maximum speed limit in most cities was 10 mph.  A three minute telephone call from Denver to New York City cost 11 bucks.  90% of doctors had no college education.  And the average life expectancy in the U.S. was 47 years.

Last but not least, the stock market had been on one of the greatest bull runs in history.  The economy had been strong for years, jobs were being created at a rapid pace, and corporate America was a profit machine.

That's right.  100 years ago to the year, America was in one of the strongest bull markets ever seen ... until the credit markets began to dry up, bringing on one of the greatest financial panics in American history.

Of course the culprits of the 1907 financial panic weren't mortgage lenders like Countrywide Credit (CYM: CFC) as is the case in 2007.  The culprits were the New York Trust Companies, specifically the "Countrywide of 1907," the proud KnickerBocker Trust Company.

And while the mortgage companies of 2007 and the trust companies of 1907 lent their money to different customers, they both had one thing in common: At the height of a bull market they both made stupid loans to people who couldn't pay them back.

Indeed, that's how all credit crunches throughout human history have started: 1) money becomes cheap, 2) money floods the system, 3) lending standards are relaxed to put all this cheap plentiful money to use in order to maximize profits, and 4) bad loans are made.

Now back in those days, the money needed to finance crop shipments from the Midwest to the East Coast in September and October usually left the New York City money market squeezed for cash during the fall.  As a result, short-term interest rates in New York tended to spike up in autumn, which is when the Panic of 1907 began.

(Yes, that is the root cause of the historic relationship between bear markets and the fall season, especially September/October.)

Once financial panics begin, they're incredibly difficult to stop.  The biggest concern in 1907 was to make sure there was enough liquidity in the system so that banks didn't stop lending.

Remember, lending is the single most important engine that drives economic growth.  When banks don't lend, the economy doesn't grow.  When banks do lend, the economy grows moderately. When banks lend aggressively, the economy grows rapidly.

That's why J.P Morgan, John D. Rockefeller and U.S. Treasury Secretary George Cortelyou were shocked to see call money rates skyrocket so rapidly.

By October 24th 1907, call money, the money lent for the purchase of stocks, was at 60% -- up from 6% the month before.  That meant that if you wanted to borrow money to buy stock, you'd have to pay interest of 60%.  By the time JP Morgan got involved, call money rates were at 100% -- and there were no lenders!

Now back in 1907 you could buy any stock on 90% margin.  That's right, all you had to do was put down 10% of the purchase price and you could buy any stock you wanted.

That's why, when call money rates skyrocketed and money stop being borrowed, the market plunged.

Stocks like United Copper, which was selling at $85 the week before, were being quoted at $15 per share.  Seemingly overnight, stocks lost 50, 60, 70, 80% of their value.  Buyers were absolutely nowhere to be found.

To stem the panic, business leaders like JP Morgan and JD Rockefeller pumped tens of millions into different trust companies (read: mortgage lenders) in order to stem the flow of the panic.  The U.S. Treasury pumped $25 million into national banks, leaving the Treasury with just $5 million left on hand.

(This was before the Federal Reserve even existed.  In fact, it was the Panic of 1907 that created the Fed.)

There is even an old story on Wall Street that JP Morgan himself intervened in the stock markets directly to stop the bleeding.

The way I've heard it from the books and the old timers was that Jesse Livermore (of "Reminiscences of a Stock Operator" fame) had correctly called the market break and was short all the main stocks, making millions of dollars in profits in a period of days.

As the market continued to collapse, Jesse continued to short more stock (this was before the zero-uptick rule) and continued to make millions in profits.

But at the very height of the panic, just as Jesse was about to sell more stocks short, JP Morgan himself appealed to Jesse's sense of patriotism to stop shorting stock!  He reasoned that although Jesse had many more millions to make, the entire financial system was at stake.

On one hand, Jesse reasoned to himself, his stock market analysis was right-on, and in the great system of capitalism his prize for being right was money, pure and simple.

On the other hand, it would be in nobody's interest if the entire financial system collapsed.  That could create a situation that could spiral out of control with intense speed and destruction.

What did Jesse do?  First, he stopped shorting stocks. Second, he began to pull in all his shorts and started issuing buy orders to all of his brokers.

It is said that his orders to buy the leading stocks of the day put a solid floor under the prices and the markets stabilized.  

I'm no Jesse Livermore here, but for the first time in my life I understand exactly what he was facing.

During the past several years I've preached nothing but patience to my wife as we've searched to buy a house for us.

Every time she saw a $500,000 home selling for $800,000 I would tell her to ignore it.  Pretend it doesn't exist.  Think about something else entirely.

"In due time we will be rewarded for our patience," I promised her over and over again as we continued to rent.  "Markets always self-correct, and when this one does we'll be in great shape."

Bowing to my considerable market experience she took me at my word.  So we waited and we waited.  All the while we kept making the landlord of the home we were renting richer and richer (to the tune of $50,000 at last count).

Fast forward to today ...

As the bottom has fallen out of the real estate market during the past six months, I knew my wife and I would be rewarded amply for our patience.

But I know that the drop over the past six months was nothing compared to what's in store in 2008 -- close to $400 Billion in mortgages will be reset to higher interest rates, and that means a world of pain for real estate prices.

Just think about it.  Right now the real estate market is crumbling largely due to a correction in pricing fueled by underwriting choices.

But add two million homes to the mix that open their mail one day and see their mortgage has risen from $1,500/month to $2,000/month, and what do you have?  A financial meltdown in the real estate market!

Or in other words, a prime opportunity for me and every other investor who was patient enough to wait.  And not just wait: if you're anything like me, you decided that the money spent renting ($50,000 for me) was a better investment than buying a home that was overvalued by at least $300,000.

So that is where I'm coming from as I write this letter to you today.  Many of you may consider that selfish.  Yes, it is selfish -- I'm trying to do what is in the best interest of myself and my family and I'm not hurting anybody to do it!  (It's called the "American Way" my friend.)

Now here's where the story gets very dicey.

On a personal level I've been furious at the recent talk of a government bailout.  I did everything right here: I was patient with my real estate investing (i.e. didn't get caught up with my emotions), I held my wife in check so she wouldn't either, and I bided my time.

I analyzed the market correctly and saw the outcome as clearly as any outcome I've ever seen in my life, and I played it almost to textbook perfection.

But as I think about it more and more, I realize this isn't about me.  Not at all.

Let me explain:

Half of the people I hear screaming at the top of their ignorant lungs would have you believe what the politicians are spinning to you -- that this is a bailout of good old fashioned American homeowners who simply got taken by the big bad fat cats on Wall Street.

If you believe that, then I have a bridge to sell you in Brooklyn.

The other half of the people screaming at the top of their ignorant lungs would have you believe that this is a bailout of the fat cats themselves.  I can't tell you how many op-ed pieces I've read from writers claiming that Treasury Secretary Hank Paulson, who is the former CEO of Goldman Sachs (SYM: GS), is running the financial Trilateral Commission, and he'll make sure the rest of his Wall Street fat cats don't get crushed by the mess they made.

I'd like to believe that.  It sure sounds good.  But the truth is that this bailout isn't about either of them.  And like I said, neither is it about me.

This bailout is about saving the system itself.

You see, as much as I agree with Reagan when he said "Government isn't the solution, it's part of the problem" and as much as it will hurt me financially, I'm beginning to see past my own needs ...

I'm beginning to see why this bailout may make some sense.

Sure, it doesn't change much:

1) Brokers who lied to mortgage applicants should be taken out and shot;

2) Homeowners who borrowed the money should stop crying like babies and blaming other people for their inability to read the mortgage agreement.  Face it folks -- if you can't read a contract, you should not own a home.  Thus, if there is a document with your signature on it, you own it at the price you agreed to pay for it, PERIOD.

3) A government bailout may artificially keep housing prices higher than they should be, and as a result, my patience and hard work as a home investor will not pay off as much as it would have if the entire system collapsed.

Sure, I'm upset that I won't be buying the home I wanted for the price I "should" buy it at.  And you have a right to be upset about it as well.

But isn't it better than walking down the street and seeing that 40% of your neighbors are unemployed due to a financial crisis that spiraled out of control after a dogged belief in free markets came back to bite us?

At this stage of my evolution, I think so, but I'm open to debate.

Interested in hearing what you think ...




Dylan Jovine
Contributing Editor
The Tycoon Report