AIM: Describe the key factors that led to and the lessons learned from Drysdale Securities

Allen divides financial disasters into three types: cases where investors or lenders (or the parent company) were misled; cases where the firm had reasonable knowledge of its positions but losses resulted from unexpectedly large market moves; and losses due to reputation or fiduciary exposure to the firm’s customers:

About Drysdale

During three months in 1976, Drysdale (a new subsidiary of Chase) obtained about $300 million in unsecured borrowing. However, the firm only had about $20 million in capital. Drysdale lost money on the positions, went bankrupt, and Chase was forced to absorb the losses.

Drysdale “took systematic advantage of a computational shortcut in determining the value of borrowed securities. To save time and effort, borrowed securities were routinely valued as collateral without accounting for accrued coupon interest. By seeking to borrow large amounts of securities with high coupons and a short time left until the next coupon data, Drysdale could take maximum advantage of the difference in the amount of cash the borrowed security could be sold for (which included accrued interest) and the amount of cash collateral that needed to be posted against the borrowed security (which did not include accrued interest).

Key factors (Drysdale)

• Chase failed to detect the unauthorized positions: Chase did not believe the firm’s capital was a risk.
• Relatively inexperienced managers, running the securities borrowing and lending operation, believe they were simply acting as middlemen between Drysdale and bond lenders
• The inexperienced managers did not correctly interpret the wording of the borrowing agreements, which indicated that Chase was taking full responsibility for payments due.

Lessons Learned (Drysdale)

• The securities industry learned that more precise methods were required to for computing collateral value on bond borrowings.
• Chase, and other firms, learned the important of a process control: contemplated new product offerings should receive prior approval from representatives of the principal risk control functions within the firm.

Comments

1. James Keating 17 Jun 2010

   Wasn’t this in February 1982 not 1976?

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