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.