Drysdale, E.S.M., Bevill Bresler. The names of these and a half-dozen other unregulated government securities firms that failed between 1975 and 1985, leaving uninsured losses of nearly $1 billion, will be recalled July 25 when the Government Securities Act of 1986 takes effect.
As of then, all government securities brokers and dealers must be registered with the Securities and Exchange Commission and join a stock exchange or a self-regulatory organization, such as the National Association of Securities Dealers. Commercial banks and thrift institutions dealing in government bonds will be regulated by their own agencies.
Dealers will have to meet minimum capital standards set by the Treasury proportionate to the market risks they take in order to better insulate investors from the possibility of failure. (Customer accounts will still not be covered by the Securities Investor Protection Corp (SIPC), which insures stock accounts up to $500,000 against failure, although government securities trading at full-service firms under the aegis of the Securities and Exchange Commission continue to enjoy SIPC protection.)
The act was fashioned as a compromise after a protracted and bitter dispute between Congress, anxious to protect investors, and financial regulators and the industry, concerned with maintaining an orderly, liquid market in the trillion-dollar-plus annual business of Treasury securities that finance the country's debt and provide funds for some government-sponsored agencies.
For 18 months investigators probed the workings of government securities dealers and the causes of corporate failures in this highly risky market where small sudden shifts in interest rates can result in huge losses. Committees paid special attention to the three most recent major insolvencies: Drysdale Government Securities Inc., an affiliate of a Wall Street broker/dealer registered with the SEC. By 1982 it had lost more than $300 million in repurchase agreements (known as "repos"), a form of trading in which government securities are used as collateral for loans. On the due date, Drysdale was unable to make $160 million in interest payments on U.S. securities it had borrowed from Chase Manhattan Bank. Chase finally agreed to make good on the losses. The Federal Reserve Bank of New York had to take action to restore liquidity to the marketplace. E.S.M. Government Securities Inc. of Fort Lauderdale, Fla. It folded in the spring of 1985 after speculating unsuccessfully on interest rates. The government securities that served as collateral had been pledged for several loans, resulting in $300 million in losses for customers. (Rules dealing with custody of collateral are included in the new law.) Among those hit was Home State Savings Bank in Ohio. A run on the thrift caused the demise of the state's deposit insurance fund. Bevill, Bresler and Schulman Asset Management Corp. A month later, fraudulent repos without proper collateral to hide trading losses also brought down this New Jersey government securities dealer. The D.C. government, a BBS customer, escaped harm because it had the collateral to sell, but others -- including Old Court Savings and Loan -- lost $235 million. In its wake, three other small government securities dealers also failed or were liquidated.
Were there more E.S.M.s and Bevill, Breslers out there about to go bust? E. Gerald Corrigan, president of the Federal Reserve Bank of New York, estimated that last year there were 200 to 300 unregulated government securities dealers in the country in addition to 40 primary dealers who report to the Fed and are required to participate continuously in the process of underwriting U.S. government securities.
In the end Congress decided last October that all previously unregulated government securities dealers would have to register with the government by July 25. (The Treasury announced last week that several other provisions of the regulations would be deferred until later this year or next because putting them into effect now would be "operationally extremely difficult.")
So far, however, it has been the regulatory equivalent of giving a party to which nobody came.
To date -- and no last-minute rush is expected -- a total of 72 dealers have registered with the SEC and the NASD. Five other firms registered with the SEC to become full-service brokers.
Treasury and industry officials unanimously expressed surprise at the small number. "We were floored that there were so few applications," said Marilyn Davis of NASD's Atlanta office. "Word of mouth had said there were so many out there."
There are several possible explanations. A fair number of the unregulated dealers are believed to be subsidiaries of registered brokerages, as Dysdale GSI was, set up to escape capital requirements. Rather than register separately, the affiliates have been folded back into the parent company. Others of the estimated 200 to 300 are undoubtedly banks and thrifts whose activities will be regulated by the comptroller of the currency or the Federal Home Loan Bank Board.
An additional, though still unquantified, number of firms apparently were unwilling or unable to meet government requirements; either not wanting regulators peeking into their operations or without enough capital or proper books, they elected to close down or go into another line or work.
Of the 72 applicants who joined the NASD, 50 are from New York, according to Tom Cassella, NASD vice president in Washington. Florida, which has had many shady securities operators, has produced only two. In an effort to "stay ahead of the con men," said Florida Comptroller Gerald Lewis, the state required all government securities dealers to register and meet SEC capital requirements last Jan. 1. Just 13 out of 34 unregulated dealers in Florida survived the cut, whatever the reason, he said.
Because Florida's elderly population is a natural market for high-yielding, government guaranteed investments like Ginnie Maes pools, which are interests in securities issued by the Government National Mortgage Association, sellers flocked to the state a decade ago. Since the state law requiring registration, the number of flashy print and broadcast ads for Ginnie Maes has subsided, said Don Saxon, director of the state's securities division.
Under the Treasury's rules, government securities dealers must have minimum capital equal to 1.2 times their measured market risk. For example, a firm that takes many different kinds of positions and has a measured market risk of $4 million on a given day, would need at least $4.8 million in capital. (The SEC uses a different method to calculate capital requirements for full service brokerage firms, including those that sell government securities, but the bottom line is similar, analysts say.)
Richard G. Jackson, president of the Government Securities Brokers Association in New York, said that interdealer brokers, some of whom have just $1 million to $2 million in capital now, will need as much as $10 million to $15 million. He added that would not be a problem, since most of them can get it from their parent companies. Interdealer brokers arrange transactions in Treasury securities amomng the primary dealers.
For many other dealers, who now meet voluntary Federal Reserve standards, no additional capital will be needed. There is, however, the cost of compliance. One previously unregulated dealer, who did not want to be identified, said the requirements by the SEC and the Fed will cost him $500,000.
Ralph Peters, chairman of Discount Corp., a primary dealer, called it "a lot of expensive red tape." Whereas John Darcey, chief financial officer of L.P. Cook & Co., said his firm's new computer could handle the paperwork easily.
Finally, will regulation of the government securities industry end the abuses, prevent other Drysdales from happening? Griffith Clarke, chairman of G.X. Clarke Co., an independent secondary dealer who opposed regulation on Capitol Hill, philosophized, "The problem of failures is not solved. The fraudulent dealers who existed before July 25 aren't going to disappear overnight. They will go to other firms. After the start-up period, unscrupulous dealers might tell clients they were regulated and that it was safe to do business with them."
Or they might switch to other investments. Con artists who once sold municipal bonds in Florida before the industry was regulated, then switched to government securities, have recently been observed peddling Australian dollar-backed bonds.