"A Crisis off Confidence"

By John Greenwald

Rumors and rising interest rates send jitters through the banking world

In Chicago, the harried Continental Illinois Bank had to dip deep into the largest rescue fund ever arranged for a U.S. lender. In Washington, D.C., World Bank officials warned that the latest jump in American interest rates will add $1.25 billion a year to the Third World's already crushing debt. In Paris, European moneymen lashed out at rising U.S. borrowing costs. On both sides of the Atlantic last week, such concerns were sending shock waves through the money world. Said Bank Analyst Stephen Berman of L.F. Rothschild, Unterberg, Towbin: "The U.S. banking system is suffering from a crisis of confidence."

The most visible trouble spot was Continental Illinois, the seventh-largest U.S. bank. Aggressive lending to energy firms and other ailing borrowers has filled its books with $2.3 billion in sour loans. After rumors that the bank was about to fail led to a run on the Chicago lender, Morgan Guaranty and 15 other big banks last week rushed to Continental's rescue with a $4.5 billion line of credit, the largest ever for an American bank. Its goal: to help avert what threatened to become the biggest collapse in U.S. banking history.

But even that effort proved too small to keep panicky corporate customers in the U.S., Europe and Japan from withdrawing $8 billion a day in deposits. By week's end the Federal Deposit Insurance Corporation and private lenders had to pump $2 billion directly into Continental. Though it normally does not insure amounts of more than $100,000, the FDIC went so far as to pledge that all the bank's depositors and creditors would be "fully protected." In addition, the Federal Reserve Board, which had also been supplying credit to Continental, promised to continue doing so until the bank's problems have been solved. And the Morgan Guaranty-led bankers, strengthened by the addition of twelve members to their group, put up $1 billion of fresh credit. Said a Continental officer: "If this can't restore confidence, I don't know what can."

Preparations for the federal bailout, the swiftest and most complete on record, began shortly after rumors started circulating about Continental on May 10. Details were hashed out in meetings and phone calls between Federal Reserve Chairman Paul Volcker, FDIC Chairman William Isaac and Comptroller of the Currency C. Todd Conover. "This is a very historic thing," said one New York banker. "This is the first time the Fed has been party to any kind of statement that 'nobody is going to lose.' "

Nonetheless, Continental Chairman David Taylor suggested last week that still more moves may be forthcoming. Conceding that "we've had some rather serious earnings problems," Taylor said the institution may have to merge with another lender and has retained the Wall Street firm Goldman, Sachs to help it find a buyer. "The candidates open to us are numbered among the top 50 banks in the world," he added. For now, Taylor gave investors the disappointing if not wholly unexpected news that Continental plans to save $20 million by omitting its next quarterly common-stock dividend.

The talk of a merger immediately sparked speculation about possible buyers. Analysts say they range from First Chicago, Continental's neighbor, to foreign banks whose operations would complement rather than compete with Continental's business. Examples: Barclay's of England and West Germany's Deutsche Bank. Taylor ruled out a sale to any firm outside banking.

Continental insisted all week that its soundness has never been in question, yet admitted that it faced problems of confidence. Said Taylor: "This bank is neither insolvent nor threatened with liquidation. But it was important that we move quickly. Uncertainty is one of the worst things that can happen to a staff or to customers." Added a Continental vice president: "Capital is the world's most cowardly commodity. It cuts and runs at the barest jiggle."

One cause of that skittishness has been the rising price of credit. After remaining at 11% since last summer, the U.S. prime rate has climbed to 12 1/2% in recent weeks, its highest level in 18 months. Credit demands created by the strong growth of the economy seem likely to push rates higher. In a revised report, the Government said last week that the G.N.P. had expanded at a remarkably robust 8.8% annual clip during the first quarter.

The interest hikes so far have made it even tougher for troubled borrowers to repay their debts. Reason: the rates they pay generally fluctuate with the prime. Among those hardest hit by the rising interest costs have been Latin American and other developing nations, which owe a staggering $810 billion to Western lenders. To keep the borrowers from defaulting, some moneymen, including Chairman Volcker, have suggested that banks consider placing a cap on the interest on their Third World loans.

But many bankers are wary of that notion. They argue that a ceiling would encourage debtors to avoid grappling with their economic problems. Others are concerned that a cap would make the Federal Reserve less reluctant to push up U.S. interest rates. Says Citibank Senior Vice President William Rhodes: "Capping has no advantage except that it sounds easy."

The next big test for a Latin debtor will come in June, when Argentina faces $1.6 billion in payments. Only a complex bailout by the U.S. and Argentina's neighbors kept the country from missing a deadline last March and forcing the banks to cut their earnings. Before more funds can be released, however, Argentina and the International Monetary Fund must reach agreement on what promises to be a painful austerity program for that country. Predicts an American banker in Buenos Aires: "It's going to be a very close race to get together with the IMF by June 30."

Climbing U.S. borrowing costs have outraged Argentine leaders. According to President Raul Alfonsin, the recent prime-rate increases will consume all the country's 1984 income from exports of meat, one of its major products. The higher rates "are jeopardizing Argentina's economic recovery and social peace," Alfonsin says, while threatening to "overrun our capacity to pay." In Brazil, whose $93 billion in foreign loans is the highest of any developing nation, officials have warned lenders that rising rates could force them to renounce their financial obligations. Declares Finance Minister Ernane Galveas: "The U.S. is playing with fire."

Members of the 24-nation Organization for Economic Cooperation and Development also attacked U.S. interest costs last week. Delegates to the group's annual Paris meeting blamed the hikes mainly on the huge U.S. budget deficit. Said British Foreign Minister Geoffrey Howe: "There has long been a nagging anxiety about the incompatibility of U.S. fiscal and monetary policy. We are anxious about interest rates, and all the more so because they are rising." French Finance Minister Jacques Delors warned that the impact of higher rates on Third World debtors "could lead to a major crisis in the banking system." Treasury Secretary Donald Regan tried to calm the jitters by noting that Congress is starting to cut the deficit. Added he: "We want to make sure that in these perilous times we support our banks. The U.S. Government stands behind the banking system, and I mean it."

The increased borrowing costs have also been creating turmoil in the U.S. bond market, where prices fall when interest rates rise. Dealers have lost tens of millions of dollars since January as bond values have tumbled more than 12%. Shaken investors saw that free fall continue last week.

The current banking woes are a continuation of the troubles that have rocked the industry in recent years. Beset by developments ranging from the 1981-82 recession to financial deregulation, even highly regarded lenders have been stumbling. Among them was Seattle's Seafirst National Bank, which BankAmerica acquired last year for $250 million in a major rescue mission. Other banks have been less lucky. A total of 48 went out of business in 1983, the most in 44 years; 28 more have failed so far this year.

Regulators have been pressing for mergers to keep more banks open. Last week, FDIC Chairman Isaac said he is eager to see takeovers of ailing East Coast savings banks. The list of those troubled institutions is believed to be headed by Manhattan's Bowery Savings Bank, whose financial performance has scarcely matched the baseball exploits of its public spokesman, Joe DiMaggio.

A new trend that worries some experts has been the rapidly spreading use of adjustable-rate mortgages. Such loans, which hardly existed three years ago, now account for some 60% of all lending for single-family homes. Typically made for several percentage points below prevailing mortgage rates, they begin rising after one year. The risk, say analysts, is that banks and savings and loans could be hit with a wave of defaults if borrowers prove unable to continue their payments.

These days, even candidates for the bestseller list seem to be saying discouraging things about banks. In a new book, The Money Bazaars, Author Martin Mayer (The Bankers; Madison Avenue, U.S.A.) argues that financial deregulation has doomed banks to lose the battle for Americans' dollars to nimbler rivals like Sears and Merrill Lynch. The traditional lenders will survive, says Mayer, but their power will inevitably shrink. Writes he: "This is the twilight of the banks."

Bankers themselves are naturally less gloomy. While they acknowledge their problems, many believe that conditions nevertheless are improving. Citicorp's Rhodes argues that the most dangerous phase of the Third World debt crisis ended last year when big borrowers like Mexico and Brazil avoided default. Says he: "The fact that the world didn't end with a bang has led to the suspicion that it might end with a whimper. What people fail to recognize in the heat of a crisis is that emergency treatment must be followed by a period of prolonged convalescence. That means there can be setbacks."

Experts agree that bankers are bound to weather their latest woes. Says Ralph Bryant, a Brookings Institution senior fellow: "It's been a bad time for the banking community in the past year or two, but we are not going to have a collapse." Bryant argues that the U.S. Federal Reserve and foreign central banks will step in whenever they are needed. Moreover, as Bryant and others note, the vast majority of America's 15,000 banks are solvent and making money.

(Total debt year-end '83 in billions of dollars) (Top lending banks in billions of dollars)

Brazil $93.1 Citicorp $4.7

Chase 2.6

Bankamerica 2.5

Mexico $89.8 Citicorp $2.9

Bankamerica 2.7

Manufacturers Hanover 1.9

Argentina $45.3 Manufacturers Hanover $1.3

Citicorp 1.1

Chase .8

Venezuela $35.5 Bankamerica $1.6

Citicorp 1.5

Chase 1.2

--By John Greenwald.

Reported by Lee Griggs/Chicago and Thomas McCarroll/New York.

With reporting by Lee Griggs, THOMAS McCARROLL