The president of the New York Federal Reserve Bank said yesterday that the spectacular failure of a tiny securities firm last week was an "aberration" that does not appear to require extensive regulatory action.
Anthony M. Solomon told the securities subcommittee of the Senate Banking Committee that, although he has an "open mind" about whether some form of regulation should be imposed on the government securities market, he believes that the failure of Drysdale Government Securities Inc. was an isolated event.
But Solomon said he does expect securities dealers to close a "loophole" that permitted Drysdale to trade way over its head using other brokers' funds.
None of the three dozen government securities dealers that the New York Federal Reserve does businesswith on a daily basis and none of the major New York banks that process securities trades has found any evidence of another Drysdale-type situation.
"If there is that type of situation, we probably would be aware of it already," Solomon testified.
Drysdale speculated its way to disaster during its brief four-month existence, apparently using $20 million of its own money and perhaps 10 times that much of other brokerage firms' money. Last week Chase Manhattan Bank, Drysdale's agent for most of its trading, assumed the firm's debts when Drysdale did not have the nearly $200 million in interest that belonged to about 30 other brokerage firms from which Drysdale had borrowed securities.
Solomon said that two problems were at the heart of the incident. Drysdale apparently took advantage of a "loophole" in government securities trading practices that enabled it to use interest owed other securities firms to finance its own speculation. And because Drysdale used Chase as a middleman in the transactions, other firms say they were unaware that their securities were in Drysdale's hands--a situation many of the firms said they would not have permitted.
Solomon said the Fed and the Association of Primary Dealers in Government Securities will study the loophole, and others and said they would not be surprised if some are closed.
The Federal Reserve Bank president also put some of the blame on Chase and the other banks that had smaller dealings with Drysdale--Manufacturers Hanover and U.S. Trust Co. He said the banks at the least should improve their "controls."
Chase and the brokers disputed who was liable for the lost interest for a day, a question that may yet be resolved in court, but the nation's third-biggest bank eventually assumed all Drysdale's debts to prevent repercussions in the securities markets.
Solomon said that, although the markets functioned smoothly last week, considering all the shocks, he felt that, had Chase not assumed Drysdale's debts, government securities dealers would have become increasingly uncertain about conditions as days went on and the markets--which swallow tens of billions of dollars of new Treasury debt each year and trade hundreds of billions of dollars of old bonds--might have "seized."
The loophole Solomon described is the difference in the way a security is valued, depending upon whether it is sold outright or borrowed. When a security is sold, the purchaser not only must pay for the security but also for the interest the security has accumulated since the last time the Treasury paid interest. When it is loaned, however, only the face value is used as a basis for the transaction.
When the interest is due from the Treasury, the borrower is supposed to pass it along to the securities firm from which the bonds or notes were borrowed.
By selling outright bonds that it had borrowed, Drysdale was able to use the interest checks from the buyers to finance its speculation. When the Treasury paid the interest, Drysdale did not have the securities any more and did not collect the interest it was supposed to pass along and had lost the interest paid by the purchasers.
Solomon said in his prepared testimony that the $20-million-capital firm controlled $6.5 billion worth of government securities, a "position" as big as firms 20 times its size. An adverse swing of one percent in the value of its holdings in one day--a common occurrence in today's volatile securities markets--would have cost Drysdale $65 million.
Donald N. Malawsky, New York regional administrator for the Securities and Exchange Commission, said that, if a federal agency had oversight on Drysdale--government securities dealers are unregulated--there would have been no guarantee that it could not have taken the same actions.