Aftershocks of a Money Tremor

By Christopher Byron.

Surveying the damage from the Drysdale default

To all appearances, it seemed pretty much business as usual in the Government securities trading rooms of Wall Street last week. But behind the scenes there was a mood of uncertainty in the once stodgy business of buying and selling U.S. Treasury bonds, bills and notes. For the brokers and dealers in the $700 billion market, the task at hand was to sort out the implications of the default two weeks ago by Drysdale Government Securities Inc. on more than $189 million worth of obligations to Chase Manhattan Bank and other major banks. Meanwhile in Washington, probes of the Drysdale affair were opened by both the Securities and Exchange Commission and a Senate subcommittee.

For Chase Manhattan, the impact of the default was plain enough. After an impressive five-year string of earnings gains, the third largest commercial bank in the U.S. was confronting the biggest single loss in its history. Still unable to explain fully how the bank's bond trading department had stumbled into its costly involvement with the little-known Drysdale in the first place, Chase had no choice but to swallow hard and announce a onetime write-off of perhaps $135 million after taxes, or more than what the bank had expected to earn in the second quarter. Another big commercial lender, Manufacturers Hanover Trust, was also hit, though its initial announcement of a likely $29 million write-off was later pared back to only about $9 million after taxes.

Bankers and brokers spent much of last week trying to nail down how Drysdale pulled off its caper. Though the nearly four-month-old company employed about 30 securities traders and operated with little more than $20 million in capital of its own, it had managed to put together a $6.5 billion portfolio of U.S. Government bonds, bills and notes. More than $4 billion of that was borrowed. Said a top Wall Street bond trader of the bewilderingly complex financial structure of the upstart firm's activities: "It was the most astonishingly leveraged operation that I have ever seen."

Basically, Drysdale's traders, headed by President Richard Taaffe and Chairman David Heuwetter, used an accounting quirk in the way Treasury securities are valued in so-called repurchase deals. These are short-term transactions in which a bank or brokerage house raises cash by selling a Treasury security to another dealer on a promise to buy it back when the deal expires. Since typical repos last for only a few days, traders normally do not take account of the accrued interest on a bond, bill or note when valuing it in the transaction. Instead, when the interest is paid by the Treasury to the current holder, the money is automatically passed back to the original owner of the security.

Drysdale's special twist was to acquire arepo from, in most cases, Chase Manhattan and then resell it on the open market at a premium price that reflected its accrued interest. Immediately thereafter, Drysdale would turn around and buy a replacement Treasury security of identical face value, but one that had less accumulated interest. The second security was then used to settle the repo account when it eventually came due. In this way, Drysdale kept its accounts in apparent balance yet continued to pocket a portion of the interest on each repo deal. High interest rates derailed the whole scheme because the bonds Drysdale had bought against the ones it borrowed failed to rise in value, forcing the firm to float more repos to pay the interest out of new premiums. Eventually, though, even that was not enough, and Drysdale had to default on the interest payments to Chase and other bankers.

Washington last week was filled with cries for closer federal control over the entire Government securities market. Said Stanley Sporkin, former enforcement chief of the Securities and Exchange Commission under President Carter and now chief counsel to the Central Intelligence Agency: "How many incidents do you need before someone says that something has to be done?" Philip Loomis, an SEC commissioner, suggested that "it might be desirable" for Government securities dealers and brokers to register with the SEC just as stockbrokers and bond traders are required to do.

On the other hand, registration and control of the sprawling market, which in terms of trading activity is many times larger than the stock and bond markets combined, could become an administrative monster. Testifying before the Senate Banking Subcommittee, Anthony Solomon, president of the New York Federal Reserve Bank, conceded that it might be helpful to require banks and brokers to report large-ticket trading transactions in Treasury obligations. But he ruled out as unfeasible a proposal to regulate the "thousands and thousands and thousands" of trades. Mark E. Stalnecker, Deputy Assistant Treasury Secretary for domestic finance, said that the Drysdale case was a "very isolated instance" and there was no need for further Government regulation in the field. At least for now, it appears that Congress will not establish any new controls over trading in Government securities.

In a hasty effort to forestall federal policing of the market, the Association of Primary Dealers in U.S. Government Securities, whose 36 members include such blue-ribbon financial firms as Bankers Trust Co., Morgan Stanley & Co. Inc. and Goldman, Sachs & Co., last week started working on some overdue ways to self-regulate their business. One proposed rule, which will probably be quickly adopted, will require that all repurchase transactions involving members must take into account accrued interest on the security. Said Association President Allan Rogers of Bankers Trust of the new rule: "Most people have favored it for a long time." Better late, apparently, than never. --By Christopher Byron. Reported by Frederick Ungeheuer/New York

With reporting by Frederick Ungeheuer/New York

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