It is never a good day when a bank president gets a call from a reporter asking if there is any truth to a rumor that his bank is preparing to file for bankruptcy. When a second reporter calls with the same question, the banker is going to have a very bad day.
The day was Tuesday, May 8, 1984, and the bank president who fielded the two calls—and vehemently denied the rumors—was Edward S. Bottum of Continental Illinois National Bank in Chicago. His boss, unfortunately, was nowhere near Chicago. David G. Taylor, the bank’s chairman and chief executive officer, was vacationing on a boat in the Bahamas.
Taylor, a Continental “lifer” whose father had worked at the bank for decades before him, had moved into the CEO’s office a few months earlier, after the bank’s directors finally replaced Roger Anderson, who had presided over the train wreck that was the Penn Square Bank collapse in 1982.
Penn Square’s collapse had revealed serious weaknesses in the bank’s internal controls and credit judgments, and it was struggling to attract the deposits it needed to remain in business. Risk-wary money market funds bailed out almost immediately, although the Chicago Board of Trade Clearing Corporation and the Chicago Mercantile Exchange remained faithful customers.
As the bank’s chief funding officer during the Penn Square crisis, David Taylor had scrambled to replace the lost domestic deposits with foreign deposits and very short-term loans from other banks, cash that came in the door for as little as twenty-four hours. Continental needed roughly $8 billion in fresh cash every day just to keep its operations going, and Taylor found the money, although Continental had dropped from sixth to eighth place in the rankings of America’s banks.
Six days earlier, on May 2, Taylor had met with his primary regulator, Todd Conover, the comptroller of the currency, and the meeting had been tense. In March, Continental had sold its profitable credit card operation so that it could pay its first-quarter dividend to its shareholders. Some regulators were quietly aghast that the bank would sell off a continuing stream of profits to make a one-time dividend payment. Conover wanted Taylor to accelerate the sale of the bank’s bad loans before he would even consider approving a dividend for shareholders in the second quarter.
So, when a battle-weary Taylor and his wife left on a scheduled vacation the following Sunday, May 6, he prudently arranged to phone in daily. When he called from the ship on Tuesday, Ed Bottum urged him to fly back to Chicago.
That same night, Bottum got a late call at home from one of his senior executives, with alarming news from Tokyo, where it was already midday on Wednesday. A little after noon that day, the trading desks at the big Japanese banks, institutions that regularly made short-term loans to Continental, had suddenly slammed the door in the bank’s face. There would be no overnight loans from Japan that day.
Those close-knit traders, glued to their newswires and telephone consoles, made multimillion-dollar trades based exclusively on trust and reputation. Perhaps the Japanese traders calculated that they wouldn’t get fired for not doing business with Continental Illinois, but certainly would get fired if they lent money to the bank and couldn’t get it back. That calculation put them at the front of what would become a classic bank run, rolling through the time zones from Tokyo to Chicago.
A team of reporters at the Chicago Tribune later pieced together what had happened, a comedy of errors with a grim final act.
On Tuesday, a reporter based in New York for the Commodity News Service filed a short, speculative story quoting “banking sources” who said that one of Japan’s financial giants might buy Continental Illinois. It also said that “federal monetary authorities” planned a “special meeting on Continental Illinois’s financial performance.” When that story reached Tokyo, it was picked up by Jiji, a Japanese newswire service that had a deal with CNS to translate, edit, and transmit its stories in Japan. But the translation went awry, turning a “rumor” of a takeover into a “disclosure.” The translation also changed “federal monetary authorities,” to “currency” authorities, which may have evoked fears that this referred to the comptroller of the currency, whose involvement would suggest more serious problems.
At three minutes before 11 o’clock on Wednesday morning, Tokyo time, this blunter story went out to Jiji’s clients, which included many major Japanese financial institutions. An hour later, the news service sent out a translation of the earlier story about Ed Bottum denying rumors of bankruptcy.
“According to both American and Japanese sources, the run on Continental began in earnest when traders at the Japanese banks saw the Jiji stories,” the Tribune concluded. “The panic followed the sun.” The word spread quickly to European banking centers, and just like that, “the European money that Continental needed to keep going was no longer there.”
When Wednesday, May 9, arrived in Chicago, the rumors arrived with it. They were picked up by alert ears at an affiliate of the Chicago Board of Trade, which promptly pulled $50 million from one of its Continental accounts.
The run had hit home.
* * *
TWO DAYS LATER, shortly before noon on Friday, May 11, FDIC chairman Bill Isaac got an urgent call from Todd Conover.
“Can you stop whatever you’re doing and come over to Volcker’s office?” Conover said.
It wasn’t really a request. Isaac canceled a luncheon speech and took a car immediately to the Fed’s gleaming white compound on Constitution Avenue. When he reached Volcker’s office, he listened as Conover briefed his two fellow regulators and a few senior staffers about the worsening situation in Chicago.
Thursday had brought little letup in the electronic withdrawals from the bank. Overnight loans were not being rolled over; maturing certificates of deposit were not being renewed. David Taylor, now back from the Bahamas, had sent telexes to two hundred foreign banks denying the rumors galloping westward from Japan, but that had only heightened the alarm. On Wednesday, Conover had taken the highly unusual step of issuing a press release to say that he did not know of any “significant changes in the bank’s operations” that would support the rumors. It had no effect on the growing panic.
The bank was running out of cash.
No one needed to be told how important it was to stop this run in its tracks. There were several thousand smaller regional and local banks with uninsured deposits entrusted to Continental Illinois, and some of them might falter or fail if they lost those funds—and that would spread the panic. Depositors at other banking giants would likely see a Continental failure as the signal to move their own funds to the safety of the Treasury market, putting other banks at risk. That, too, would spread the panic.
These men might not have known it yet, but the reaction could reach even farther than they feared. David Taylor had lured back deposits from a number of money market funds over the past year, and if Continental failed, some of them might have to “break the buck”—that is, they might be unable to meet their implicit promise to always redeem their shares for a dollar. That would send the panic surging into the mutual fund industry, a market that these men did not regulate. A sudden exodus of cash from money market funds, regulated by the SEC, would have exacerbated the overall financial gridlock, because money market funds were becoming an important source of short-term credit for other banks and financial institutions, and even for some major corporations.
Volcker, Isaac, and Conover saw something that many of their overseers in Congress did not grasp: confidence in a nation’s financial system is fragile, so delicate it could be cracked by the light tap of an unfounded rumor in Tokyo. A giant bank failure in Chicago would hit it like a sledgehammer. You could argue whether depositors would really grow panicky and view all banks with the same alarm, but if it did happen, you had a staggering mess on your hands, one that could derail economic activity for months, trigger business failures across the country, and leave an entire generation wary of any kind of financial risk, as had happened in the 1930s.
So, even though rescuing Continental Illinois would almost certainly trigger withering accusations that the regulators were “bailing out the big boys” while letting little banks fail on a weekly basis, there wasn’t really any question about whether to do this. If a bunch of small retention ponds are leaking and there is a rapidly growing crack in the Hoover Dam, you shore up the Hoover Dam. The question was, how?
The FDIC had the authority to put $2 billion into the bank, but the magnitude of Continental’s hemorrhaging was such that all three men were afraid that this gesture would not be enough to calm the panic. They decided to wait until Conover had spoken again with Continental’s executives. To give him time to do that, Volcker made sure that the Federal Reserve Bank of Chicago expedited the bank’s request for an emergency loan of $3.6 billion. The money would tide the bank over until the weekend—and it would buy everyone some time.
* * *
IN CHICAGO, DAVID Taylor reached out by phone to Lewis T. Preston, chairman of Morgan Guaranty Bank in New York, to seek his help in organizing an emergency line of credit from the community of giant “money center” banks. All of them had reason to ensure Continental’s orderly survival, because any one of them could be next. Several had already had to jack up the rates they paid on certificates of deposit as the price of attracting funds.
Taylor and Preston spent that weekend tracking down their counterparts at fifteen of the nation’s top banks. By Sunday night, it looked as if Washington’s help would not be needed. Taylor sent telexes to his largest overseas depositors, reporting that sixteen of the nation’s largest banks, led by Morgan Guaranty, had set up a $4.5 billion “safety net” line of credit for Continental Illinois.
It was an enormously impressive response from the private sector, and Continental announced the arrangement with great fanfare on Monday morning, May 14. While it was not explicit, everyone seemed to know that the mighty Federal Reserve also stood ready to lend to Continental, if necessary.
To the horror of the bankers and regulators, the impact of this historic gesture was exactly zero. The global run continued throughout the day on Monday. In just nine days, the bank had lost 30 percent of its previous funding—a hemorrhage three times larger than the worst bank runs that would occur in the aftermath of the 2008 financial crisis.
David Taylor had nowhere left to turn but to Washington.
* * *
AT 10 A.M. on Tuesday, May 15, Todd Conover and Bill Isaac returned to Paul Volcker’s office. Shaken by the failure of the bank consortium’s effort, they agreed that the FDIC should proceed immediately to pump $2 billion into Continental, and began to work out the details. After an hour and a half, the three regulators left for the Treasury Building to answer a summons from Secretary Regan, who wanted to be briefed on the situation before he left for Europe the next day. Regan did not oppose the plan, but later suggested that the banks in the consortium be asked to contribute to the cash infusion.
After the meeting, Volcker returned to the Fed and prepared to head to New York, where he was scheduled to receive an honorary degree from Columbia University the next day.
Lewis Preston discreetly summoned the other bankers in the “safety net” consortium to a meeting at 9 o’clock Wednesday morning at a Morgan Guaranty building in Midtown Manhattan. Wary of sparking more ruinous rumors, the easily recognized Volcker slipped into the Morgan building via a loading dock that was used for armored car deliveries. He joined Isaac, Conover, and the New York Fed’s president, Anthony Solomon, as an elite squadron of top bankers filed into the conference room with their aides. All told, about three dozen people were at the secret meeting, all of them deeply worried.
Volcker, who had artfully avoided sitting at the head of the table, made a few remarks from the sidelines, urging the bankers to “act quickly and decisively to demonstrate to the world at large that we [have] the ability to cope with a major problem.” Bill Isaac reported on the FDIC’s plan and proposed that the bankers contribute $500 million to the rescue effort, as Don Regan had suggested. There were, by one account, some “patriotic speeches” from several of the bankers about coming together for the greater good—although Volcker later recalled that Tom Theobald, a vice chairman at Citicorp, had memorably asked, “Why would I want to help a competitor?” As the negotiations stretched into the afternoon, Volcker left to collect his honorary degree—his failure to do so would certainly have fueled fresh market worries.
Bankers and regulators worked through the night until the deal was done. At 10 a.m. on Thursday, May 17, David Taylor got the word from New York that he could convene a press conference to announce the historic rescue package: a cash injection of $1.5 billion from the FDIC and $500 million from seven major banks, and a new line of credit from the original “safety net” consortium, which ultimately would include more than two dozen banks. The Fed, of course, would remain ready to serve as the lender of last resort if the need arose.
The most critical part of the package was the FDIC’s assurance that the approach it would use to stabilize Continental would fully protect “all depositors and other general creditors.” In other words, unlike Penn Square, Continental would not be shut down through a payoff, which would have left creditors and uninsured depositors with losses. In fact, the FDIC had handled most previous bank failures without resorting to a payoff—Penn Square had been the exception. Bill Isaac, who had resisted the more common kind of rescue deal for Penn Square, was now on board. Having just experienced a dangerously contagious bank run that imperiled what was still a solvent institution, his top priority was financial stability.
It was essential that this rescue package deliver a knockout blow to the panic besetting Continental Illinois, and a guarantee that the FDIC would find a way to avoid inflicting losses on depositors and creditors might do that. Isaac certainly hoped it would.
And, to the immense relief of Washington and Chicago, it did.
* * *
ONE WEEK AFTER the Continental Illinois rescue, as details of the cliffhanger negotiations emerged, the foreign exchange markets grew utterly chaotic, with jittery investors selling dollars “in response to worries over the stability of the United States banking system.” Perhaps foreign bankers really didn’t understand how America’s Rube Goldberg regulatory system worked and therefore couldn’t fully trust its promises about Continental Illinois. At Volcker’s direction, and for the first time in three years, the Fed secretly pumped $135 million into the market in a single day to stabilize the dollar.
Clearly, the Continental Illinois crisis was far from over.
With the FDIC and the Federal Reserve standing behind it, Continental ought to have been a magnet for depositors, given the above-market interest rates it was offering. Yet, the foreign investors who had fled in the stampede had not returned. Money market funds were still steering clear. Big institutional investors were on the sidelines. The only path toward permanent stability seemed to be a merger with another large bank, and in mid-June, David Taylor turned his full attention to finding a suitable partner.
The bank was living on borrowed time. As June slipped into July, the stock market awaited Continental’s next quarterly financial statement. While continuing to sell off small subsidiaries, it announced that it was postponing its second-quarter report while negotiations with possible merger partners continued. But it soon became clear that there simply was no credible buyer for what had recently been considered the mightiest bank in Chicago, an underwriter of the nation’s biggest futures markets, and one of the top ten banks in the country.
By early July, Bill Isaac at the FDIC and his counterparts at the Fed and the comptroller’s office had given up on their merger hopes and devised an innovative plan to permanently stabilize Continental Illinois: the FDIC itself would invest several billion dollars in the bank and buy the bulk of its bad loans, in exchange for preferred shares that would make it the bank’s largest stockholder. The unprecedented agreement was widely expected to be announced on Thursday, July 26.
Then, at the last minute, the deal was almost torn apart by yet another jurisdictional battle: Treasury secretary Regan belatedly, and publicly, balked, saying he thought certain details of the plan were “inappropriate” and “bad public policy.”
What on earth was going on? Why had Regan, who had supported the Continental rescue in May, suddenly turned hostile? The question nagged at Irvine H. Sprague, a veteran Washington official who was the third member of the FDIC’s board, alongside Todd Conover and Bill Isaac.
After one particularly trying meeting, Sprague asked what Treasury was trying to do. “One high Treasury official said to me: ‘This is 1984; we might look at it differently another year’—a hint that the administration was seeking to distance itself from the largest bank bailout in history during a presidential election year.”
Yet there was another sore point for the treasury secretary. Regan, like John Shad and Todd Conover, supported a pending bill that would allow banks to expand into new businesses, so long as they did so through separate subsidiaries of the banks’ parent holding companies. The idea was that the holding company structure would protect the banks from the risks posed by those new ventures. But because of restrictive bond covenants, the only practical way to inject cash quickly into Continental was through the holding company. Sprague later speculated that Regan was “concerned that the precedent would undermine the validity” of the argument that holding companies would insulate banks from danger.
When Regan publicly attacked the rescue plan, Bill Isaac was publicly silent, but privately he “hit the ceiling,” Sprague said. Sprague was fuming, too.
“Different problems required different solutions,” Sprague said later. As he saw it, the FDIC and Treasury could “massage our prejudices by allowing the holding company to fail. Or we could save the bank.” And by saving the bank, they could reduce the risk that a highly contagious panic would spread throughout the financial system.
Finally, the logjam broke on Wednesday evening, July 25. Cooler heads had apparently prevailed at Treasury, or perhaps at the White House. The Treasury Department pedaled firmly away from Regan’s demands. “They are the banking regulators,” one unidentified Treasury official told the New York Times, with an almost audible shrug.
At the FDIC that evening, Bill Isaac outlined the rescue package during a conference call with Volcker, Conover, and the leaders of the House and Senate banking committees. Isaac also reminded them that “no taxpayer money” would be used in the rescue plan because the FDIC was financed by premiums paid by the banking industry. Meanwhile, his staff worked through the night on the paperwork so the deal could be announced in Chicago on Thursday morning.
It was an “extraordinary intervention in the banking business,” according to the New York Times. A new management team was put in place, with David Taylor returning to his finance position, his white-knuckle mission accomplished. At the end of September, shareholders of Continental Illinois approved the FDIC’s purchase of an 80 percent stake in their bank, the price of avoiding a collapse that would have wiped them out entirely.
By then, the world had learned a little more about how precarious the whole episode had been—the Fed’s need to step into the foreign currency markets in May, the huge loans Continental needed just before the rescue in July, the staggering $12 billion in deposits that had hemorrhaged from the bank since the first of the year.
Something like this wasn’t supposed to happen, but it nearly did. And those who struggled to prevent it knew how easily it could happen again.