The failure of Penn Square Bank, an Oklahoma City-based lender with only one branch, in 1982 should never have been more than a footnote in some banking regulator’s report. However, in the process of growing its balance sheet over 10x in the preceding five years, predominantly to the energy sector, it had also sold participations in the loans it was originating to larger banks. In particular, it had sold $1bn of these loans to Continental Illinois, at the time the seventh largest commercial bank in the US with around $40bn in assets.

The losses Continental Illinois took on these loans, with over 50% becoming bad, were a key reason for its failure two years later, but it was not alone as Chase Manhattan and a number of other banks had to take large losses on loans they had bought from Penn Square too. Its failure is recounted, in Belly Up by Philip Zweig, and all the blame is landed on the bank’s management, in particular Bill Patterson, a senior executive there.

Penn Square’s failure was due to its voracious appetite to grow in a highly cyclical sector which then turned downwards with understandable consequences, as it was facilitated by weak underwriting controls with limited collateral to back the loans it was making. To fund the growth, Penn Square also relied on wholesale funding which was the catalyst for calling an end to the satire as there was a deposit flight when concerns started to filter out as well as it being the catalyst for Continental Illinois’s collapse not long after.

Equally telling when we looked at the experience of the UK in the early 1990s was an email response we received from Nationwide Building Society, today seen as a very conservative lender, about their experience. “The Society was the market leader in all housing initiatives at this time; shared ownership; shared equity, key worker loans, 100% loans; self-build, etc...  Any initiative that encouraged marginal owner occupiers into the market was led by the Society.”

The response went further: “Unfortunately, at the peak of the market is the point at which your lending criteria should be its most stringent not its most lax. So the Society rapidly became the market leader in arrears, possessions and losses. Some 44% of our arrears in this period came from 95%-100% lending and 45% from 100% lending. The Society learnt its lesson about high LTV [loan to value] lending which has stayed with us for a long period.”

As bank investors, we draw comfort that banks’ exposure to residential and commercial real estate is at much lower loans-to-value than in 2008 or 1990, in part driven by regulation, and that their exposure to riskier areas such as real estate development loans, construction or energy loans is similarly much lower.

Conversely, Northern Rock grew its profits every single year during the early 1990s’ recession and housing market downturn, unlike larger banks such as Bank of Scotland and Barclays. By 2006, however, it somehow came to believe that lending up to 125% of the value of a house to borrowers was prudent lending with understandable consequences as it was overly reliant on wholesale funding. It remains one of the oddest meetings we have ever had with the CFO of a bank, as he tried to justify its strategy, albeit it was in close competition with a number of other banks at the time with their incontinent view of lending.

Nevertheless, none of our meetings with bank management have yet to match that of a bank examiner’s meeting at Penn Square with Patterson. He had shelves lined with caps bearing the logos of different customers of the bank. When the examiner asked about a particular loan, Patterson would reach back, pull the relevant cap from the shelf, put it on his head and turn back to the examiner before answering a question. “The examiner then named a company that Patterson had no hat for. Instead he pulled his wild card, a Mickey Mouse cap with strings dangling down from the ears. Patterson once again turned to the national bank examiner, jiggled the strings to make the ears flap. Smiled and said: “Well, what about it?”.”

Thankfully, meetings with banks are not like that. Fifteen years on from the global financial crisis more of the risk has shifted off bank balance sheets into capital markets and to non-bank investors¹ with sub-prime lending, where it exists, shifting to FinTech lenders. Furthermore, banks have significantly more capital and liquidity today, making a repeat of the runs we saw in 2007-08 highly unlikely. As bank investors, we draw comfort that banks’ exposure to residential and commercial real estate is at much lower loans-to-value than in 2008 or 1990, in part driven by regulation, and that their exposure to riskier areas such as real estate development loans, construction or energy loans is similarly much lower.

With the selloff in financial markets, valuations for global banks have now fallen to levels that not only discount a deep downturn but one in which profitability remains depressed into perpetuity. For example, taking data from March 2009 lows to the end of September 2022, global banks today have only ever been cheaper on 245 days since then or 7% of the time, using price to book ratios, suggesting while the short-term direction of travel in equity markets remains uncertain, the risk/reward on any reasonable timeframe is very much now one favouring buyers.

Days spent at or below different valuation levels

Source: Bloomberg, 30 September 2022.

1. For example, sub-investment grade corporate debt financed by non-banks (as % of GDP) rose to 17% in 2021, compared to 8% in 1990, whereas for banks the level has remained stable at 5%.