Why Banks Are Worried About Low Oil Prices

By Markets Fool.com

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The Continental Illinois Bank Building in Chicago. Following a sharp drop in oil prices in the early 1980s, Continental Illinois careened toward insolvency and became America's first too-big-to-fail bank after the FDIC nationalized it in 1984.

Most Americans are thrilled about the low price of oil, but bank analysts aren't among them -- at least not in their professional capacity. Their concern stems from the financial industry's experience in the early 1980s, when a similarly steep drop in energy prices triggered a wave of bank failures, culminating in the nationalization of the nation's seventh-biggest bank by assets and the birth of too big to fail.

There's little reason to think events in the oil market now will wreak the same degree of havoc they did three decades ago. But despite the universal assurance of bank executives over the last few weeks, this should not be interpreted to mean there won't be repercussions. Banks will fail, it just won't be the big ones.

Many of the issues in the 1980s can be traced to Penn Square Bank, a midsize lender based in Oklahoma City. As oil prices soared following the oil embargos of the 1970s, Penn Square underwrote billions of dollars in loans to wildcatters and oil services companies. Instead of keeping the loans on its own books, however, Penn Square syndicated them to some of the nation's largest and most prestigious banks, including Chase Manhattan, Seattle First National Bank, and Continental Illinois.

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Everything was fine when oil prices where high and borrowers were able to service their loans. But when the price of oil plummeted in the latter half of 1980, energy loans followed suit. Penn Square was the first to fail, seized by regulators on July 4, 1982. Seattle First National Bank, which had purchased $400 million in oil and gas participations from Penn Square, came next, collapsing into the arms of Bank of America in the middle of 1983. Less than a year after that, Continental Illinois, the seventh-largest bank in the country, was nationalized by the FDIC thanks to losses on $1 billion worth of toxic Penn Square-originated energy loans.

The damage didn't stop there. Because Penn Square's loan book grew at a faster pace than its deposits, it relied on higher-yielding, but often uninsured, brokered deposits from industry peers. All told, according to former FDIC Chairman Irvine Sprague's book Bailout: An Insider's Account of Bank Failures and Rescues, 29 commercial banks, 44 savings and loan associations, and 221 credit unions deposited money at Penn Square in an effort to squeeze a little more interest out their idle funds. It was a textbook example of the danger of stretching for yield, as uninsured depositors and other claimants would ultimately receive only 65% of their money back.

Of course, it's tempting to conclude history will not repeat itself. Beyond the fact that the Penn Square-induced wave of failures is a seminal moment in American banking, it also happened a mere three decades ago, or well within the living memories of most bank executives. As JPMorgan Chase CEO Jamie Dimon said two weeks ago:

I would just add that ... I'm a little surprised that people are so surprised when commodities move like this. Commodities have moved like this my whole life ... to me, all commodities have had that kind of volatility and oil has had even more volatility, so in the oil business, you've got to prepare for something like that. That is the way it's going to be and that's the way it's going to be for the rest of your life and yes, speculation, inventory, and all those things may affect it in the short run.

Yet, it's important to keep in mind that Dimon is one of our generation's ablest bankers. He has a visceral understanding of and respect for risk. And as the head of America's most storied financial institution, he is uniquely positioned to grasp history's lessons. Prior to the latest economic crisis, for instance, while most financiers were rationalizing the origination and securitization of subprime mortgages, Dimon was imploring his subordinates that "No one has the right to not assume that the business cycle will turn! Every five years or so, you have got to assume that something bad will happen."

The unfortunate truth, in other words, is that most bank executives either don't care about history's lessons, quickly forget them, or never learn them in the first place. "Unburdened with the experience of the past, each generation of bankers believes it knows best, and each new generation produces some who have to learn the hard way," wrote Sprague. There are few better examples of this than Continental Illinois itself, the original too-big-to-fail bank. As Sprague recounted:

Continental is an example of a big bank that forgot its history and was condemned to repeat its past. [...]

[It] was brought to its knees in the Great Depression by the same kind of bad loan syndrome that nearly ruined it fifty years later. The investment was different -- utilities in the 1930s, oil and gas in the 1980s -- but the fallacies were the same: concentration of assets, out-of-territory lending, and pursuit of growth at any cost. And the motivation in both instances was absolutely the same: Go for the fast buck; a bigger bank means more compensation for its management.

The point is that it's nave to conclude, as many bank executives did on their fourth-quarter conference calls, that the latest trend in oil prices won't reverberate throughout the financial industry.

Will it have a material impact on the big banks? Probably not, as companies such as JPMorgan, Bank of America, and Citigroup are widely diversified across a range of businesses, many of which stand to benefit from lower energy prices -- think consumer-focused business lines such as credit cards and mortgages. But some smaller community lenders will inevitably have overcommitted their balance sheets to the still-fledgling U.S. energy boom. For these banks, the lessons from history will come too late.

The article Why Banks Are Worried About Low Oil Prices originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America, Citigroup Inc, and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.