Wall Street's Panic That Wasn't

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A sudden default rattles an already edgy market

U.S. Treasury securities are regarded by moneymen as excellent investments. After all, those bonds, notes and bills are issued by the American Government. But for a brief and unnerving period last week, the business of buying and selling them gave Wall Street jitters aplenty. The problem was not the creditworthiness of the U.S., but rather the solvency of a tiny and little-known Wall Street securities firm, Drysdale Government Securities Inc.

The Federal Reserve controls the U.S. money supply by buying and selling bonds and notes in the securities markets. On a normal business day, about $25 billion to $35 billion in so-called federal paper changes hands. Thirty-six of Wall Street's largest securities dealers, including Goldman, Sachs & Co., First Boston Corp. and Salomon Bros., are the dominant traders in the $700 billion market. As interest rates have gyrated in this market in recent years, those dealings have become attractive to other firms. Last February, for example, Drysdale, a $5 million spin-off of the 92-year-old Drysdale Securities Corp. brokerage house, opened its doors.

Through its aggressive dealmaking, the fledgling company, which had only about 20 traders operating out of a fifth-floor attic above a Wall Street area clothing shop, elbowed its way into the thick of play. Using what they thought to be sophisticated, computer-guided trading strategies based on a secret computer program code-named Arnold, Drysdale's two top dealers, Richard Taaffe, president, and David Heuwetter, chief trader, managed in little more than three months' time to amass an astonishing $4 billion-plus portfolio of borrowed U.S. Treasury securities.

The group's main activity was to speculate in the volatile and complex world of repurchase agreements. In a typical repo, a brokerage firm raises cash by selling some Treasury notes or bonds to another dealer or bank with the understanding that it will repurchase them a few weeks or months later. The bank thereby, in effect, gives a short-term loan to the brokerage firm, and the collateral for it is the Government securities.

Since the bank legally owns the securities during the period covered by the deal, it can use them to create a so-called reverse repo with a third party, and that party can do the same with yet a fourth buyer. The firm buying the securities from the bank speculates that it will be able to sell them for more than it paid.

Though repo deals can wind up involving dozens middlemen, the interest that the U.S. Treasury pays regularly on the certificates always goes back to the original owner of the note or bond. Whenever the Treasury sends out interest checks to the holders of its securities, that amount is paid by each repo buyer back to the preceding seller in the chain.

Drysdale's repo troubles had been quietly brewing for weeks, as credit market conditions began to undermine the company's assumption that interest rates were going higher. Instead of the generous profits that Arnold had predicted, Drysdale had a steady stream of losses. The real crisis started last Monday, when the firm failed to meet $250 million in interest due to Chase Manhattan Bank, its principal repo supplier.