Betting Billions on a Bank

By Stephen Koepp

The Feds come to the rescue of failing Continental Illinois

Huddled behind closed doors in Washington for the past two months, federal officials and bankers feverishly drafted a plan for the biggest bailout of a private company in U.S. history. The group of three dozen rescuers shuttled from one drab Government conference room to another, working 120-hr, weeks and pausing only occasionally to munch on fried chicken or hamburgers. Until the last minute, dozens of details were still undecided. But finally, William Isaac, chairman of the Federal Deposit In surance Corp., announced at a Washington press conference that the FDIC would put up $4.5 billion to rescue Chicago's failing Continental Illinois Bank. The commitment dwarfs the biggest previous U.S. bailout, the Government's 1979 guarantee to Chrysler of more than $1.2 billion in loans.

Since early May, Continental has been eroded by the most relentless run on a major bank since the Great Depression. At least one-third of its $30 billion in deposits has drained away. Despite an unprecedented $7.5 billion in emergency loans from the Government and 28 private banks, the outflow could not be stemmed. The banking system's difficulties in helping one of its key institutions have diminished public confidence in all U.S. banks. Even though each deposit up to $100,000 in a federally chartered financial institution is insured, many Americans began wondering about the safety of the money in their banks. Financiers feared that the failure of Continental, once the eighth-largest U.S. bank, could spark a chain reaction of similar collapses and set off financial panic.

The highly complex plan announced last week calls for the FDIC to hold 80% of Continental's stock. The agency hopes to create a more solid bank by shrinking the institution to less than three-fourths its former size. The bank will sell the FDIC $4.5 billion worth of its bad loans for $3.5 billion, taking a $1 billion loss on the deal. In addition, the agency will give Continental another $1 billion to put it in better financial shape. In a final sign of support, the FDIC stated, "If, for any reason, the permanent assistance package proves to be insufficient, the FDIC will commit additional capital or other forms of assistance as may be required."

The huge bailout represented a painful step for the Reagan Administration, which is philosophically opposed to Government intervention to save failing firms. Treasury Secretary Donald Regan described the structure of the bailout as "bad public policy," because it puts a federal agency out on a limb to protect private investors. In a 4 1/2-page memorandum to the heads of the three federal agencies that regulate the banks--Isaac, Comptroller of the Currency C.T. Conover and Federal Reserve Chairman Paul Volcker--Regan argued that the action was "implicitly extending a U.S. Government guarantee to all bank holding-company creditors."

The three Government regulators decided to go ahead largely because the alternative to a takeover was a potentially dangerous bank failure. Moreover, the FDIC stressed that its ownership of Continental is temporary; it intends to sell out as soon as the bank is healthy once again. That process may take several years, however. After the rescue plan was announced, the White House issued a lukewarm statement supporting it.

Continental's takeover marks the end of a valiant struggle by Chairman David G. Taylor to keep the bank afloat. "This is not the go-it-alone path we aspired to, but at this point it is the best course open to us," he told employees last week in a press conference carried on closed-circuit TV. Taylor, who was named head of Continental last February, became one of the first victims of the takeover. Both he and President Edward S. Bottum were ousted, although they will remain for an interim period as vice chairmen. The FDIC immediately named new top officers and asked for the resignations of the bank's board of directors. Other resignations of Continental officials are expected to follow.

Taylor's successor will be John E.

Swearingen, 66, who retired last September as chairman of Standard Oil of Indiana. His partner in running Continental will be William S. Ogden, 56, a former vice chairman of Chase Manhattan.

Swearingen was chosen for his high profile in Chicago civic affairs and his tough management style; Ogden was selected for his expertise in international lending. Said Swearingen last week: "It is impossible to overestimate the importance of Continental to the country and to Chicago."

The takeover deal must be approved by Continental shareholders, who still hold 20% of the bank stock and stand to be major losers under the plan. Continental stock has already fallen from 25 1/4 to 4 1/2 since last September. They are expected to endorse the agreement because the only alternative is bankruptcy, which would wipe out the entire value of their shares. Approval is expected in September.

Depositors and employees of Continental greeted the rescue with relief, even though it was the last thing they wanted a few months ago. While many customers have fled the bank, others have stuck with it out of loyalty. Says Donald Romans, vice president of Bally Manufacturing, a billion-dollar customer: "We will support Continental as long as it is able to support our business." Some fallen-away depositors like the Kemper Money Market Fund, which last May stopped buying Continental's certificates of deposit, are thinking about returning. Said Kemper Portfolio Manager Frank Rachwalski:

"Continental will have essentially no bad loans. They're probably in better shape than any U.S. bank."

The bailout is expected to boost mo rale inside the bank, which has lost a host of key employees by resignation. Observed Stuart Greenbaum, a finance professor at Northwestern University: "The loss of self-respect and pride among people at the bank has been enormous." Now that a comeback could be under way, he adds, many employees will want to stick around and try to redeem their reputations along with that of the bank's. Continental may soon rekindle its archrivalry with crosstown competitor First Chicago.

Says Chairman Barry Sullivan, who worked with Ogden at Chase: "Before long I'm going to have to ask to meet him on a football field and beat his brains out."

This is not the first tune the 127-year-old Continental has been bailed out by the Federal Government. In 1934 the Reconstruction Finance Corp. rescued Continental after a series of bad Depression loans. Continental later regained prosperity and helped turn Chicago's downtown financial district on LaSalle Street into the futures-and commodities-trading capital of the world. But trouble returned as a result of the bank's go-go lending during the 1970s. Under former Chairman Roger Anderson, who was eased out last February, Continental lent freely for oil and gas drilling, condominium development and Latin American projects; many of the projects went bust. The biggest blow came in September 1982, when Oklahoma City's Penn Square Bank failed. Continental held more than $1 billion in Penn Square's bad energy loans. Continental last week released the results of a 5 1/2-month-old internal probe that blamed the Penn Square involvement on three Continental lending officers, who have since been fired. One of them had accepted $565,000 in personal loans from the Oklahoma City bank. In the summer of 1981, a young vice president, Kathleen Kenefick, had warned superiors about Penn Square's problems, but her report was largely ignored.

By last May, Continental had clamped down on its freewheeling lending and was carrying out a recovery plan. Then rumors began to circulate that federal officials were concerned about the bank's problems and were trying to arrange a merger with three Japanese financial institutions. The reports were untrue, but that did not matter.

They soon became a self-fulfilling prophecy. The rumors, first published by the Commodity News Service and then repeated around the world, prompted many foreign depositors to begin taking their money out of Continental. The FDIC arranged emergency infusions of cash and pushed Continental to find a merger partner. A number of leading banks, including New York's Citicorp and Chemical Bank and First Chicago, examined Continental's books; they were unwilling to take over the ailing bank without large amounts of financial help from the FDIC, which the agency was unwilling to give.

That forced the FDIC to become a rescuer of last resort.

Most experts believe the action was unavoidable because of Continental's dependence on large, mostly uninsured deposits from U.S. and foreign institutions.

When the run started, only 7% of Continental's deposits were from consumers, with the rest from institutional clients.

Big corporate customers, whose deposits are above the $100,000 FDIC insurance limit, are quicker to pull their money out of a troubled bank than small depositors, who are usually insured. That situation made Continental vulnerable to the runaway rumors.

Bank regulators also feared that if overseas depositors lost money in a Continental failure, they might start pulling their accounts from other big U.S. banks as well. Smaller institutions could face failure if they lost large amounts of money on deposit with Continental. The shock waves might extend to local companies doing business with those banks. In short, what was at stake in Continental's crisis was the stability of the entire international banking system. Said Democratic Senator William Proxmire of Wisconsin, a vocal opponent of the Chrysler and Lock heed rescues: "For the first time I favor a bailout. In this case it was absolutely essential."

One ominous implication of the Continental bailout is that nationalization might become a common way to salvage large banks that run into trouble. FDIC Chief Isaac, a lawyer who favors deregulation of banks, argues that the rescue is a long way from nationalization. He contends that his agency will not be come involved in the day-to-day running of Continental. If the Chrysler case is any precedent, however, the Government can easily be tempted to involve itself in a company's affairs. While federal watch dogs were scrutinizing Chrysler, Washington bureaucrats were even deciding whether the company could keep its corporate planes.

Isaac was quick to point out that "not one nickel of taxpayers' money" will be spent on Continental because the rescue funds will come from FDIC reserves, which are made up of earnings collected on insurance premiums from banks. Yet the chairman of the House Banking Committee, Rhode Island Democrat Fernand St Germain, objects to any Government agency committing itself to such an expensive bailout without getting congressional approval. Said St Germain: "If there are enough Continentals, then we can rest assured that Mr. Isaac will be standing here, hat in hand, asking for congressional appropriations to replenish the funds."

Other critics believe the Continental rescue proves that the FDIC has a big-bank bias. Said Democratic Senator David Boren of Oklahoma: "The result of FDIC policy seems to encourage concentration of banking in a few large institutions and requires discipline only of small banks. Oklahomans are justifiably bitter about this double standard, especially when the collapse of Penn Square Bank doubled the state's bankruptcy rate."

The Continental situation has unquestionably dealt a setback to the movement for less banking regulation. Banks, which were tightly controlled for nearly half a century after the financial crisis of the Depression, have been wandering almost freely across state lines and into such new businesses as insurance, stock brokerage and other financial services. Politicians and regulators are likely to be more cautious about allowing banks to enter different fields. In fact, some reregulation of banks may result. St Germain plans to hold hearings in September on the Continental bailout, which he believes shows why banks should be forbidden to expand too far afield.

Above all, however, suggests that a bank's worst problems often start in its own executive suites. The basic trouble with Continental was poor management that led to bad loans. Says David C. Gates, a New York City bank consultant: "Mismanagement caused Continental's problems, not deregulation. I think you had a corporate culture gone wild; they thought they could do no wrong."

-- By Stephen Koepp.

Reported by Gisela Bolte/ Washington and J. Madeleine Nash/Chicago

With reporting by Gisela Bolte; J. Madeleine Nash