Volcker (38 page)

Volcker was only partly right. International investors caused a disturbance in May 1984, but not because of irresponsible Federal Reserve policies. Nevertheless, the crisis would reverberate into the twenty-first century.

On Wednesday, May 9, 1984, at eleven o'clock in the morning, local time, the Japanese news agency Jiji released a story saying, “A bank source in New York disclosed that one of three Japanese financial institutions … is negotiating for the acquisition of … Continental Illinois Bank.”
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The rumor might have started a bidding war if Continental, with $40 billion in assets, had been a healthy bank worthy of a takeover battle. Instead, it conveyed the message that the seventh-largest bank in the United States, with too many nonperforming loans on its books, needed a cash infusion.
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Although it was ten o'clock at night on May 8, in Chicago, and Continental's Greek-columned home on LaSalle Street was shut for the night, the story triggered a run on the bank typical of nineteenth-century America. Federal deposit insurance, introduced in 1934 to short-circuit banking panics, was limited to $100,000 per account, and covered less than $3 billion of the total $30 billion in deposits at Continental.
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Electronic communications permitted bank withdrawals at the speed of a computer keystroke even in 1984, making Continental Illinois the poster child for a modern banking panic.

Japanese money market traders, who normally lent funds to Continental by purchasing its short-term liabilities, started selling rather than buying soon after the news release on the morning of May 9. Investors in Europe followed suit when trading began there a few hours later. The Chicago institution was known as a “hot money bank,” according to Donald Wallace, a vice president in the bond department at the investment bank Goldman Sachs.
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More than 40 percent of its liabilities,
$16 billion, arrived from overseas, and $8 billion had to be renewed every day.
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Wallace turned philosophical in describing Continental's problem: “Banking is all about rolling over funds, and once this money stopped being rolled over it was
gonzoed
—gone.”
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No bank can survive a run on its own. Bankers owe money payable on demand or on very short notice but extend loans to businesses over longer time horizons. Bank loans cannot be liquidated (sold quickly) without incurring substantial loss, and any attempt to call loans to repay all depositors at once ends in failure. The core function of a central bank is to serve as a bank for banks, to provide funds when no one else will, to spread a safety net beneath the banking system. Commercial banks in the United States turn to the Federal Reserve as the lender of last resort, tendering securities as collateral at the discount window (now done electronically, like everything else), in exchange for cash reserves.

The Federal Reserve Bank of Chicago, one of the twelve regional branches of the system, threw a lifeline to Continental by lending it $3.6 billion on Friday, May 11, 1984.
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Continental's borrowing that day was nearly four times larger than the average indebtedness to the Fed of all 5,800 member banks during the previous eighteen months.
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Borrowing reserves at the Fed telegraphs a bank's weakness, but no one outside the system knew the extent of Continental's indebtedness. Nevertheless, the run gathered steam after the Chicago Board of Trade, Continental's longtime customer and neighbor on LaSalle Street, withdrew $50 million from the bank, including funds held for its commodities traders.
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Volcker thought that the signal to abandon ship from sophisticated customers at Continental could sink the seventh-largest bank in the United States. No depositor wants to stand last in line, especially those with more than $100,000 in their accounts. And he worried that the damage could swamp other banking giants with weak balance sheets that relied on foreign funds to remain afloat. He told the FOMC, “Continental is probably manageable with difficulty … Having two or three $40 billion institutions [in trouble] is a horse of a different color.”
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Volcker needed a plan to raise capital for Continental to bolster public confidence—but he could not do that alone. The structure of bank supervision in the United States resembles a Byzantine mosaic,
with responsibilities splintered among a variety of independent federal agencies and fifty different state banking authorities. Volcker turned to two men with little exposure outside the world of commercial banking, even though they were both presidential appointees. The outcome of their discussions confirmed the emerging doctrine of Too Big to Fail, and firmly implanted moral hazard into the DNA of American finance.
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Volcker would object, but not strongly enough.

Todd Conover, William Isaac, and Paul Volcker crafted a plan to rescue Continental Illinois. Conover was the comptroller of the currency, appointed by Ronald Reagan to head the Office of the Comptroller, an independent agency within the U.S. Treasury that dates back to the Civil War.
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The comptroller supervises and regulates nationally chartered banks such as Continental Illinois. Isaac was chairman of the Federal Deposit Insurance Corporation, appointed to the three-person board by Jimmy Carter in 1978 and becoming chairman after Reagan was elected in 1981. The FDIC, established as an independent government agency during the Great Depression, insures deposit accounts in virtually every bank in the country, including Continental.
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On Tuesday, May 15, 1984, these three men gathered at ten o'clock in the morning in Volcker's office at the Federal Reserve Board.
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Isaac later summed up the case for a rescue. “The system could not withstand the failure of Continental. Virtually every money center bank in the country was loaded up with loans to less-developed countries and had a lot of other problems. Bank of America, First Chicago, Manufacturers Hanover, Chemical Bank, and Chase Manhattan were among the [most vulnerable] … Moreover some 2,500 small correspondent banks had billions on deposit … If we allowed Continental to go down, a number of those banks would fail.”
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Volcker added an additional concern: “A default by a top-ten bank would have hurt us abroad. And we needed the inflow of international capital.”
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Conover assured his colleagues, based on the most recent examination reports, that Continental was solvent, with assets worth more than liabilities.
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Isaac proposed that the FDIC invest $2 billion in the form of a subordinated loan to shore up Continental's capital, thus signaling to depositors and other creditors that the bank would survive.
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And Volcker agreed that the Fed would continue to lend money, on a secured
basis, to replace lost deposits until the situation stabilized. No one knew how long that would take.

Volcker turned to his Rolodex, as he had during the Mexican crisis, and asked Lewis Preston, chairman of Morgan Guaranty Trust Company, which later merged into JPMorgan Chase, to assemble the country's leading financiers for a meeting with the three regulators the following morning at nine o'clock. The capital infusion would carry more weight with private banker participation.
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Volcker knew that secrecy was crucial. He hoped the discussions at Morgan would end before graduation exercises at Columbia University, scheduled for Wednesday, May 16, in the afternoon, at which he was to receive an honorary degree.
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Failure to show at that event would fan the rumors circling Continental and turn deposit outflows into a raging flood. He had agreed to keep a low profile when arriving at Morgan Guaranty's branch office on Fifth Avenue by entering the building through the armored car loading dock. “The plan brought back memories of my undercover efforts in Tokyo and Bonn in 1973. I hoped it would be more successful.”
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It was.

On the morning of May 16, Volcker slipped in undetected, joining Connor and Isaac in a Morgan boardroom.
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He noticed the Morgan humidor on a sideboard and vowed to stay away—Lewis Preston's cigars were too rich for his taste. Also present were senior officers of the top seven banks in the United States, including Thomas Lebrecque, president of Chase Manhattan; John McGillicuddy, chairman of Manufacturers Hanover; and Thomas Theobald, vice-chairman of Citibank.

After opening remarks by Preston to welcome the group, Volcker, seated on one side of the highly polished long table, urged the bankers “to act quickly and decisively to demonstrate to the world at large that we had the ability to cope with a major problem.”
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Isaac then said that the FDIC planned to invest $2 billion in Continental but suggested that the capital infusion would carry more weight if the banks picked up $500 million of it, reducing the FDIC's investment accordingly.
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Isaac's proposal drew mixed reviews. McGillicuddy of Manufacturers Hanover praised the FDIC's initiative, but Theobald of Citibank said, “Why would I want to help a competitor?”
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Citibank advocated free enterprise, especially when it applied to others. The remaining bankers at the table expressed a more practical concern: Would a capital infusion
be sufficient to save Continental? The bankers left the meeting without reaching a consensus.

Isaac then told Volcker that “the FDIC wanted to issue a statement that no creditor … would suffer a loss at Continental.”
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Volcker was not pleased. “That would set a bad precedent. It means depositors no longer have to monitor their bank's risk exposure. Frankly, I think that between your capital infusion and our loans at the discount window we should be able to stabilize Continental.”
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“That's easy for you to say,” Isaac responded. “All your exposure is collateralized, but we're on the hook for two billion dollars if Continental is forced into bankruptcy. I can't afford to let that happen.”
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Volcker knew Isaac was right on both counts. While the Federal Reserve's lending at the discount window was fully collateralized by loans on Continental's books, the FDIC's $2 billion investment was subordinated to other claims. Still, Volcker worried about the problem of moral hazard and thought they should withhold the blanket guarantee to preserve some ambiguity in the safety net. He had always liked the notion that borrowing at the discount window was a privilege and not a right for precisely the same reason: Bankers behave more responsibly if they worry.

“Well, I've got to go and get that damn honorary degree or people will start thinking that we've really got a problem,” Volcker said. “Just try to keep the wording of any release as vague as possible.”
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He left by the loading dock, of course, went uptown to the Columbia campus for his degree, and returned at the end of the day, greeted by the following draft announcement:

In view of all the circumstances surrounding Continental Illinois Bank, the FDIC provides assurance that, in any arrangements that may be necessary to achieve a permanent solution, all depositors and other general creditors of the bank will be fully protected and service to the bank's customers will not be interrupted.
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He liked it even less in print.

Volcker lost the argument to temper the doctrine of Too Big to Fail.
Perhaps he did not try hard enough. And he squandered the moral high ground two months later by supporting the FDIC's plan to pay the creditors of the bank holding company, rather than limiting the rescue to the bank itself, over objections from the U.S. Treasury.
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According to Volcker, “The holding company was mostly a shell, so it had little practical consequence.”
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More important, the FDIC's guarantee of all deposits at the bank had made immediate headlines: “U.S. Throws Full Support Behind Continental Illinois in Unprecedented Bailout to Prevent Banking Crisis.”
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And that was the policy decision establishing the broad safety net. Volcker reaped immediate collateral benefits.

The rescue plan for Continental announced on Thursday, May 17, 1984, stopped the run before it snowballed into a panic. At the FOMC meeting five days later, Volcker protégé Jerry Corrigan persuaded the committee to omit the crisis-qualifier “while taking account of [unusual] financial strains” from their final policy directive. Corrigan said that inserting that phrase “would perhaps elevate even further the concerns … that the basic course of monetary policy is going to be undone by these developments.”
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The Record of Policy Actions for the May 22, 1984, FOMC meeting, released with the usual delay, omitted any reference to Continental Illinois.
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The Fed was free to pursue its anti-inflationary policies.
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Fifteen months later, on August 6, 1985, Volcker treated himself to an extra helping of dessert, two slices of Boston cream pie, to mark his sixth anniversary as chairman of the Federal Reserve Board. He could afford it. Inflation had declined to 3.4 percent during the previous twelve months, compared with more than 12 percent during his first year on the job.
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No one had expected that kind of progress. Keynesians such as Samuelson said it was impossible, monetarists such as Friedman said the Fed was doing it all wrong, and the politicians complained about high interest rates.

Volcker had suppressed inflation even as the economy expanded from the recession of 1982. It was now almost three years into the economic upturn, unemployment had declined to its lowest level in more than five years, and inflation remained subdued.
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The price of gold, a
carbon monoxide detector for inflationary expectations, had actually declined since 1982.
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Volcker had avoided the Federal Reserve's nemesis of the past, remaining too easy for too long, and he felt justified in having persuaded Barbara two years earlier to accept his reappointment as chairman.
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