BULL STREET - The art of the Con

Penn Square Crumbles

The Penn Square Bank of Oklahoma City got its start in 1960 as a small financial institution and was located in a small shopping center for 22-years.  In 1972, William “Beep” Jennings took over control of the bank and simultaneously OPEC started moving the price of oil higher.  Nobody’s fool, Jennings knew a good thing when he saw one, and created a new department to make loans to the oil-and-gas-industry in Oklahoma. These were also times when people did not care much what their return was going to be as long as they were able to take a bite-sized write-off from their tax returns.

Thus, although Jennings was at the right place at the right time, he did not realize that not everyone who claimed to be looking for oil really was.  There were many who were only looking for the opportunity to leverage their investments in order to be able to find more tax deductions and the more that they could leverage their write-offs, the less they would have to pay Uncle Sam.  Penn Square was also a dinky bank as far as banks go, and had a lending limit that could not have accommodated the drilling of one deep well.  Thus, the bank had to either find a way to accommodate the real players or concentrate on the mixed bag of not quite serious folks whom they were attracting.

It did not take the aggressive new management of Penn Square long before they found the right way to position themselves.  Being in the heart of oil country, they could act as an introducing agent to other banks and sell them their overage loans.  Thus, they could get into a market where there were real players.  This seemingly did a couple of really good things for banks like Chicago’s Continental and New York’s, Chase.  Both banks fancied themselves as oil experts.  All banks in the country were saddled by branch banking restrictions.  Thus, by buying loans instead of making them, they would effectively acquire a branch in Oklahoma with evading the Banking Regulations.  In addition, who would know the oil field in Oklahoma better then a bank that is right there?  Little did they know.

In the meantime, Jennings did the same thing that Lincoln Savings and Loan along with others had tried. He set up a department to market jumbo CDs that paid substantially higher interest rates that the garden variety. Considering the hot oil market and that Penn Square’s clientele was really larger money-center banks, it didn’t take a long time before a massive amount of this highly questionable paper was walking out the door. 

Penn Square soon stopped taking any part of the loans they were making, and concentrated on turning them around to the city slickers for the one-percent they got for making the loan and some additional vigorish that they received for servicing the debt.  However, Penn Square was not being very careful about the loans they were making.  Money was available from the “big city boys” for all comers and rarely if ever was an oil loan refused.  Thus, Penn Square had a conflict of interest with the loan buyers.  Penn Square saw this deal is its second coming and the money center banking people relied upon Penn Square for their due diligence.  The people at Penn Square Bank had never even learned how to spell the word.

To Penn Square, servicing a loan meant keeping the pot boiling and getting the loans out the door.  Loans were sold where literally none of the documentation had been checked, there were contracts where documents were missing, there were agreements that were never signed, there were contracts where no UCC filings had been made, and just about every other egregious practice that one bank can foist upon another was going on at Penn Square Bank.  Jennings would make oral commitments without any paperwork, fund the loans and then the borrower had little interest in coming back to the bank to complete the papers.  He probably wasn’t even liable because he never signed anything.  Moreover, the unfinished loans could not be resold in the secondary market because of among other problems, their lack of uniformity.

If things looked bad at this point, they soon got a lot worse.  When the loans started backing up, Penn Square didn’t want to ruin their reputation by having their bank customers get stuck with defaulting collateral so that a determination was made by the bank that rather than have anyone ever know that a Penn Square loan had gone bad, they would make the payments for the client and the funding bank would never be the wiser.  Continental and Chase never had a bad Penn Square credit, which made them even more contented with the situation and they asked for more and more paper.  Penn Square on the other hand didn’t have all of the ready funds to take on what was becoming an avalanche of defaults, so they kicked the plot up a notch by making a new loan to each defaulter, and selling that paper to the money center banks.  Thus, they had created their own cache of money to repay whatever went bad by sticking the banks that didn’t know that there already had been a default with more paper from the same bad credit.  “This was surely a wondrous idea,” said Jennings in a moment of self-appreciation.

Some of Jennings’ loan officers just couldn’t get the paper out the door fast enough and so there were replaced with people that would not need to carefully take the time to do things right.  The top dog in Jennings oil and gas department became Bill Patterson ([146]) who although he was still in his twenty’s was entrusted with the entire oil and gas department, which accounted for over 80% of Penn Square’s business. This was a man that had been called “Monkeybrains,” by his friends.  However, Patterson married into a lot of money and it was in Texas style banking.  He was able to get a job working for one of his father-in-law’s institutions but was not allowed to make a decision, loan out money or talk to clients of the bank.  Jennings must have seen something in Patterson that he admired and brought him aboard at Penn Square with great fanfare.  Patterson played his role for Jennings to the hilt, Patterson soon became known by everyone for his idiosyncrasies, such as “wearing a Mickey Mouse hat while doing business with prospective clients and drinking beer from his cowboy boots at swank Oklahoma City watering holes.” ([147]) His father-in-law, we are told, started celebrating the moment he left his bank, and considering what happened, for all we know may still be celebrating the event today.  

Paterson did what Jennings wanted; he ran a truly loose ship, an anathema in the banking fraternity.  One of the major things that Paterson never checked on was to see that the money that the bank gave them went for what was agreed to in the loan documents.  Thus, when the show closed, in the cases of many loans that had been made by Penn Square, you couldn’t even find the drilling rig, the pipe, or the location of a well.  Paterson always said that he was loaning with his heart and no one could argue with that statement. If that hadn’t given the bank enough headaches, the oil blip did not last forever and because of excellent conservation measures put in place by the administration and over-production by OPEC, oil prices tanked. Even the occasional, well-documented, legitimate loans soon became an anathema to Penn Square and their bank partners. The world had gone from energy short to dramatically over produced in just a few short years. Many projects, especially those that entailed deep drilling, soon became economic dinosaurs.

The bank examiners and regulators were aware of what was happening in the oil patch and forced Penn Square to tighten its controls over loans. They also demanded that the bank bring in a full-time professional president, increase its reserves, bring in addition executives with substantial banking experience, and tighten up lending requirements. However, the game was already a little “long in the tooth” and the regulators demands were too little and too late. Seeing the handwriting on the wall, Penn Square attempted to lend themselves out of trouble and only made things a hundred times worse. The quality of borrowers continued to decrease and loan defaults sharply increased. 

The borrowers were also hip to the fact that when you owe a bank a small amount, they are your creditor.  When the loan becomes larger, they become your partner.  Many perceptive Oklahomans kept edging their loans right into the stratosphere and Paterson was always quick to oblige.

Penn Square’s money also went to political contributions.  One the large borrowers from Penn Square was J. D. Allen, the co-chairman of the Finance Committee of the Republican National Committee.  Allen went bust after Penn Square collapsed and his debts in bankruptcy exceeded $300 million.  Continental or Chase must have eventually discovered that their money  was literally given away in political contributions.  Robert Hefner III, listed as one of the richest men in America, was another major customer of the bank.  When the banks started to look for collateral to grab, all they found was a man whose debts exceeded his liabilities.

Continental Bank of Chicago, who was on the receiving end of the Penn Square fiasco to the tune of $1 billion, went later went bankrupt in large part because of that and  because the bank was determined to be “too big to fail” it became the recipient of a $5 billion government bailout.  The bank was never the same after that and even today, its character is drastically different.  Seattle First National had to be merged with Bank of America in order to save it.  Chase had problems that made these seem almost incidental and managed to get by because of a much larger capital base that was needed to survive Penn Square and it commando loan officers.

By the spring of 1982, regulators came back to Penn Square for another look at what was going on. What they discovered was literally unbelievable. The bank had now gotten into so much trouble that the Federal Reserve arranged an emergency loan for the bank. This gave examiners a chance to get some breathing room while they took a more critical look. It was determined that there was literally no helping the bank and when Penn Square’s doors were closed by the FDIC bank examiners on July 5, 1982, the bank’s total assets had risen from $29 million in 1974 to over $500 million at the time of closing and it became the seventh largest shuttering of a bank by that institution.  More startling yet was the fact that a bank with only $500 million in assets could lose more that $2 billion, the biggest single bank loss in the history of the United States to that time.

Arthur Young had been the auditors in the banks earlier days and for the years of 1976 through 1979, they gave the bank a clean bill of health. In 1980, the auditors did not like what they were seeing and qualified its audit relative to whether or not loan reserves were sufficient to cover potential problems. Young found that the paper work backing up the bank’s loans were literally a mess. Jennings was not at all pleased with Young’s decision to qualify their opinion and summarily dumped the accounting firm and replaced it with Peat Marwick and Mitchell.

We know that it represents good business practice for the incoming accounting firm to check with the outgoing firm to find out what the relationship was between the client and the accounting firm and why they were leaving. At this point we get two totally separate stories. Peat Marwick stated that they had made such an inquiry and were told in no uncertain terms that Young had told them that “free of significant problems”. Young’s position, which can’t really be refuted, is the fact that they had qualified the audit and whether they brought it to Peat Marwick’s attention or not, is really begging the issue. Young really couldn’t do more to wave a red flag than qualify their opinion.

In spite of the knowledge that they may be stepping on a powder keg, Peat Marwick stepped into the breach. They joined the team just in time to be hit by lightening and as such they came in for some really rough treatment when congress tried to figure out what had occurred.  Peat Marwick enraged the house by making the statement that their audit (which had been clean) was intended only for the bank’s directors.  Yet various members of the house including a usually calm Fernand St. Germain, Chairman of the investigation.  He made the following comment:

“You are not aware of the fact that the people at Penn Square dealing with brokers gave your reports … to people, credit unions, S&Ls around this nation who put enormous sums of money into this institution based on your audit reports, since that was all that was available… Did it come as a complete and total surprise to you, like the fact that when you get to be 10 years old you find out that there is no Santa Claus?”

Naturally, the Peat Marwick and Mitchell partner that had given the stunningly imbecilic response to the House Committee had a really bad hair day. Peat Marwick’s situation is doubly troublesome because Arthur Young & Company who had been doing the audit pre-1980 had determined in 1980 that they would be issuing a qualified opinion.  In 1981, Jennings fired Arthur Young and hired Peat Marwick. Peat Marwick was intimately aware that the reason that Young wanted to qualify the audit was their opinion that loan loss reserves were substantially low. This in turn meant that expected loan failures, especially from Young’s point of view, were heading skyward.

Peat Marwick did not find doing Penn Square’s books clear sailing. As a matter of fact they were bothered enough by the condition of the bank’s books and records to tell the Board of Directors at Penn Square that they had better get their act together. However, in spite of that, Peat Marwick neither qualified their opinion, footnoted the financials nor informed the shareholders. A discussion on that subject was conducted during a meeting of the congressional subcommittee examining the events leading to the Penn Square debacle. This particular skirmish was  between Congressman George Wortley and Peat Marwick’s Jim Blanton and it was indeed enlightening:

Congressman Wortley:       Were Penn Square’s internal controls adequate?

Mr. Blanton:                         No, sir. We don’t believe they were adequate.

Congressman Wortley:       Well, did you criticize them in the public statement?

Mr. Blanton:                         No, Sir.

Congressman Wortley:       You only criticized them in the management letter?

Mr. Blanton:                         That is correct.

Congressman Wortley:       Do you think that is fair to the public? And is that a custom of the profession?

Mr. Blanton:                         I am not sure that I can determine what is fair or unfair to the public. I can say that it is a normal procedure to issue a management letter, and that we do not address in the financial statements or in footnotes all of the problems of a client.

Congressman Wortley:       Well, do you not feel that you have a responsibility to someone other than your client, in this case Penn Square? Is the whole purpose of an audit not to make certain that things are verified and the public is adequately informed of it, and shareholders and investors and depositor?           

The Office of the Comptroller of the Currency (OCC) was also introduced into the Congressional testimony and it certainly was not helpful to Peat Marwick’s position in view of the fact that both the OCC audit and that of the accounting firm were undertaken simultaneously:

“The unqualified opinion was rendered despite the identification of excess collateral exceptions, discovery of incidences where the bank was making payments of principal and interest to the correspondent banks on certain participations without first receiving payment from the borrowers, and acceptance of a reserve for possible loan losses which was deemed inadequate by the examiners during their review of the loan portfolio.”

Not only did Peat Marwick take the account, but they gave Penn Square an unqualified report card. Moreover, they did it at a time when Peat Marwick’ s Oklahoma City partners had two million in loans outstanding to Penn Square and a line of credit of a million dollars. Clearly, this represented an unacceptable conflict of interest, but that didn’t seem to both the Peat Marwick people in the least. Penn Square did make an effort to get rid of the loans and sold them off but four days before the bank closed, they were back on the books. I must say that we are speechless, but as usual, the accountants that do the kind of work Peat Marwick did in this case seem always to pay a price.

In the meantime, the shareholders got even, they filed lawsuits totaling over $1 billion against the Peat Marwick firm and charged them with just about every crime in the book. The U.S. Department of Justice filed actions against a dozen of the accountant’s current and former employees and to wrap up the dirty details, the FDIC sued Peat Marwick for $90 million. All of the incidents above were settled and the exact details are not public information. On the other hand, there isn’t much question that Peat Marwick paid dearly for its short-term romance with the people at Penn Square Bank. 

Patterson was found guilty of twenty-six counts bank fraud. A similar case took place in federal court in Chicago, which ended in a mistrial. When the day was over and a plea bargain had taken place, Patterson pled  guilty of misapplication of banks funds a was sent to federal prison for two years. An associate of Patterson also was sent to jail for similar bank related problems.

 

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