How Drysdale affair almost stymied US securities market
It was Sunday evening, May 16, when an officer at Chase Manhattan Bank took a phone call from a small brokerage house, an event that has since sent shudders through the nation's financial community.
On the phone was an official of Drysdale Government Securities Inc., with which the bank did business. He told the Chase officer that the company ''may have a problem'' meeting a $160 million interest payment due the next day on some $3.2 billion of government securities. Could Chase, he asked, the nation's third-largest bank, possibly lend it $200 million to tide Drysdale over?
This phone call last week set off a series of emergency meetings at the Federal Reserve Bank and caused Chase Manhattan to absorb a loss of $135 million.
Exactly how the crisis developed, which blew up faster than a summer thunderstorm, is still open to some speculation. And, in fact, the US Senate's securities subcommittee began hearings this week to try to discover what nearly caused the government securities markets to come to a standstill. The Securities and Exchange Commission is likewise investigating the affair, while Chase has its outside auditors and lawyers trying to sort out what happened.
Unraveling the mystery at Drysdale Government Securities, a company that had only $30 million in capitalization, is proving complicated. Drysdale was a dealer in the ''secondary market'' in government securities. This means that it bought and sold government securities from other broker-dealers for its own account.
Drysdale and its officers, who included Richard Taaffe, president, and David Heuwetter, head trader, were dealing in a particularly arcane part of the government securities markets known as repurchase and reverse repurchase agreements.
In brief, a ''repo,'' as it is called, usually involves an institution that needs cash and agrees to deposit an amount of government securities with a broker-dealer as collateral for a loan.
The institution agrees to buy back the securities at the end of a specified period, usually at a price that gives the lender an attractive rate of return. This rate is known as the ''repo rate.''
In a reverse repo, an institution wants securities and pays cash to a broker-dealer to get them. The broker agrees to buy them back at a later date. That institution, however, must pay the original holder of the securities the interest paid by government when the securities come due.
Drysdale was using the reverse repo strategy when it used Chase as an agent to go to 30 major broker-dealer firms in search of government securities. On May 15, a date when government pays interest on many securities, the action started. Drysdale was unable to transfer the interest from the securities to the 30 firms. They, in turn, held Chase responsible for the money.
In practice, points out Alvin Markle, a vice-president at Butcher & Singer Inc., no securities actually change hands. The escrow agent, in this case Chase, merely has a computer entry indicating the change in ownership.
Dealers like Drysdale, exchanging cash for securities, provide liquidity in the markets. With the blossoming of the federal deficit and more government securities along with it, Drysdale-type dealers have become increasingly important. They typically maintain portfolios of government securities worth billions of dollars and are constantly trading the securities that make up the portfolios.
But exactly how Drysdale intended to profit by obtaining the securities is not known. Dealers in government securities point out that there are countless strategies.
According to James Draper, a partner at FSI Securities, Drysdale was thought to be conducting what is called a ''match book'' trading strategy. In this strategy, considered conservative by most dealers, Drysdale would have looked for tiny discrepancies in prices between various government issues. On a $4 billion portfolio, which is the size of portfolio most analysts believe Drysdale was running, this strategy would have produced modest profits or losses.
Mr. Draper says he, like other dealers in government securities, is still trying to understand how such minimum risk could result in such a large default by Drysdale, and how Drysdale, with only $30 million in capital, could afford a
Whatever, its strategy didn't work.
Thus, on May 16, when Drysdale asked Chase for the loan, it was just before Drysdale had to meet the $160 million in interest payments. A spokesman for Chase, Fraser Seitel, says, ''The facts are that they did not get a loan.'' Instead, Willard Butcher, the chairman of Chase, and a team of officials at the bank met all day May 17 to try to understand the problem. Then at 6 p.m. the bank called together the 30 broker-dealers involved for a meeting at the Federal Reserve Bank of New York.
Mr. Butcher told the brokers that Chase wasn't certain what its legal liability was, but understood it had a responsibility to the 30 brokers. It suggested the creation of a special fund into which Chase would kick in $90 million and the broker-dealers would forgo their $160 million in interest. The brokers objected, and on May 19 Chase said it would write off a $135 million loss from its second-quarter earnings. Chase's actual loss is thought to have totaled $270 million.
Chase pointed out that the $135 million written off was the equivalent of one quarter's earnings. And Mr. Butcher, on May 21, told 2,000 key employees that even though Chase was embarrassed, ''the bank had too much momentum to let the affair stand in its way.''
Two other banks, Manufacturers Hanover Trust and US Trust Company, also acknowledged that they acted as agents in lending much smaller amounts of securities to Drysdale. Both banks immediately said they would meet the interest payments due, which put additional pressure on Chase. Mr. Seitel denied reports that the Federal Reserve Board had also pressured the bank.
At US Trust, the bank said losses due to Drysdale would be minimal. And at Manufacturers Hanover Trust, an original estimate of a $29 million loss is now considered too high, since the bond market has recently turned in favor of the bank.
If the banks had not come to the rescue, the securities industry could have been wading in trouble.
According to Mr. Seitel, Chase determined that if it did not make the payments, the entire government securities market might have come to a halt because of a breakdown in confidence.
A week later, according to dealers, the secondary markets in government securities continue to be very thin, with few deals being done. And government dealers report that last week the repo market was virtually dead. Mr. Markle, the Butcher & Singer vice-president, commented, ''It may cut down on the liquidity of the economy.''
One source working for an institution involved in the controversy said the Drysdale affair raised more questions than there were answers. For example, he asked, how can this happen so easily, and is there a need for more regulatory intervention. Another source says that the Federal Reserve Board had been watching Drysdale for some time. This source wondered why the board did not act sooner when it questioned the firm's tactics. The Drysdale affair, he concluded, would probably make the Fed more conservative as well.