Financial Disasters

53

There is not much question as to how Drysdale managed to obtain the

unsecured funds. The firm 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 date, 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).
4.1.1.4 How the Unauthorized Positions Failed to Be Detected Chase Manhattan
allowed such a sizable position to be built up largely because it believed
that the firms capital was not at risk. The relatively inexperienced managers
running the securities borrowing and lending operation were convinced they
were simply acting as intermediaries between Drysdale and a large group of
bond lenders. Through their inexperience, they failed both to realize that
the wording in the borrowing agreements would most likely be found by a
court to indicate that Chase was taking full responsibility for payments due
against the securities borrowings and to realize the need for experienced
legal counsel to review the contracts.
4.1.1.5 How the Unauthorized Positions Were Eventually Detected There was some
limit to the size of bond positions Drysdale could borrow, even given the
assumption that the borrowings were fully collateralized. At some point,
the size of the losses exceeded the amount of unauthorized borrowings
Drysdale could raise and the firm had to declare bankruptcy.
4.1.1.6 Lessons Learned The securities industry as a whole learned that it
needed to make its methods for computing collateral value on bond borrowings more precise. Chase, and other firms that may have had similar control
deficiencies, learned the need for a process that forced areas contemplating
new product offerings to receive prior approval from representatives of the
principal risk control functions within the firm (see Section 3.7).
4.1.1.7 Further Reading Chapter 14 of Stigum (1989) gives a detailed description of the Chase/Drysdale incident, some prior misadventures in bond
borrowing collateralization, and the subsequent market reforms.

4.1.2 Kidder Peabody

4.1.2.1 Incident Between 1992 and 1994, Joseph Jett, head of the government bond trading desk at Kidder Peabody, entered into a series of trades