What happened 100 years before the 2008 recession?

“I think the system is basically sound”.

These were the words of the US President, George Bush.

Now, we know he was wrong.

In 2008, he said this about the markets.

Other key people had said similar lines.

Standard and Poor’s had assured that there was no global crisis building.

US Federal Reserve’s chair, Alan Greenspan had comforted by saying the worst was already over.

100 Years Ago

Around the year 1900, the US economy was roaring.

New inventions like the telephone, electric supply, and petrol/diesel-powered vehicles had completely turbocharged possibilities in the US.

New companies were created. More roads, railway lines, mines, and construction were being built.

New factories were coming up – some of the most technologically advanced in the world.

It was an incredible time.

There were enough companies wanting to do things. But there was not enough money for the job.

So what did the companies do?

They turned to investors.

Since the economy was doing well, the stock markets were doing well too.

This in turn attracted more investors. More and more people were tempted to invest in companies.

It worked fine.

Trusts & Banks

Banks keep people’s money.

They then take this money and give out loans to others.

The interest they receive is their income.

Yes – banks take depositors’ money and give them out as loans.

What happens if a depositor asks for his money?

Banks maintain some portion of the total money as reserves. So if a few people ask for their money back, the bank can give them their money.

The assumption here is that not all people will ask for their money at the same time.

If a large number of a bank’s depositors ask for their money back, the bank fails (or collapses).

This situation is called a bank run, or simply, a run.

It is a horrible situation – because panic spreads. If one bank fails, people fear other banks might fail – and they rush to take their money out of other banks.

As they rush to take out money from other banks, other banks also start collapsing.

Such a chain reaction can trigger a massive banking system collapse.

To prevent this from happening, banks have to ensure they always have enough cash with them. They cannot give out all their depositors’ money.

Thus, ensuring that the bank is trusted by people.

In 1907, banks in the US were supposed to maintain 25% of the depositors’ money.

This means that if a bank received a total of $10 million from its depositors, it had to keep at least $2.5 million in cash. The remaining $7.5 million could be given out as loans.

Back in 1907, there was another institution – trusts.

Trusts also kept money from depositors. But they were not a part of the payments system.

So, they were not required to keep 25% of the depositors’ money in the form of cash.

Instead, they could keep it as low as 5%.

These trusts used to lend money to stock brokers and investors.

Banks were not allowed to give loans without collateral. But trusts were allowed to do so.

Trusts were allowed to give extremely short-term loans – the loans had to be repaid the same day.

What do you do if you want to buy shares using borrowed money – but for a longer period of time?

Take a loan from the trust. Buy shares (or bonds, or whatever asset you want).

Now, you can use this asset as collateral to borrow money from banks.

Once you have the money, you can return the amount to the trust.

The bank’s loan is due later. So, you have shares (or bonds, etc) that you bought using borrowed money – that you can hold on to for longer than a day.

United Copper

United Copper was a copper mining and smelting company.

The company’s share price was quite low.

The brothers who owned this company had a suspicion that their company’s shares were being forced to be low by short-sellers.

Short sellers are a kind of investors who make money when stock prices fall (instead of going up).

They borrow stocks (do note: stocks, not money). Then they sell the stocks in the market. Later, when the share price falls, they buy the same amount of shares (as they had borrowed).

These shares can now be given back to the lender of the shares.

In short, you ask your friend to borrow his car. You go and sell his car immediately. Later, when the car’s price falls, you buy it.

Now, you can return this car to your friend.

You sold the car at a higher price. And bought it back at a lower price.

The difference is your profit.

That’s how short selling works.

When too many shares are being sold short, many factors start acting.

More shares are available in the markets. Other investors think similarly, etc.

This is what the brothers behind United Copper thought was happening.

They decided to fight it.

How?

They would keep buying shares in their company. That would cause the share price to go up.

When the share price goes up (instead of going down), short sellers suffer a loss.

Using borrowed money, the brothers started buying shares. They managed to drive up their company’s share price from $37 to $60.

When they stopped buying the shares, the price came down a bit – to $50.

The first part of their plan had succeeded – somewhat.

The next plan was to demand share certificates from the brokers. The brothers had assumed that the brokers would be unable to do so – because they had lent out the shares to short sellers.

To their surprise, the brokers were able to give them their share certificates.

It was at this point that the brothers realized that their assumption had been wrong.

There was no short-seller conspiracy.

The brothers would have to sell shares to pay back the money they had borrowed. This would cause share prices to fall.

News broke out and soon, investors started selling United Cooper shares. The price fell to $10.

Now, at this share price, even if the brothers sold their shares, they would not have enough money to pay back.

Bank Run

Panic started spreading.

The trust that had lent money to the brothers had a bank run. Depositors demanded cash back.

They did not have cash.

A long chain of panic spread. People feared their money would be stuck in these banks that did not have money.

Any bank that had links to this trust faced the risk of a bank run.

How do you stop this chain reaction?

You honor the depositors.

Banks and trusts tried desperately to arrange cash for withdrawers. They tried to assure depositors that their money was safe.

Soon, some of them started running out of cash.

This was a problem.

This was a problem: if the panic had continued to spread, bank runs would start experiencing bank runs — even in the biggest of banks. People would try to withdraw their money from all kinds of banks, small or big.

The only way out?

Give banks and trusts more cash.

Banks approached one of the world’s richest bankers of that era – JP Morgan.

After some hesitation, he agreed to give his own money to banks and trusts – in the interest of keeping the banking system functional.

He then approached other rich financial and industrial institutions to give cash for this purpose.

It eventually worked. The system was stabilized.

Back then, a central bank did not exist. JP Morgan had played the role of a central bank – to ensure everything remained stable.

2008 Recession

The Panic of 1907 seems oddly similar to the Great Recession of 2008 — almost 100 years later.

Both were triggered by excessive speculation — certain key players going overboard.

Both were caused by runs happening on banks or other financial institutions.

Both spread like a plague to other institutions.

In both cases, large amounts of cash needed to be put into the system.

Both had a global impact.

Both required external support to stabilize the system and restore confidence – JP Morgan in 1907 & the US Fed in 2008.

Both led to long-term reforms.

After 2008, the US Fed made many key regulations.

Interestingly, after 1907, the result was the creation of the US Fed itself!

Yes — the US Fed was created to handle and prevent a situation like the panic of 1907.

The images above were generated using AI tools.