In Sunday's Outlook section, Chase Manhattan was incorrectly identified as the nation's second-largest bank. It is third largest; Citicorp is second. Also, a chart accompanying the article should have been credited to the House Banking Committee rather than the comptroller of the currency.
THE AMERICAN banking system is facing a crisis of confidence caused by the dubious judgment of some of the biggest banks in the country.
Most bankers hate to deal with evidence of their own colleagues' slipshod behavior, but this summer it has been inescapable. Giants of the industry including Chase Manhattan, the nation's second largest bank, and Continental Illinois, the sixth, have been caught making the kind of unsound loans that large, sophisticated banks are not supposed to make.
Chase not only had bought $212 million worth of what Federal Deposit Insurance Corp. Chairman William Isaac describes as "shoddy, speculative" energy loans from the now-defunct Penn Square National Bank, but had to admit to large potential losses in the failures of two Wall Street securities dealers, Drysdale Securities and Lombard-Wall.
Continental was on the hook for a cool $1 billion in Penn Square participations, and has loans totaling another $1 billion to more than a dozen troubled corporations, including International Harvester and susbidiaries of Dome Petroleum, companies struggling to avoid bankruptcy. Continental also is involved in a small way in the Lombard-Wall fiasco.
As a result, a sense of unease has swept financial markets: large and small investors are combing through their holdings, quietly taking money out of all but the (seemingly) strongest banks, selling off commercial paper that doesn't have the best ratings, and often putting the money in Treasury bills, sacrificing higher return for more security.
The investment markets are anxious about the future. "So far, the system has been kept intact, at some cost, but intact," says Henry Kaufman of Salomon Bros., the Wall Street investment bankers. "But you don't know when you'll get blindsided (by an unexpected new crisis)."
How did the financial system slip into such a fragile state? Experts blame a combination of greed, speculative practices and bad management among bankers -- a hunger for the fast buck and rosy quarterly earnings reports that will look good to stock market analysts. And there is a kind of incestuous undercurrent: bankers trust bankers, says an expert, so they often plunge into a business relationship with another bank without traditional, cautious checking in advance. That's how Penn Square became such an entangling mess for big banks like Chase and Continental Illinois.
Unless a bank is really well run, says an insider, a bank loan manager in a big institution is likely to operate under a quota systems, something like a traffic cop handing out tickets. Says one who knows:"He may have $100 million that he's supposed to lend out for energy, and if he comes back in and says he's only been able to place $60 or $80 million, they'll say, 'Hey, if you can't do it, we'll get someone who can.' "
Right now, the big push is loans for Southeast Asia, the expert continues: "Suppose the guy in the international department has his 100 (million dollars), and he knows he can't lend money to Poland or the Communist bloc countries any more. Say he had 25 of the l00 scheduled to go to them. He doesn't turn the 25 back, right? So he's pouring that into the Far East. Not every bank, mind you, but enough to get you worried."
In other words, the old-fashioned image of a tight-fisted banker who carefully allocates his own bank's money to the best available credit risks no longer applies to big-time banking. The object in many big banks is to make as many loans as possible, not to restrict lending to the most reliable possible customers.
Professionals on Wall Street were not surprised to find that the big banks had stubbed their toes, although a few eyebrows were lifted at the amounts of money so casually dispensed by presumably sophisticated managements like Chase and Continental. An Aug. 4 report made public by Goldman Sachs & Co. shows that senior officials at Continental knew as far back as the fall of 1981 that they were in trouble at Penn Square, a fact kept quiet at the time.
Karen Lissakers of the Carnegie Endowment for Peace, a long-time student of the banking industry, says: "It's really appalling: The banking industry is badly run, and big bankers have been making the same mistakes domestically they have been making for years internationally."
Just as many European banks are overexposed in their loans to eastern Europe, key U.S. banks made huge loans to Mexico, which might have to default unless the banks permit Mexico to postpone its payments to them. As international authorities struggled to make sense out of Mexico's $80 billion foreign debt, the mere rumor that four or five big U.S. banks were in deep trouble because of their commitments in Mexico was enough to shake the stock market last week.
A federal regulator elaborates: "Bankers tend to look at areas that will produce a lot of loans." And a New York investment expert puts it more cynically: "Like other people, bankers follow fashions. First it was real estate -- and nothing could go wrong, although we know what happened. (Many banks were badly burned by the collapse in value of big real estate investment trusts in the 1970s.) Then it was international lending. And finally, after OPEC hiked prices, what could be better than energy loans?"
The root of the problem, according to Felix Rohatyn, senior partner of the New York investment banking firm of Lazard Freres, is "a kind of U-turn in banking away from conservative practices." Beginning in the 1960s, he says, "performance" became the criterion by which financial institutions were judged, leading "to an almost inevitable sacrifice in the quality of restraints vis-a-vis the desire for growth."
In this "go-go" atmosphere, exacerbated recently by volatile, double-digittinterest rates and at least 10 sizable corporate bankruptcies in the United States this year, the world's leading banks (Banco Ambrosiano abroad is illustrative of the problem in Europe) are beginning to hurt badly. A major threat to European banks, especially in West Germany, is a potential default on huge loans they have made to Poland and Romania.
The experts seem to agree that the banking industry's problems are not universal, but were produced by the questionable judgment of individual institutions. According to knowledgeable sources in New York, it was not mere happenstance that other major banks, like Citicorp, Morgan Guaranty and Manufacturers Hanover Trust, did not get involved in Penn Square loan particpations.
In Wall Street, it is reported that Continental Illinois has been forced to borrow money in Europe at premiums ranging from 1/2 to as much as 3/4 of a percentage point above going rates to cover funds withdrawn by worried depositors here, including money market funds now willing to sacrifice a fraction of a point of interest for security. Although Chase has not yet had to pay a premium to attract its usual certificate of deposit business, some institutional investors are reported to be squeamish about leavings funds in Chase.
These unsettling events reinforce the anxiety in financial circles over the failure of the Penn Square National Bank of Oklahoma City on July 5. Some 60 banks -- including Chase, Continental and Seattle-First National Bank -- had participated with Penn Square in making what turned out to be $2 billion in bad loans to stimulate energy production in the Southwest.
The FDIC's decision to close Penn Square's doors on July 5 significantly shook the banking system: It not only laid bare the involvement of Chase and Continental in Penn Square's energy loan mill but, for the first time, Uncle Sam did not bail out a weak bank of some size by merging it with stronger bank. It allowed Penn Square, with $465 million in deposits, to go belly-up, paying off only the $215 million in insured deposits up to the FDIC's limit of $100,000 per depositor.
As a consequence, a total of 132 credit unions, savings and loan associations, smaller banks and individuals who were careless -- or greedy -- enough to place money in Penn Square over the $100,000 insurance ceiling will lose money. Snared by Penn Square's offer of premiums ranging from 1 to 3 points over going rates, these eager-beaver depositors put it $250 million over the insurance limit. Ultimately, the FDIC expects to lose about $100 million in making good on the insured portion of Penn Square's deposits. Credit unions and other institutions will have to swallow losses of about $50 million, assuming $200 million can be salvaged to repay uninsured depositors from Penn Square's remaining assets.
"What you're seeing now is a flight to quality -- perhaps a flight to certainty," says a multinational banker in New York.
"You pick a big bank where you'd rather have your CD even though you may know another bank is better run. (In other words, a depositor may reckon that even a badly run major bank is safer, because the government will never allow such a bank to fail.) But God, you really don't know what's underneath there, and my God, with the times the way they are, and all these bankruptcies, who knows what's in their portfolio? So why take a chance?"
Latest available government figures show that of the 14,7l8 insured U.S. banks, 270 are listed as potential failures with perhaps 20 per cent of those having a high "probability" of failure. Roughly 1,000 others are on a watch list as banks with problems, but where failure is "only a remote probability." Ironically, that was the category in which the comptroller of currency, responsible for supervising national banks, had placed Penn Square. And Penn Square was never downgraded to a "potential" or "probable" failure during the two-year period in which the comptroller had become anxious about the bank.
On balance, few see the banking system heading for a 1930s-style bust. There is, after all, a $12.3-billion pool of Federal insurance of deposits up to $100,000 in all banks. (Federal savings and loan associations are insured separately, as are state S&Ls and credit unions.)
Most government regulators, including Isaac of the FDIC (which made the basic decision not to try to merge Penn Square into another bank, but close it up), insist that Penn Square is "an abberation."
A current investigation indicates unbelievably slipshod conditions at that overgrown shopping center bank. There were notes not signed and collateral not collected. There were apparently illegal practices, including insider trading. House investigators as well as the comptroller's office the case expect that criminal as well as civil charges eventually will be brought against some Penn Square principals.
But the problem is not isolated. Penn Square has already triggered the collapse of another small bank, the Abilene Bank of Texas. Nervous depositors, responding to rumors that Abilene also had made poor energy loans, pulled $100 million out of the bank. Here, however, the FDIC was able to arrange the more traditional merger with a larger bank in Texas.
As investors all over the country probe for weaker spots in their portfolios, additional failures may follow. Penn Square will also exact a toll among top bankers at Chase, Continental and Seattle, some of whom will surely pay for their indiscretions with their jobs. And ultimately, Congress may force some changes in the regulatory system that will provide for greater public disclosure of the condition of shaky banks like Penn Square.
The Federal Reserve System -- although it won't admit it publicly -- responded to the tremors generated by the Penn Square failure by pumping enormous reserves into the banking system. This accounts in part (recession is the other prime reason) for the recent downturn in interest rates. Responsible officials in Washington also say it is "inconceivable" that a really major bank would be allowed to fail -- because that would touch off an international panic.
What worries regulators in Washington and analysts in New York is that a deepening recession threatens the value of the loan portfolios held by many banks. Because of high interest rates and falling sales, large and small companies alike have been piling up short-term debt at the banks -- and face a cash flow crisis.
Some of these companies will go broke, and won't be able to pay off their bank loans unless there is a dramatic and unexpected reversal in the economy.
Federal Reserve Board Governor Charles Partee last May testified before a House Committee that corporate interest payments rose to an astonishing 40 percent of their total earnings during the first three months of this year, compared to less than 10 per cent in 1965. In an interview last week, Partee said that this percentage had risen, perhaps to more than 50 per cent, because earnings have shrunk further.
If there is a silver lining to this cloud, it is a manifest retrenchment in the banking business. The sobering effect of Penn Square has led to a new caution in the industry. Money market funds have been moving some investments out of banks that they now consider to be more risky than others, and have joined in a "search for quality." notably by placing more of their cash into Treasury bills.
But this conservative trend, Kaufman warns, "will have a retarding influence on economic activity. You can't have it both ways."
Partee agrees with Isaac's assessment that Penn Square is an exception. Yet the comptroller of the currency had only rated Penn Square a 3 on a 1-to-5 danger scale, meaning a bank where failure was only "a remote possibility." Thus, there may be more fragility in the system than the regulators are admitting. There is a only-barely-disguised feeling at the FDIC that the comptroller's office was not totally on the ball in the Penn Square mess.
Kaufman suggests that the Reagan administration's emphasis on deregulation has reduced the incentive for top-quality bank inspectors to stick with the comptroller's office, or to pursue their jobs vigorously.
Former Comptroller of the Currency John Heimann, now co-chairman at Warburg, Paribas, Becker in New York, points out that until Penn Square, the banking world seemed to have the ultimate restorative weapon in the closet: Uncle Sam stood there, in the form of the Federal Reserve Board and the FDIC, presumably ready to bail out any failure. To be sure, some managements might be wiped out in a merger, and stockholders might be hurt -- but the depositors wouldn't lose any money.
Now, Heimann observes, that old perception is no longer wholly valid. True, the biggest banks will certainly be bailed out in a crisis. But how about smaller ones? A more cautious assessment is reinforced, Heimann says, by two other significant developments: first, the decision of the Italian central bank not to stand behind the troubled Banco Ambrosiano, despite a reassuring 1975 "concordat" among central banks; and second, the pressure from some factions in the Reagan administration to precipitate a default of major banks' loans to Poland, as a way of pressuring the Soviet Union.
When federal regulators, somewhat belatedly, faced up to what they now describe as the "sick" nature of Penn Square, they found that the bank's contingent liabilities -- that is, its potential obligations to other banks and individuals -- were so large, perhaps as much as $3 billion, that it was not feasible to merge it with another institution.
Rohatyn makes the point that the banks' bolder search for growth and profits in the 1970s has put great strains on management, especially middle management. And as Kaufman notes, the government's acceptance of monetarist economics led to sudden deregulation of the financial industry. This produced both volatile interest rates, which are a challenge to bankers, and also an unprecedented degree of competition for bankers who weren't used to scrapping for deposits.
The banking system has survived a number of crises in the past decade, including the Penn Central collapse, the withdrawal of fund anands by the Iranian government after the American hostages were taken, the threatened bankruptcies of New York City and the Chrysler Corp., and the failures of the Franklin National Bank of New York and of the Herstatt Bank in West Germany.
It held together primarily because the "authorities" -- international and national -- pretty much did what was expected of them. The Germans revamped their banking system after Herstatt, the Federal Government bailed out New York City, the Federal Reserve bailed out Franklin National's depositors, and the international banking community managed to keep the lid on during the crisis with Iran.
Whether this 'last resort' network remains intact is now the question. Many bankers admit privately they would rather have seen Penn Square blended into another bank -- as Fed Chairman Paul Volcker initially urged -- not to reward bad management in Oklahoma, but to reduce the overall risk to the system.
In an interview this week, Comptroller Conover defended Penn Square's 3 rating, saying the bank "deteriorated rapidly" after the oil drilling business "crashed" in the fall of 1981. Yet, Penn Square was carried as a 3 right down to the end. As late as January 1982, Conover admits, his office thought the outlook for Penn Square had turned favorable.
Isaac complained in an interview that Conover was late in telling him how serious Penn Square's problems were, never hinting how bad the crisis was until June 30, although Conover sits on the FDIC board. Conover responds that responsible deputies were in touch in May and June, but that he himself wasn't sure "it was a bank insolvency (losses exceeding capital) until July 5," the day the bank was closed. Isaac insists that Conover should have been able to tell the FDIC of the real condition at least a month or two earlier.
Credit union managers and others trapped in the Penn Square debacle complain they, too, had no clue or warning from government agencies that Penn Square was in trouble.
Yet, for every eager-beaver credit union manager who put his depositers' money into Penn Square for an extra couple of points of interest, there were hundreds more who resisted that temptation. And while Chase and Continental were suckered into the energy "participation" loans, Citicorp, Morgan Guaranty, Manufacturers Hanover and hundreds of other big banks proved to be smarter (on this issue, at least.)
"We just can't afford a fail-safe regulatory system," argues Conover. "If we take all of the risk out, we might just as well nationalize the banks. It wan't an easy decision, it was a tough call (to close down Penn Square). But if a bank is always bailed out, then we in effect have 100 per cent deposit insurance.
"One of the good things that comes out of this is that people are looking more carefully at where to put deposits, banks are applying stricter credit standards -- and that's all part of the discipline of the markets. But the guys that are hurt, like Chase, their reputations have suffered, and that's the way it should be."