The Creature from Jekyll Island by G. Edward Griffin. Chapter 3. Protectors of the Public. The game called Bailout, as it actually has been applied to specific cases including Penn Central, Lockheed, New York City, Chrysler, Commonwealth Bank of Detroit, First Pennsylvania Bank, Continental Illinois, and others.
In the previous chapter, we offered the whimsical analogy of a sporting event to clarify the maneuvers of monetary and political scientists to bail out those commercial banks which comprise the Federal Reserve cartel. The danger in such an approach is that it could leave the impression the topic is frivolous. So, let us abandon the analogy and turn to reality.
Now that we have studied the hypothetical rules of the game, it is time to check the scorecard of the actual play itself, and it will become obvious that this is no trivial matter. A good place to start is with the rescue of a consortium of banks which were holding the endangered loans of Penn Central Railroad. Penn Central. Penn Central was the nation's largest railroad with 96,000 employees and a payroll of $20 million a week. In 1970, it also became the nation's biggest bankruptcy.
It was deeply in debt to just about every bank that was willing to lend it money, and that list included Chase Manhattan, Morgan Guarantee, Manufacturers Hanover, First... National City, Chemical Bank, and Continental Illinois. Officers of the largest of those banks had been appointed to Penn Central's Board of Directors as a condition for obtaining funds, and they gradually had acquired control over the railroad's management.
The banks also held large blocks of Penn Central stock in their trust departments. The arrangement was convenient in many ways, not the least of which was the bankers sitting on the board of directors were privy to information long before the public received it, which would affect the market price of Penn Central stock. Chris Wells, in the Last Days of the Club publication, describes what happened. Quote, On May 21st, a month before the railroad went under, David Bevin, Penn Central's chief financial officer privately informed representatives of the company's banking creditors that its financial condition was so weak it would have to postpone another attempt to raise $100 million in desperately needed operating funds through a bond issue. Instead, said Bevin, the railroad would seek some kind of governmental loan guarantee.
In other words, unless the railroad could manage a federal bailout, it would have to close down. The following day, Chase Manhattan's trust department sold 134,300 shares of its Penn Central holdings. Before May 28th, when the public was informed of the postponement of the bond issue, Chase sold another 128,000 shares.
David Rockefeller, the bank's chairman, vigorously denied Chase had acted on the basis of inside information. End quote. More to the point of this study is the fact that virtually all major management decisions which led to Penn Central's demise were made by or with the concurrence of its board of directors, which is to say, by the banks that provided the loans. In other words, the bankers were not in trouble because of Penn Central's poor management.
They were Penn Central's poor management. An investigation conducted in 1972 by Congressman Wright Patman, chairman of the House Banking and Currency Committee, revealed the following. The banks provided large loans for disastrous expansion and diversification projects. They loaned additional millions to the railroad so it could pay dividends to its stockholders.
This created the false appearance of prosperity and artificially inflamed the economy. the market price of its stock long enough to dump it on the unsuspecting public. Thus, the bank managers were able to engineer a three-way bonanza for themselves. They first received dividends on essentially worthless stock, second, they earned interest on the loans which provided the money to pay those dividends, and third, they were able to unload 1.8 million dollars.
million shares of stock after the dividends, of course, at unrealistically high prices. Reports from the Securities and Exchange Commission showed that the company's top executives had disposed of their stock in this fashion at a personal savings of more than a million bucks. Had the railroad been allowed to go into bankruptcy at that point and been forced to sell off its assets, The bankers still would have been protected. In any liquidation, debtors are paid off first, stockholders last, so the manipulators had dumped most of their stock while prices were relatively high.
That is a common practice among corporate raiders who use borrowed funds to seize control of a company and then toss the debt-ridden, dying carcass upon the remaining stockholders, or in this case, the taxpayers. The public be damned. In his letter of transmittal accompanying the staff report, Congressman Patman provided this summary.
Quote, it was as though everyone was a part of a close-knit club in which Penn Central and its officers could obtain, with very few questions asked, loans for almost everything they desired, both for the company and for their own personal interests. where the bankers sitting on the board asked practically no questions as to what was going on, simply allowing management to destroy the company, to invest in questionable activities, and to engage in some cases in illegal activities. These banks, in return, obtained most of the company's lucrative banking business. The attitude of everyone seemed to be, while the game was going on, that all these dealings were of benefit to every member of the club, and the railroad and the public be damned.
End quote. The banking cartel, commonly called the Federal Reserve System, was created for exactly this kind of bailout. Arthur Burns, who was the Fed's chairman, would have preferred to provide a direct infusion of newly created money, but that was contrary to the rules at that time. In his own words, quote, Everything fell through.
We couldn't lend it to them, ourselves, under the law. I worked on this thing in other ways, end quote. The company's cash crisis came to a head over a weekend, and in order to avoid having the corporation forced to file for bankruptcy on Monday morning, Burns called the homes of the heads of the Federal Reserve Banks around the country and told them to get the word out immediately that the system was anxious to help. On Sunday, William Treiber, who was the first vice president of the New York branch of the Fed, contacted the chief executives of the ten largest banks in New York and told them that the Fed's discount window would be wide open the next morning. Translated, that means the Federal Reserve System was prepared to create money out of nothing and then immediately loan it to the commercial banks so they, in turn, could multiply and re-lend it to Penn Central and other corporations such as Chrysler, which were in a similar straits.
Furthermore, the rates at which the Fed would make these funds available would be low enough to compensate for the risk. Speaking of what transpired on the following Monday, Burns boasted, quote, I kept the board in session practically all day to change regulation Q so that money could flow into CDs at the banks, end quote. Looking back at the event, Chris Wells approvingly describes it as, quote, what is by common consent the Fed's finest hour, end quote.
Finest hour or not, the banks were not that interested in the proposition. unless they could be assured the taxpayer would co-sign the loans and guarantee payment. So the action inevitably shifted back to Congress. Penn Central's executives, bankers, and the union representatives came in droves to explain how the railroad Its continued existence was in the best interest of the public, of the working man, of the economic system itself.
The Navy departments spoke of protecting the nation's, quote, defense resources. Congress, of course, could not callously ignore these pressing needs of the nation. It responded by ordering a retroactive 13% pay raise for all Union employees. After having added that burden to the railroad's cash drain and putting it even deeper into the hole, it then passed the Emergency Rail Services Act of 1970, authorizing $125 million in federal loan guarantees.
None of this, of course, solved the basic problem, nor was it really intended to. Almost everyone knew that, eventually, the railroad would be nationalized. which is a euphemism for becoming a black hole into which tax dollars disappear. This came to pass with the creation of Amtrak in 1971 and Conrail in 1973. Amtrak took over the passenger services of Penn Central, and Conrail assumed operation of its freight services along with five other eastern railroads. Conrail technically is a private corporation.
When it was created, however, 85% of its stock was held by the government. The remainder was held by employees. Fortunately, the government's stock was sold in a public offering in 1987. Amtrak continues under political control and operates at a loss.
It is sustained by government subsidies. which is to say by taxpayers. In 1997, Congress dutifully gave it another $5.7 billion, and by 1998, liabilities exceeded assets by an estimated $14 billion.
Conrail, on the other hand, since it was returned to the private sector, has experienced an impressive turnaround and has been running at a profit. paying taxes instead of consuming them. In that same year, 1970, the Lockheed Corporation, which was the nation's largest defense contractor, was teetering on the verge of bankruptcy. The Bank of America and several smaller banks had loaned 400 million bucks to the Goliath, and they were not so anxious to lose the bountiful interest income stream that flowed from that. Nor did they wish to see such a large bookkeeping asset disappear from their ledgers.
In due course, the banks joined forces with Lockheed's management, stockholders, and labor unions, and the group descended on Washington. Sympathetic politicians were told that if Lockheed were allowed to fail, 31,000 jobs would be lost. Hundreds of subcontractors would go down, thousands of suppliers would be forced into bankruptcy, and national security would be seriously jeopardized. What the company needed was to borrow more money, and lots of it. But because of its current financial predicament, no one was willing to lend.
The answer? In the interest of protecting the economy and defending the nation, The government simply had to provide either the money or the credit. A bailout plan was quickly engineered by Treasury Secretary John B. Connolly, which provided the credit. The government agreed to guarantee payment of an additional $250 million in loans, an amount which would put Lockheed 60% deeper into the debt hole than it had ever been before.
But... That made no difference now. Once the taxpayer had been made a cosigner to the account, the banks had no qualms about advancing the funds.
The not-so-obvious part of this story is that the government now had a powerful motivation to make sure that Lockheed would be awarded as many defense contracts as possible and that those contracts would be as profitable as possible. This would be an indirect method of paying off the banks with tax dollars, but doing so in such a way as not to arouse public indignation. Other defense contractors, which had operated more efficiently, would lose business, but that could not be the case.
be proven. Furthermore, a slight increase in defense expenditures would hardly be noticed. By 1977, Lockheed had indeed paid back this loan, and that fact was widely advertised as proof of the wisdom and skill of all the players, including the referee and the game commissioner.
A deeper analysis, however, must include two facts. First, there is no evidence that Lockheed's operation became a more cost-efficient during those years. Second, every bit of the money used to pay back the loans came from defense contracts, which were awarded by the same government which was guaranteeing those loans.
Under such an arrangement, it makes little difference if the loans were paid back or not. Taxpayers were doomed to pay the bill either way. New York City Although the government of New York City is not a corporation in the usual sense, it functions as one in many respects, particularly regarding debt.
In 1975, New York had reached the end of its credit rope and was unable even to make a payroll. The cause was not mysterious. New York had long been a welfare state within itself, and success in city politics was traditionally achieved by lavish promises of benefits and subsidies for the, quote, poor. Not surprisingly, the city also was notorious for political corruption and bureaucratic fraud.
Whereas the average large city employed 31 people per 1,000 residents, New York had 49. That's an excess of 58%. The salaries of these employees far outstripped those in private industry. While an x-ray technician in a private hospital earned 187 bucks per week, a porter working for the city earned 203. The average bank teller earned 154 bucks per week, but a changemaker on the city subway received 212. And municipal fringe benefits were fully twice as generous as those in private industry within the state. On top of this... mountainous overhead were heaped additional costs for free college education, subsidized housing, free medical care, and endless varieties of welfare programs.
City taxes were greatly inadequate to cover the cost of this utopia. Even after transfer payments from Albany and Washington added state and federal taxes to the tank, the outflow continued to exceed the inflow. There were now only three options.
Decrease city taxes, reduce expenses, or go into debt. The choice was never in serious doubt. By 1975, New York had floated so many bonds, it had saturated the market and could find no more lenders. Two billion dollars of this debt was held by a small group of banks dominated by...
Chase Manhattan and Citicorp. When the payment of interest on these loans finally came to a halt, it was time for serious action. The bankers and the city fathers traveled down the coast to Washington and put their case before Congress.
The largest city in the world could not be allowed to go bankrupt, they said. Essential services would be halted and millions of people would be without garbage removal, without transportation, even without police protection. Starvation, disease, and crime would run rampant through the city.
It would be a disgrace to America. David Rockefeller at Chase Manhattan persuaded his friend Helmut Schmidt, Chancellor of West Germany, to make a statement to the media that the disastrous situation in New York could trigger an epidemic. international financial crisis.
Congress, understandably, didn't want to turn New York into a zone of anarchy, nor to disgrace America, nor to trigger a worldwide financial panic. So, in December of 1975, it passed a bill authorizing the Treasury to make direct loans to the city of up to $2.3 billion. an amount which would more than double the size of its current debt to the banks. Interest payments on the old debt resumed immediately.
All of this money, of course, would first have to be borrowed by Congress, which was itself deeply in debt. And most of it would be created, directly or indirectly, by the Federal Reserve System. That money would be taken from the taxpayer through the loss of purchasing power called inflation, but at least the banks could be repaid, which is the object of the entire game. There were several restrictions attached to this loan, including austerity program and a systematic repayment schedule. None of these conditions was honored.
New York City has continued to be a welfare utopia and is unlikely that it will ever get out of debt. By 1978, the Chrysler Corporation was on the verge of bankruptcy. It had rolled over its debt to the banks many times, and the game was nearing an end. In spite of an OPEC oil embargo, which had pushed up the cost of gasoline, and in spite of the increasing popularity of small automobile imports, the company had continued to build the traditional gas hog. It was now saddled with a mammoth inventory of unsellable cars, and with a staggering debt which it had acquired to build those cars.
The timing was doubly bad. America was also experiencing high interest rates, which, coupled with fears of U.S. military involvement in Cambodia, had led to a slump in the stock market. Banks felt the credit crunch keenly, and in one of those rare instances in modern history, The money makers themselves were scouring for money. Chrysler needed additional cash to stay in business.
It was not interested in borrowing just enough to pay the interest on its existing loans. To make the game worth playing, it wanted over a billion dollars in new capital. But in the prevailing economic environment, the banks were hard-pressed to create anything close to that kind of money. Managers, bankers, and union leaders found common cause in Washington. If one of the largest corporations in America was allowed to fold, think of the hardship to thousands of employees and their families.
Consider the damage to the economy as shockwaves of unemployment move across the country. Tremble at the thought of lost competition in the automobile market, of only two major brands from which to choose instead of three. Well, could anyone blame Congress for not wanting to plunge innocent families into poverty, nor to upend the national economy, nor to deny anyone their constitutional right to freedom of choice? So, a bill was passed directing the Treasury to guarantee up to $1.5 billion in new loans to Chrysler.
The banks agreed to write down the amount of money they would need to pay the Treasury down $600 million of their old loans and to exchange an additional $700 million for preferred stock. Both of these moves were advertised as evidence the banks were taking a terrible loss but were willing to yield in order to save the nation. How magnanimous of them.
It should be noted, however, that the value of the stock which was exchanged for previously uncollectible debt rose drastically after the settlement was announced to the public. Furthermore, not only did interest payments resume on the balance of the old loans, but the banks now replaced the written down portion with fresh loans, and these were far superior in quality because they were fully guaranteed by the taxpayers. So valuable was this guarantee that Chrysler, in spite of its previously poor debt performance, was able to obtain loans at 10.35% interest, while its more solvent competitor, Ford, had to pay 13.5%.
Applying the difference of 3.15% to $1.5 billion, with a declining balance continuing for only six years, produces a savings in excess of $165 million. That is a modest estimate of the size of the federal subsidy. The real value was far greater, because without it, the corporation would have ceased to exist, and The banks would have taken a loss of almost their entire loan exposure.
Federal Deposit Insurance Corporation. It will be recalled from the previous chapter that the FDIC is not a true insurance program, and because it has been politicized, it embodies the principle of moral hazard, and it actually increases the likelihood that the bank failures will occur. The FDIC has three options when bailing out an insolvent bank. The first is called a payoff.
It involves simply paying off the insured depositors and then letting the bank fall to the mercy of the liquidators. This is the option usually chosen for small banks with no political clout. The second possibility is called a sell-off.
and it involves making arrangements for a larger bank to assume all the real assets and liabilities of the failing bank. Banking services are uninterrupted and aside from a change in the name, most customers are unaware of the transaction. This option is generally selected for small and medium banks.
In both a payoff and a sell-off, FDIC takes over the bad loans of the failed bank, and supplies the money to pay back the insured depositors. The third option is called a bailout, and this is the one which deserves our special attention. Ervin Sprague, a former director of the FDIC, explains, quote, In a bailout, the bank does not close, and everyone, insured or not, is fully protected.
Such privileged treatment is accorded by FDIC only rarely to an elect few."That's right, he said everyone, insured or not, is fully protected. The banks which comprise the elect few generally are the largest ones. It is only when the number of dollars at risk becomes mind-numbing that a bailout can be camouflaged as protection of the public. Sprague says, The FDI Act gives the FDIC board sole discretion to prevent a bank from failing, at whatever the cost. The board need only make the finding that the insured bank is in danger of failing and, quote, is essential to provide adequate banking service in its community, end quote. The FDIC boards have been reluctant to make an essentiality finding unless they perceive a clear and present... danger to the nation's financial system."End quote. Favoritism towards the large banks is obvious at many levels. One of them is the fact that in a bailout, the FDIC covers all deposits, whether insured or not. That is significant because the banks pay an assessment based only on their insured deposits.
So if uninsured deposits are covered also, that coverage is free. More precisely, paid by someone else. What deposits are uninsured? Those in excess of $100,000 and those held outside the United States. Which banks hold the vast majority of such deposits?
The large ones, of course, particularly those with extensive overseas operations. The bottom line is that the large banks get a whopping free ride when they're bailed out. Their uninsured accounts are paid by FDIC, and the cost of that benefit is passed to the smaller banks and, of course, to the taxpayer.
This is not an oversight. Part of the plan at Jekyll Island was to give a competitive edge to the large banks. Unity Bank.
The first application of the FDIC essentiality rule was, in fact, an exception. In 1971, Unity Bank and Trust Company in the Roxbury section of Boston found itself hopelessly insolvent, and the federal agency moved in. This is what was found.
Unity's capital was depleted, most of its loans were bad, its loan collection practices were weak, and its personnel represented the worst of two worlds, overstaffing and ill-paying. inexperience. The examiners reported that there were two persons for every job, and Neither one had been taught the job.
With only $11.4 million on its books, the bank was small by current standards. Normally, the depositors would have been paid back, and the stockholders, like the owners of any other failed business venture, would have lost their investment. As Sprague himself admitted, quote, If market discipline means anything, stockholders should be wiped out when a bank fails.
Our assistance would have the side effect of keeping stockholders alive at government expense, end quote. But Unity Bank was different. It was located in a black neighborhood and was minority owned.
As is often the case when government agencies are given discretionary powers, decisions are determined more by political pressures than by logic or by merit, and Unity was a perfect example. In 1971... The specter of rioting in black communities still haunted the halls of Congress.
Would the FDIC allow this bank to fail and assume the awesome responsibility for new riots and bloodshed? Sprague answers, quote, Neither Will, another director, nor I had any trouble viewing the problem in its broader social context. We were willing to look for a creative solution.
My vote to make the essentiality finding and thus save the little bank was probably foreordained, an inevitable legacy of Watts. The Watts riots ultimately triggered the essentiality doctrine. End quote. On July 22, 1971, the FDIC declared that the continued operation of Unity Bank was indeed essential and authorized a direct infusion of $1.5 million.
Although appearing on the agency's ledger as a loan, no one really expected repayment. In 1976, in spite of the FDIC's own staff report that the bank's operations continued, quote, as slipshod and haphazard as ever, end quote, the agency rolled over the loan for another five years. Operations didn't improve, and on June 30, 1982, the Massachusetts Banking Commissioner finally revoked Unity's charter.
There were no riots in the streets, and the FDIC quietly wrote off the sum of $4.463 million as the final cost of the bailout. Commonwealth Bank of Detroit. The bailout of the Unity Bank of Boston was the exception to the rule that Small banks are dispensable, while the giants must be saved at all costs. From that point forward, however, the FDIC game plan was strictly according to Hoyle. The next bailout occurred in 1972 involving the $1.5 billion bank of the Commonwealth of Detroit.
Commonwealth had funded most of its phenomenal growth through loans from another bank, Chase Manhattan in New York. When Commonwealth went belly up, largely due to security speculation and self-dealing on the part of its management, Chase seized 39% of its common stock and actually took control of the bank in an attempt to find a way to get its money back. FDIC Director Sprague describes the inevitable sequel.
Quote, Chase officers suggested that Commonwealth was a public interest problem that the government agency should resolve. That unsubtle hint was the way Chase phrased its request for a bailout by the government. Their proposal would come down to bailing out the shareholders, the largest of which was Chase.
End quote. The bankers argued that Commonwealth must not be allowed to fold because it provided, quote, essential banking services to the community. That was justified on two counts. One, it served many minority neighborhoods, and two, there were not enough other banks in the city to absorb its operation without creating an unhealthy concentration of banking power in the hands of a few.
It was unclear what the minority issue had to do with it, inasmuch as every neighborhood in which Commonwealth had a branch was served by other banks as well. Furthermore, if Commonwealth were to be liquidated, many of those branches undoubtedly would have been purchased by competitors, and service to the communities would have continued. Judging by the absence of attention given to this issue during the war, discussions, it is apparent that it was merely thrown in for good measure, and no one took it very seriously. In any event, the FDIC did not want to be accused of being indifferent to the needs of Detroit's minorities, and it certainly did not want to be a destroyer of free enterprise competition.
So, on January 17, 1972, Commonwealth was bailed out with a $60 million loan plus numerous federal guarantees. Chase absorbed some losses, primarily as a result of Commonwealth's weak bond portfolio, but those were minor compared to what would have been lost without FDIC intervention. Since continuation of the bank was necessary to prevent concentration of financial power, FDIC engineered its sale to the First Arabian Corporation, a Luxembourg firm funded by... Saudi princes. Better to have financial power concentrated in Saudi Arabia than in Detroit.
The bank continued to flounder, and in 1983, what was left of it was resold to the former Detroit bank and trust company now called Comerica. Thus, the dreaded concentration of local power was realized after all, but not until Chase Manhattan was able to walk away from the deal with most of its losses covered. First Pennsylvania Bank.
The 1980 bailout of the First Pennsylvania Bank of Philadelphia was next. First Penn was the nation's 23rd largest bank with assets in excess of $9 billion. It was six times the size of Commonwealth, 900 times larger than Unity.
It was also the nation's oldest bank, dating back to the Bank of North America, which was created by the Continental Congress in 1781. The bank had experienced rapid growth and handsome profits largely due to the aggressive leadership of its chief executive officer, John Bunting, who had previously been an economist with the Federal Reserve Bank of Philadelphia. Bunting was the epitome of the era's go-go bankers. He vastly increased earnings ratios by reducing safety margins, taking on risky loans, and speculating in the bonds market. As long as the economy expanded, these gambles were profitable, and the stockholders loved him dearly. When his gamble on the bond market turned sour, however, the bank plunged into a negative cash flow.
By 1979, First Pen was forced to sell off several of its profitable subsidiaries in order to obtain operating funds, and it was carrying $328 million in questionable loans. That was $16 million more than the entire stockholder investment. The bank was insolvent, and the time had arrived to hit up the taxpayers for the loss. The bankers went to Washington and presented their case. They were joined by spokesmen from the nation's top three, Bank of America, Citibank, and of course the ever-present Chase Manhattan.
They argued that not only was the bailout of First Pen essential for the continuation of banking services in Philadelphia, it was also critical to the preservation of world economic stability. The bank was so large, they said, if it were allowed to fail, it would act as the first domino leading to an international financial crisis. At first, the directors of the FDIC resisted that theory and earned the angry impatience of the Federal Reserve.
Sprague recalls, quote, We were far from a decision on how to proceed. There was strong pressure from the beginning not to let the bank fail. Besides hearing from the bank itself, the other large banks, and the comptroller, we heard frequently from the Fed.
I recall at one session, Fred Schultz, the federal deputy chairman, argued in an ever-rising voice that there were no alternatives. We had to save the bank. He said, quit wasting time talking about anything else. The Fed's role as a lender of last resort first generated contention between the Fed and FDIC during this period. The Fed was lending heavily to First Pen, fully secured, and Fed Chairman Paul Volcker said he planned to continue.
continue funding indefinitely until we could work out a merger or a bailout to save the bank."The directors of the FDIC did not want to cross swords with the Federal Reserve System, and they most assuredly did not want to be blamed for tumbling the entire world economic system by allowing the first domino to fall. Quote, the theory had never been tested. said Sprague. I was not sure I wanted it to be just then, end quote. So in due course, a bailout package was put together which featured a $325 million loan from FDIC, interest-free for the first year at subsidized rate thereafter, about half the market rate. Several other banks, which were financially tied to First Pen and which would have suffered great losses if it had folded, loaned an additional $175 million and offered a $1 billion line of credit. FDIC insisted on this move to demonstrate that the banking industry itself was helping and that it had faith in the venture. To bolster that faith, the Federal Reserve opened its discount window offering low-interest funds for that purpose. The outcome of this particular bailout was somewhat happier than with the others, at least as far as the bank is concerned. At the end of the five-year taxpayer subsidy, the FDIC loan was fully repaid. The bank has remained on shaky ground, however, and the final page of this episode has not yet been written. Continental, Illinois. Everything up to this point was but mere practice for the big event which was yet to come. In the early 1980s, Chicago's continental Illinois was the nation's seventh largest bank. With assets of $42 billion and with 12,000 employees working in offices in almost every major country in the world, its loan portfolio had undergone spectacular growth. Its net income on loans had literally doubled in just five years, and by 1981 had... rocketed to an annual figure of $254 million. It had become the darling of the market analysts and even had been named by Dunn's Review as one of the five best managed companies in the country. These opinion leaders failed to perceive that the spectacular performance was due not to an expertise in banking or investment, but to the financing of shaky business enterprises and foreign governments which could not obtain loans anywhere else. But the public didn't know that and wanted in on the action. For a while, the bank's common stock actually sold at premium over others which were more prudently managed. The gaudy fabric began to unravel during the 4th of July weekend of 1982. with the failure of the Penn Square Bank in Oklahoma. That was the notorious shopping center bank that had booked a billion dollars in oil and gas loans and resold them to Continental just before the collapse of the energy market. Other loans also began to sour at the same time. The Mexican and Argentine debt crisis was coming to a head. and a series of major corporate bankruptcies were receiving almost daily headlines. Continental had placed large chunks of its easy money with all of them. When these events caused the bank's credit rating to drop, cautious depositors began to withdraw their funds, and new funding dwindled to a trickle. The bank became desperate for cash to meet its daily expenses. In an effort to attract new money, it began to offer unrealistically high rates of interest on its CDs. Loan officers were sent to scour the European and Japanese markets and to conduct a public relations campaign aimed at convincing market managers that the bank was calm and steady. David Taylor, the bank's chairman at the time, said, We had the Continental Illinois Reassurance Brigade, and we fanned out all over the world in the fantasy land of modern finance glitter is often more important than substance image more valuable than reality the bank paid the usual quarterly dividend in august in spite of the fact that this intensified its cash crunch. As with the Penn Central Railroad 12 years earlier, that move was calculated to project an image of business-as-usual prosperity, and the plan worked, for a while at least. By November, the public's confidence had been restored, and the bank's stock recovered to its pre-Penn Square level. By March of 1983, It had risen even higher, but the worst was yet to come. By the end of 1983, the bank's burden of non-performing loans had reached unbearable proportions and was growing at an alarming rate. By 1984, it was $2.7 billion. That same year, the bank sold off its profitable credit card operation to make up for the loss of income and to obtain money for paying stockholders their expected quarterly dividend. The internal structure was near collapse, but the external facade continued to look like business as usual. The first crack in that facade appeared at 1139 a.m. On Tuesday, May 8th, Reuters, the British news agency, moved a story on its wire service stating that banks in the Netherlands, West Germany, Switzerland, and Japan had increased their interest rate on loans to Continental, and that some of them had begun to withdraw their funds. The story also quoted the bank's official statement that rumors of pending bankruptcy were, quote, totally preposterous, end quote. Within hours, another wire, the Commodity News Service, reported a second rumor, that a Japanese bank was interested in buying it. Continental, world's first electronic bank run. As the sun rose the following morning, foreign investors began to withdraw their deposits. A billion dollars in Asian money moved out that first day. The next day, a little more than 24 hours following Continental's assurance that bankruptcy was totally preposterous, its long-standing customer, the Board of Trade Clearing Corporation. Located just down the street, withdraw 50 million bucks. Word of the defection spread through the financial wire services, and the panic was on. It became the world's first global electronic bank run. By Friday, the bank had been forced to borrow $3.6 billion from the Federal Reserve in order to cover its escaping deposits. A consortium of 16 banks, led by Morgan Guarantee, offered a generous 30-day line of credit, but all this was far short of the need. Within seven more days, the outflow surged to over $6 billion. In the beginning, almost all of this action was at the institutional level. Other banks and professionally managed funds, which closely monitor every minuscule detail of the financial markets, The general public had no inkling of the catastrophe, even as it unfolded. Chernow says, quote, The Continental Run was like some modernistic fantasy. There were no throngs of hysterical depositors, just cool nightmare flashes on computer screens, end quote. Sprague writes, quote, Inside the bank all was calm. The teller lines moved as always, and bank officials recalled, no visible sign of trouble, except in the wire room. Here, the employees knew what was happening as withdraw order after order moved on the wire, bleeding Continental to death. Some cried. End quote. This was the golden moment for which the Federal Reserve and the FDIC were created. Without government intervention, Continental would have collapsed. its stockholders would have been wiped out, depositors would have been badly damaged, and the financial world would have learned that banks not only have to talk about prudent management, they actually have to adopt it. Future banking practices would have been severely altered, and the long-term economic benefit to the nation would have been enormous. But with government intervention, The discipline of a free market is suspended, and the cost of failure or fraud is politically passed to the taxpayers. Depositors continue to live in a dream world of false security, and banks can operate recklessly and fraudulently. with the knowledge that their political partners in the government will come to their rescue when they get into trouble. FDIC generosity with tax dollars. One of the challenges at Continental was that, while only 4% of its liability was covered by FDIC, quote, insurance, the regulators felt compelled to cover the entire exposure. which means that the bank paid insurance premiums into the fund based on only 4% of its total coverage, and the taxpayers now would pick up the other 96%. FDIC Director Sprague explains, quote, Although Continental Illinois had over $30 billion in deposits, 90% were uninsured foreign deposits or large certificates, substantially exceeding the $100,000 insurance limit. Off-book liabilities swelled Continental's real size to $69 billion. In this massive liability structure, only some $3 billion within the insured limit was scattered among 850,000 deposit accounts. So it was in our power and entirely legal simply to pay off the insured depositors, let everything else collapse, and stand back to watch the carnage."That course was never seriously considered by any of the players. From the beginning, there were only two questions. How to come to Continental's rescue by covering its total liabilities, and equally important, how to politically justify such a fleecing of the taxpayer. As pointed out in the previous chapter, The rules of the game require that the scam must always be described as heroic effort to protect the public. In the case of Continental, the sheer size of the numbers made the ploy relatively easy.
There were so many depositors involved, so many billions at risk, so many other banks interlocked. It could be claimed that the economic fabric of the entire nation, or even of the world itself, was at stake. And who could say that it was not?
Sprague argues the case in familiar terms. Quote, an early morning meeting was scheduled for Tuesday, May 15th at the Fed. We talked over the alternatives.
They were few. None, really. Treasury Secretary Reagan and Fed Chairman Volcker raised the familiar concern about a national banking collapse, that is, a chain reaction if Continental should fail.
Volcker was worried about an international crisis. We all were acutely aware that never before had a bank even remotely approaching continental size closed. No one knew what might happen in the nation and in the world. It was no time to find out just for the purpose of intellectual curiosity. End quote.
The final bailout package. The bailout was predictable from the start. There would be some preliminary lip service given to the necessity of allowing the banks themselves to work out their own problem. That would be followed by a plan to have the banks and the government share the burden. And that finally would collapse into a mere public relations illusion.
In the end, almost the entire cost of the bailout would be assumed by the government and passed on to the taxpayer. At the May 15 meeting, Treasury Secretary Reagan spoke eloquently about the value of a free market and the necessity of having the banks mount their own rescue plan, at least for a part of the money. To work out that plan, a summit meeting was arranged the next morning among the chairmen of the seven largest banks.
Morgan Guarantee, Chase Manhattan, Citibank, Bank of America, Chemical Bank, Bankers Trust, and manufacturers of Hanover. The meeting was perfunctory at best. The bankers knew full well that the Reagan administration would not risk the political embarrassment of a major bank failure.
That would make the president and the Congress look bad at re-election time. But still, some kind of tokenism was called for to preserve the administration's conservative image. So, with urging from the Fed and the Treasury, The consortium agreed to put up the sum of $500 million, an average of only $71 million for each, far short of the actual need. Chernow describes the plan as make-believe and says, quote, they pretended to mount a rescue, end quote. Sprague supplies the details, quote, the bankers said they wanted to be in on any deal, but they did not want to lose any money.
They kept asking for guarantees. They wanted it to look as though they were putting money in, but at the same time, wanted to be absolutely sure they were not risking anything. By 7.30 a.m., we had made little progress.
We were certain the situation would be totally out of control in a few hours. Continental would soon be exposing itself to a new business day, and the stock market would open at 10 o'clock. Isaac, another FDIC director, and I held a hallway conversation.
We agreed to go ahead without the banks. We told Conover, the third FDIC director, The plan, and he concurred. Later, we got word from Bernie McKeon, about our regional director in New York, that the bankers had agreed to be at risk.
Actually, the risk was remote, since our announcement had promised 100% insurance. The final bailout package was a whopper. Basically, the government took over Continental Illinois and assumed all of its losses.
Specifically, the FDIC took $4.5 billion. in bad loans and paid Continental $3.5 billion for them. The difference was then made up by the infusion of a billion dollars in fresh capital in the form of stock purchase. The bank, therefore, now had the federal government as a stockholder controlling 80% of its shares, and its bad loans had been dumped onto the taxpayer. In effect, even though Continental retained the appearance of a private institution, It had been nationalized.
Lender of last resort. Perhaps the most important part of the bailout, however, was that the money to make it possible was created, directly or indirectly, by the Federal Reserve System. If the bank had been allowed to fail, and the FDIC had been required to cover the losses, the drain would have emptied the entire fund.
with nothing left to cover the liabilities of thousands of other banks. In other words, this one failure alone, if it were allowed to happen, would have wiped out the entire FDIC. That's one reason the bank had to be kept operating, losses or no losses, and that's why the Fed had to be involved in the bailout. In fact, that was precisely the reason the system was created at Jekyll Island. to manufacture whatever amount of money might be necessary to cover the losses of the cartel.
The scam could never work unless the Fed was able to create money out of nothing and pump it into the banks along with credit and liquidity guarantees. Which means, if the loans go sour, the money is eventually extracted from the American people through the hidden tax called inflation. That is the meaning of the phrase lender of last resort.
FDIC director Irvin Sprague, while discussing the press release which announced the continental bailout package, describes the Fed's role this way, quote, The third paragraph granted 100% insurance to all depositors, including the uninsured, and all general creditors. The next paragraph set forth the conditions under which the Fed, as lender of last resort, would make its loans. The Fed would lend to Continental to meet any extraordinary liquidity requirements that would include another run.
All agreed that Continental could not be saved without 100% insurance by the FDIC and unlimited liquidity support by the Federal Reserve. No plan would work without these two elements, end quote. By 1984, quote, unlimited liquidity support, end quote.
had translated into the staggering sum of $8 billion. By early 1986, the figure had climbed to $9.24 billion and was still rising. While explaining this fleecing of the taxpayer to the Senate Banking Committee, Fed Chairman Paul Volcker said, The operation is the most basic function of the Federal Reserve. It was why it was founded. With those words, he has confirmed one of the more controversial assertions of this book.
Small banks be damned. It has been mentioned previously that the large banks receive a free ride on their FDIC coverage at the expense of the small banks. There could be no better example of this than the bailout of Continental Illinois.
In 1983, the bank paid a premium into the fund of only $6.5 million to protect its insured deposits of $3 billion. The actual liability, however... including its institutional and overseas deposits, was ten times that figure, and the FDIC guaranteed payment on the whole amount.
As Sprague admitted, quote, small banks pay proportionally far more for their insurance and have far less chance of a continental-style bailout, end quote. How true. Within the same week that the FDIC and the Fed were providing billions in payments, stock purchases, loans, and guarantees for Continental Illinois, it closed down the tiny Bledsoe County Bank of Pikeville, Tennessee, and the Planters Trust and Savings Bank of Opelousas, Louisiana. During the first half of that year, 43 smaller banks failed without an FDIC bailout.
In most cases, a merger was arranged with a larger bank, and only the uninsured deposits were at risk. The impact of this inequity upon the banking system is enormous. It sends a message to bankers and depositors alike that small banks, if they get into trouble, will be allowed to fold, whereas large banks are safe, regardless of how poorly or fraudulently they are managed.
As a New York investment analyst stated to news reporters, Continental Illinois, even though it had just failed, was, quote, obviously the safest bank in the country to have your money in, end quote. Nothing could be better calculated to drive the small, independent banks out of business or to force them to sell out to the giants. And that, in fact, is exactly what has been happening since 1984. Since 1984, while hundreds of small banks have been forced out of business, The average size of the banks, which remain with government protection, has more than doubled.
It'll be recalled that this advantage of the big banks over the smaller competitors was also one of the objectives of the Jekyll Island Plan to begin with. Perhaps the most interesting and depressing aspect of Continental Illinois bailout was the lack of public indignation over the principle of using taxes and inflation to protect the banking industry. The smaller banks have complained of the unfair advantage given to the larger banks, but not on the basis that the government should have let the giant fail. Their lament was that it should now protect them in the same paternalistic fashion.
Voters and politicians were silent on the issue, apparently awed by the sheer size of the numbers and the specter of economic chaos. Decades of public education had left their mark. After all, wasn't this exactly what the government schools have taught as the proper function of government?
Wasn't this the American way? Even Ronald Reagan praised the action. From aboard Air Force One on the way to California, the president said, It was the thing that we should do, and we did it. It was in the best interest of all concerned.
End quote. The Reagan endorsement brought into focus one of the most amazing phenomenon in the 20th century. The process by which America had moved to the left towards statism while marching behind the political banner of those who speak the language of opposing statism.
William Greider, a former writer for the liberal Washington Post and the Rolling Stone, complains, quote, the nationalization of Continental. was in fact a quintessential act of modern liberalism the state of intervening in behalf of private interests and a broad public purpose in this supposedly conservative era federal authorities were setting aside the harsh verdict of market competition and grossly expanding their own involvement in the private economy in the past conservative scholars and pundits have objected loudly at any federal intervention in the private economy, particularly emergency assistance for failing companies. Now, they hardly seem to notice.
Perhaps they would have been more vocal if the deed had been done by someone other than the conservative champion, Ronald Reagan."End quote. Four years after the bailout of Continental Illinois, the same play was used in the rescue of Bank of Oklahoma, which was a bank holding company. The FDIC pumped $130 million into its main banking unit and took warrants for 55% ownership. The pattern had been set. By accepting stock in a failing bank in return for bailing it out, the government had devised an ingenious way to nationalize banks without calling it that. Issuing stock sounds like a business transaction in the private sector, and the public didn't seem to notice the reality that Uncle Sam was going into banking. The second reason to abolish the Federal Reserve. A sober evaluation of this long and continuing record leads to the second reason for abolishing the Federal Reserve System. Far from being a protector of the public, it is a cartel. Operating against the public interest. End of chapter 3.