The Creature from Jekyll Island

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 Guaranty, 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 that 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 Perm Central’s stock. Chris Welles, in The Last Days of the Club, describes what happened:

On May 21, a month before the railroad went under, David Bevan, 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 an attempt to raise $100 million in desperately needed operating funds through a bond issue. Instead, said Bevan, the railroad would seek some kind of government 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 28, 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.

More to the point of this study is the fact that virtually all of the 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 inflated the market price of its stock long enough to dump it on the unsuspecting public. Thus, the banker-managers were able to engineer a three-way bonanza for themselves. They (1) received dividends on essentially worthless stock, (2) earned interest on the loans which provided the money to pay those dividends, and (3) were able to unload 1.8 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 $1 million.

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, bleed off its assets to other enterprises which they abo control, 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:

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.

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: Everything fell through. We couldn’t lend it to them ourselves under the law … I worked on this thing in other ways.

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 Perm Central and other corporations, such as Chrysler, which were in 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: I kept the Board in session practically all day to change regulation Q so that money could flow into CDs at the banks. Looking back at the event, Chris Welles approvingly describes it as what is by common consent the Fed’s finest hour.

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. Perm Central’s executives, bankers, and union representatives came in droves to explain how the railroad’s continued existence was in the best interest of the public, of the working man, of the economic system itself. The Navy Department spoke of protecting the nation’s defense resources. Congress, of course, could not callously ignore these pressing needs of the nation. It responded by ordering a retroactive, 13½ percent 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.

Lockheed

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 to the Goliath and they were not 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 sub contractors 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. Connally, which provided the credit. The government agreed to guarantee payment on an additional $250 million in loans — an amount which would put Lockheed 60% deeper into the debt hole than it had been before. But that made no difference now. Unce the taxpayer had been made a co-signer 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 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 proven. Furthermore, a slight increase in defenses 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 more cost efficient during these 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 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 poor. Not surprisingly, the city also was notorious for political corruption and bureaucratic fraud. Whereas the average large city employed thirty-one people per one-thousand residents, New York had forty nine. That’s an excess of fifty-eight percent. The salaries of these employees far outstripped those in private industry. While an X-ray technician in a private hospital earned $187 per week, a porter working for the city earned $203. The average bank teller earned $154 per week, but a change maker 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 educations, 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 take, the outflow continued to exceed the inflow. There were now only three options: increase 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 international financial crisis.

Congress, understandably, did not want to turn New York into a zone of anarchy, nor to disgrace America, nor to trigger a world-wide financial panic. So, in December of 1975, it passed a bill authorizing the Treasury to make direct loans to the city 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 game.

There were several restrictions attached to this loan, including an austerity program and a systematic repayment schedule. None of these conditions was honored. New York City has continued to be a welfare utopia, and it is unlikely that it will ever get out of debt.

Chrysler

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 unsaleable 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 shock waves 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 $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. It should be noted, however, that the value of the stock which was exchanged for previously uncol-lectable 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 one and-a-half billion dollars, 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, ihe 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 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 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, the 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 bailout, and this is the one which deserves our special attention. Irvine Sprague, a former director of the FDIC, explains: 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 large 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 cost. The board need only make the finding that the insured bank is in danger of failing and is essential to provide adequate banking service in its community … FDIC boards have been reluctant to make an essentiality finding unless they perceive a clear and present danger to the nation’s financial system.

Favoritism toward 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 un insured deposits are covered also, that coverage is free — more precisely, paid by someone else. What deposits are tminsured? 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 are bailed out. Their uninsured accounts are paid by FDIC, and the cost of that benefit is passed to the smaller banks and 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 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: If market discipline means anything, stockholders should be wiped out when a bank fails. Our assistance would nave the side effect … of keeping the stockholders alive at government expense. 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 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:

Neither Wille [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.

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 as slipshod and haphazard as ever, the agency rolled over the loan for another five years. Operations did not 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 $4,463,000 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 Common-Wealth 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 securities 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:

Chase officers … suggested that Commonwealth was a public interest problem that the government agencies 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.

The bankers argued that Commonwealth must not be allowed to fold because it provided essential banking services to the community. That was justified on two counts: (1) it served many minority neighborhoods and, (2) 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 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 & 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 twenty-third largest bank with assets in excess of $9 billion. It was six times the size of Commonwealth; nine hundred 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 bond market. As long as the economy expanded, these gambles were profitable, and the stockholders loved him dearly. When his gamble in the bond market turned sour, however, the bank plunged into a negative cash flow. By 1979, First Penn 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 taxpayer for the loss.

The bankers went to Washington and presented their case. Fhey 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 Penn 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 fall, 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:

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 Fed 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 lender of last resort first generated contention between the Fed and FDIC during this period. The Fed was lending heavily to First Pennsylvania, fully secured, and Fed Chairman Paul Volcker said he planned to 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. The theory had never been tested. said Sprague. I was not sure I wanted it to be just then. So, in due course, a bailout package was put together which featured a $325 million loan from FDIC, interest free for the first year and at a subsidized rate thereafter; about half the market rate. Several other banks which were financially tied to First Penn, 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 Dun’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 awhile, the bank’s common stock actually sold at a premium over others which were more prudently managed.

The gaudy fabric began to unravel during the Fourth of July weekend of 1982 with the failure of the Perm 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 that time, said: We had the Continental Illinois Reassurance Brigade and we fanned out all over the world. 1

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 feet that this intensified its cash crunch. As with the Perm Central Railroad twelve years earlier, that move was calculated to project an image of business-as-usual prosperity. And the ploy 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 11:39 a.m. On Tuesday, May 8, 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 totally preposterous. Within hours, another wire, the Commodity News Service, reported a second rumor: that a Japanese bank was interested in buying 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 twenty-four 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 — withdrew $50 million. 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 sixteen banks, lead by Morgan Guaranty, offered a generous thirty-day line of credit, but all of 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: The Continental run was like some rnodernistic fantasy: there were no throngs of hysterical depositors, just cool nightmare flashes on computer screens. Sprague writes: Inside the bank, all was calm, the teller lines moved as always, and bank officials recall no visible sign of trouble — except in the wire room. Here the employees knew what was happening as withdrawal order after order moved on the wire, bleeding Continental to death. Some cried.

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 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 four percent of its liability was covered by FDIC insurance, the regulators felt compelled to cover the entire exposure. Which means that the bank paid insurance premiums into the fund based on only four percent of its total coverage, and the taxpayers now would pick up the other ninety-six percent. FDIC director Sprague explains:

Although Continental Illinois had over $30 billion in deposits, 90 percent 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 a 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 — of the world itself — was at stake. And who could say that it was not so. Sprague argues the case in familiar terms:

An early morning meeting was scheduled for Tuesday, May 15, at the Fed … We talked over the alternatives. They were few — none really … [Treasury Secretary] Regan 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’s 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.

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 Regan 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 Guaranty, Chase Manhattan, Citibank, Bank of America, Chemical Bank, Bankers Trust, and Manufacturers 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 they pretended to mount a rescue. Sprague supplies the details:

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 ten 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, 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 percent 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 b y the infusion of $1 billion in fresh capital in the form of stock Purchase. The bank, therefore, now had the federal government as a stockholder controlling 80 percent 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 bail out 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’s the meaning of the phrase lender of last resort.

FDIC director Irvine Sprague, while discussing the press release which announced the Continental bail-out package, describes the Fed’s role this way:

The third paragraph … granted 100 percent 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 percent insurance by FDIC and unlimited liquidity support by the Federal Reserve. No plan would work without these two elements.

By 1984, unlimited liquidity support 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 bail out 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, Small banks pay proportionately far more for their insurance and have far less chance of a Continental-style bailout.

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, forty-three 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 obviously the safest bank in the country to have your money in. 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, 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 will be recalled that this advantage of the big banks over their smaller competitors was also one of the objectives of the Jekyll Island plan.

Perhaps the most interesting — and depressing — aspect of the Continental Illinois bailout was the lack of public indignation over the principle of using taxes and inflation to protect the banking industry. 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 fall. 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 government schools have taught is the proper function of government? Wasn’t this the American way? Even Ronald Reagan, viewed as the national champion of economic conservatism, praised the action. From aboard Air Force One on the way to California, the President said: It was a thing that we should do and we did it. It was in the best interest of all concerned.

The Reagan endorsement brought into focus one of the most amazing phenomena of the 20th century: the process by which America has moved to the Left toward 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:

The nationalization of Continental was, in fact, a quintessential act of modern liberalism — the state 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 had objected loudly at any federal intervention in the private economy, particularly emergency assistance for failing companies. Now, they hardly seemed to notice. Perhaps they would have been more vocal if the deed had been done by someone other than the conservative champion, Ronald Reagan.

Four years after the bailout of Continental Illinois, the same play was used in the rescue of BankOklahoma, 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.

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.

Summary

The game called bailout is not a whimsical figment of the imagination, it is for real. Here are some of the big games of the season and their final scores.

In 1970, Penn Central railroad became bankrupt. The banks which loaned the money had taken over its board of directors and had driven it further into the hole, all the while extending bigger and bigger loans to cover the losses. Directors concealed reality from the stockholders and made additional loans so the company could pay dividends to keep up the false front. During this time, the directors and their banks unloaded their stock at unrealistically high prices. When the truth became public, the stockholders were left holding the empty bag. The bailout, which was engineered by the Federal Reserve, involved government subsidies to other banks to grant additional loans. Then Congress was told that the collapse of Penn Central would be devastating to the public interest. Congress responded by granting $125 million in loan guarantees so that banks would not be at risk. The railroad eventually failed anyway, but the bank loans were covered. Penn Central was nationalized into AMTRAK and continues to operate at a loss.

In 1970, as Lockheed faced bankruptcy, Congress heard essentially the same story. Thousands would be unemployed, subcontractors would go out of business, and the public would suffer greatly. So Congress agreed to guarantee $250 million in new loans, which put Lockheed 60% deeper into debt than before. Now that government was guaranteeing the loans, it had to make sure Lockheed became profitable. This was accomplished by granting lucrative defense contracts at non-competitive bids. The banks were paid back.

In 1975, New York City had reached the end of its credit rope. It had borrowed heavily to maintain an extravagant bureaucracy and a miniature welfare state. Congress was told that the public would be jeopardized if city services were curtailed, and that America would be disgraced in the eyes of the world. So Congress authorized additional direct loans up to $2.3 billion, which more than doubled the size of the current debt. The banks continued to receive their interest.

In 1978, Chrysler was on the verge of bankruptcy. Congress was informed that the public would suffer greatly if the company folded, and that it would be a blow to the American way if freedom-of-choice were reduced from three to two makes of automobiles. So Congress guaranteed up to $1.5 billion in new loans. The banks reduced part of their loans and exchanged another portion for preferred stock. News of the deal pushed up the market value of that stock and largely offset the loan write-off. The banks’ previously uncollectable debt was converted into a government-backed, interest-bearing asset.

In 1972, the Commonwealth Bank of Detroit — with $1.5 billion in assets, became insolvent. It had borrowed heavily from the Chase Manhattan Bank in New York to invest in high-risk and potentially high-profit ventures. Now that it was in trouble, so was Chase. The bankers went to Washington and told the FDIC the public must be protected from the great financial hardship that would follow if Commonwealth were allowed to close. So the FDIC pumped in a $60 million loan plus federal guarantees of repayment. Commonwealth was sold to an Arab consortium. Chase took a minor write down but converted most of its potential loss into government-backed assets.

In 1979, the First Pennsylvania Bank of Philadelphia became insolvent. With assets in excess of $9 billion, it was nine-times the size of Commonwealth. It, too, had been an aggressive player in the ‘80s. Now the bankers and the Federal Reserve told the FDIC that the public must be protected from the calamity of a bank failure of this size, that the national economy was at stake, perhaps even the entire world. So the FDIC gave a $325 million loan — interest-free for the first year, and at half the market rate thereafter. The Federal Reserve offered money to other banks at a subsidized rate for the specific purpose of relending to First Penn. With that enticement, they advanced $175 million in immediate loans plus a $1 billion line of credit.

In 1982, Chicago’s Continental Illinois became insolvent. It was the nation’s seventh largest bank with $42 billion in assets. The previous year, its profits had soared as a result of loans to high-risk business ventures and foreign governments. Although it had been the darling of market analysts, it quickly unraveled when its cash flow turned negative, and overseas banks began to withdraw deposits. It was the world’s first electronic bank run. Federal Reserve Chairman Volcker told the FDIC that it would be unthinkable to allow the world economy to be ruined by a bank failure of this magnitude. So, the FDIC assumed $4.5 billion in bad loans and, in return for the bailout, took 80% ownership of the bank in the form of stock. In effect, the bank was nationalized, but no one called it that. The United States government was now in the banking business.

All of the money to accomplish these bailouts was made possible by the Federal Reserve System acting as the lender of last resort. That was one of the purposes for which it had been created. We must not forget that the phrase lender of last resort means that the money is created out of nothing, resulting in the confiscation of our nation’s wealth through the hidden tax called inflation.