The collapse of Drysdale Government Securities this week made front page news out of a back room business where billions of dollars change hands on the basis of telephone calls and a trader's word means as much as a written contract.
While the nation's stock and commodity markets operate in impressive buildings whose visitors' galleries offer guided tours, the government securities market is nothing but a network of communications wires connecting the offices of some 30 companies.
They deal in the national debt, buying and selling U.S. Treasury bonds, Treasury notes and T-bills in much the same way that stocks or wheat are traded.
Even in these outer limits of the financial world, Drysdale Government was known as "adventuresome and aggressive," one employe of the firm admitted.
That is as close to an explanation as anyone at Drysdale has offered of how a company that went into business only four months ago could trigger a major financial calamity.
Drysdale's basic strategy when it thought bond prices were going down was to borrow bonds through Chase Manhattan Bank, then sell the borrowed bonds to customers such as corporations and investment funds. Drysdale hoped to repay Chase with cheaper bonds it purchased later--usually just a few days later.
Bond prices don't have to change very much to make a profit on such a deal. If the price of a $1 million Treasury bond drops by one tenth of one percent, Drysdale could make a $10,000 profit on the transaction. When it was trading bonds by the billions, the potential profits were huge.
The transactions were put together as two special kinds of loans called repurchase agreements and reverse repurchase agreements--repos and reverse repos in the jargon of government bond traders.
Trading in the most common types of repos and reverse repos totals $60 billion a day, industry officials say.
A repurchase agreement amounts to a short term loan. If Drysdale needed $1 million cash for its operations, it would turn over $1 million worth of government bonds to Chase and promise to "repurchase" them a few days later. The interest rates on such loans are lower than on other bank loans, because the loan is fully collateralized and there is theoretically little risk.
Drysdale's dealings with Chase involved reverse repros. Drysdale in effect borrowed government bonds from Chase, which was to "repurchase" them later. Chase, however, didn't just pull bonds out of its vault to lend to Drysdale. Chase instead got the bonds from about 30 Wall Street brokers who deal in government securities.
Chase's precise role in the transactions is a question that one banking source predicted will produce "some God-awful lawsuits."
Chase contends it was simply acting as Drysdale's agent, but the brokers who provided the bonds say the bank was dealing on its own--borrowing government securities from brokers and relending them to Drysdale.
A banking official familiar with Drysdale's dealings said a typical transaction would work something like this:
Drysdale would borrow $1 million worth of bonds from Chase and immediately resell them. The transaction would be handled by telephone and computer, without any paper changing hands.
Under the rules of the game, Drysdale put up $1 million in cash as collateral to borrow the bonds. It was the same $1 million that Drysdale got by selling the bonds to its customer.
Drysdale, however, collected more than $1 million from its customer.
Since the bonds had been issued some time ago, they had already earned some interest, but the payment date for the interest had not yet arrived. The bonds Drysdale dealt with often were those on which the interest would be paid in just a few days.
Last week, for example, a buyer might have paid Drysdale $1,060,000 for a million dollars worth of bonds on which the interest was due to be paid May 15.
After selling the bonds, Drysdale had $1 million to give Chase as collateral, plus $60,000 that it could use for short term investments. Since the bonds belonged to Chase, so did the interest. But Drysdale had the use of that interest money from the time it sold the bonds until the time the interest payment was due on Monday, in this hypothetical example.
On a $100 million deal, Drysdale could generate $6 million that it could use for short term investments. Because the interest rates on repros are lower than those on conventional loans, Drysdale had a source of low cost capital.
The trouble was, that last Monday, when Drysdale was supposed to turn that interest money over to Chase, it couldn't. Where the money is, no one will say.
One possibility is that Drysdale lost some or all of it because its short term investments were unprofitable.
Another likely difficulty is that the bond market didn't behave the way Drysdale expected. Instead of going down--so it could repay Chase with cheaper bonds--prices could have gone up--so it had to buy more expensive bonds to repay its loans.
Very probably, Drysdale got caught in both those vises at once.
Bond prices often move up one day and down the next, or wiggle back and forth during a single day.
Drysdale probably had dozens--if not hundreds--of different deals going on at once.
In today's highly volatile bond markets, it's impossible to know exactly what happened without access to Drysdale's records, and federal banking officials reportedly hadn't gotten very far in that direction yesterday.