In an attempt to forestall the type of speculation that led to the failure of tiny Drysdale Government Securities Inc. last May--a failure that nearly threw the financial system into panic and cost Chase Manhattan Bank $117 million--the Federal Reserve on Aug. 2 will change the way it values government notes and bonds for trading purposes, according to Wall Street sources.
All government securities dealers are expected to adopt the same system by September, sources said.
Drysdale used a quirk in the way government securities dealers valued notes and bonds to generate the cash it used for its speculative trading. With only $20 million in capital, Drysdale was able to buy and sell more than $6 billion of government securities. Its portfolio of securities was as big as that held by Salomon Brothers Inc., the nation's biggest dealer, who has 20 times the capital of Dysdale.
Drysdale would sell a security it did not own, then borrow that security from another dealer to complete the sale transaction. The value of the bond would include not only the market price, but also the interest due but not yet paid by the government, which makes interest payments twice a year.
The bond could be borrowed by Drysdale for only the market value. But when Drysdale sold the bond, it received both the market value and a payment equal to the accrued interest. As a result, Drysdale could temporarily use the accrued interest it received from the purchaser to finance further speculation. Drysdale collapsed because, at the time it had to pay interest back to the original owners of the bonds, Drysdale had lost it speculating.
By including accrued interest in the value of the bond, the Federal Reserve and other dealers will prevent small, undercapitalized firms from using the accrued interest they supposedly held in trust as part of their own funds.