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Boom to Bust


The year was 1982 and I had just started my first job out of college with Interfirst Bank in Dallas, Texas. Interfirst at the time was the 9th largest bank in the country based on assets (loans), 95% of which were based on oil and gas interests. It was an exciting time. The economy in Texas was humming with oil prices around $28 per barrel and Interfirst was growing exponentially, diversifying their loan portfolio into real estate. That year the bank hired a record 85 finance majors out of colleges like Harvard and Wharton (I was from lowly Indiana University) into their analyst training program where we all worked directly for various lending officers of the bank. Our work consisted of taking a prospective borrower's (almost all of which were oil exploration companies) financials and breaking the numbers out into various ratios for lending committee decisions. Once out of the training program, which was to last about a year, our next step was to become lending officers ourselves. For 90% of us, this never happened.

In the summer of 1983 the oil embargo broke down and oil prices plummeted to around $13 per barrel. What was great for the rest of the country was death to Texas and several of the surrounding states. It turned out that all the numbers we were crunching for the lending committee were superfluous. The only number they looked at in deciding whether or not to make a loan was collateral value: if things went wrong the bank could seize the assets (which were essentially real estate and oil rigs) and sell them to recoup the principal amount. The cash flow analysis that we performed was irrelevant, and we certainly did not perform this analysis using various levels of oil prices. If we had, it would have clearly shown that as asset prices fluctuated, so would cash flow and most of the loans the bank was making would default.

The lending committee also did not seem to realize (or ignored) the fact that as cash flow faltered, so would the value of the collateral. Within six months of the collapse of the price of oil, oil rigs were selling at 25 cents on the dollar and real estate prices dropped 50%. Diversifying into real estate was anything but, as there was a high correlation among different assets. The bank had clearly lost sight of the forest for the trees.

I was the only analyst that I can remember that did not get fired, for I was adept at Lotus 1-2-3, one of the first spreadsheet programs for personal computers. I developed a spreadsheet that could do scenario analysis: plug in various prices for oil and see what would happen to loan servicing. I soon found myself sitting next to the top officers of the bank for hours at a time pouring over, ironically, cash flow analysis. I was the star of the bank, a star barely out of college who didn't have a clue as to what he was doing (other than following some basic tenets taught to me in business school). But then, apparently, neither did anyone else.

Unfortunately the cash flow analyses weren't very encouraging. As you might suspect because of the shoddy lending practices it basically showed that oil prices would have to go back up to their previous levels for the bank to survive. The collateral value might as well have been worthless: 50 cents on the dollar does nothing when leverage is involved.

My daily meeting with the bank officers turned into meeting with the regulators. They quickly became discouraged as well; even though I was not privy to high level discussions, I believe at some point they began to encourage a merger of Interfirst with other banks as at least a partial solution to Interfirst's disintegration of capital. Interfirst merged with Republic Bank, which later merged with Texas Commerce Bank. This spreading of risk (at this point losses) was not enough to offset the huge imbalances created by what only can be termed as mismanagement of leverage. This conglomerate went bankrupt as the entire region sank into near depression. Several years later North Carolina National Bank quietly bought all the beleaguered assets of this episode from the government at 10 cents on the dollar. When the region recovered those reflated assets catapulted NCNB to a new level and they renamed themselves NationsBank.

I learned several lessons from this experience, some of which I admit have left me more conservative than the average man. First, I learned how fragile a business can be. Tail risk (unexpected events) are often not properly managed: overestimating tail risk can render a business too conservative and it will die the slow death; underestimating tail risk can leave a business exposed to a quick death. I personally believe that in general tail risk is underestimated. Secondly I learned that leverage is neither bad nor good. Credit expansion is necessary to grow the economy. The building of leverage is almost always a good thing as it drives expansion. This process, however, must always be tempered for prudence. The level of debt does matter because the risk of the cost of debt service rising to unmanageable levels increases.
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