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I made the mistake of finding Charlie Sheen’s Twitter account tonight. All the references to WINNING reminded me of Don Henley’s “Garden of Allah.”

“No shame, no solution, no remorse, no retribution. Just people selling t-shirts. Just opportunity to participate in the pathetic little circus! And winning…winning…winning…”

From the same Introduction to Business textbook from 1982 that I talked about in a previous post (about the future of banking at home) comes a case study/discussion module about two banks that nearly collapsed. More interesting reading from a 2010 perspective.

I am reprinting the entire case study and letting it speak for itself. Remember that this is from the early 1980s and reflects the economy and banking as it was at that time. Although I say that, I think you’ll find, as I did, that as much as things have changed…they haven’t.

Since I decimated the rest of the text book and sent it off to recycling, I apologize as I do not have an author for the text book or source information for this this discussion prompt.

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Two Banks That Nearly Collapsed.

People born and raised after the Great Depression tend to think of banks as formidably strong, permanent institutions. The truth is there have hardly been any big bank collapses in the past half-century. But you may be surprised at how close several banks have come, and how recently.

For these banks, the incredible volatility of interest rates and the economy in recent years was nearly fatal: First Pennsylvania Bank, the nation’s oldest, and First Chicago Corp., one of the ten biggest U.S. banks. What’s even more interesting than how the two banks got into such hot water is what the federal banking agencies did to save them – and why they considered it urgent to do so.

The problem at First Pennsylvania was partly a case of an error in judgment by management, compounded by circumstance. The bank had been in trouble for investing its funds in ways that federal regulators thought too risky, so the bank’s management decided to switch to a sure bet: government securities. But the bank’s guess on which direction interest rates would go turned out to be wrong. Betting that interest rates were going to tumble, First Pennsylvania borrowed lots of short-term funds to buy millions in long –term government bonds that were paying what seemed to be a high interest rate. But then interest rates started soaring, and the bank had to pay ever-higher rates for its short-term money, while the return it got on the bonds was paltry in comparison. The squeeze got so tight that First Pennsylvania couldn’t borrow any more short-term money, and some big lenders and depositors began fleeing from the bank.

First Pennsylvania was finally forced to turn to the Fed, the lender of last resort, to borrow more than $700 million. Even then, it wasn’t immediately rescued and had to go to the FDIC, the only federal agency allowed to make long-term loans to banks. But the FDIC considered the case pretty hopeless and agreed to lend the bank money only if some other large U.S. banks would kick in money at their own risk. Eventually, a group of twenty-seven banks went in with the FDCI and bailed out First Pennsylvania.

The trouble at First Chicago illustrates how banks have been hurt by investment alternatives such as money-market funds in a time of volatile interest rates. A new chairman, A. Robert Abboud, came to run the bank in 1976, when it was already in trouble for lending too much money to risky real-estate investment trusts. Many of these REITs collapsed during the 1975-76 recession, and the bank couldn’t recover a sizeable amount of the money it had lent out. To turn First Chicago around, Abboud switched to a very conservative lending program, and the strategy began to work. But trouble came again in the late 1970s, when interest rates jumped and savers pulled massive amounts of money out of the banks to get higher rates from money-market funds. The bank then had to borrow more money, partly to compensate for the leakage in deposits, at a time when short-term interest rates were rising fast.

Federal banking authorities could legally have declared First Chicago bankrupt, but they didn’t, and the bank continues to work out its problems. Why didn’t the government allow First Chicago to go bankrupt? Because, as Abboud explained, “we were too big. If the news had been let out, it would have busted the financial system.” Banks don’t fail just because they have losses. They can keep adding more debt, rolling over loans and servicing customers – but only as  long as their depositors still have enough confidence to keep their money in the bank and as long as the bank’s lenders have enough confidence to keep extending more credit.

These two episodes illustrate how much the U.S. banking agencies and the banks themselves need our faith and trust. If we began to fear the collapse of a major bank and withdrew our money in a rush, that bank could actually fail. And then we might begin to doubt all banks. The entire banking system would take a severe beating and could even begin to unravel.

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A bank bailed out by the government. Another bank “too big to fail.” Oh indeed, how history repeats itself.

The discussion questions were interesting as well. Originally asked in 1982, consider your answers now in 2010.

1. Why is it important for the bank regulatory agencies to prop up a failing bank? Do you think there are circumstances under which they shouldn’t do so?
2. Does the story of the rescue of First Pennsylvania and First Chicago give you more confidence in the U.S. banking system, or less? Why?

If there is any writer whose career I greatly admire, it’s this guy. He created all those great television shows (The Rockford Files, The Greatest American Hero, The A-Team, Hardcastle & McCormick, among others) and then wrote novels later in his career which read like his TV shows. I love his books (and his shows!).
 
I tip my pen to you, sir. You will be greatly missed.
 

…but despite that, I’m attempting to get back into something of a regular blogging mode.