San José State University Department of Economics applet-magic.com Thayer Watkins Silicon Valley & Tornado Alley USA Penn Square Bank of Oklahoma City, Oklahoma Background of the Penn Square Bank Penn Square Bank was the bank in Penn Square shopping center in Oklahoma City, Oklahoma. The story of Penn Square Bank Mark is told in Mark Singer's book,funny Money. Penn Square Bank was a small, neighborhood bank until control of it was acquired by William "Beep" Jennings in 1972. Jennings proceeded to promote a more agressive style of operations. For example, he created a special department to make loans to the oil-and-gas industry in Oklahoma. The OPEC oil price increases which started in 1973 had made energy exploration a much more lucrative venture than it 1 of 5 9/3/08 3:50 PM
had been before. But there was an adverse selection problem in the energy exploration field. As a bankruptcy lawyer acquaintance of Mark Singer, the author of Funny Money, expressed it, "You've got thirteen thousand oil and gas companies in Oklahoma; maybe fifteen hundred are looking for oil and gas, the rest are looking for investors." (p.12) Development of the Problem At the start Penn Square had capital of four million dollars. Under the rules for national banks, of which Penn Square was one, the largest loan that Penn Square could make to a single customer was ten percent of its capital; i.e., $400,000. This meant that if a borrower wanted a million dollars, Penn Square would have to find another bank to provide the other $600,000. Very soon Penn Square was making loans in excess of its limits and quickly selling the "overline" to other banks. There were some banks, notably Continental Illinois and Seattle First National, that were eager to buy such "overlines." It was a way that they could participate in the higher interest rates on oil-and-gas lending in Oklahoma without having banking operations in Oklahoma. Buying loans made by Penn Square not only gave such banks a way around the restrictions on interstate banking but they were counting on banks like Penn Square to have expertise about local conditions that it would be impossible for them to acquire. The Problem in Full Bloom Penn Square began to market most of their loans to "upstream" banks like Continental Illinois and Chase Manhattan. These large U.S. banks were presuming Penn Square was doing all of its homework and only making good loans. Penn Square was focusing more on the one percent fees it earned for making the loans and on the service fees it received for servicing the loans for the upstream banks which purchased the loans. Servicing meant collecting the interest and principal payments and forwarding them to the loan buyer. This situation of Penn Square receiving fees for writing the loan but not shouldering the risk associated with the loan was dangerous. Penn Square had an incentive to ignore negative factors in 2 of 5 9/3/08 3:50 PM
the loan applications and soon many of the loans were made with incomplete documentation. Jennings developed the notion of character banking; i.e., lending on the basis of his perception of the character of the borrower rather than the financial fundamentals of the loan project. Jennings often made verbal committments to the borrower without formal applications being completed. The paperwork was to be handled later. But this made it difficult for Penn Square's loan officers to do a proper job on the paperwork for the loan. If the committment on a loan had already been made and the funds withdrawn, how could the loan officer include negative aspects in the paperwork. To do so would have created an embarassing situation in a bank audit or jeopardized the sale of the loan in the secondary market. The practice of Penn Square servicing these loans for upstream purchasers also created a financial hazard. Penn Square was selling hundreds of millions of dollars of loans. When some borrower was not meeting payments on a loan Penn Square had an incentive to make the payments itself rather than allow the loan to be revealed as bad and cause the upstream banks to hesitate to buy more. Later Penn Square could make a new loan to the insolvent borrower and then sell that to some upstream bank. To the upstream banks all their loans purchased from Penn Square appeared to be performing well. Jennings hired loan officers who would make loans as easily as he did. This meant not only aggressively soliciting business but streamlining the application process. The head of the oil-and-gas department was Bill Patterson. Patterson was a jolly guy who his fraternity brothers called "Monkeybrains." He married into a wealthy Texas family which owned banks. Patterson was given a job at one of the family banks but was allowed only to do menial things. An officer at this bank said that there was no way that Patterson would ever be trusted to loan out a dime of the bank's funds. Patterson left and obtained a position at Penn Square Bank. Jennings perceived him as a hard working employee who would not question Jennings' easily lending policy. Not only did Patterson accept Jennings lending policy he managed to put it into overdrive. One lender told of being in Patterson's office to negotiate a four hundred thousand dollar loan. While these negotiations were being carried out Patterson was carrying on negotiations with two other customers on two telephones. With this loose control of lending one can easily imagine how the 3 of 5 9/3/08 3:50 PM
quality of the loans made by Penn Square reached record depths. Not only was there the problem of the riskiness of the ventures and the inadequacy of the creditworthiness of the borrowers, but there was a major moral hazard problem. The borrowers often spent the funds for airplanes and cars instead of oil drilling equipment and so forth. Many of the borrowers recognized that they had "debtor leverage." If a borrower owed ten thousand dollars a bank was likely to take legal action to collect, but if the debt was ten million dollars the creditor often had as much, if not more, to lose by forcing the debtor into bankruptcy. The debtor could use that leverage to extract another loan from the creditor. When bank regulatory authorities became critical of Penn Square's dubious loans, Patterson and others could retort that Continental Illinois, one of the biggest lenders in the U.S., was willing to buy them so they couldn't be that bad. Even borrowers were finding vindication in this easy money world. "If my banker is willing to lend me millions to carry out this project then maybe it is not such a wild venture after all." Some of the borrowers used the funds to make political campaign contributions and gained political influence. J.D. Allen, a heavy borrower from Penn Square was made a co-chairman of the finance committee of the Republican National Committee. After the collapse of Penn Square J.D. Allen filed for bankruptcy with $317 million in debts. Another major customer of Penn Square Bank was Robert Hefner III. Forbes magazine listed him as one of the richest individuals in America with assets of around $150 million. Actually his net worth was negative. The End of Penn Square Bank and the Banks that Bought its Loans When Penn Square Bank collapsed several upstream banks had losses each in the hundreds of millions of dollars. Seattle First National Bank was merged with Bank of America to prevent failure. 4 of 5 9/3/08 3:50 PM
Continental Illinois was saved only by a $5 billion bailout by the Federal Reserve System. Source: Mark Singer, Funny Money HOME PAGE OF applet-magic HOME PAGE OF Thayer Watkins 5 of 5 9/3/08 3:50 PM