The First Modern Financial Crisis – Drysdale Securities

 

A calendar-appropriate repost.

It was nearly 42 years ago, Sunday evening, May 16, 1982 when an officer at Chase Manhattan Bank took a phone call from a small brokerage house, an event that sent shudders through the nation’s financial community and nearly crashed the government securities market.   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 $200 million interest payment owed to Chase and due the next day on some $3.2 billion of government securities.   Could the Chase, then the nation’s third-largest bank,  see its way clear to lending Drysdale $200 million to tide Drysdale over and allow it to not default on the $200 million already due?     It was really just a way to paper over the impending default and kick the can down the road.    If Chase could help Drysdale hang on just a little longer ….

Drysdale was capitalized at about $30 million.   How did Chase get so overexposed to a small shop like Drysdale?    And what was Drysdale up to that cost the Chase $200 million.

It is a cautionary tale of greed and sloth.   It’s about being right at the wrong time.  It’s about the importance of positive proof and control in finance.  And Its about how words matter and how just a few words can make all the difference.   

Drysdale was a small government securities dealer.    It was the brain child of head trader David Heuwetter.   He was the original smartest-guy-in-the-room.    Traders are competitive by nature and Heuwetter took great pleasure in rubbing other trader’s noses in his winning trades.   The story goes that he’d routinely show up in Wall St bars and announce “I picked off you today.    I got you, and I got you, and I got you-again”.  Everybody apparently despised him.   

Back then, interest rates had been sky high as the Volker Fed tried to wring inflation from the economy.    Heuwetter’s prediction was that they had succeeded and that shortly, interest rates would fall and bond prices rise dramatically.   He wanted to position Drysdale to profit from the move.  But Drysdale’s capital was thin and Heuwetter was looking to bet big.  How to raise the cash?

Thanks to Drysdale the rules for borrowing securities have changed, but at the time, if you borrowed interest bearing securities, you put up cash as collateral.    The amount corresponded to the market price of the securities … but did not include the accrued interest.    On the contrary, If you purchased or sold interest bearing securities the total paid or received was market price plus the accrued interest.   Drysdale’s strategy was to exploit this money difference.    They’d borrow securities with high accrued interest amounts and sell them short.   They’d pay market price on the Borrows.    But they’d receive market price plus the accrued interest on the short sales.  They’d use the difference – the accrued interest – to buy call options on the long Treasury bond.   When the market turned, as Heuwetter was sure it soon would, they’d lose a little on the shorts, but make a killing on the options!     So they did it.    Big.   

They went to their bank, Chase, and arranged to borrow high accrued interest US  Treasuries.    Lots of them.   They borrowed from others too, but mainly from Chase.    

The thing that made this strategy work was the accrued interest.    It was both an opportunity and a risk.     If those Borrows were still open when the interest payment day on the borrowed securities came … Drysdale would be on the hook to pay that interest to the firms they had borrowed from.     So not only did they have to be right.    They had to be right – right away.  

This enormous trade still hadn’t worked out when the April 1982 interest payments were due, but Drysdale Finagled their way to make the payments.    But May was different.   The May payments were huge.   If the thing hadn’t worked out by May, they were in deep trouble.   May came.  The payments were technically due on the 15th.    Thankfully that was a Saturday.    That gave them an extra weekend.   They scrambled but it was a no go.  … Drysdale was sunk.    And they were taking the Chase with them.   (FYI – Heuwetter was right.    But the market move he predicted didn’t happen until August.   Timing is everything)

In their corporate mind, Chase was not at risk in the Drysdale transaction.    Chase believed they were acting as an agent for another firm.   

See, the securities that Chase was lending to Drysdale did not originate with Chase.    Chase, themselves, borrowed them from another small firm … a specialized ‘finder’ … named Buttonwood Securities.    

Buttonwood’s function in the market was to keep track of who had what and was willing to lend.   So … if you need to borrow Securities you don’t need to search hither and yon for someone who (1) has what you want and (2) is willing to lend.    You just call Buttonwood or someone like them.     They already have that sussed out.   That’s what they do.   But Buttonwood does not want any risk.    They want to get paid for putting A and B together and that’s it.   So all their trade tickets say “Buttonwood, As Agent”.    The “As Agent” wording tells your counterparties that you are not the Principal in this trade.    You are the arranger only.    And you are supposed to disclose whom you are acting on behalf of.   If anything goes wrong, you walk away.    You, as agent only, are not responsible.    

So Buttonwood was acting as agent.  Their trade tickets said “Buttonwood, As Agent, Borrows from …”.    And.   “Buttonwood, As Agent, Lends to Chase”

Chase believed they, too, were acting as Agent, and argued that in the legal proceedings that followed.   They certainly had offsetting Borrows from Buttonwood vs Loans to Drysdale.    But while Buttonwood’s trade tickets all said “Buttonwood, As Agent” … all of Chase’s just said “Chase”.    “Chase Borrows from Buttonwood”.    “Chase Lends to Drysdale” Legally, That makes a world of difference   

That wording means Chase is Principal in these trades.   If anything goes wrong, the buck stops with them.   So when Drysdale couldn’t pay Chase, Drysdale, as Principal, went bankrupt.     But also as Principal, Chase was still on the hook to pay Buttonwood, regardless of whether or not they got paid themselves.   If Chase’s trade tickets had said “Chase as Agent” then both Chase and Buttonwood would have walked away and the fiasco would have involved Drysdale and whomever the initial Lenders were.    But that’s not what Chase’s tickets said.   So Chase was on the hook.   

The people in Risk Management at Chase, who knew how much the exposure to Drysdale was, never looked at the actual trade tickets to check they said “As Agent.”  And the people putting up the tickets, who knew they just said “Chase”, didn’t know the total exposure.     On such small things does a $200 million loss depend.    

The next day The Feds arrived at Drysdale’s offices to basically put crime-scene tape around the entire shop, and (allegedly) announced – “Somebody is going to jail! We don’t know who yet, and we don’t know why, but you guys almost crashed the Government Securities market – somebody is definitely going to jail.” And someone did.  Not for anything related to the actual incident, mind you.   Drysdale hadn’t done anything wrong.    The Feds had to dig back years, all the way to some ancient Drysdale Treasury Dept filings that were a bit sketchy to find something on the top guys they wanted. But they did.  And people went to jail for mail fraud.

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  1. kedavis Coolidge
    kedavis
    @kedavis

    Once the Clampetts closed their account, Drysdale just couldn’t hang on.

    • #1
  2. DonG (CAGW is a Scam) Coolidge
    DonG (CAGW is a Scam)
    @DonG

    kedavis (View Comment):

    Once the Clampetts closed their account, Drysdale just couldn’t hang on.

    Jethro, like Hunter, pissed away the family fortune on hookers and blow.

    • #2
  3. Arahant Member
    Arahant
    @Arahant

    Ekosj: He was the original smartest-guy-in-the-room.

    I doubt that he was by about three-hundred-thousand years.

    • #3
  4. kedavis Coolidge
    kedavis
    @kedavis

    DonG (CAGW is a Scam) (View Comment):

    kedavis (View Comment):

    Once the Clampetts closed their account, Drysdale just couldn’t hang on.

    Jethro, like Hunter, pissed away the family fortune on hookers and blow.

    Maybe.  But what do you suppose Elly May was into?

     

    (And Jethro was a nephew/cousin, not Jed’s son.)

    • #4
  5. CarolJoy, Not So Easy To Kill Coolidge
    CarolJoy, Not So Easy To Kill
    @CarolJoy

    The meat of the matter, as far as I can tell:

    “So Buttonwood was acting as agent.  Their trade tickets said “Buttonwood, As Agent, Borrows from …”.    And.   “Buttonwood, As Agent, Lends to Chase”

    “Chase believed they, too, were acting as Agent, and argued that in the legal proceedings that followed.   They certainly had offsetting Borrows from Buttonwood vs Loans to Drysdale.    But while Buttonwood’s trade tickets all said “Buttonwood, As Agent” … all of Chase’s just said “Chase”.    “Chase Borrows from Buttonwood”.    “Chase Lends to Drysdale” Legally, That makes a world of difference

    “That wording means Chase is Principal in these trades.   If anything goes wrong, the buck stops with them.   So when Drysdale couldn’t pay Chase, Drysdale, as Principal, went bankrupt.     But also as Principal, Chase was still on the hook to pay Buttonwood, regardless of whether or not they got paid themselves.   If Chase’s trade tickets had said “Chase as Agent” then both Chase and Buttonwood would have walked away and the fiasco would have involved Drysdale and whomever the initial Lenders were.    But that’s not what Chase’s tickets said.   So Chase was on the hook.”

    Of course this whole exercise of fraud as a Wall Street business scheme was dwarfed by the 2006 mortgage industry collapse which eventually became the 2008 Economic Collapse. A world of hurt ended up enveloping middle class Americans.

    But those at the top of the ponzi scheme called Wall Street had managed to parlay the mortgages that came about during the housing boom into sliced and diced financial entities that could be gambled on.   So a tranch of X numbers of 10’s of thousands of mortgages sliced up in such a confusing way that  no individual mortgage was part of any deal all became “investment opportunities.” Even people way over in Norway used those investment opportunities to be part of a foundation for retirement funds and more.

    Everyone was hurt except two groups: the people on Wall Street who had some 23 to 32 trillions of Bailout Dollars leaked to them by Tim Geithner, and the people of  Iceland who refused to bailout the top financial people in their midst. Icelanders  suffered greatly for a short while. But they recovered while all the other Western societies rode  out the suffering of their middle and lower classes over a long L-shaped recovery period.

    In any event, I did enjoy the ending where the Drysdale people were caught red-handed for some past crime and did hard time, I guess for mail fraud. (If only Tim Geithner, who should have been charged with RICO for his activities while at the New Yourk Fed Reserve, had to do hard time. Even if only for his lying under oath to Congress on two occasions.)

    • #5
  6. kedavis Coolidge
    kedavis
    @kedavis

    CarolJoy, Not So Easy To Kill (View Comment):

    The meat of the matter, as far as I can tell:

    “So Buttonwood was acting as agent. Their trade tickets said “Buttonwood, As Agent, Borrows from …”. And. “Buttonwood, As Agent, Lends to Chase”

    “Chase believed they, too, were acting as Agent, and argued that in the legal proceedings that followed. They certainly had offsetting Borrows from Buttonwood vs Loans to Drysdale. But while Buttonwood’s trade tickets all said “Buttonwood, As Agent” … all of Chase’s just said “Chase”. “Chase Borrows from Buttonwood”. “Chase Lends to Drysdale” Legally, That makes a world of difference

    “That wording means Chase is Principal in these trades. If anything goes wrong, the buck stops with them. So when Drysdale couldn’t pay Chase, Drysdale, as Principal, went bankrupt. But also as Principal, Chase was still on the hook to pay Buttonwood, regardless of whether or not they got paid themselves. If Chase’s trade tickets had said “Chase as Agent” then both Chase and Buttonwood would have walked away and the fiasco would have involved Drysdale and whomever the initial Lenders were. But that’s not what Chase’s tickets said. So Chase was on the hook.”

    Of course this whole exercise of fraud as a Wall Street business scheme was dwarfed by the 2006 mortgage industry collapse which eventually became the 2008 Economic Collapse. A world of hurt ended up enveloping middle class Americans.

    But those at the top of the ponzi scheme called Wall Street had managed to parlay the mortgages that came about during the housing boom into sliced and diced financial entities that could be gambled on. So a tranch of X numbers of 10’s of thousands of mortgages sliced up in such a confusing way that no individual mortgage was part of any deal all became “investment opportunities.” Even people way over in Norway used those investment opportunities to be part of a foundation for retirement funds and more.

    Everyone was hurt except two groups: the people on Wall Street who had some 23 to 32 trillions of Bailout Dollars leaked to them by Tim Geithner, and the people of Iceland who refused to bailout the top financial people in their midst. Icelanders suffered greatly for a short while. But they recovered while all the other Western societies rode out the suffering of their middle and lower classes over a long L-shaped recovery period.

    In any event, I did enjoy the ending where the Drysdale people were caught red-handed for some past crime and did hard time, I guess for mail fraud. (If only Tim Geithner, who should have been charged with RICO for his activities while at the New Yourk Fed Reserve, had to do hard time. Even if only for his lying under oath to Congress on two occasions.)

    Sounds like this is the origin of the expression “If you owe the bank a thousand dollars and can’t pay, you have a problem.  If you owe the bank several million dollars and can’t pay, the bank has a problem.”

    • #6
  7. DonG (CAGW is a Scam) Coolidge
    DonG (CAGW is a Scam)
    @DonG

    kedavis (View Comment):
    Maybe.  But what do you suppose Elly May was into?

    OnlyFans, of course.   Well Golly!

    • #7
  8. Steven Seward Member
    Steven Seward
    @StevenSeward

    kedavis (View Comment):

    Once the Clampetts closed their account, Drysdale just couldn’t hang on.

    Ya beat me to it!  My mouth was watering to put a Milburn Drysdale reference into this thread.  I swear, I once had a customer who worked for McMann and Tate Advertising!

    • #8
  9. Bryan G. Stephens Thatcher
    Bryan G. Stephens
    @BryanGStephens

    Ekosj: The Feds had to dig back years, all the way to some ancient Drysdale Treasury Dept filings that were a bit sketchy to find something on the top guys they wanted. But they did.  And people went to jail for mail fraud.

    Because it is not about justice.

    • #9
  10. Annefy Coolidge
    Annefy
    @Annefy

    Bryan G. Stephens (View Comment):

    Ekosj: The Feds had to dig back years, all the way to some ancient Drysdale Treasury Dept filings that were a bit sketchy to find something on the top guys they wanted. But they did. And people went to jail for mail fraud.

    Because it is not about justice.

    I always hate when a situation ends with a conviction for mail fraud or tax evasion.

    Arguing that point I recently found myself arguing on the side of Al Capone.

    It stinks of: show me the man and I’ll find the crime.

    PS – great post. Thanks for sharing.

    • #10
  11. Ekosj Member
    Ekosj
    @Ekosj

    Annefy (View Comment):

    Bryan G. Stephens (View Comment):

    Ekosj: The Feds had to dig back years, all the way to some ancient Drysdale Treasury Dept filings that were a bit sketchy to find something on the top guys they wanted. But they did. And people went to jail for mail fraud.

    Because it is not about justice.

    I always hate when a situation ends with a conviction for mail fraud or tax evasion.

    Arguing that point I recently found myself arguing on the side of Al Capone.

    It stinks of: show me the man and I’ll find the crime.

    PS – great post. Thanks for sharing.

    I recall seeing a snippet in the WSJ from back in the cocaine ‘80’s….apparently there was some large dealer in South Florida.    Everybody knew who he was and what he did, but the operation was so tight and he was so well insulated that they couldn’t catch him.   I guess he figured the only way he’d get pinched was the Capone way.    So, to avoid the tax-evasion angle he actually paid his taxes:

    Occupation:  Importer

    Income:   X dollars

    Tax due: $

    He was the government’s cash cow!   They were more or less silent partners.

    • #11
  12. kedavis Coolidge
    kedavis
    @kedavis

    Ekosj (View Comment):

    Annefy (View Comment):

    Bryan G. Stephens (View Comment):

    Ekosj: The Feds had to dig back years, all the way to some ancient Drysdale Treasury Dept filings that were a bit sketchy to find something on the top guys they wanted. But they did. And people went to jail for mail fraud.

    Because it is not about justice.

    I always hate when a situation ends with a conviction for mail fraud or tax evasion.

    Arguing that point I recently found myself arguing on the side of Al Capone.

    It stinks of: show me the man and I’ll find the crime.

    PS – great post. Thanks for sharing.

    I recall seeing a snippet in the WSJ from back in the cocaine ‘80’s….apparently there was some large dealer in South Florida. Everybody knew who he was and what he did, but the operation was so tight and he was so well insulated that they couldn’t catch him. I guess he figured the only way he’d get pinched was the Capone way. So, to avoid the tax-evasion angle he actually paid his taxes:

    Occupation: Importer

    Income: X dollars

    Tax due: $

    He was the government’s cash cow! They were more or less silent partners.

    But at that income level, his marginal tax rate must have been very high.  It’s hard to believe a criminal would be willing to part with so much of their lucre.

    • #12
  13. Ekosj Member
    Ekosj
    @Ekosj

    kedavis (View Comment):

    Ekosj (View Comment):

    Annefy (View Comment):

    Bryan G. Stephens (View Comment):

    Ekosj: The Feds had to dig back years, all the way to some ancient Drysdale Treasury Dept filings that were a bit sketchy to find something on the top guys they wanted. But they did. And people went to jail for mail fraud.

    Because it is not about justice.

    I always hate when a situation ends with a conviction for mail fraud or tax evasion.

    Arguing that point I recently found myself arguing on the side of Al Capone.

    It stinks of: show me the man and I’ll find the crime.

    PS – great post. Thanks for sharing.

    I recall seeing a snippet in the WSJ from back in the cocaine ‘80’s….apparently there was some large dealer in South Florida. Everybody knew who he was and what he did, but the operation was so tight and he was so well insulated that they couldn’t catch him. I guess he figured the only way he’d get pinched was the Capone way. So, to avoid the tax-evasion angle he actually paid his taxes:

    Occupation: Importer

    Income: X dollars

    Tax due: $

    He was the government’s cash cow! They were more or less silent partners.

    But at that income level, his marginal tax rate must have been very high. It’s hard to believe a criminal would be willing to part with so much of their lucre.

    Beats jail and Zero

    • #13
  14. GLDIII Purveyor of Splendid Malpropisms Reagan
    GLDIII Purveyor of Splendid Malpropisms
    @GLDIII

    Ekosj (View Comment):

    Annefy (View Comment):

    Bryan G. Stephens (View Comment):

    Ekosj: The Feds had to dig back years, all the way to some ancient Drysdale Treasury Dept filings that were a bit sketchy to find something on the top guys they wanted. But they did. And people went to jail for mail fraud.

    Because it is not about justice.

    I always hate when a situation ends with a conviction for mail fraud or tax evasion.

    Arguing that point I recently found myself arguing on the side of Al Capone.

    It stinks of: show me the man and I’ll find the crime.

    PS – great post. Thanks for sharing.

    I recall seeing a snippet in the WSJ from back in the cocaine ‘80’s….apparently there was some large dealer in South Florida. Everybody knew who he was and what he did, but the operation was so tight and he was so well insulated that they couldn’t catch him. I guess he figured the only way he’d get pinched was the Capone way. So, to avoid the tax-evasion angle he actually paid his taxes:

    Occupation: Importer

    Income: X dollars

    Tax due: $

    He was the government’s cash cow! They were more or less silent partners.

    To be honest the Government doesn’t really mind griff, as long as they get their cut. Run a number game go to jail, run a lottery “for the children” no problem.

    Even when they (your “representatives”) later admit it just goes into the general fund and they are under no obligation to spend it “on the children” after they sold the program.

    • #14
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