Penn Square Bank

1981

Penn Square Bank of Oklahoma City was a small storefront bank in a shopping mall, with a drive-by window. Bill P. Jennings, an ambitious banking executive in oil-rich Oklahoma, bought it in 1974 right after OPEC had imposed the U.S. oil embargo. Jennings “had a concept” to turn Penn Square into an investment bank.

Penn Square would lend to energy producers in Oklahoma, then break these loans into parcels, keep a small percentage and sell off the rest in chunks to the large money center banks around the U.S.

Besides high yields, these oil-backed loan (OBL) “participations” were attractive tax shelters. About $2B were sold in total. Penn Square’s assets increased by 300% year-on-year, as oil prices ran up tenfold.

Everything was great until 1981 when oil prices decreased and interest rates skyrocketed. Changes to the tax code reduced investors’ need for tax shelters. Suddenly, these OBL participations owed the investors more than they were worth.

The core OBL concept was fundamentally flawed, not because loans were being sold off-balance sheet (this business continues viably into the present) but because commodity prices are two-way risk and credit defaults are only one-way risk. Prices can rise or fall—and at any point in time, we do not know whether the next traded price will rise or fall. By contrast, credits tell the borrower how much to repay and when. There is no question of receiving more than the contract amount (except by accident). There is only the risk of receiving less. It’s a very different risk profile. Like oil and water, these two types of risk don’t blend.

But there was also hanky-panky going on at Penn Square. Bill Patterson, Jennings’s right-hand man, wasn’t a banker at heart. He dressed oddly (one day in lederhosen and a plumed hat, another in a three-piece suit sporting a World War II German army hat) and he promoted his clients’ investments. It was alleged that Penn Square deals were done in the back room of a men-only bar only for oil men and horse traders.

In May 1982, some investors sued Penn Square for fraud, which ignited a bank run on deposits. When it was shut down on July 5, the FDIC paid out $207M but left $163M of uninsured depositors without funds. Collapse further triggered major losses at half a dozen large banks including the biggest buyer of participations, Continental Illinois National Bank and Trust, which failed in 1984 and eventually was acquired by Bank of America. Chase Manhattan, another victim, merged with JP Morgan in 2001.

References:

New York Times “Penn Square’s Failed Concept”
The Encyclopedia of Oklahoma History and Culture