Modern Banking

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1 July 1984

Officials admitted the run had continued, forcing the bank to sell another $5 billion in assets.

10.7.2. The Resolution

žContinental was divided into a ‘‘good’’ bank and a ‘‘bad’’ bank.

žThe FDIC paid $2 billion for problem loans with a face value of $3 billion. The ‘‘bad’’ bank was to be managed for the FDIC by a newly formed service subsidiary of Continental. Any loans to sovereigns or guaranteed to sovereigns were exempted. The FDIC committed itself to assume as much as $1.5 billion in other troubled loans over a 3-year period. The purchases would take place at book value.

žThe FDIC assumed Continental’s $3.5 billion debt to the Reserve Bank of Chicago rather than paying cash. The FDIC was to repay the Chicago Fed over 5 years.

žThe FDIC was to provide a $1 billion capital infusion in return for preferred stock, convertible into 80% of Continental’s common stock.

žThe FDIC replaced the Continental board and management team.

10.7.3. A Review of How the Problems at Continental Arose

Between 1974 and 1981, Continental grew rapidly, acquiring many loans that ultimately resulted in losses. The period 1982 – 84 was the aftermath of what happened once significant loan problems had been uncovered. The discussion is largely with reference to the bank, not the bank holding company.

Mr Roger E. Anderson became Chairman and Chief Executive Officer in 1973. He and a management team set strategic goals, the objective of which was to transform Continental from a midwestern country bank to a world class bank.

Between 1974 and 1981, Continental’s assets grew by an average of over 13% per year. In 1984 it had $45.1 billion in total assets, making it the sixth largest bank in the USA, up from the eighth largest in 1974. Continental grew faster than any other wholesale bank in this period. In 1973, Continental had launched an aggressive campaign on segments of the banking market to increase market share. It rapidly built up its consumer loan portfolio.

A private placement unit was created that secured a foothold in the market by arranging placements of debt for small companies. It expanded globally by structuring syndicated eurodollar loans, making advances in direct lending to European multinational companies, and becoming active in project financing.

Like most banks, Continental suffered during the collapse of the real estate investment trust industry in the mid-1970s. Continental’s management, however, handled the problem well – its recovery from the real estate problems was more successful than most other large banks with similar problems. As a result, Continental remained active in property lending throughout the period.

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The recession of 1974 – 75 saw Continental emerge with one of the best loan loss records of its peer group, suggesting management knew how to deal with economic downturns. Some of Continental’s main competitors had suffered financial problems, which enabled the bank to take advantage of a competitive opportunity and become the premier bank in the midwest.

The OCC conducted eight examinations of the bank during the period 1974 – 81, all of which were favourable. The bank’s handling of its problem loans following the 1974 – 75 recession was considered superior to most other wholesale money centre banks.

In 1972 the bank had expanded the individual lending officers’ authority and removed the loan approval process from a committee framework. In 1976 the bank reorganised itself, eliminating ‘‘red-tape’’ from its lending procedures. Major responsibility was delegated to lending officers in the field, resulting in fewer controls and levels of review. The idea was to provide lending officers with the flexibility to quickly take advantage of lending opportunities as they arose. While decentralised lending operations were common among money centre and large regional banks, Continental was a leader in this approach. Management believed such an organisational structure would allow Continental to expand market share and become one of the top three banks lending to corporations in the USA.

In light of this rapid growth, the OCC examiners stressed the importance of adequate controls, especially in the loan area. The examiners noted certain internal control problems, especially the exceptions to the timing of putting problem loans on the bank’s internal watch list. However, given the bank’s historical loan loss experience and proven ability to deal with problem situations, supervisors were not seriously concerned about the weaknesses they had reported.

Management implemented new internal controls, in response to the OCC report, including computer-generated past due reports and a system to track exceptions in the internal rating process.

In the period 1974 – 81 Continental sought to increase loan growth by courting companies in profitable, though in some cases high-risk, businesses. Lending officers were encouraged to move fast, offer more innovative packages, and take on more loans. This aggressive lending strategy worked well for the bank: its commercial and industrial loan portfolio grew from $4.9 billion in 1974 to $14.3 billion in 1981. It expanded its market share in the late 1970s (rising from 3.9% at the end of 1974 to 4.4% at year-end 1981), when many other money centre banks were losing out to foreign banks, the growing commercial paper market and other non-traditional lenders.

As part of its corporate expansion, Continental was very aggressive in the energy area. In the early 1950s it had created an oil-lending unit and was, reportedly, the first major bank to have petroleum engineers and other energy specialists on its staff. The economic consequences of the 1973 oil embargo and the resulting fourfold increase in world oil prices meant energy self-sufficiency became a top priority on the national political agenda. Various administrations and Congress launched initiatives to increase domestic production and reduce energy consumption. Continental, having cultivated this niche from the 1950s, became a key energy sector lending bank.

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The commercial and industrial loan portfolio (including its energy loans) produced high returns for Continental – average returns were consistently higher than those of other wholesale money centre banks. The financial markets reacted favourably to the aggressive loan strategy adopted by Continental.

Analysts noted its stable assets and earnings growth, its excellent loan loss record, and its expertise in energy sector lending. In 1976, Continental Illinois Corporation’s ratio of market price to book value began to rise – up to this date, it had lagged behind other money centre banks.

The rapid growth in its assets was funded by the purchase of wholesale money, including federal funds, negotiable certificates of deposit, and deposits from the interbank market. It had limited access to retail banking markets and core deposit funding because of state regulations in Illinois which effectively restricted the bank to unit bank status. Purchased funds made up 70% of the bank’s total liabilities, substantially higher than the peer group average.

In the 1976 inspection by the OCC, examiners expressed concern about the bank’s liquidity and its reliance on Fed funds, foreign deposits and negotiable CDs. By the summer of 1977, the bank had improved its liquidity and enhanced its monitoring systems. OCC examiners concluded that the bank was adequately monitoring its funding, and maintaining control. However, the bank was requested to submit quarterly status reports on classified assets over $4 million, and also to submit monthly status reports.

Continental’s heavy reliance over this period on purchased money, which had a higher interest cost on retail deposits, offset much of the gain that accrued from the higher loan yields. Higher funding costs reduced Continental’s net interest margin to a level well below its peer group. However, the bank was able to maintain its superior earnings growth because of low overheads (due to the absence of domestic branches and few foreign branches compared to its peer group) and non-interest expenses. Continental’s ratio of non-interest expenses to average assets was far below its peer group average.

Throughout the late 1970s the OCC expressed concern not only about asset quality, but about capital adequacy as well. During the 1976 examination, the OCC pointed out the absence of a capital growth plan by Continental, which was unlike most other large national banks. In response, the bank prepared a 3-year capital plan and took immediate measures to increase capital, including cutting the size of its 1976 dividends to the holding company by $15 million. The bank holding company issued debt and used the proceeds to inject $62 million into the bank’s surplus account. However, asset growth outpaced capital growth, and capital declined throughout 1980.

The 1979 OCC examination noted the continued improvement in Continental’s asset quality. Classified assets had declined from 86% to 80% of gross capital funds. Liquidity was also considered adequate. The OCC did note some problems in the bank’s internal credit review system – deficiencies were cited in the identification and rating of problem loans and in the completeness of credit files. OCC examiners also stressed the importance of a strong capital base, in light of Continental’s rapid asset growth rate.

The 1980 examination drew similar conclusions. Liquidity was considered acceptable. Asset quality continued to improve – classified assets as a percentage of gross capital funds declined to 61%. This figure was lower than the average for other money centre banks.

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At the 1981 examination, the OCC was satisfied with Continental’s quality and consistency of earnings. Though holding down dividends had resulted in a steady source of capital augmentation, capital still needed to be brought in line with asset growth. Liquidity was considered adequate to meet any external pressures. The OCC reported that suitable systems of managing funding and rate sensitivity were in place.

In response to the 1981 examination, the management at Continental denied there was a problem with the quality of the loan portfolio, given the state of the economy at the time, especially record high interest rates. But they stated that close, continued attention would be provided to the quality of the loan portfolio. Improvements were to be made to ensure loans were reviewed on schedule.

Throughout 1981, financial analysts believed that Continental would continue to exhibit superior growth because of its position as prime lender to the energy industry, its potential for an improved return on assets, and its record of loan losses. Continental was complimented for its choice of energy lending as a niche market.

10.7.4. The Demise of Continental: January 1982–July 1984

To fully understand Continental’s demise, it is necessary to review the history of Penn Square Bank’s involvement. Penn Square was one of the most aggressive lenders in a very active drilling part of the country – Oklahoma City. Its loan-generating ability exceeded its legal lending limit as well as its funding ability, so Penn Square originated energy loans and sold them to other banks, including Continental and Seattle First National Bank.

Although Continental began purchasing loans from Penn Square as early as 1978, significant growth in loan purchases did not occur until 1981. At the end of the 1981 OCC examination, Penn Square loan purchases were in excess of $500 million; at the start of the 1982 examination, they had risen to a total value of $1.1 billion. At their peak in the spring of 1982, loans that originated at Penn Square represented 17% of Continental’s entire oil and gas portfolio.

The OCC made a quarterly visit to Continental in March 1982, ahead of their main examination. The energy sector was in decline, but even so, bank officials said they were comfortable with their expertise in the area. In the May 1982 examination, the OCC planned to focus on the energy portfolio – a specialist was assigned to the OCC to assist in the examination. OCC’s concerns heightened when it was found, at the OCC examination of Penn Square, that Continental had purchased a significant quantity of bad loans from Penn Square. The OCC informed Continental of the serious situation at Penn Square and extended their examination to November, working closely with internal auditors at Penn Square and independent accountants to assess the damage.

On 5 July 1982, Penn Square failed. Continental was directed by the OCC to implement a number of corrective measures; the bank complied. In August, the OCC informed management of its intention to formalise these directives by placing the bank under a Formal Agreement: the Comptroller and OCC staff met with senior management at Continental to discuss the bank’s condition and the impending agreement.

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Continental officers recommended an addition to loan loss reserves of $220 million. The OCC and Continental’s accountants, after a review, accepted this figure as realistic. It was published on 21 July along with a full statement of Continental’s second quarter results.

Continental’s auditors, supported by accountants from Ernst and Whinney, remained in Oklahoma City reconciling Continental’s records with Penn Square data, assisting in the Penn Square portfolio assessment programme and preparing loan workouts. In late August and early September, each loan purchased from Penn Square was reviewed by OCC examiners, who discussed their findings with the senior management at Continental before the third quarter results were released. The review resulted in $81 million being added to the bank’s provision for loan losses in the third quarter, as reported in Continental Illinois Corporation’s 14 October, 1982 press release. It also indicated that non-performing assets had risen to $2 billion, up $700 million from the previous quarter.

Simultaneous with the credit review, Continental undertook an extensive review of the people involved in the Penn Square relationship and lending policies, procedures and practices. Based on the recommendations of an independent review committee appointed by Continental’s board of directors, Mr Lytle, Mr Bergman and his superior, Mr Baker ceased to work for the bank. Other bank personnel were reassigned.

The internal review committee, in the second phase, recommended:

žCodification of bank lending policies and procedures.

žEnhancement of secured lending and related support systems.

žImprovement in cooperation between loan operations and the line.

žRevision of loan operations activity to improve its reliability and productivity.

žFormulation of a credit risk evaluation division, as had been recommended by the OCC, to strengthen the bank’s credit rating system and enhance credit risk identification, evaluation, reporting and monitoring.

Following the Penn Square collapse, the domestic money market’s confidence in Continental was seriously weakened. The bank’s access to the Fed Funds and domestic CD markets was severely restricted – Continental lost 40% of its purchased domestic funding in 1982.

Continental moved quickly to stabilise and restore its funding. Meetings were held with major funds providers, ratings agencies and members of the financial community. Public disclosures were periodically issued to correct misinformation. In the autumn of 1982, liquid assets were sold or allowed to mature. As the domestic markets for funds dried up, Continental shifted to the European interbank market. Foreign liabilities began to approach 50% of the bank’s total liability structure.

Continental’s parent holding company maintained its 50 cents per share dividend in August 1982. The earnings level did not warrant a dividend of this size, but the holding company management felt it was a necessary step to restore confidence and to raise capital in the market place.

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after their appointment they instituted key management and organisational changes to aid in the bank’s recovery. External market conditions during the second half of 1983, however, slowed Continental’s recovery. Increasing interest rates squeezed net interest margins, loan demand was weak, and non-performing energy loans rose further as the energy industry continued to decline.

The general sentiment of bank analysts towards Continental was negative after Penn Square. It had become apparent to bank analysts by early 1983 that Penn Square wasn’t Continental’s only problem. Most analysts believed that Continental’s stock would not recover in the short-term.

At the time of the 1983 examination, the condition of Continental had further deteriorated since the 1982 examination. Asset quality and earnings remained poor. Capital was adequate on a ratio basis, but under pressure due to asset and earnings problems. Funding had improved, but was still highly sensitive to poor performance and other negative developments. The bank was found to be in compliance with the terms of the Formal Agreement. In December 1983, the OCC examination was completed and the Comptroller and senior OCC staff met Continental’s board of directors to discuss the findings.

A revised recovery plan for 1984 called for a further reduction in assets, enhanced capital-raising efforts, and a reduction in non-interest expenses and staff. Non-essential businesses, such as real estate and the bank’s credit card operation, were to be sold to improve capital and refocus the bank on wholesale banking. Merger alternatives would be pursued with the assistance of Goldman Sachs, which had been retained in September 1983. Plans were also accelerated to transfer additional responsibilities to Taylor and Bottum.

In February 1984, Mr Taylor replaced Mr Roger Anderson as Continental’s CEO; Mr Bottum was elected President. External events in the first quarter of 1984 produced further problems for the new management team. Asset quality continued to deteriorate and Continental recorded an operating loss for the first quarter of 1984.

Continental’s condition as of 31 March 1984 remained poor. An OCC examination began on 19 March and targeted asset quality and funding. It concluded that continued operating losses and funding problems could be anticipated unless the bank’s contingency plan to sell non-performing assets was successful. But details of this plan were not available at the completion of the examination on 20 April.

The Comptroller and his staff met with Continental’s Chairman, CEO and President on 2 May to discuss the bank’s dividend policy and contingency plan for selling non-performing assets. Following the meeting, the Comptroller concluded that the OCC’s approval of the payment of the second quarter dividend to the holding company in part depended on the successful implementation of provisions contained in the contingency plan, specifically, the sale of non-performing assets.

Later that month, market confidence in Continental deteriorated still further – rumours of the bank’s impending bankruptcy were fuelled by two erroneous press reports on 8 May that concerned the purchase of or investment in the bank. From that point on, the OCC was in continual contact with the bank and other bank regulatory agencies, especially the FDIC. On 10 May the OCC took the unusual step of issuing a news release stating that