Wall Street's Panic That Wasn't

By Christopher Byron

A sudden default rattles an already edgy market

U.S. Treasury securities are regarded by moneymen as excellent investments. After all, those bonds, notes and bills are issued by the American Government. But for a brief and unnerving period last week, the business of buying and selling them gave Wall Street jitters aplenty. The problem was not the creditworthiness of the U.S., but rather the solvency of a tiny and little-known Wall Street securities firm, Drysdale Government Securities Inc.

The Federal Reserve controls the U.S. money supply by buying and selling bonds and notes in the securities markets. On a normal business day, about $25 billion to $35 billion in so-called federal paper changes hands. Thirty-six of Wall Street's largest securities dealers, including Goldman, Sachs & Co., First Boston Corp. and Salomon Bros., are the dominant traders in the $700 billion market. As interest rates have gyrated in this market in recent years, those dealings have become attractive to other firms. Last February, for example, Drysdale, a $5 million spin-off of the 92-year-old Drysdale Securities Corp. brokerage house, opened its doors.

Through its aggressive dealmaking, the fledgling company, which had only about 20 traders operating out of a fifth-floor attic above a Wall Street area clothing shop, elbowed its way into the thick of play. Using what they thought to be sophisticated, computer-guided trading strategies based on a secret computer program code-named Arnold, Drysdale's two top dealers, Richard Taaffe, president, and David Heuwetter, chief trader, managed in little more than three months' time to amass an astonishing $4 billion-plus portfolio of borrowed U.S. Treasury securities.

The group's main activity was to speculate in the volatile and complex world of repurchase agreements. In a typical repo, a brokerage firm raises cash by selling some Treasury notes or bonds to another dealer or bank with the understanding that it will repurchase them a few weeks or months later. The bank thereby, in effect, gives a short-term loan to the brokerage firm, and the collateral for it is the Government securities.

Since the bank legally owns the securities during the period covered by the deal, it can use them to create a so-called reverse repo with a third party, and that party can do the same with yet a fourth buyer. The firm buying the securities from the bank speculates that it will be able to sell them for more than it paid.

Though repo deals can wind up involving dozens middlemen, the interest that the U.S. Treasury pays regularly on the certificates always goes back to the original owner of the note or bond. Whenever the Treasury sends out interest checks to the holders of its securities, that amount is paid by each repo buyer back to the preceding seller in the chain.

Drysdale's repo troubles had been quietly brewing for weeks, as credit market conditions began to undermine the company's assumption that interest rates were going higher. Instead of the generous profits that Arnold had predicted, Drysdale had a steady stream of losses. The real crisis started last Monday, when the firm failed to meet $250 million in interest due to Chase Manhattan Bank, its principal repo supplier.

Chase Manhattan Chairman Willard Butcher then called together the heads of seven of the brokerage firms from which it had obtained the securities. Butcher told the moneymen that his bank would not be making the interest payments that were supposed to be due to them that day because Drysdale Government Securities had not paid Chase. The banker said that Chase could not be considered legally responsible for the money owed by Drysdale, but was willing to go ahead anyway and and put put $90 million into a $250 million pool until the situation was cleared up. Included among the astonished listeners were the heads of some of the bluest chips of American finance: Merrill Lynch; Goldman, Sachs; and Salomon Bros.

The executives were furious when they heard Butcher argue that Chase had no obligation because the bank had been merely a transfer agent between the brokerage houses and Drysdale. Their arrangement had been with Chase, the brokerage houses argued, not with Drys dale. Chase seemed to be breaking the most fundamental rule of Wall Street: a dealer stands behind his deal. Said one an gry brokerage house executive: "We had taken a negative view of Drysdale's opera tions from the start, and we never had any direct dealings with them at all. We did not know for whom Chase was acting." Added a colleague: "This is going to hurt Chase a lot. I think Butcher panicked."

On Tuesday afternoon the New York branch of the Federal Reserve called to gether the chairmen of New York City's ten largest banks to discuss the possible repercussions of Chase's refusal to make the interest payment. Officials were very fearful that if Chase persisted, some securities firms might find themselves in a cash squeeze. After the session, the Feder al Reserve issued a statement saying that it "stood ready as a lender of last resort" to help any commercial banks temporarily short of cash. It was the first time since the mini-financial panic following the 1970 bankruptcy of the Penn Central Railroad that the Federal Reserve had put out such a market-soothing statement.

Chase was even more isolated from the financial community the next day, when Manufacturers Hanover Trust, which had also been involved in Drysdale repo deals, announced that it would make good to brokerage houses on some $29 million in weekend interest payment defaults by Drysdale. Only three hours later, a thoroughly chastened Chase reversed it self and said that it would also honor its commitments after all.

Though Wall Street executives insist ed that the market's stability had not been really shaken last week, in private some moneymen were much less sanguine. Said one investment banker: "The episode showed that the system can work if the proper people apply pressure at the right time, but the reaction could have been terrible. Adverse news is one thing, but un certainty at the core of adverse news can create widespread panic." Even if the banks manage to collect something from Drysdale, the anticipated after-tax loss of $135 million that Chase expects to suffer from the affair will probably wipe out the bank's earnings for the second quarter.

By Christopher Byron.

Reported by Frederick Ungeheuer/New York

With reporting by Frederick Ungeheuer

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