Just before the July Fourth weekend in 1982, a banker sat in a conference room at Continental Illinois National Bank in Chicago and stared in disbelief at the federal bank examiner seated across from him.
The examiner was tapping a stack of documents, the paperwork for a loan that Continental Illinois had bought from Penn Square Bank, an aggressive “oil patch” lender in Oklahoma City. The examiner was saying the loan was bad—there wasn’t enough collateral behind it, and Continental Illinois would have to write it off.
No, the banker protested. That loan was backed by the unlimited guarantee of a wealthy individual affiliated with the drilling venture that was being financed.
“No, all you have is smaller limited guarantees,” the examiner said; the guarantees did not fully cover the loan.
The banker was shaken. Partly on his watch, Continental had paid nearly $1 billion to buy loans from Penn Square Bank. He had been personally reassured about the questioned loan’s terms by Penn Square’s top oil and gas banker, an exuberant young man he considered a close friend.
The examiner had already moved on to the next set of documents, raising fresh questions about other loans.
As soon as the banker could, he hurried to his office. He knew that bank examiners were at the Oklahoma bank, too; news coverage was suggesting that there were some problems there. His friend, his primary contact at Penn Square, had insisted the bank was just experiencing normal growing pains after a hot spurt of success. Federal regulators just wanted Penn Square to find $30 million in fresh capital—and his friend had assured him that new investors were being recruited.
Increasingly anxious, the Chicago banker telephoned his friend at home in Oklahoma City. “You’ve got to go to your office, or have someone go to your office, and get the examiners to unseal your files,” the Chicago banker told him urgently. “You’ve got to send me the unlimited guarantee that you got to back up that loan.”
“I’m sorry,” his friend replied. “I never got it.”
Without that unlimited guarantee, the loan was not worth what Continental Illinois had paid for it, if it was worth anything at all. Was the examiner right about all the other Penn Square loans stacked up on the table in the Continental Illinois conference room?
The examiner was right about most of them—enough to destroy the banker’s career and enough to profoundly shake the market’s confidence in Continental Illinois itself.
And that would be enough to shake the financial foundations of Chicago.
* * *
IT WOULD BE hard to overstate how much the explosive ingenuity of Chicago’s futures markets had been underwritten by Chicago’s major banks: First National Bank of Chicago, Harris Bank and Trust, and especially Continental Illinois.
In 1971, when Leo Melamed was drumming up support for his new foreign currency futures market, he feared that the giant national banks would see the Merc as competition for their own foreign currency business and shun the new product. And many did: one New York banker warned Melamed that foreign currency futures would serve no purpose “other than to cater to people slightly more sophisticated than those who go to the track.”
But Chicago’s bankers were cut from the same innovative cloth as its traders. They quickly rallied to support the new foreign currency exchange. By recommending currency futures to their institutional customers and adding their executives’ names to the Merc’s list of advisers, they gave the venture worldwide credibility.
The global ambitions of Continental Illinois were a match even for those of the Merc. By the summer of 1982, the bank had grown into the sixth largest in the country, and it ranked first in commercial and industrial loans. In 1978 the respected Dun’s Review had published a glowing profile of Continental Illinois’s chief executive, Roger E. Anderson, and called the bank “one of the five best managed companies” in the United States.
There were problems, of course—enormous ones that confronted the entire banking industry. Interest rates on new loans were sky-high, which meant that high-quality companies weren’t eager to borrow. Meanwhile, Federal Reserve regulations capped the amount of interest that banks and savings and loans could pay to their small-scale depositors, prompting many people to pull their cash out of banks to get the higher rates offered by money market mutual funds. The Fed was reluctant to lift the interest rate cap, for fear it would doom the already shaky savings and loan industry, where institutions were failing at the rate of about five every week.
Bankers such as Roger Anderson at Continental Illinois believed the best way to survive this storm was to get bigger and broader—to push into every new market that regulators would open to them, while expanding traditional lending operations as far as the market would bear. Some markets, notably the brokerage and securities underwriting business, remained largely closed to them, but they were beating on the doors.
Clearly, a legislative fix was needed, and Congress was ineffectively mulling over what it should do when the summer of 1982 went spectacularly sour.
The problems at Penn Square quickly became public, thanks to an alert reporter for American Banker, the bible of the banking industry. The crisis at the bank was a shock to its depositors, but they may have been the only ones who were surprised. Rival bankers in the oil patch had watched skeptically as Penn Square ballooned from “a sleepy, $30 million-asset suburban retail bank” in the mid-1970s to a $500 million bank whose loan portfolio was stuffed with risky oil and gas loans.
The bank’s troubles had also been detected by at least one of its regulators. For more than two years, examiners from the Dallas outpost of the Office of the Comptroller of the Currency had been discreetly prodding the bank to tighten its loan standards and curb its prodigious growth. The bank’s top managers had made earnest promises and temporary improvements. Meanwhile, they kept selling their loans upstream to a handful of big banks, including Continental Illinois.
Examiners had arrived to give Penn Square a checkup in April 1982. After spending a week or two poring through drawers of half-completed or unreliable loan documents, they knew they were facing a full-blown disaster. Writing off the troubled loans they had already looked at would wipe out the bank’s capital, and there were still many more file cabinets to open. On May 11 they sent a warning to Washington.
The warning eventually reached their boss, C. Todd Conover, a California banking industry consultant tapped by President Reagan to run the Office of the Comptroller of the Currency, an independent agency within the Treasury Department that was the official regulator of roughly twelve thousand nationally chartered banks, including Penn Square.
On June 23, Conover issued the order that gave Penn Square a week to find $30 million in new capital. He alerted one of his two fellow bank regulators, William M. Isaac, the chairman of the FDIC, which had insured Penn Square’s deposits. The next day, Conover called the third regulator involved, Paul Volcker at the Fed, to tell him that Penn Square would likely need some kind of emergency loan in the next few days. And on June 30, after a week of crisis, an FDIC team swooped in to take charge in Oklahoma City, and the Fed extended a $20 million loan to brace the bank for the fatal run that regulators had feared, and had just barely headed off.
In 1982, federal deposit insurance was capped at $100,000. Tempted by Penn Square’s high CD rates, many customers, including about 170 banks and other financial institutions, had put much more money into their Penn Square accounts than the FDIC insurance would cover. In fact, the total of uninsured deposits was roughly $250 million, which would constitute the largest loss by bank depositors since the Great Depression.
It was an acid test for Bill Isaac, who had been appointed to the FDIC board by Jimmy Carter and elevated to the chairmanship by Ronald Reagan. As Isaac saw it, unless the troubled bank could somehow find a new owner or merge into an existing bank, the FDIC would have to do a “payoff.” In a payoff, depositors get paid up to the FDIC insurance limit, and the bank is slowly wound down. Depositors whose accounts exceed the FDIC limit get IOUs for the rest of their money. Those chits are paid from whatever can be salvaged from the failed bank’s loan portfolio. Creditors, who in this case would include Continental Illinois and the other upstream banks, get any crumbs left over.
For Paul Volcker, word that almost two hundred financial institutions could be damaged by the Oklahoma bank’s collapse was terrible news arriving at the worst possible moment.
Volcker’s team was already on high alert; the Mexican government faced a substantial bank loan payment in August, and other Latin American debtor nations were looking shakier every day. Another small government securities firm in Los Angeles had faltered in early June in the aftermath of the Drysdale crisis, and credit concerns were still unsettling the Treasury markets. Now they had to contend with a bank failure that might cast fresh doubts on the creditworthiness of all major banks.
The fragile banking system had been a worry at the Fed for several years, but in the tenth month of a steep and deep recession, those concerns had escalated. The jumbo size that banks hoped would make them safer also made their problems more of a threat to the overall financial system. It used to be that only a handful of giant banks posed such risks, but Penn Square showed that a small, obscure bank could be just as dangerous to financial stability. New fault lines had been formed because banks increasingly sold their local loans to other banks far afield. Only a map of those transactions, a document impossible to construct, would reveal which banks might be damaged when bad loans blew up.
So, when Paul Volcker heard about Penn Square, he firmly opposed the FDIC’s plan to do a payoff and argued for a workout that would prevent any losses to depositors or upstream creditors.
Initially, Conover agreed with Volcker—after all, that was how a troubled bank was routinely rescued—but neither of them could prevail with Isaac, who argued convincingly that no sane bank would agree to merge with Penn Square when no one yet knew the scale of its liabilities, except that they reached into the billions. For the same reason, the FDIC could not just take over the bank itself and operate it. So, although the FDIC had never done a payoff for “any bank even remotely approaching this size,” to Isaac it looked like the only option.
* * *
GIVEN ALL THAT, it is not surprising that Volcker was cranky on Wednesday afternoon, June 30, 1982, when he gaveled the twelve-member Federal Open Market Committee to order.
The main item on the agenda was Mexico, which was on the verge of its own financial crisis because it owed its bankers $20 billion and was having trouble repaying its debts.
A failure by Mexico to repay its bank loans would be a body blow to the U.S. banking industry. The five largest banks in the country would lose between one-third and three-quarters of their capital to a Mexican default. The next five largest banks, including Continental Illinois, would lose between a quarter and half their capital. And that was just Mexico. There were a lot of shaky debtor nations in line behind it. Volcker got committee approval for the confidential emergency financial package that the Fed, the Treasury, and the International Monetary Fund were drafting for Mexico and recessed the meeting until the following day.
When the committee gathered the next morning, Volcker shared the saga of Penn Square.
“In general terms we have a potentially serious banking problem,” he began, “arising out of a bank in Oklahoma that is teetering, or more than teetering.”
The bank itself wasn’t “all that significant,” he said. No one would have picked it as a systemic threat to the financial system. Still, its reckless lending to the oil industry reflected “a psychology, I suppose, that anybody who digs a hole in the ground now, or even promises to dig a hole in the ground, has a bonanza—because the price of oil was going to go up forever. And the price of oil suddenly doesn’t go up forever, and all these loans look awful.”
How many other loans on the books of America’s banks were solid only if prices continued to climb at a feverish pace? How many had been made solely because no one imagined that Volcker could actually defeat the inflation that had afflicted the nation for a decade?
Over the July Fourth weekend, Volcker convened officials from the FDIC and from the comptroller’s office to discuss the Penn Square situation, and the group decided that Treasury secretary Donald Regan should be consulted. When Regan arrived, casually dressed, he took a seat on the sofa and listened to the opposing arguments.
Volcker and Conover thought there was a big risk of chaos in the financial markets if the Oklahoma bank were shut down on the FDIC’s terms. Bill Isaac made his case for market discipline, for taking a stand on Penn Square to show that there was not an unlimited safety net for reckless banks. It is not clear if Regan sided with Isaac, as one account suggested, or if Conover thought he had and left Volcker outvoted. In any case, in the early evening of Monday, July 5, the order was given for the FDIC to begin a payoff operation at Penn Square.
A ferocious crisis of confidence, sent special delivery from Oklahoma City, had been dropped on Continental Illinois’s doorstep. And it wouldn’t stop there.
When the New York Stock Exchange opened on July 6, Continental’s share price fell almost 10 percent on the news from Oklahoma. Losses on its Penn Square loans put Continental almost $61 million in the red when it closed the books on the second quarter of 1982.
Within weeks, senior executives at the bank admitted that they had known about problems with some of their Penn Square loans as early as the previous fall, but they insisted they had no reason to doubt the overall soundness of the Oklahoma bank. Ominously, a major credit rating agency cut the bank’s rating.
The virus was spreading beyond Chicago. On the West Coast, Seattle First National Bank, known as Seafirst, had purchased more than $400 million in poorly documented oil loans from Penn Square. A week after the FDIC acted, Seafirst laid off four hundred employees and warned investors it would incur substantial losses. On the East Coast, Chase Manhattan, still smarting from the Drysdale mess of a month earlier, soon reported its own embarrassing losses on Penn Square loans. In the Midwest, Michigan National Bank owned $190 million in loans purchased from the Oklahoma bank. Penn Square losses had led one savings and loan to be declared insolvent, while another was severely impaired and several more had been hurt badly. More than 130 federally chartered credit unions had uninsured deposits with the failed bank and would have to wait for the FDIC to find additional assets before they could fully recover their cash.
On July 15, Volcker told FOMC members during a conference call that there was “nervousness in the market about financial institutions in general” in the wake of the Penn Square crisis. “Enormous numbers of rumors are being generated, which get reported to me regularly,” he added.
Preston Martin, a former thrift industry regulator who had recently been appointed to the Fed board, agreed. He had heard market people “talking about what bank is going to fail next.” He concluded, as did Volcker, that to tighten their grip on inflation at that moment would indicate to everyone “that we are not taking seriously the downside risk inherent in an unstable, illiquid market.”
It bothered the “inflation hawks” on the committee to stand pat, but they all agreed the situation was just too fragile for them to do anything else.
* * *
THE NEXT MORNING, a little after 10 o’clock, Congressman Benjamin Rosenthal, the New York Democrat who had led the fierce silver hearings two years earlier, banged his gavel to open the first House hearings on the Penn Square crisis.
“The Penn Square Bank failure is a dramatic reminder of the need for an effective bank regulatory system,” Rosenthal said. “Many millions of dollars will be lost by depositors and other financial institutions because of this failure, in spite of Federal supervision and in spite of Federal deposit insurance coverage.”
Rosenthal pressed to learn how one set of bank regulators, those in the comptroller’s office, could have known about Penn Square’s problems for more than two years without alerting other financial regulators. The answer, of course, was that sharing details with other financial regulators would virtually guarantee the bank runs they were trying to prevent.
Then Rosenthal called Comptroller Todd Conover and FDIC chairman Bill Isaac to testify.
Isaac’s candor seemed to soothe Rosenthal. The Penn Square outcome wasn’t optimal, the FDIC chief conceded frankly. Ideally, a troubled bank can be sold to a healthier one, with some FDIC assistance, and all customer deposits are thereby protected. Unfortunately, in this case, Penn Square’s lending practices were so dubious that it was impossible to arrange a merger.
Isaac had a knack for preempting Rosenthal’s attacks. “Many people are asking: ‘How could this have happened? Why did this bank fail and how did so many other financial institutions get involved? Is this failure evidence of other problems in the financial system?’” His questions were, indeed, what Rosenthal was asking.
“The short answer is that, at best, this bank engaged in shoddy, speculative banking practices,” Isaac answered. “Its problems were the result of loans which should never have been made.”
He felt certain, he said, that while there might be a few other sinkholes like Penn Square in the financial landscape, they “will be few and far between.”
As for Continental Illinois and the other giant banks hurt by Penn Square’s collapse, they could withstand their likely losses, he said. “If one can identify a silver lining behind the dark cloud of the Penn Square affair,” Isaac said, with far more optimism than was warranted, “we should expect that all financial institutions will be more prudent in the future.”
And if one could identify a lesson, a target for reform, behind those same storm clouds, he continued, it was that something needed to be done about the nation’s fragmented approach to regulating its banks. What purpose did it serve for five regulatory agencies to oversee America’s deposit-taking institutions? Why were there three separate deposit insurance funds—one for national banks, another for savings and loans, and a third for credit unions? And was it possible to provide more public disclosure about the condition and business practices of insured institutions?
“I firmly believe that significant reforms in our regulatory apparatus are needed,” Isaac concluded. “It is my sincere hope that the experiences of the last two weeks will provide the impetus to move forward on these issues.”
* * *
EVERY FRESH CRINGE of anxiety in the banking system during that long, shaky summer of 1982 was also felt on the floor of the New York Stock Exchange.
The Dow Jones Industrial Average, which had popped above the historic 1,000-point line twice in the month immediately after Reagan’s election, had spent the summer hovering around the 800-point mark.
About the only good news during the hard times of 1981 and 1982 was that Paul Volcker’s bitter anti-inflation medicine seemed to be working. Inflation had plummeted from north of 12 percent to below 6 percent, and it looked to be heading even lower, which made bond investors a little less worried and stocks a little more attractive.
Even so, on Thursday, August 12, 1982, the stock market sank for the eighth day in a row. The Dow closed at 776.92 points, more than 5 percent below its level when the month began. About 50 million shares were traded, up a bit from the previous day but nothing to get excited about. The bear market was more than a year and a half old. What could you expect?