Banking's Crumbling Image

By Christopher Byron

Bad loans are causing big troubles for America 's financial industry

Banks and bankers have long been considered the bedrock of American business. The sober executives dressed in dark blue and talked in hushed tones, as befitted their serious calling. Their judgment was considered Solomonic, and their financial institutions were believed to be as solid as the vaults in which their cash was stored.

No more. A surprising number of American bankers are now winning a reputation for bad loans, poor decisions and weak management. In the past six months, 22 banks have failed, and last week two major U.S. banks announced large second-quarter losses. It was the first time since World War II that one of the top ten American banks had suffered a three-month loss. New York's Chase Manhattan reported that it lost $16.1 million between April and June, while the figure for Chicago's Continental Illinois was $60.9 million during the same period.

The U.S. banking industry is by far the safest and soundest in the world. Deposits in the more than 14,000 institutions belonging to the Federal Deposit Insurance Corporation are guaranteed by the Government for up to $100,000 for each account. Since the FDIC program was established in 1934, 578 member banks have gone out of business for one reason or another, but no depositor has ever lost a penny in an insured account.

Even so, people are growing edgy about whether their deposits are still as safe as money in the bank. In recent months, newspaper reports of financial strains on local banks and savings and loan associations have brought crowds of agitated depositors into bank lobbies to withdraw their funds from cash-squeezed institutions in Miami, Hartford, Conn,, Abilene, Texas, and a number of other towns and cities. A recent survey by Burke Marketing Research Inc. of Cincinnati showed that nearly 90% of Americans questioned now have some concern about the stability of U.S. financial institutions. Only about 10% feel any real confidence in the present banking climate.

Figures released by the FDIC last week give grounds for worry. Since January the agency's problem list of state and national banks with significant financial difficulties has increased from 223 to 268, the largest number since the aftermath of the 1973-75 recession.

On Wall Street, investor jitters have sent the industry into a slide, dropping share prices of a number of big money-center banks, including Chase Manhattan and Chemical Bank, to an average of only four times earnings. That is roughly the price-earnings ratio of the severely depressed oil drilling industry.

The woes of banks have largely been caused by the combination of high interest rates and an economy that shows little sign of recovering from almost three years of stagnation. Last week the Commerce Department reported that the U.S. gross national product grew during the second quarter at an inflation-adjusted annual rate of 1.7%. Yet at the same time, the Government also sharply scaled back an earlier GNP estimate for the first quarter, reporting that the economy actually sank 5.1% on an annual basis during the January-to-March period instead of the initially estimated 3.7%. Moreover, the Bureau of Labor Statistics last week announced that consumer prices rose during June at a compound annual rate of 13.3% for the second month in a row.

The weak economy is not the only cause of industry trouble. Many difficulties can be traced back to hasty and ill-considered loans that should never have been made. In recent weeks some of the biggest and most respected names in American banking have turned up as red-faced losers in very questionable investment deals.

In May, Chase Manhattan, the third largest U.S. bank, suffered after-tax losses of more than $117 million from interest payment defaults on loans to Drysdale Government Securities Inc., an obscure and thinly capitalized Wall Street trading firm that went bankrupt four months after it opened for business. Other big names involved in the Drysdale collapse included Manufacturers Hanover, the fourth largest American bank.

Last month the blue-chip banking fraternity received another blow when Perm Square Bank, a small and poorly managed Oklahoma City lender, folded after having invested heavily in risky oil and gas ventures. Penn Square's lending had been supported by, among others, Continental Illinois, the sixth largest commercial bank, Chase Manhattan and Seafirst Corp. of Seattle.

The banks hit by the Penn Square failure were looking for culprits last week. Chase Manhattan cleaned out its institutional banking division, where the Penn Square deals were approved. Chairman Willard Butcher fired one executive vice president and one senior vice president, demoted another executive vice president, and let go seven lower ranking officials. Chairman William Jenkins of Seafirst dismissed a senior vice president and the bank's chief lending officer. Continental Illinois has not yet taken any disciplinary action.

Banks, like many other sectors of the economy, are having troubles adjusting to slowing inflation. During the go-go years, bank officers often sought to stay competitive by rushing into trendy new investment schemes. They made too many loans to businesses that would remain viable only as long as the economy kept growing strongly. Says Franklin R. Edwards, a professor of banking at Columbia University: "The problem that many banks currently experience is not a function of irresponsibility or imprudence, but of operating in a more competitive environment. Deregulation of the industry and the expansion of financial services have caused the competition to heat up, and this has caused banks to push beyond their areas of expertise."

In the early 1970s, for example, American banks invested more than $11 billion in real estate investment trusts that soon slumped along with the economy. Many banks in the 1970s also delved into international currency speculation. Such perilous betting eventually helped bankrupt Franklin National Bank in 1974.

Some of the riskiest loans in recent years were those made by such big money-center banks as Chase Manhattan, Citibank and Bank of America to Eastern European countries. Today those nations look like so many financial dominoes. In recent weeks Western bankers have been working to devise a rescheduling plan for at least part of the $25 billion that Poland alone owes.

At the same time, American and European bankers are worried about the heavy loans made to Rumania, East Germany and Hungary. Eastern European satellite countries now owe Western bankers and governments $60 billion, and those countries are strapped just to make the interest payments on the debt. illions of dollars have been lent to troublesome credit risks in Latin America like Mexico, Brazil and Argentina. All together, this debt to U.S. banks now totals $62 billion. Warns one top Chase Manhattan banker: "If Latin America goes into default, it will bring down all the major banks in this country."

During the past five years, banks have rushed to loan billions of dollars to real estate developers in the highly cyclical, boom-bust business of commercial-office-building construction. In doing so, they have helped fuel a building expansion that real estate experts fear may soon collapse.

In addition to the risky loans, the Drysdale and Penn Square affairs have shown surprisingly loose management for an industry that always prided itself on tight controls. The rush to profits seems to have sometimes overruled good sense. Said Robert Empie, the Oklahoma state banking commissioner, about the Penn Square case: "All kinds of opportunistic, illegitimate operators were getting loans there. Many had just been in the oil business for two or three years. I damn sure think that Continental Illinois had incompetent people involved with Penn Square. When it came to checking loan documentation, for example, the work was very sloppy." Richard Fredericks, a bank analyst for Montgomery Securities in San Francisco, concurs. Says he: "Continental Illinois' internal documentation for the Penn Square loans was poor. The usual safeguards fell down."

As long as the U.S. economy remains sluggish and many companies continue to teeter on the brink of bankruptcy, some banks will be wobbly, even though American banking is basically solid. Says Arthur Soter, a bank analyst for New York's Morgan Stanley: "By the time this recession is over, the cases of sheer stupidity may be far less than in the mid-1970s, but overall losses could turn out to be worse." Like the hard-pressed companies and countries to which they have made heavy loans, U.S. banks now have to face up to serious past mistakes and pressing current problems. --By Christopher Byron. Reported by Patricia Delaney/Chicago and Frederick Ungeheuer/New York

With reporting by Patricia Delaney, Frederick Ungeheuer

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