Not often you get a history lesson from Variance, the Casualty Actuarial Society’s peer-reviewed journal, but the latest issue has a highly readable account of the Penn Square Bank collapse in the early ’80s. The episode turns out to be an ERM primer that eerily parallels the 2008 financial meltdown.
Penn Square was a teeny bank in an Oklahoma strip mall. When it collapsed, the U.S. banking system teetered. The largest failure was Continental Illinois, the nation’s seventh largest, with $40 billion in assets.
Australian academic Shauna Ferris calls the collapse “a beginner’s guide” in how to throw the bank system off kilter, pointing out that we don’t have to learn about systemic risk by picking through the debris of 2008.
Naturally, a great many books and articles have been written recently, explaining the causes of these bank failures and asking, “What can we learn from this banking crisis, so that we can avoid such problems in the future?”
In this paper, we will be asking “What should we have learned from the previous banking crisis?”
Penn Square was a sleepy hometown bank until 1975 when Beep Jennings took it over and led the industry into the predictible inflation and bursting of an asset bubble.
The bubble came from the shock in oil prices in the 1970s. The price of a barrel of oil rose ten-fold in less than a decade, thanks to political instability in the Middle East. And some forecasters thought the trend would continue. Forecasting another doubling of oil prices in 10 years made you conservative.
Suddenly, the oil sitting beneath Texas and Oklahoma became fabulously valuable. But drilling is expensive, so oil companies large and small needed to borrow heavily.
And there was Penn Square Bank, in the middle of it. The new ownership expanded into lending to energy companies.
But drilling is risky for lenders. If the well is dry, the loan defaults. Normally, lenders adhere to strict guidelines. And they diversify. Lending to many types of business hedges against a collapse in any one. By following the rules, you can make steady profits and, at worst, live to bank another day.
But if you don’t follow the rules, you can make a killing, until you get killed. In retrospect, Penn Square had the shampoo business plan:
- Lather – Concentrate in one industry, abandon underwriting standards, book outrageous profits and attract the attention of the entire banking industry.
- Rinse – sell off those loan portfolios to the people slathering over your profits.
- Repeat – Those loan sales free up capital, so make some more dodgy loans.
At first, Penn Square didn’t see its actions as particularly risky, and a lot of people in the industry agreed. That’s the point.
They were all caught in the bubble – an apt metaphor since it tells you how quickly the phenomenon grows, how insulated the bubble boys are and how quickly things can pop.
When everything popped, Penn Square turned increasingly desperate and fraudulent. Ferris writes how brokers, regulators and accountants responded weakly or not at all, until it came time to bail out those deemed too big to fail. (Here’s the pdf.)
But basically, you already know the story she tells. You have lived it.
Look back. Substitute housing for oil. I don’t have to hold your hand through the parallels, do I? Ferris even finds parallels to the notorious credit default swaps. Penn Square propped up zombie borrowers by issuing them letters of credit (without collateral), so the zombies could get loans elsewhere, with the cash flow keeping them current on their Penn Square loans.
I can quibble with the piece by noting the enormous role leverage played in the ’08 crisis, much larger than anything the Penn Square crisis had to confront. But I think that is part of her point. The ’08 crisis was so big, so shattering, that the best lesson we can learn from it is that we will see it again.
As we have seen, many of the banking prac- tices which caused problems in the 1980s reappeared decades later–albeit in slightly different garb–and contributed to the current banking crisis. Booms inflated asset prices; subprime lenders lent too much against the value of inflated collateral; the sale of loans undermined lending standards and then spread the risks throughout the banking system; investors naively relied on the risk assessments of intermediaries who had conflicts of interest; reliance on short-term funding increased liquidity risks; financial institutions were allowed to sell credit default insurance without maintaining the capital needed to cover the risks; audited financial statements were misleading; and regulators were too slow to take effective action.
As time goes by, the lessons of past failures are forgotten–and then we must learn them again.