Continental Illinois National Bank & Trust -- which was rescued from failure three years ago in the largest federal bank bailout -- violated federal banking rules last week when it bailed out a subsidiary that was itself close to failure because of losses from the stock market's plunge, federal bank regulators said yesterday.
The subsidiary, First Options of Chicago Inc., found itself short of cash and close to failure last week because of the stock market collapse. First Options is the largest of the firms that match buyers and sellers of stock options and options on stock indexes -- a portfolio of stocks based on a standard market index. Last week's wild trading in stock index options was a key factor in the stock market's volatility.
To cover trading losses, First Options borrowed hundreds of millions of dollars from Continental bank but returned an estimated $25 million within 24 hours when regulators told the bank it had exceeded the amount it is permitted to lend to a single borrower, federal bank regulators said.
Continental signed a consent agreement yesterday promising the bank will never again exceed authorized lending limits to First Options or any other borrower, the Office of the Comptroller of the Currency, a key bank regulator, said in a prepared statement. Although the comptroller's office would not disclose how far over the lending limit Continental bank had gone, sources estimated the amount was $25 million.
First Options eventually borrowed the rest of the cash it needed from the bank's parent holding company, Continental Illinois Corp.
The holding company announced yesterday that it expects a loss for the quarter ending Dec. 31 because of a $90 million writeoff that First Options will take as a result of the stock market plunge.
The size of the quarterly loss will depend on how much profit the holding company gets from other subsidiaries, primarily from the bank. The U.S. government, which owns 60 percent of the holding company's stock, would lose income if the company does not pay a dividend to stockholders.
Continental's violation of federal safety rules -- and expected quarterly loss -- comes as debate rages over the safety of allowing banks to own securities subsidiaries.
First Options profits from commissions on trades that it processes for various customers, including many traders on the floor of the Chicago Board Options Exchange who deal in stock options. It also profits by lending money to traders to help finance stock and options positions.
As a clearing house that completes options transactions, First Options was hurt when traders who had borrowed money suffered losses and were unable to come up with additional cash to repay their lenders. In many cases, if traders go broke, First Options must absorb the losses.
In 1984, Continental Illinois was saved from failure by a $4.5 billion government bailout.
The bank has returned to health, but the government still owns 60 percent of the holding company's stock that it inherited in the rescue plan.
Because of the government's stake in Continental, many of the bank's competitors criticized federal regulators for allowing the bank to buy a new subsidiary, especially one tied to the relatively risky area of options trading.
If First Options had been allowed to fail, Continental would have lost nearly $800 million in loans and investments in the company.
Having First Options borrow from the holding company enables Continental to sidestep federal limits on how much a bank can lend to one borrower, but it does not satisfy critics who argue that borrowing from the holding company could prove as damaging to the bank.
Every dollar the holding company must use to support its securities subsidiary means one less dollar to insure the soundness of its bank subsidiary, they argue.
Continental Bank bought First Op-tions last year for $125 million incash, making it the first big bank to jump fully into the options market. Federal regulators approved the sale after Continental promised to treat First Options like any other borrower and observe limits on how much a bank can lend a single borrower.
"In a consent agreement you neither admit nor deny wrongdoing, but you don't enter into a consent agreement unless you have a problem," said a banking regulator close to the agreement. The regulator asked not to be identified.