An epic stock market battle took place in 1901. Two heavyweights fought for control of a railroad, cornered the market, and forced the biggest short squeeze of the last century.
The Union Pacific was a railroad nobody wanted to touch, not even J.P. Morgan, in1898. It was mired in bankruptcy — receivership in the hands of the government. But Edward Henry Harriman saw an opportunity.
Through a syndicate of backers — the Vanderbilts, Rockefellers, Goulds, Ameses, and Kuhn, Loeb & Co. — Harriman took control of the road. In total, they paid $75 million for 1,800 miles of railroad and got every penny back in profits within three years.
Harriman recognized that expansion through acquisition was the most efficient way to lower costs and ensure profitability for Union Pacific. He quickly bought up competing railroads until Union Pacific dominated the U.S. west of Omaha.
Harriman needed to expand east. So he set his sights on a key acquisition. Chicago was the railroad hub of the country. Anyone moving people or products by rail from east to west, or vice versa, had to go through Chicago. The Chicago, Burlington & Quincy Railroad was a critical piece in controlling that movement. Buying the Burlington railroad would make the Union Pacific the strongest railroad in the country.
James Hill had similar ideas. Hill, with the backing of J.P. Morgan, controlled the Northern Pacific Railroad. The Northern Pacific did a great deal of business moving cotton from the South to Seattle to be shipped off to Asian markets. Acquiring the Burlington Railroad would make the Northern Pacific the dominant railroad in the country.
Charles Perkin was president of the Burlington railroad and was closing in on retirement. A sale was imminent.So the first battle of Harriman and Hill was fought over the Burlington.
Harriman bid first. Perkins set the going rate for Burlington at $200 a share in cash. Harriman countered $150 a share in cash or $200 a share in Union Pacific bonds. Perkins turned him down. Unrelenting, Harriman began buying Burlington stock in the open market.
At the same time, Hill proposed a Burlington merger with Northern Pacific, was told the price and also began buying shares in the open market. Eventually, Perkins chose Hill over Harriman. The backing of Morgan helped but Perkins believed Hill offered a better home for Burlington.
There was a delicate balance of power in the railway world; the acquisition of the Burlington by Hill would smash it and give him the dominant influence. That was repugnant to Harriman temperamentally, and alarming to his associates financially. They went to Hill. They expressed their views and amiably added that while they thought he had “paid a damn fool price for Burlington” — as one of them put it to me — they were willing to participate, so that everybody should be satisfied and the status quo maintained. They desired peace, even at $200 a share for Burlington stock. War would mean millions of waste…
Harriman said nothing more to Hill but to his associates he showed how Hill could be defeated by the purchase of the controlling interest in the North Pacific. That was cheaper and easier than to buy an equal interest in Burlington…
Hill and Morgan never fully controlled the Northern Pacific. Collectively they only held about a 23% interest in the company. They believed that nobody would attempt to seize control of a $155 million railroad through the market.
It is important to understand the mood of the time. Ordinary investors had recently been worked into a frenzy as U.S. Steel shares were promoted and railroad stocks were rising fast on various rumors of insider accumulations and mergers. Lefevre recounts a “raging public speculation in stocks” while Clews talks of a “restless sea of reckless stock speculation that swept the American people into its vortex, with all its razzle-dazzle extravagance.”
In this hyped-up environment, Harriman’s attempt to retaliate against Morgan for grabbing the Burlington acted like a spark igniting a pool of gasoline. The resulting jump in prices, then panic, caused “intense excitement, demoralization, and confusion” that “convulsed the stock market in a way that alarmed money lenders, destroyed confidence, and caused a general rush to sell stocks which brought them down with a crash, involving many thousands in ruinous losses,” according to Clews’s account.
From May to April of 1901 Harriman quietly bought a majority of Northern Pacific preferred and $37 million in common stock — $80 million in total. He was 40,000 common shares short of majority control.
Hill, suspecting something was up, confronted Jacob Schiff in the Kuhn, Loeb & Co. offices, who admitted everything. Hill was furious. But he had a problem. He needed Morgan’s approval before he could fend off Harriman, but Morgan was vacationing in France. A telegram was sent and he waited.
Meanwhile, Harriman placed the order for the final 40,000 shares of Northern Pacific to be bought on May 4, a Saturday trading session. Only the order was never filled. A junior partner at Kuhn, Loeb & Co. bungled it. Jacob Schiff found out but also ignored it.
Morgan’s telegram reply finally reached Hill in the evening of Sunday, May 5.
On Monday, May 6, the mad scramble began. Hill and his backers quickly bought up 200,000 shares in Northern Pacific that day. Its stock price rose from $110 to $130 in the buying spree. Later that day, Harriman found out his 40,000 share order never went through. Neither side held a majority.
Feeling the price rise was unwarranted, traders began shorting Northern Pacific stock.
When you short a stock you’re betting that its price will fall. To profit, you need to borrow shares, sell them at the market price, then buy the shares back at a lower price. With the shares back in your possession, you return the borrowed shares to the lender. The borrowing is done for a fee, of course. So your profit is the difference between the money you collected when you sold the borrowed shares and the money you paid to buy those shares back (plus the cost to borrow).
Short selling is a simple process that can go horribly wrong because, with the stock market, anything can happen in the short run. Losses are limited only by how high a stock’s price can go. You need to keep enough money in your account to cover losses (your broker will demand it). And, as the Northern Pacific short sellers found out, the price can quickly move against you and shares may not be available when you need to buy them.
On Tuesday, May 7, Northern Pacific shares were bid up to $150. Short sellers in the stock started feeling the pressure. They could dump other holdings to cover their losses or close out their short positions at a big loss.
By Wednesday afternoon, the decision was made for them. The market was off by 20 points. Yet, Northern Pacific stock rose to $200.
The squeeze was on.
That night, brokers crowded into the Waldorf hotel and filled the air with tobacco smoke and rumor… Broker Bernard Baruch observed the scene: “One look inside the Waldorf that night was enough to bring home the truth of how little we differ from animals after all. From a palace the Waldorf had been transformed into the den of frightened men at bay.”
Unbeknownst to Harriman, Hill seized enough shares for control the day before. Yet, neither party was willing to sell.
It became obvious on Thursday that more shares were sold short than could be bought back in the market. Northern Pacific rose quickly as short sellers rushed frantically to cover their positions. Except, no shares were available. Harriman and Hill had cornered the market. The stock price was bid up — $300, $500, $800, and finally $1,000 a share.
The deadline to deliver shorted shares was 2:15 pm Thursday. Short sellers dumped everything as their Pacific Northern losses grew. It set off a market-wide panic. Margin loan rates spiked to 60%, compounding the selling.
Realizing the worst, Morgan and Harriman called a truce and devised a plan. The major houses — J.P. Morgan, Kuhn, Loeb & Co., and others — announced they would not force delivery at the deadline. Northern Pacific sold off.
The short sellers in Northern Pacific got a lucky break. They were allowed to close their short positions at $160 a share. They only suffered a devastating loss instead of total annihilation.
Sources:
Harriman, The American Magazine 1907
Reminiscences of a Stock Operator (Annotated Edition)
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