Energy Loans and the Failure of Penn Square

The oil crises of the 1970s were events that reordered the global economy. Energy consuming economies, like those of the European countries after Les Trente Glorieuses (the ‘Thirty Glorious Years’), saw their strong growth suddenly grind to a halt. At the same time, energy producing regions received a windfall. The U.S. economy was a microcosm of the world at this time. Many industries and regions stagnated while others thrived. An Oklahoma bank, Penn Square Bank, was firmly in the latter sort of area. Yet the oil shortages ebbed and when they did, the consequences led to the failure of not only Penn Square but, eventually, a far larger bank investing in Penn Square’s energy loans.

Penn Square Bank

Penn Square Bank was a small Oklahoma bank, formed in 1960. One of its founders was U.S. Senator from Oklahoma and former Governor of the state, Robert S. Kerr. Yet, it was not illustrious in all respects. Years after it was founded, the bank still only possessed one branch, located in a shopping center in Oklahoma City. Still, this was simply a reflection of the fractured nature of banking in that part of the country. Prior to 1983, banks in Oklahoma were restricted by state law to operating from a single branch, so all of the state’s banks were small by legal requirement. Oklahoma, then home to about three million people, had hundreds of small independent banks.

In the most relevant years of the Penn Square story, the bank’s chairman was William Paul Jennings, who had also co-founded the bank before leaving and returning to it in the mid-1970s. He was the son of a local banker. Yet, Jennings could have been a controversial figure. He had previously been associated with a financial scandal wherein shares in a company called Four Seasons Nursing Centers were sold aggressively, including through placements to customers that had no intention of buying them. The trouble encountered by Penn Square Bank was of an entirely different sort though.

Energy Loans

The setting of the Penn Square fiasco was the energy producing regions of the United States during the oil crises of the 1970s. Oklahoma’s energy industry was booming then; oil employment in the state tripled from around 34,000 in the early-1970s to 102,000 in 1981. In this period, Penn Square dove into oil and gas lending starting from around 1978. As it happens, despite the bank’s location in the region, Penn Square had not previously engaged in this business; it only had one oil and gas loan in its $40 million portfolio before this point.

Yet, a recent hire, William George Patterson, was given management of the new energy lending business of the bank, free from managerial control by the bank’s other loan officers. The rush into oil and gas loans was marked. Many new loans to borrowers in the industry exceeded the size limit set out for the bank’s loans and oil and gas assets came to represent 80% of Penn Square’s lending activity. By 1980, Penn Square’s growth had prompted a special bank examination which noted the bank’s high exposure to energy assets.

The appeal of the energy industry was clear. The oil crises of the 1970s made loans to businesses in the sector attractive. Many looked for oil and gas investments in the Unites States and, in the Anadarko Basin centered on Oklahoma, there was plenty of natural gas, but it was trapped deep underground. In the southern end of basin, the sedimentary layers where the gas could be found got as deep as 40,000 feet. In the past, the depth of these deposits and the regulated price of natural gas discouraged development. These conditions changed when the Natural Gas Policy Act, enacted in 1978, deregulated prices for natural gas extracted from depths below 15,000 feet, starting from late-1979.

The Iranian Revolution led to the second oil crisis of the 1970s and bank interest in oil and gas loans was ignited. However, energy reserves, especially those that are not yet developed and producing, are difficult to value. Oilmen requesting loans generally possess more specialized knowledge of their niche industry than their lenders do; they can make more sense of geologists’ reports, for example. Nonetheless, the business is simply subject to heightened uncertainty generally.

Loan Participations

Penn Square grew rapidly in this period. Its assets grew to $91 million by year-end 1978 and $141 million a year later. These assets were funded with deposits offering high rates. Penn Square sourced these deposits through deposit brokers who placed other banks’ and credit unions’ deposits at institutions offering the highest rates. Still, Penn Square had access to loan opportunities that were too big for them to fund by themselves.

To continue growing, Penn Square sold participation interests, offering a form of pass-through exposure to these loans, to other banks. This gave partnering banks exposure to energy company loans originated by Penn Square at a time when the former had considerable demand for loans to oil and gas businesses while energy prices were high. For banks in other parts of the country, energy loans offered an opportunity to diversify their loan portfolios. In a fragmented banking environment when most banks were strong only in a local environment where commercial clients could be concentrated in particular industries, this diversification was sought after. Further, in the depressed business environment of the 1970s, banks noticed lower demand for borrowing by their local existing clients, so they looked to banks elsewhere, like Penn Square, to deploy surplus funds.

Penn Square sold $2.5 billion in these loan participations. Continental Illinois National Bank of Chicago, the largest buyer, bought over $1 billion of them. First National Bank of Seattle bought $400 million and Chase Manhattan Bank bought $275 million. Michigan National Bank and the Northern Trust Company of Chicago also bought more than $100 million each. These allowed Penn Square to earn fee revenue to supplement net interest income from the loans it funded and held itself.

For the participant-banks, these arrangements allowed them to obtain access to energy loans with little effort expended in drumming up business themselves. Unfortunately, participants generally conducted little review of the loans they were buying and some loans were poorly documented. Penn Square was also offering loans on more aggressive terms to win business from other lenders, something it was successful in doing, bringing Penn Square and its practices to the attention of other Oklahoma banks.

Failure

Before too many years with such high oil prices, energy production rose, demand was sliding, and the merit of oil and gas investments was weakening. Drilling rigs were paused meaning that wells which existed in plans never came into production. So, loans backed by reserves went bad and could not be collected on. For a while, Penn Square and its participants rolled over interest into new loans but borrowers remained delinquent for substantial periods of time thereafter; a quick recovery never came and, in fact, conditions would become only more challenging.

Penn Square’s losses were already mounting but a further $28.5 million loss was recognized after September 1981. This was a large fraction of the bank’s own assets but does not include the much larger losses borne by its partners, the banks which bought participations from Penn Square. Loan losses, which grew sharply in 1981, had to be reported to the FDIC and became public information that way. However, seeking not to draw too much attention to them, Penn Square did not include such figures in its own annual report.

Regulators ordered Penn Square to curtail its growth in mid-1980. The bank reached an agreement with regulators to, among other things, better supervise its oil and gas division which had operated outside the usual reporting structure for underwriters. By early 1982, the bank had failed to make sufficient progress, at least in the eyes of the local administrator of the Office of the Comptroller of the Currency, in nine of ten areas of the agreement. In fact, Penn Square only kept growing; its assets grew to $288 million by year-end 1980 and $394 million by year-end 1981.

Negative coverage of the bank made an appearance with an April 26, 1982 American Banker story written by Phillip L. Zweig. Pressure from analysts and bank examiners was being applied not only on Penn Square but also on the banks that had bought its loan participations. Large depositors began withdrawing money by late June. It was a rapid failure from this point. The bank was deteriorating quickly and garnered little interest from acquirers. So, Penn Square was declared insolvent on July 5, 1982 and it was closed by regulators that same day.

Penn Square had deposits of $470 million at the time, making it the fourth largest American bank failure after the creation of the Federal Deposit Insurance Corporation. The FDIC only protected the first $100,000 in deposits for each Penn Square depositor. The rest, $250 million in uninsured deposits between all the large depositors, would be represented by pending unresolved claims against the bank. It was the first time the FDIC had not rescued an institution outright or protected all deposits. Many of these depositors were other banks and credit unions and the uninsured deposits of credit unions alone came to $111 million.

In 1982, Chase Manhattan charged off $75 million in loan participations from Penn Square. First National Bank of Seattle recognized losses on its participations too and this led to its merger with Bank of America. Perhaps the most substantial consequence was a bank run which commenced against Continental Illinois, which would later fail itself, becoming the largest bank failure in the U.S. until 2008.

Lesson

There was remarkable interest in this small Oklahoma bank after it collapsed. This is not because of its own size. Penn Square, even after years of tremendous growth, was still an approximately $500 million bank, small even for the time. Continental Illinois, by contrast, was a bank with $40 billion in assets. Yet, the former led to the failure of the latter. Penn Square assumed such importance because it had been the channel through which banks obtained exposure to the energy industry at a time when that became an attractive, perhaps too attractive, market in which to make loans.

More from the Tontine Coffee-House

Read about the development of energy resources in what is now Azerbaijan during the 1870-80s, the funding of hydraulic fracturing projects in the United States, and the economic effects of Norway’s development of North Sea Oil resources. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.