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.
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.
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.
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.
Financial newspapers covered the saga and began reporting on the many banking connections of the Heinze brothers and Morse. Augustus Heinze owned the State Savings Bank of Butte, Montana, and was president of Mercantile National Bank. Morse held ownership positions in multiple banks.
The Montana bank failed first, fueling distrust of any financial institution linked to the Heinze brothers and Morse. Depositors at Mercantile National Bank began withdrawing their funds, prompting Augustus to ask the New York Clearing House for help. From there, the panic spread to trust companies, which provided liquidity to the stock market but had lighter regulatory requirements than banks.
When trust companies began failing, a cash shortage spread to the financial markets. The stock market was at risk of collapse until banker J.P. Morgan organized emergency funding.
Robert F. Bruner and Sean D. Carr, authors of the book "The Panic of 1907: Heralding a New Era of Finance, Capitalism, and Democracy, Second Edition," identify two underlying problems that caused the United Copper scheme to spark wide-scale panic among investors and depositors:
Interestingly, both factors also played roles in the 2008 financial crisis. First, the repeal of the Glass-Steagall Act in 1999 gave banks more freedom to invest. Then, high demand for mortgage-backed securities (MBS) linked the housing and mortgage markets to investing financial institutions around the world. High demand for MBS inflated housing prices. A necessary pullback in housing values sparked a subprime mortgage crisis, which in turn lowered the value of MBS. As a result, institutions that held MBS on their balance sheets were suddenly short on capital.
Learn more: What is the Federal Reserve?
Six years after United Copper's stock crashed, the Federal Reserve Act was signed into effect. The act established the Federal Reserve System and gave it the authority to supervise banks and manage the money supply.
Learn more: The Fed rate cut: What it means for bank accounts, CDs, loans, and credit cards
Today, the Fed is broadly responsible for promoting currency stability and trust in U.S. financial institutions. The central bank is not tasked with managing the stock market, though its actions do affect stock prices and investor sentiment.
As explained by David Materazzi, CEO of investing software provider Galileo FX, "the Fed doesn't control stock prices directly, but it sets the conditions for how businesses perform."
The Fed's management of interest rates is an example. Rate adjustments are intended to encourage two outcomes: full employment and stable prices. The continued health of the financial markets is an indirect consequence.
Chief investment strategist Steve Wyett of financial services company BOK Financial said, "An environment with full employment and price stability is one where companies can make money and pursue plans to grow, which leads to a better overall economy for us all, and positive capital market returns."
On an as-needed basis, the Fed may also take steps to soften the impact of financial crises, including stock market crashes. Post-crisis, the Fed would be involved in analyzing the crisis and suggesting appropriate regulatory responses.
The Panic of 1907 provides four important takeaways for individual investors:
Equity investors cannot avoid stock market crashes. They can, however, limit the impact of market declines by resisting panic. Markets do recover, either on their own or with some help from the Fed. Those who wait for that recovery, rather than selling in a panic, are better positioned to realize strong long-term returns.
This article was edited by Tim Manni.