How could a three-monthold government bond firm, capitalized at $30 million, confuse 30-odd respected bond dealers and force the third and fourth-largest banks in the United States to pay a minimum of some $160 million in interest to various dealers? These questions are reverberating around the canyons of Wall Street. Only the new firm, Drysdale Government Securities Inc., knows the real story, but to date, it isn't talking.
The picture that has emerged so far is this: Being the new guy on the block, and with visions of greatness, DGSI wanted to grow big -quickly. However, DGSI needed someone to act as a buffer with 30-odd dealers. Chase Manhattan and the Manufacturers Hanover banks fulfilled that role.
Those large banks borrowed government securities from dealers and retail accounts and then re-loaned the securities to DGSI. When that occurs, the accured coupon interest on the bonds is not paid to the lender. Only the principal is paid to the lenders, with the time-honored understanding that when the coupon interest becomes due and is paid, the borrower forwards the interest to the true owner and lender of the securities.
Knowing this, DGSI sold to a client a highcouponed bond whose interest payment date was close at hand. In this transaction, the buyer paid DGSI both the principal and interest. DGSI in turn, paid the principal to the bank from whom they borrowed the bond and then used the interest to finance their operations.
Here is where the picture becomes fuzzy because it is unclear how they used the interest. Did they buy more bonds on margin for greater leverage? Did they purchase financial futures on margin? Whatever they did blew up last Monday when some $160 million of coupon interest on the borrowed bonds became due and was paid. However, DGSI, not having the bonds, was unable to pay the interest to the banks so that they could pay the original owner.
The lenders then looked to the banks for their interest, and the banks reluctantly agreed to pay, which averted a major crisis. To incur an interest payment to some $160 million, dealers suggest that somewhere between $2 billion and $4 billion of government securities were involved. The debacle touched all the fixed-income markets and created uncertainties.
When it was realized that the firm was in trouble Monday afternoon, dealers feared that securities would have to be liquidated and the government market dropped sharply. The dealers who loaned the securities to the banks were afraid that they would not receive their interest. Also, dealers amy have entered into trades involving the bonds they had loaned the banks. Realizing that they would not get them back, they were afraid that they would have to go into the market and buy a similar security to make good on their deliveries.
In the money market area, there was an immediate flight to quality. Treasury bills were in great demand and yields went screaming lower. By week's end, the three-month T-bill had declined 80 basis points. The twoyear Treasury auction attracted a greater demand than was anticipated. Dealers shied away from commercial banks in financing their positions. And it took higher yields to sell Chase's money market paper.
The municipal market had several sizeable deals to offer: the $680 million Washington Public Power issue and the $3.5 billion New York State TRAN issue. Neither issue was a ball of fire initially, but as money market rates followed T-bills lower, and the federal funds rate fell on Thursday, the entire bond market picked up.
Which brings us to the Federal Reserve. As the Fed supplied reserves on Thursday, the federal funds rate dropped below 14 percent, short rates fell, bond prices rose, and it appeared that Chase Bank was very much on the Federal Reserve's mind.