Continental-Illinois
Rise & Fall
Nationalization
Bailout
Too Big To Fail?
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.
• Gets $50
million from
Reconstruction
Finance
Corporation.
Depression
1960s
• $3 billion in
deposits
• 5,000
employees
• 77 branches
and affiliates
worldwide
(40% of
revenue).
• 8,200
employees in
Chicago
1970s
• From hierarchical
structure to “matrix
management”
• Concern that this led to
bad energy loans due to a
lack of supervision
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 weren’t any international
banking people.
-- James P. McCollom, The Continental Affair
“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
Continental vs. Peers
• Much higher reliance on “purchased
funds” (> 70%)
• Higher yield on C&I loans (+ 1%)
• Higher growth of C&I loans (1.5X)
• Lower nonperforming loan (1974-78 -.2%)
• Huge growth in energy loans (26% of C&I
in 1979 vs. 47% in 1981).
1976 - 1981
Dun’s
Review
First Boston
Salomon
Brothers
• December 1978
• One of the five best managed companies in
America (joining Boeing, Schlumberger,
General Electric and Caterpillar).
• “Superior management at the top, and its
management is very deep.”
• “One of the finest money-center banks
going.”
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.
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.
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 finder’s 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
Continental’s share went from $25 to $40 in
less than two years.
FDIC Chairman Walter Isaac’s Suggestions after Penn Square
the board of directors should have fired the management
brought in strong management from outside
taken a huge loan write-off
eliminated its dividend to stockholders.
Continental’s response to this plan: “This will be the end of
the bank, and you will be to blame.”
1982 - 1984
• “Rumors of the impending bankruptcy of the Continental Illinois bank, the
nation’s seventh largest, circulated through the international financial community
today. Robert McKnew, senior vice president and treasurer of the Continental,
May 8, 1984 reacted angrily to the rumors. He called them ‘totally preposterous.’”
May 9, 1984
May 10,
1984
May 11,
1984
• Foreign depositors – mainly Japanese banks – decline to renew $1 billion in CD
deposits.
• Office of the Comptroller of Currency, breaks with policy to say that it is unaware
“of any significant changes in the bank’s operations, as reflected in its published
financial statements, that would serve as the basis for rumors about Continental.”
• Continental loses $3.6 billion more in deposits, much of it from European banks.
“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.”
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)
Bailing Out Continental Illinois
Discount Window
Bank Lending Group
Federal Assistance Package
Find a Purchaser
Federal Equity Stake
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
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 bank’s domestic
correspondent banks started withdrawing
funds, furthering the run
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)
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.
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
Finding a Merging Partner
• During this Federal Assistance Period, the Federal
Reserve’s 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
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
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
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
Too Big To Fail?
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
bank’s 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
AreMoral
BanksHazard
“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
AreMoral
BanksHazard
“Special”?
• Bank Runs
– Classic example of a prisoner’s 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
AreMoral
BanksHazard
“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
Was Continental-Illinois“Special”?
Moral Hazard
– “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-Illinois’s 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-Illinois’s failure
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
“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 FDIC’s insurance
fund and decrease public’s confidence in regulatory regime
• FDIC’s 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
Moral Hazard in Theory but in
Practice?
• Can depositors serve as effective monitors of banks
financial activity?
– Most depositors aren’t “true” investors – they pick bank based
mostly on non-risk related factors such as convenience of
location and customer service
– Most depositors don’t want to invest time and effort in
researching bank’s 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
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
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 don’t leave the impression that the safety net is
infinite in size and we can take any number of failures at once, because I don’t
think you believe that and I know I don’t believe that.
Volcker: To the best of my knowledge, there were characteristics of the
Continental Illinois Bank that were unique.
Congress Reacts and Narrows FDIC’s
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.”
Congress Reacts and Narrows FDIC’s
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.
Congress Reacts and Narrows FDIC’s
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
Nationalization
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/
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.
Levels of Nationalization
No Nationalization
Quasi-Nationalization
Nationalization
Purchase Company
• Cover insured depositors
• Assets are liquidated for creditors
• Ex. Penn Square
• Cover insured depositors
• Estimate asset value and give to uninsured depositors
• Stockholders wiped out
• Ex. IndyMac (general creditors received 50%)
• Cover both insured and uninsured depositors
• Stockholders are wiped out (“make whole” agreement)
• Ex. Continental Illinois
• Shareholders receive some value
• Cover all creditors
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 nation’s assets, while the top 10
banks now hold over 2/3s of nation’s 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?mod=article-outset-box#
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
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
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.
Banks are closed and liquidated almost without exception only
when they are insolvent—when 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 don’t
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. That’s 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).