Continental-Illinois

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Continental-Illinois
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September 8, 1929 It will be the largest bank
in the world to be housed under one
roof. Second largest bank in the country to
National City in New York. Culmination of a
series of Chicago bank mergers spanning 71 years.

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• From hierarchical structure to matrix
  management
• Concern that this led to bad energy loans due to
  a lack of supervision

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If you were going to bank with somebody, you
wanted to see them as well as their balance
sheet. It was a relationship business,
commercial banking. A long-term business. . . .
You stuck with the company and the customers
through the ups and downs of the business cycles,
and they stuck with you. That was the main
problem for Dave Kennedy when he decided the
Continental would have to become a great
international bank in order to remain a great
American bank. There werent any international
banking people. -- James P. McCollom, The
Continental Affair
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An old-fashioned bank, practicing old-fashioned
prudence, would expand its lending only in step
with its deposit base. . . . The modern banks
that practiced managed liabilities had no such
inhibitions. . . . As long as they could borrow
freely, there was no internal brake on how fast
they could expand. Greider, Secrets of the
Temple
Bank A 1958 Bank B 1968 Bank C 1978
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Continental vs. Peers

• Much higher reliance on purchased funds (gt 70)
• Higher yield on CI loans ( 1)
• Higher growth of CI loans (1.5X)
• Lower nonperforming loan (1974-78 -.2)
• Huge growth in energy loans (26 of CI in 1979
  vs. 47 in 1981).

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1976 - 1981
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May 29, 1981 Chairman of Continental-Illinois
Roger A. Anderson becomes highest paid banker in
the United States, pulling in a whopping 710,440
(1.6 million in 2009 dollars). President John
Perkins is also on the list with just under
600,000 salary.
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Penn Square Bank Collapse

• Specialized in high-risk loans to the oil and gas
  industry
• Assets had grown from 62 million in 1977 to 520
  million in 1982.
• Failed in July 1982.
• Only 207 million of 470 million deposits were
  insured.
• Serviced 2 billion in loans - 1 billion for
  Continental.

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Penn Square . . . acted as a business scout in
the oil patch for Continental and others. When
Penn Square booked loans and reached its lending
capacity, it simply offered a share of the action
to the larger banks, collected the equivalent of
a finders fee, then turned around and went out
to find more oil prospectors who needed money.
This was very profitable for everyone, while it
lasted. - William Greider, Secrets of The
Temple Continentals share went from 25 to 40
in less than two years.
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Continentals response to this plan This will
be the end of the bank, and you will be to blame.
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1982 - 1984
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• Your chairman is Mr . . . Taylor?
• Yes.
• And Mr. Roger Anderson?
• Mr. Anderson is retired.
• Now the position of Mr. Taylor is -- ?
• He is the chairman of our bank.
• None of our managers seems to be familiar with
  that name.
• Mr. Taylor become chairman in February.
• And Mr. Conover?
• Mr. Conover is the comptroller of the currency.
• He is with the Federal Reserve.
• No. His office is in the Treasury Department.

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The problems of Continental Bank essentially
reflect serious weaknesses in the domestic loan
portfolio of a bank that had engaged in
aggressive growth and lending practices for some
time, including heavy involvement and
participation in energy loans of the Penn Square
Bank that failed two years ago. These problems,
and other credit losses, were reflected in
earnings pressures and consequent loss of market
confidence. - Paul Volcker, Fed Chairman, to
Senate Committee (July 1984)
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Bailing Out Continental Illinois
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Discount Window

• 3.6 billion May 11, 1984
• This was not enough to stop the run on
  Continental Illinois or make it solvent
• Traditionally a short-term device so that banks
  can meet capital reserve requirements

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Bank Lending Group

• Weekend Following the Discount Window Loan
• Group of 16 Banks to Loan 4.5 billion to
  Continental Illinois
• Again, Insufficient to stop the run
• During this time, the banks domestic
  correspondent banks started withdrawing funds,
  furthering the run

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Federal Assistance Package

• FDIC Provided 1.5 bn
• FDIC also participated 500 mn to a Group of
  Commercial Banks
• Capital Infusion was in form of interest-bearing
  subordinated notes
• Variable Rate 100 basis points higher than 1-yr
  T-Bills
• Fed Stated it would meet any liquidity needs of
  Illinois Continental
• Group of 24 Major US Banks agreed to 5.3 in
  unsecured funding
• FDIC promised to guarantee all creditors and
  depositors, even those above the 100,000 limit
  (TBTF)

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12 USCA 1823(c)(1)
(c) Assistance to insured depository
institutions(1) The Corporation is authorized,
in its sole discretion and upon such terms and
conditions as the Board of Directors may
prescribe, to make loans to, to make deposits in,
to purchase the assets or securities of, to
assume the liabilities of, or to make
contributions to, any insured depository
institution(A) if such action is taken to
prevent the default of such insured depository
institution (B) if, with respect to an insured
bank in default, such action is taken to restore
such insured bank to normal operation or (C)
if, when severe financial conditions exist which
threaten the stability of a significant number of
insured depository institutions or of insured
depository institutions possessing significant
financial resources, such action is taken in
order to lessen the risk to the Corporation posed
by such insured depository institution under such
threat of instability.
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FDIC Guarantee

• The guarantee of depositors and creditors above
  the 100,000 limit was controversial
• People worry about the moral hazard problem
• Deemed necessary because of many other financial
  institutions having funds invested in Continental
  beyond 100,000

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Finding a Merging Partner

• During this Federal Assistance Period, the
  Federal Reserves goal was to find someone to
  merge with Continental Illinois
• This is what normally happened when smaller banks
  became insolvent in the preceding years
• Fed searched for 2 months but could not find a
  suitable partner
• Continental Illinois was obviously much bigger
  than previous banks that had been merged under
  these circumstances
• The economy was not entirely healthy making it
  harder to find a merging partner

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Government Ownership

• After the failed search for a merging partner,
  the government purchased 4.5 bn of bad loans
  from Continental Illinois
• The bank had to charge-off 1 bn but this was
  offset by a cash infusion of 1 bn
• The government received non-voting preferred
  stock that could be converted to common stock
  which amounted to a 79.9 ownership stake

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Government Actions after the Takeover

• Old Management and Boards of Directors were
  forced out
• One of the perceived benefits of the plan was
  that it made ownership and management feel the
  brunt of the loss. The ownership was harmed but
  the massive dilution of their shares and
  management was forced out
• Installed John Swearingen as CEO of the holding
  company and William Ogden of CEO of the bank
• These New Executives replaced the Boards of
  Directors, but the Government could veto
  membership

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Bank of America Buys Continental Illinois for
1.9 bn

• August 31, 1994
• 939 Million in Cash
• 21.25 Million Shares of Stock
• 37.50/share
• Government began selling stake in 1986,
  divesting one-third of shares
• Completed divestment in 1991

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Too Big To Fail?
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Moral Hazard
Why Bail out a Bank?

• Like many other firms, banks offer a particular
  bundle of services (most notably liquidity and
  lending services)
• A bank failure need not signal the failure of the
  larger banking system or the regulatory structure
• As with any other firm, a bank failure merely
  demonstrates that its bundle of products is no
  longer demanded by the market
• The existence of failing institutions may be a
  sign of health rather than a sign of malaise
  since it indicates either that innovation is
  driving obsolete firms out of the industry, or
  that competition is driving inefficient firms out
  of the market
• A bank failure also helps speed along the
  reallocation of the banks assets to a more
  efficient set of enterprises

See Macey Miller, 88 Colum L Rev 1153 and
Fischel et. al., 73 Va. L. Rev. 301
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Moral Hazard
Are Banks Special?

• Bank Runs
• Regulatory Costs
• Contagion
• Ripple Effect
• Domino Effect
• Money Supply
• Credit Crunch

See Macey Miller, 88 Colum L Rev 1153 and
Fischel et. al., 73 Va. L. Rev. 301
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Moral Hazard
Are Banks Special?

• Bank Runs
• Classic example of a prisoners dilemma
• Yet how is this different than short-term
  creditors of any firm?
• Ratio of current assets to current liabilities is
  lower at banks
• Yet there are many non-governmental solutions
• Banks holding more liquid assets, higher premiums
  paid to depositors, contractual right to stop
  conversion of deposits
• Regulatory Costs
• Cost of failure is paid for by healthy banks and
  taxpayers
• Yet the regulatory structure is premised on banks
  being special circularity problems

See Macey Miller, 88 Colum L Rev 1153 and
Fischel et. al., 73 Va. L. Rev. 301
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Moral Hazard
Are Banks Special?

• Contagion
• Ripple Effect
• Bank failure will cause public to lose confidence
  in the financial system, resulting in widespread
  bank runs
• Yet bank failures are often firm-specific (ex.
  fraud) and failure of other firms also has
  signaling power (ex. failure of manufacturing
  company indicates that banks holding certain
  loans might fail) banks can recycle the
  withdrawn funds back to the solvent banks
  experiencing bank runs
• Domino Effect
• Many banks hold deposits in the failed bank
• Yet the failure of any firm is likely to have
  systemic effects on other firms (such as the
  firms in their supply chain)
• Effect of Widespread Bank Failures
• Money Supply
• Decrease in money supply can impose high social
  costs
• Yet the Fed Reserve mitigates this problem by
  serving as lender of last resort
• Credit Crunch
• Bernanke paper importance of banking human
  capital
• Yet failure of other firms also disrupts
  investment projects by disrupting supply chains
  (especially when there are few substitutes for
  the good or service offered)

See Macey Miller, 88 Colum L Rev 1153 and
Fischel et. al., 73 Va. L. Rev. 301
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Moral Hazard
Was Continental-IllinoisSpecial?

• Ripple Effect
• Concern that failure of Continental-Illinois
  would lead to widespread depositor runs,
  impairment of public confidence in the broader
  financial system, or serious disruptions in
  domestic and international payment and settlement
  systems.
• Regulators worried about the effects on at least
  three other financially vulnerable banks (First
  Chicago, Manufacturers Hanover, and Bank of
  America)
• No clear evidence that this fear was justified
• Continental-Illinoiss failures were
  firm-specific fraud and participation in highly
  speculative loans
• G. Kaufman, Federal Reserve Bank of Chicago
  indicating that bank runs do not take the form of
  currency drains out of the system, but of
  redeployment of deposits to other, presumably
  less risky banks of similar characteristics. A
  run on a bank no longer translates into a run on
  the banking system . . . .
• Domino Effect
• Continental had an extensive network of
  correspondent banks, almost 2,300 of which had
  funds invested in Continental more than 42
  percent of those banks had invested funds in
  excess of 100,000, with a total investment of
  almost 6 billion. The FDIC determined that 66
  of these banks, with total assets of almost 5
  billion, had more than 100 percent of their
  equity capital invested in Continental and that
  an additional 113 banks with total assets of more
  than 12 billion had between 50 and 100 percent
  of their equity capital invested
• Subsequent empirical study indicated that only
  six banks would have collapsed as a result of
  Continental-Illinoiss failure

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The Inherent Tradeoff in Too Big To Fail
Systemic Risk vs. Moral Hazard

• Exacerbated Existing Moral Hazard
• Government eliminated the incentive for
  depositors and general creditors to monitor
  banking risk and fraud
• FDIC insurance is absolute thus comes with none
  of the traditional mechanisms employed by
  insurance companies to reduce moral hazard (i.e.
  deductibles and premiums based on underlying
  risk)
• Without depositor or general creditor monitoring,
  risk taking is largely dictated by interaction
  between preferences of management and
  shareholders
• While managers are typically more like fixed
  claimants (due to human capital concerns),
  shareholders are residual claimants who will push
  the bank to pursue risky projects

See Macey Miller, 88 Colum L Rev 1153 and
Fischel et. al., 73 Va. L. Rev. 301
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Too Big to Fail and the Incentive for Banks to
Grow

• FDIC clearly delineated the reasons for the Too
  Big to Fail doctrine
• Failure of large bank leads to higher risk of
  ripple effects on smaller banks
• Failure of small banks more likely to be viewed
  by depositors as isolated, firm-specific
  incidents
• Failure of large bank can seriously deplete the
  FDICs insurance fund and decrease publics
  confidence in regulatory regime
• FDICs employment of purchase and assumption
  agreements favored large and medium sized banks
• Under this regulatory regime, uninsured
  depositors are highly likely to flock from small
  banks to medium and large sized banks

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Moral Hazard in Theory but in Practice?

• Can depositors serve as effective monitors of
  banks financial activity?
• Most depositors arent true investors they
  pick bank based mostly on non-risk related
  factors such as convenience of location and
  customer service
• Most depositors dont want to invest time and
  effort in researching banks activity
  free-riding and collective-action problem
• Depositors could suffer from excessive optimism
• Depositors will often wait until insolvency is
  imminent and a bank run will not provide a
  meaningful signal to management
• Depositors might react to false insolvency
  information or rumors and thus send inaccurate
  signals to management

See Garten, 4 Yale J. on Reg. 129
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The Argument for Moral Hazard in Practice

• Depositors need not view risk as a primary
  consideration when choosing banks moral hazard
  effect on the margin
• Free-riding/collective action monitoring problem
  can be resolved through ex ante premium payment
  to depositors
• Even if depositors conduct more research before
  choosing bank then once their money has been
  deposited, banks constantly need to attract new
  depositors who will in turn provide needed
  monitoring at investment decision phase
• Higher premium payments will send important
  signal to management/shareholders and this
  disciplinary mechanism can serve as a substitute
  to deposit withdrawal
• Withdrawal of funds is not costless and may cost
  more than investing in research to determine
  validity of bank rumors

See Macey and Garrett, 5 Yale J. on Reg. 215
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Initial Congressional Reaction Worries about
TBTF Policy
Volcker appeared before the Senate Banking
Committee in July 1984, he faced questions about
whether the Fed favored big banks like
Continental over small banks, and whether the
printing of money would have to stop. Sen
Riegle I just hope that we dont leave the
impression that the safety net is infinite in
size and we can take any number of failures at
once, because I dont think you believe that and
I know I dont believe that. Volcker To the
best of my knowledge, there were characteristics
of the Continental Illinois Bank that were
unique.
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Congress Reacts and Narrows FDICs Bailout Powers

• Reasons for Reform
• Prompted by continuing dissatisfaction with the
  Too Big to Fail doctrine
• Bailout of Bank of New England Corporation (21
  billion)
• Higher deposit insurance premiums
• Questionable status of Bank Insurance Fund
• Some legislators wanted to prevent protection of
  uninsured depositors but most legislators and
  regulators favored flexibility to deal with
  systemic risk
• Alan Greenspan insured depositors might need to
  be rescued in the interests of macroeconomic
  stability, but there would also be circumstances
  in which large banks fail with losses to
  uninsured depositors but without undue disruption
  to financial markets.

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Congress Reacts and Narrows FDICs Bailout Powers

• Federal Deposit Insurance Corporation Improvement
  Act of 1991 (FDICA)
• FDIC resolutions were now required to proceed
  according to a least-cost test, which would
  mean that uninsured depositors would often have
  to bear losses.
• The FDIC was prohibited from protecting any
  uninsured deposits or nondeposit bank debts in
  cases in which such action would increase losses
  to the insurance fund.
• One important effect of the least-cost provision
  was that the FDIC would not be able to grant
  open-bank assistance unless that course would be
  less costly than a closed-bank resolution
• Exception for systemic risk
• At least two-thirds of both the FDIC Board of
  Directors and the Board of Governors of the
  Federal Reserve must recommend that an exception
  be made, and this recommendation must then be
  acted upon by the secretary of the treasury in
  consultation with the president.
• The General Accounting Office then reviews any
  such actions taken and reports its findings to
  Congress
• FDICIA limited the discretion the agency had
  exercised under the old cost test and
  essentiality provisions of the FDI Act.

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Congress Reacts and Narrows FDICs Bailout Powers

• Effect of FDICIA
• From 1986 through 1991, 19 percent of bank
  failure and assistance transactions resulted in
  the nonprotection of uninsured depositors. From
  1992 through 1994, the figure rose to 62 percent.
  
• On the basis of total assets, the average
  percentage of uninsured depositors suffering a
  loss was 12.3 percent from 1986 through 1991, but
  from 1992 through 1994 it increased to 65 percent

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Nationalization
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Terminology

• Conservatorship
• Conservatorship is . . . person or entity be
  subject to the legal control of another person or
  entity, known as a conservator. When referring to
  government control of private corporations such
  as Freddie Mac or Fannie Mae, conservatorship
  implies a looser, more temporary control than
  does Nationalisation.
• Receivership
• When a company is put in receivership, it is
  controlled by a receiver, a person placed in
  the custodial responsibility for the property of
  others, including tangible and intangible assets
  and rights.
• Nationalization
• act of taking an industry or assets into the
  public ownership of a national government or
  state.
• --------------------------------------------------
  --------------------------------------------------
  ---------------------
• According to Wikipedia, Fannie Mae and Freddie
  Mac are seen as examples of conservatorship,
  receivership and nationalization. The terms are
  often interchangeable, especially in the
  situation of government takeover of banks.
• Conservatorship and receivership have a
  connotation of shorter periods of control.

http//www.wikipedia.org/
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Penn Square Bank Push Toward Nationalization
Penn Square Bank failed in June 1982. Penn
Square 450m in assets Continental Illinois
33 bn At the time, Penn Square was 3 of
Continental Illinois total loans. And, 17 of
total oil and gas loans The chain reaction
between Penn Square and Continental Illinois made
the government wary of Continental Illinois
collapse. Penn Square increased awareness adding
to the run on Continental Illinois.
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Levels of Nationalization
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Concerns

• William I. Isaac, head of FDIC during Continental
  Illinois Collapse, notes three concerns about
  using nationalization now
• (1)Any nationalization of a bank will require
  shrinking the bank, which is difficult in tough
  economic times with the fear of deflation
• (2)Nationalization requires a reasonable exit
  strategy
• BofA and CitiBank are simply too big to sell,
  particularly if foreign investors are not allowed
  to purchase.
• Continental Illinois only had 2 of nations
  assets, while the top 10 banks now hold over 2/3s
  of nations assets.
• Also, Continental Illinois was a plain-vanilla
  bank in comparison.
• (3)Finding people to run these companies while
  nationalized will be difficult.

http//online.wsj.com/article/SB123543631794154467
.html?modarticle-outset-box
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Have we already nationalized?

• Nationalization is a bit of a fuzzy line. When
  you have something like AIG, the insurance
  company, which is 80 percent owned by the
  taxpayers, has it been nationalized or not? And
  that's a little bit unclear.
• --Paul Krugman

http//www.pbs.org/newshour/bb/business/jan-june09
/banknational_02-24.html
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How much did the government lose on Continental
Illinois?

• Total Money loaned by FDIC 4.5 bn
• Total Lost 1.1 bn
• Percentage Lost 24 percent

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Unsecured Creditors Nationalization

• In a nationalization, the bondholders will take
  one of the largest losses
• Two problems
• Bondholders are probably the best-organized
  investor class that there is. You're talking
  about little old ladies, pension funds, and
  foreign governments.
• R. Christopher Whalen of Institutional Risk
  Analytics predicts that bondholders for BofA and
  CitiBank will take a 70 loss if not everything.
• http//www.msnbc.msn.com/id/29412829/
• Can the government force unsecured creditors to
  bear the loss outside of bankruptcy?
• With a deposit-taking bank If the assets are
  worth less than the liabilities, the FDIC is
  authorized to force unsecured creditors to share
  the loss.
• But the FDIC has no such authority over bank
  holding companies
• For holding companies, the unsecured creditors
  will bear the loss in bankruptcy, but after the
  Lehman Brothers, bankruptcy is usually not
  considered a good option.

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Banks are closed and liquidated almost without
exception only when they are insolventwhen their
liabilities exceed their assets and when
circumstances combine with other severe problems.
. . . Considered over the history of the FDIC,
bank liquidations with losses to insured
depositors and creditors have not been the normal
procedure for dealing with problem banks.
Normally, a high value is placed on maintaining
banking services regardless of the size of the
bank, consistent with minimizing the cost to the
insurance fund. Continental, however, was not
insolvent. The Federal Reserve was founded to
serve as a lender of last resort in times of
liquidity pressures of this sort, so they dont
spread through the rest of the system to innocent
parties not involved in Continental Illinois at
all we were founded so that there should be that
elasticity in the system. Thats what a central
bank is all about, to provide liquidity in those
circumstances. We are just carrying out the most
classic function of a central bank. -- Volcker
testimony (July 1984).