Downing Drysdale April 9, 2013 at 12:18 am

Scott Skyrm helpfully reminds us of an historic failure, that of Drysdale. The origin of the failure was a glaring arbitrage between the US repo market in the 80s and the treasury market. The former did not account for accured interest on repo’d t-bills, while the latter did. Drysdale’s head trader

started short-selling U.S. Treasurys outright, where he received the price plus the accrued interest. Then he borrowed the securities to cover his shorts in the Repo market, paying only the market price. He was getting the full use of the accrued interest on the bonds at no cost. In order to maximize to amount of cash he was collecting, he concentrated on shorting Treasurys about half way between the semi-annual coupon payment dates. With years of declining bond markets, he had made a lot of money shorting the Treasury market and by February 1982 his trades reached $4.5 billion in short positions and $2.5 billion in long positions… Overall, it was not a bad trading strategy since he won under two out of three possible market scenarios. If the bond market went down, he made a lot of money. If the market stayed the same, he earned free interest on the cash the trade generated. [But] If the Treasury market rallied, he risked a significant amount of money.

The problem, then, was that he was exposed to rising prices which would kill his short. Needless to say, that happened in spring 1982, and Drysdale collapsed. What happened next is insightful.

Drysdale had conducted their Repo trading mostly through Chase’s Securities Lending Department and Drysdale’s counterparties believed they were facing Chase and not Drysdale. Chase believed they were acting “as agent” for Drysdale, so they would not accept responsibility for the $160 million in coupon interest payments on that Monday, but the problem grew even worse. Up until then, the government securities market had operated under the assumption that the buyer in a Repo trade was entitled to liquidate the trade in the event of a default by the seller. There was no law on books differentiating a Repo from a collateralized loan and there had never been a case in court to set a precedent. The market was unsure whether they could liquidate the Drysdale/Chase Repo trades.

The lack of clarity as to the bankruptcy status of a Repo left Chase with a major dilemma. If the bank refused to pay the coupon interest to the Street and that contributed to any of those securities dealers going bankrupt, a future court ruling against Chase could expose them to liability for the damage they caused. However, if Chase made the coupon interest payments for Drysdale, they were clearly taking a loss and would line up as a creditor of Drysdale in the bankruptcy. It was a lose/lose situation.

On Wednesday, the Fed intervened and called together the heads of the 20 largest banks and securities dealers for a meeting at the Fed’s New York office. Not only was there pressure put on Chase from the dealer community, but also by the Fed itself. Though the Fed would later announce that their only involvement was hosting a meeting, quite similar to the future meetings for Long Term Capital Management in 1998 and Lehman Brothers in 2008. The next day Chase relented and, as they say, the rest is history.

The FED, then, prevented a market failure by leaning on Chase in the way central banks do. There were profound financial stability reasons for doing this, not least because of the uncertainty in the legal status of repo. Without knowing if a repo was a collateralised loan or a sale/buyback, no one knew what the exposure was. The law was subsequently clarified in favour of the latter interpretation (thanks to another bankruptcy Scott discussed, that of Lombard-Wall), but the lesson is clear: don’t engage in lots of transaction of uncertain legal status.

2 Responses to “Downing Drysdale”

  1. Financiers rewriting history alert!

    Isn’t this really just an early instance of the financial industry exerting its TBTF muscle (in this case with the misguided complicity of the Fed) by developing a product that was clearly not supported by the law, allowing it to grow large, and then demanding that Congress rewrite the law “to protect financial markets.”

    Article 9 of the UCC has (and had) a broad definition of a secured transaction (“a transaction, regardless of its form, that creates a security interest in personal property or fixtures by contract”) that is deliberately designed to capture those transactions where the economic substance is one of collateralized lending — and in fact leases can easily be treated as secured transactions. And, thus, (under the assumption that Wall Street even in the 1980s had a reasonable number of lawyers on staff) the status of repos wasn’t uncertain. On the contrary, it was clear that the law was highly unlikely to allow a repo to be liquidated upon default. And, indeed, the bankruptcy court held in Lombard-Wall that the repo’d securities had to be turned over to the bankruptcy estate. (In re Lombard-Wall, 23 B.R. 165 (Bkrcy.N.Y. 1982); see also http://www.newyorkfed.org/research/epr/06v12n1/0605garb.pdf p. 35.)

    Kenneth Kettering describes the practice of creating TBTF markets and then demanding changes in the law here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1012937 . I have a post discussing this phenomenon here: http://syntheticassets.wordpress.com/2010/10/11/moral-hazard-and-the-foreclosure-crisis/ .

    There’s a lot of evidence that the financial industry drew the opposite conclusion from the one that you draw: Do engage in lots of transactions of uncertain legal status, because we have the political power to get the law changed.

  2. Thank you – most insightful. I will chase those references and mull on what you have said. There is immediate force to your argument, though…