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Out of Aces

This essay originally appeared at The DailyReckoning.

Picture this: On one side of the negotiating table was Frederick Augustus Heinze, the illustrious American copper magnate. The "Boy Wonder" was only 29, but already a celebrity among the business barons of the day. The Brooklyn-born entrepreneur was, by all accounts, brilliant, uncompromising, dashing - and very rich.

On the other side of the table was Walter Hull Aldridge, a bright metallurgist, representing the Canadian Pacific Railroad. At issue between them was a copper smelter Heinze owned in Trail, British Columbia, along with a short-line railroad called the Columbia & Western.

The Canadian Pacific Railroad was feeling its oats about this time - having generated a substantial profit the year before - its trains laden with incoming settlers and freight. Flush with cash to invest, the railroad had visions of expanding across western Canada, hauling coal, coke, wheat, machinery, lumber and metals across the resource-rich region.

The Canadian Pacific was interested in Heinze's rail because it fit nicely in their plans. Late in 1897, they made an offer for it. Heinze, though, wouldn't sell just the railroad. He would sell the whole shebang - smelter and rail - or he wouldn't sell at all. His asking price was $1.2 million. Heinze was running a bluff - his Canadian operations were not doing so well, and his American interests demanded his attention. The Trail operation's outlook was not so bright, either, with the threat of competing smelters being built in the area.

The railroad wanted the C&W badly enough, however, and finally agreed to include the smelter in their offer. Now they were struggling to meet Heinze's price.

The two negotiators worked late into the cold night of Feb.11, 1898, and reached an impasse. Heinze offered to play poker for the difference, which was about $300,000. Aldridge - wisely, I think - declined. Heinze had a reputation as a good poker player.

Eventually, the railroad swallowed hard and met Heinze's price. Just like that, the Canadian Pacific Railroad was in the smelter business. Aldridge stayed on as managing director of the company that the railroad created to house the smelter. Under Aldridge's direction, the smelter not only supplied copper, but was also putting out pure lead and fine gold and silver by 1902.

Flush with cash from the sale, Heinze moved to New York and became involved in banks and trusts - a move that would lead to his undoing. "Most men gamble with her [Fortune]," Ralph Waldo Emerson once observed, "and gain all, and lose all, as her wheel rolls." Heinze, not content to live with his riches, made a bid for more.

In the early 1900s, most banks were prohibited from taking on trust accounts (wills, estates, etc.) by their charters. Trust companies were specifically set up to deal with this business. Though initially, trusts were regarded as safe-haven investments, they eventually became highly speculative - they were like the hedge funds of their day. And like the hedge funds of today, trusts became heavily invested in the stock market using extreme leverage, or borrowed money. They didn't keep much in the way of reserves and were susceptible to sudden adverse changes in stock prices.

Also, trust company directors were often involved in banks, and the banks, though they could not do trust business, could own trusts. As a result, there was this web of connected relationships between some of the large speculators and the banks. This was not so different from the way the now-infamous hedge fund Long Term Capital Management was intertwined with many of the nation's financial institutions when it failed in 1998 - threatening to take the whole financial system with it before a bailout was arranged.

So when, on Oct. 16, 1907, the price of United Copper closed at $15 - down 76% from its high only two days earlier - the headlines the next day were grim. "Copper Breaks Heinze," blared the Boston Post. Heinze was heavily invested in United Copper. If Heinze were only a copper speculator, history may be been quite different. But Heinze owned a bank and was associated with a number of other banks.

He was president of Mercantile National Bank, for example, a position that he promptly relinquished as his plight became public. But it didn't prevent a run by Mercantile's depositors in the wake of the news, as depositors scrambled to get their money for fear that the bank might be involved with Heinze's losses. Other banks rallied around Mercantile and supported it, however, which helped it weather the storm.

Heinze's bank, Butte Savings Bank, failed the next day, as did the brokerage owned by his brother. The real backbreaker was when the Knickerbocker Trust Co., in New York, experienced a run on its deposits. Its president, Charles Barney, was an associate of Heinze. Knickerbocker had 18,000 depositors, and in a matter of hours, worried depositors had skinned the Knickerbocker for some $8 million.

No one came to Knickerbocker's aid - not even the great J.P. Morgan, who would assist other troubled banks during the crisis. Some historians believe that this was part of a deliberate campaign by the banks to destroy the credibility of the trusts. The banks felt threatened by the growth of the trusts, and reasoned that if the Knickerbocker failed, the public would lose faith in the trusts and the banks would gain. Plus, a man like Heinze had many enemies eager to capitalize on his plight. Or perhaps Morgan didn't like what he saw in Knickerbocker and thought it beyond help.

In any event, Barney, Knickerbocker's president, shot himself dead that night, and the Knickerbocker Trust did not open for business the next day. Runs began in earnest, hitting banks and trusts all over New York. As one historian put it, "The financial fires that were intended to ruin Heinze and the trust companies quickly roared out of control, and the Panic of 1907 became a nondiscriminatory economic catastrophe for the entire nation." The spark for the Panic of 1907 may have been a personal vendetta gone awry. As Glasscock observes, "F. Augustus Heinze was to the Panic of 1907 as the Archduke Franz Ferdinand was to the World War."

Even so, the Panic of 1907 was like many of the crises that went before it and would happen after it. It was inevitable, because highly leveraged and overextended lenders and speculators lead to eventual ruin.

The Panic of 1907 was not the worst financial crisis in American finance, but it was critically important because the forces in favor of creating a national bank - the Federal Reserve Bank - would gain strength, and the tide of public opinion increasingly supported the idea. As a lender of last resort, the Federal Reserve Bank would bail out failed banks and thereby stem future panics. The Federal Reserve Bank was established in 1913.

The real problem was that the banks had been allowed to renege on their obligations to redeem their deposits in gold. This allowed them to inflate, to pyramid deposits and loans on a smaller and smaller base of gold. The excess funds created fueled speculation in the market. Failure was unavoidable in such situations.

Today, with a Federal Reserve Bank and deposit insurance, we seem to have done away with the quaint notion of a bank run. Instead, we suffer near-continuous debasement of our currency, a mostly gradual, but sure erosion in purchasing power. We suffer from debts and deficits that would be impossible under a strict gold standard. Who is the better for it?

The Panic of 1907 broke Heinze at the age of 37. With former partnerships broken, millions lost, his reputation in tatters, and nearly two years spent on legal battles - Heinze was exonerated - the defeated Copper King headed back to Butte, where he was welcomed as a hero, with an automobile procession and a live band celebrating his return. In Montana, he would live out his final years rehabilitating some of his remaining mines. His health, though, was failing. In 1914, only 44 years old, he suffered a hemorrhage of the stomach caused by cirrhosis of the liver, and he died.

His biographer, Sarah McNelis, writes, "There was discussion of establishing a scholarship or erecting a monument to retain his name and contribution to the city [of Butte]. After the initial shock of his death faded, however, the talk must have ceased; no such memorial was established." Today, Heinze is almost forgotten.

Stories such as that of Heinze are intriguing to me because I see in these events so many parallels with today's markets. I have long been fascinated by the timeless qualities of finance, the constants of greed and speculation and easy money, which forge the familiar patterns of boom and bust. "Easy money makes a wild town," Glasscock observes. It also makes for a wild stock market.

In the Knickerbocker Trust, you have what may be a metaphor for Fannie Mae, a large, but troubled financial institution, whose failure could also spark a wider financial panic. Like the Knickerbocker Trust, Fannie Mae is no favorite of the banks, which claim that Fannie's special privileges give it an unfair advantage in the mortgage business. Those who have been bullied by Fannie in the past would shed no tears should it get stuck in a financial pickle.

In Heinze, you see any number of beleaguered executives - men who tasted early success, rode it to create brilliant fortunes, only to be forced to resign in disgrace, with much of their empires disintegrated.

These tales are classic tragedies, told again and again in the dusty tomes of financial history, with new ones being written nearly every day.

Editor's Note: Chris Mayer predicts that the scandal at Fannie Mae will have far greater economic implications that anyone is ready for...and that's just one of the events he sees unfolding in our near future. To find out all seven of his forecasts for this year, see here: 7 Stunning Predictions for 2005

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