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The long-forgotten failure of a government securities dealer is a reminder of the havoc caused by a default in payments in the funding markets. More from Barrons.com: • Taking an Option on an Options Exchange• The Charts Weigh in on Gold, Silver• A Revenue Tune-Up at Sirius XM
As anniversaries go, round numbers are important, while prime numbers get short shrift. So it probably escaped your attention that Tuesday is the 29th anniversary of the failure of Drysdale Government Securities. Long before Long-Term Capital Management went bust in 1998, or Lehman Brothers a decade later, this medium-sized bond dealer's collapse threatened the underpinnings of a then-shaky financial system.
The anniversary of the Drysdale bust comes as the U.S. Treasury reached its statutory debt ceiling Monday, which is just the opening in what is likely to be weeks', if not months, of political sturm und drang as the White House and Congress battle it out over spending cuts.
The conjunction of the two events isn't totally accidental, however. May 15 is a big interest and principal payment date for the Treasury, for which it has to borrow to meet those obligations. Drysdale used a loophole — long since plugged — that revolved around such interest-payment date.
All of which is trivia that interests bond geeks and nobody else. But the real relevance is the key role that Treasury securities play in funding the financial system, which may not be fully appreciated. And that may be the greatest danger if the game of chicken over the debt ceiling goes over the cliff and the Treasury defaults.
First, let us return to those days of yesteryear when Treasury yields were measured in double-digits, not a handful of basis points. While short-term rates did recede from their 20% peak at the end of 1980 when Jimmy Carter was cleaning out the closets of the White House shortly before his departure, the fever in the bond market had yet to break. Treasury note yields still were up in the teens, with two-year notes yielding about 14%, which presented risk and opportunity.
The principals of Drysdale found an ingenious way to raise free money to finance their speculative positions, which were a bet that Treasury yields had to break lower because the economy, which still was in a deep recession, just couldn't stand double-digit interest rates. They were right, but early — which can be fatal to speculators. As John Maynard Keynes famously observed, the market can remain irrational longer than you can remain solvent.
But here was the key to Drysdale's ploy: it financed its position in the repurchase-agreement market by borrowing the securities with the greatest accrued interest. Then it sold those same notes, and received their price plus the accrued interest, which was substantial in those days of coupons in the teens. The difference bankrolled the firm's positions — worth $4 billion, which was real money back then. How was that possible? The repo market corrected this anomaly, belatedly.
The gambit worked — until the interest payment date, when Drysdale had to pay the interest on the securities it had borrowed. On Monday, May 17, 1982, when interest was paid on many of the notes Drysdale borrowed (May 15 fell on the weekend that year as it did this year), the firm had to pony up the dough. As it happened, it didn't have it.
Chase Manhattan Bank, Drysdale's counterparty on the repo transactions, had to pony up the $160 million Drysdale owed. Ultimately, Chase wound up losing $270 million on its dealings with Drysdale. (Chase then was a very different entity from today. A diagram of fish eating other fish might be helpful, but years later Manufacturers Hanover was swallowed by Chemical Bank, which later merged with Chase, which in turn was taken over by JP Morgan.)
Chase took the hit for its miscreant customer. The principals of Drysdale Government Securities ultimately pleaded guilty to securities charges, but it was Chase that had to pay in order that the repo market — on which the entire financial edifice is built — continued to function.
Scams such as Drysdale's are impossible today. But the functioning of the financial system still depends on the soundness of the collateral as well as the soundness of the counterparties in any transaction.
Which brings us back to the current discussion of the debt ceiling. In Saturday's Wall Street Journal, former hedge fund manager Stanley Druckenmiller asserted that, if the U.S. government were a few days late in paying its debts but the ensuing crisis truly forced Washington to put its fiscal in order, the default would be forgotten in the mists of history.
This is a persuasive argument not to give in and pass another debt-ceiling increase that doesn't address the nation's fiscal situation and continues the U.S. down the path of fiscal oblivion. Indeed, it's argued that a few days' default would be preferable to the status quo. And the world knows America is good for the money, unlike Greece or other sovereign debtors.
That, however, does not take into account the vital role Treasury securities play in the global financial system, serving as collateral to finance a myriad of transactions. They can serve this function because of the assumption — not assessment, but assumption — that the risk that the U.S. government will not pay its obligations, in full and on time, is nil.
One person's (or government's) liabilities are another's assets. Those assets may be used as collateral for borrowings, the fuel on which the global markets run. A disruption of this process, even for a day, would have repercussions far into the future.
That underlies the warnings from Treasury Secretary Tim Geithner on down about the dire consequences of a U.S. default, which is projected to hit in early August without an increase in the debt ceiling. It is the collateral damage, literally, that would take the greatest toll. With this vital form of collateral impaired, the funding markets could be hit in incalculable ways.
Just how is impossible to say. Having lived through the nightmare that followed Lehman Brothers' collapse in September 2008, the Federal Reserve and other central banks presumably would be better prepared to cope with a U.S. debt crisis.
The Drysdale collapse was miniscule in comparison, but Chase wound up taking the hit to make good on its customer's obligations, which allowed the repo and government securities markets to continue functioning.
It seems that it takes a crisis to get anything meaningful accomplished in Washington. But a default by the U.S. Treasury would be a wholly contrived and preventable crisis, with unknown costs and questionable benefits. Anything that could be decided after a default could be done before a crisis, even at the eleventh hour.
During the Cold War, the prospect of mutually assured destruction, or MAD, prevented the use of the nuclear option. Using default to cure America's debt problems would be as if the weapon were turned on ourselves.
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