Out of Aces

Throughout the course of financial history, a similar tale has been told over and over again: Overly confident businessmen and women that gulped at success and became drunk with power…only to be stuck with the aftertaste of defeat. Chris Mayer explores…

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.

The Panic of 1907: Making a Play For More

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.

The Panic of 1907: Things Get Even Worse

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: Its Relevance Today

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.

Regards,

Chris Mayer
for The Daily Reckoning
February 16, 2005 — London, England

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.

Christopher W. Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Christopher’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is also the editor of the Fleet Street Letter.

So far, dear reader, it really has been another American Century. In the last century, America was still young, restless, earnest, with bulging muscles and an empty head… full of energy and ideas…bursting to make things and sell them…to make a name for itself…to get rich by working hard. In the 21st century, on the other hand, America has become soft, middle aged, with its noggin full of TV drivel – no wonder she seems to want to make a public spectacle of herself.

The tech bubble on Wall Street in the late ’90s was silly and embarrassing. It really didn’t matter. In fact, it was entertaining…and educational. People who should have lost money did. And they probably would have lost a lot more, but the feds stepped in and started throwing cash around. And now the whole country – economically and politically – has bubbled up.

From Washington, D.C. comes news that the real estate bubble is still taking air. Prices in the region rose 24% last year – six times as fast as GDP, eight times the rate of CPI inflation, 10 times a much as stocks. When you’re making that kind of money, why save? And why not enjoy it? It’s so easy to "take out" a little from time to time to pay for college, vacations, and renovations.

"When one segment of society loses its head," said a dinner guest last night, "it seems to infect the whole body of society: individuals, government and business, too."

Over the last five years, houses have beaten stocks almost everywhere in America. In hot markets – major cities on both coasts – the gains in houses have been spectacular. Many buyers never set foot on the property, says the Washington Times report. They buy before the place is built…and flip it before the carpet is laid down. And from our own MoneyWeek magazine in London comes news that the English are getting in on the game as well. Property prices in London have peaked out. Getting no offers, a friend told us she had taken her apartment off the market. "It was all a kind of fantasy," she explained. "We thought we were going to make so much money on it, we couldn’t not sell it. But we actually like the place and are happy to hold onto it."

But in America, the fantasy of getting rich without risk or sweat has entered the bone marrow. Neither NASDAQ crash…nor a war…nor a recession…nor a drop in the dollar…has been able to get it out. Instead, it grows…metastasizes…and weakens the whole nation. And even the English want a piece of the action. House prices are still very high in England…and seem to be going down. So, many English buyers are looking for houses in America, says the MoneyWeek report. They might live in a rented apartment in London, but they have the pride of homeownership and the hope of profits – in America.

Yesterday, we mentioned our "Trade of the Decade." We made a little from rising gold prices, so far. And a little from falling stock prices. But the best is still ahead, we think. Richard Russell pointed out yesterday that dividend yields rose to over 10% at the bottom of the ’30s bear market. At the darkest moment of WWII, they rose to 7.8%. And again in ’82, they were over 7%.

When things look good, by contrast, yields fall. In 1929, yields fell to 3.1%. Never have they been lower than 2.6% – until recently. Now, dividend yields are below 2%. Never have stocks been more expensive, in other words, then they have been for the last five to seven years. Investors have made no money in that time. Instead, they’ve been worn out with mini-rallies and mini-retreats…back and forth, burning up energy…paying commission and taxes. Sooner or later, they’ll get tired of it and stocks will go down. Then, they’ll sink to the point where they yield 6%…7%…maybe even 10%.

The only reason they haven’t gone down yet is the same reason U.S. consumers continue to ruin themselves…and housing speculators get so rich – the Greenspan Fed has humbugged them all. Now investors, homeowners, and speculators – all suffer the same symptoms – recklessness and delusions of grandeur.

More news, from our team at The Rude Awakening:

————–

Tom Dyson, reporting from Baltimore…

"The Superdollar – high quality counterfeit bank notes – identical in appearance to one hundred-dollar-bills – started cropping up en masse during the 1990s. Could desperate dictators be using them as a weapon against the United States?"

————–

Bill Bonner, back in London:

*** Being confident can be a wonderful trait…it can aid you in snagging a great job, and it can certainly help you out with the ladies. But over-confidence can prove to be quite fickle…something our resident small-cap superstar, James Boric, is just now realizing…his sense of self-confidence is so great that it may cause him to lose his job. Addison Wiggin explains:

"Just this week, our ebullient, in-house small cap sleuth says he’s found the two best stocks you could possibly own in 2005.

"James is so sure he’s found this year’s big winners, he’s willing to pay you DOUBLE the cost of a subscription to his advisory service – if he’s wrong.

"Double the subscription price, eh?

"Let me explain something. I’m James’ publisher. It’s my job to root out any hair-brained scheme he might come up with… before he gets a chance to send it to you. After all, I’m the one who has to foot the bill if he’s wrong."

*** Fannie Mae may have faded from the news of late, but not from our thoughts…

Citigroup recently admitted to a 6.3% stake in Fannie Mae. Given that Fannie Mae has a $60 billion market cap, Citigroup’s stake is worth $366 billion. Since December 31, 2004, Fannie’s stock has declined by 11.2%, handing Citigroup an unrealized mark-to-market loss of $410 billion year-to-date.

"For every cent Fannie’s stock price goes down, Citigroup loses nearly $600,000 dollars," says Rude Awakening editor, and former Citigroup employee, Tom Dyson, while gleefully punching numbers into a calculator. "Today it’s down $1.09. Thing is, every portfolio in corporate America owns Fannie stock…pension funds, mutual funds, insurance companies, financial conglomerates…and they’re all getting hit. Incidentally, Citigroup is not the largest holder…Capital Research and Management Company owns nearly 10% of Fannie, and Fidelity Management & Research Corp own over 8%. I don’t know what these entities are, or who controls them, but if Fannie stock keeps falling, I suspect we may find out!"

*** A couple letters from our charming and intelligent readers:

"I find it quite remarkable that 9 out of 10 of your readers should take issue with your characteristically perceptive, witty and truthful thoughts last Friday on the similarities between ‘received religion’ and ‘received democracy’. What, I wonder, is the insight of your critics that they think is denied to you; or, perhaps more importantly, what is the uncertainty that causes them to castigate you in such vituperative terms? And what is the DR’s demographic anyway?

"I’ve been a delighted fan of the DR and especially of your own writing, for some time now, and naturally assumed that since generally, we all choose for our daily reading material which appeals to our own prejudice, I had imagined that most DR readers were – well – sort of like you and me. If the criticism you printed is typical of the readership I can only assume that mostly ‘shoeshine boys’ in the red states are reading you. I wonder how the readership pans out between the United States and Europe?

"Like you, I am a churchgoer, and I find your observation of the ‘millions of frauds and misrepresentations’ between the early Christians and Greeks and today’s overblown religion and democracy wonderfully illuminating.

"However – as our political masters are fond of re-iterating triumphantly – we are where we are, and those few of us willing and able some Sundays to hear the Gospel message in all its original and historical clarity must face the fact that for more and more people in the world (of all religions and none) ‘Christianity’ is becoming synonymous with ‘Crusader’. Of course, as your Normandy priest pointed out, our obligation is for each to cherish his or her own individual light and show it forth wherever he happens to be: but I do find the misrepresentation of Christianity in the political dialogue regrettable and disturbing."

And another:

"I’m sorry to hear that 10:1 against your reflections is the ratio. I for one am pleased to read ideas that let me know that I’m not the only one disillusioned with the mainstream pabulum that Americans are being fed.

"I’ve heard that we get the government we deserve; beneficent powers help us if that is indeed the case. ‘Living is easy with eyes closed’ goes the song; not much survival potential there. Killing to make the world a better, safer place to be? Oh yeah, it’s sure worked in the past; just look at the world we live in today. I enjoyed very much your slant on vanity being the force behind ‘world changers;’ made sense. Too many parallels today to past world changers for comfort. The religious folks I’ve known that I had any respect for took care of their own gardens and didn’t tell others what to grow."