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) j   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ........  Collection: Paul A. Volcker Papers Call Number: MC279  Box 12  Preferred Citation: Congressional Correspondence, September 1982 [Folder 2]; Paul A. Volcker Papers, Box 12; Public Policy Papers, Department of Rare Books and Special Collections, Princeton University Library Find it online: http://findingaids.princeton.edu/collections/MC279/c455 and haps://fraser.stlouisfed.orearchival/5297 The digitization ofthis collection was made possible by the Federal Reserve Bank of St. Louis. From the collections of the Seeley G. Mudd Manuscript Library, Princeton, NJ These documents can only be used for educational and research purposes ("fair use") as per United States copyright law. By accessing this file, all users agree that their use falls within fair use as defined by the copyright law of the United States. 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Mudd Manuscript Library 65 Olden Street Princeton, NJ 08540 609-258-6345 609-258-3385 (fax) mudd@princeton.edu   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  U  4  4  A REPORT ON DRYSDALE AND OTHER RECENT PROBLEMS OF FIRMS INVOLVED IN THE GOVERNMENT SECURITIES MARKET  INTRODUCTION AND SUMMARY During the past few months the successive problems of Drysdale Government Securities Inc. and, to a lesser degree, Comark, and Lombard -Wall, Inc. have disturbed the Government securities market and touched off a critical review of credit standards and operating practices in that market.  Although none  of these three firms was on the Federal Reserve's list of primary reporting dealers in Government securities and the Federal Reserve does not have formal regulatory authority over the Government securities market, the Federal Reserve had a concern with the recent events and their implications for the functioning of the Government securities market.  For a number of years, the Federal  Reserve has exercised surveillance over developments in this market, centered on close monitoring of the activities of selected firms--now numbering 36--that have met the Fed's criteria for active market participation and financial integrity.  Essentially,  these are also the firms with which the Federal Reserve carries out open market operations to implement national monetary policy. While its attention is ordinarily focused on the reporting dealer firms, the Federal Reserve has also sought to follow up on   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  .  _  2_  situations involving other market participants, to keep abreast of their implications for the overall functioning of the market. Despite the initial impact and cumulative concern generated by Drysdale et al, the Government securities market has continued to function well throughout the summer, providing secondary market liquidity as well as underwriting support to the Treasury's new issues.  Market-making by dealers recovered fairly  quickly from the adverse effects of each episode, but a general tightening of credit standards and market practices has begun. Consistent with this, the Federal Reserve has been strengthening its own surveillance role as well as working with dealers to change market practices that allowed the failing firms to conduct operations well beyond the limits of prudence in relation to their capital.  As developed in this report, while there were distinct  differences among the three problem cases, a common flaw appears to have been the ability of the firms to raise working capital from careless or unwitting customers, working capital the firms put at risk in their own activities. The market for Treasury securities is a largely selfregulating market--although a number of the participating dealer firms are under one or another regulatory framework because of their other activities or their form of organization. Institutions are expected to monitor their own risk exposure in trading, lending and financing activities with due regard to prudent business standards.  When all participants follow such  standards, the ability of any participant to carry positions is constrained by the credit exposure others are willing to risk in   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  3_  -  relation to that participant's capital position. Such limitations broke down in these three cases.  In the  Drysdale case the firm raised funds by borrowing securities, then selling them to realize principal and accrued interest in excess of the cash it provided against the securities.  It was able to do  this on a huge scale by using banks as "blind brokers" to screen its identity from those lending securities.  The extent of  Drysdale's losses from its trading activities was first revealed when the firm could not meet its $160 million liability for interest payments on May 17.  In the Comark case, some of the  firm's customers reportedly allowed the firm to retain custody of securities purchased from it; the firm's borrowing against these securities apparently concealed a shortage of working capital until the firm proved unable to meet its customers' demands for their securities.  In the case of Lombard-Wall, customers advanced  funds in excess' of the value of the securities they received under repurchase contracts; in other instances they received funds from Lombard -Wall of lesser value than the securities they provided. The excess funds thus acquired enabled the firm to carry out other activities well beyond what its own capital warranted. The Federal Reserve's responsibility for the supervision and regulation of banking organizations also led it to give special attention to the involvement of several large banks, particularly with Drysdale.  Without the support of essential bank  services such as securities lending and securities clearance, Drysdale -- 4nd to some extent the other two firms -- would not have been able to build positions to unsustainable levels and   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  p  .  , -4 _  suffer losses far beyond their own capital. A review by Federal Reserve bank examiners of the banks' relationships with the firms indicated that the banks generally viewed themselves as intermediaries between borrowers and lenders of securities of the highest quality (U.S. Governments) --facilitating transactions that involved little, if any, inherent risk.  The banks in processing, and occasionally arranging, the  transactions followed the standard market practice of not including accrued interest in valuing securities lent under repurchase agreement.  Apparently because the banks viewed the  activity as essentially riskless from a credit risk point of view, some of them did not subject the firms involved and their activity to the rigorous credit reviews and controls that are a standard feature of the banks' more traditional functions.  There were  deficiencies in the internal control and monitoring systems at two of the banks servicing Drysdale, so that middle and senior management were not alerted to a sharply increasing volume of transactions and the heavy concentration of business with one customer.  At one bank, a compensation program may have encouraged  the generation of excessive volume. The immediate effect of the Drysdale affair was a widespread review and tightening of credit procedures.  This process  itself contributed to the demise of the other two firms whose operations were not supportable on their existing capital base. Increased attention to risk exposure also reduced significantly the resources available to other firms with small   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  4 _ 5-  capital positions and increased somewhat the costs they encountered in financing their positions.  These indications of  intensified market discipline, working to constrain the risks market participants can run with borrowed funds, should be considered basically healthy.  At the same time, there is some  ground for concern about the possibility of hasty overreactions that could cause problems for sound firms as well as marginal ones. In response to these developments, the Federal Reserve is taking the lead in working to improve practices in the Government securities market.  To this end, it has strengthened its own  commitment to overseeing the market and working with the primary reporting dealers to reduce the likelihood of similar incidents in the future.  It has already taken steps to modify the practice  that enabled Drysdale to raise the capital supporting its large speculative positions.  All dealers reporting to the Federal  Reserve have been informed in writing that they are expected no later than October 4, 1982, to include the value of accrued interest in all their repurchase or reverse repurchase transactions.  The Federal Reserve made this change in the valuation of  its own transactions beginning in August 1982.  The Federal Reserve  also intends to develop guidelines to evaluate the capital adequacy of the dealers that report to it.  Information on these guidelines  will be made available to the primary regulators of banks and investment firms.  Through this and improvements in other market  practices, the Federal Reserve expects to reinforce and monitor the market's own self-regulatory discipline so that capital and market practices will constrain the risks that can be run in the Government securities market.  Experience will show whether these  arrangements regarding oversight of the Government securities   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  i -6 -  market will be sufficient or whether it will be necessary to seek authority from the Congress for more formal regulation. As for the commercial banks, all took prompt action to investigate and correct deficiencies brought to light by their relationships with Drysdale.  The banks appear to have taken the  appropriate step of discontinuing the practice of "blind -brokering" in their intermediary relationships.*  The two banks who  experienced significant losses as a result of their securities lending activities in support of Drysdale's operations suspended all securities lending activities, pending completion of a thorough review of the risks involved and the development of strengthened policies and procedures for the conduct of the activities.  At the bank reporting the largest loss from its  Drysdale relationship, the employment of those officers who were directly responsible for the activities has been terminated, either voluntarily or involuntarily. The reviews initiated by the banks involved with Drysdale and by other banks providing services to participants in the securities markets were, in some measure, responsible for the difficulties encountered by Comark and Lombard -Wall--as weaknesses existing at those firms were revealed.  Increased attention by  banks providing securities clearance services to the financial  * The question of whether these banks were acting as agent or principal in dealing with Drysdale GSI may ultimately have to be decided in court. For convenience, the banks may be referred to as "intermediaries" and Drysdale GSI as "principal" in this report without seeking to prejudge the legal issue.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -  _ 7-  condition of the firms for whom they clear securities caused a reappraisal of the Comark and Lombard -Wall relationships. The banks decided to discontinue clearing for the two firms and the firms were unable to find other banks willing to serve as clearers. The increased awareness by banks of the credit risk aspects of securities clearance activities is seen as beneficial. At the same time, it is important to the orderly functioning of the marketplace that banks avoid unduly precipitous terminations of clearing relationships -- meanwhile protecting themselves through careful monitoring and control of activities. Early in 1982, the Federal Reserve Bank of New York alerted the Task Force on Supervision of the Federal Financial Institutions Examination Council to its concerns about the growing use of repurchase agreements by depository institutions and the potential risks associated with repurchase agreements entered into in large volume with institutional investors or brokers.  The  Examination Council's Task Force decided that each of the agencies should issue a supervisory circular alerting the institutions for which it had supervisory responsibility to the risks involved in repurchase agreements.  On April 21, 1982 the Federal Reserve Bank  of New York issued such a circular setting forth the perceived risks and conclusion that "...banks should obtain sufficient financial information on and analyze the financial condition of those institutions and brokers with whom they engage in repurchase transactions."   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Federal Reserve examiners had, prior to Drysdale, begun a  8  review of banks' internal procedures and practices related to repurchase agreements.  The Drysdale incident caused a further  review of examination procedures related to securities servicing and securities lending activities which banks provide in support of repurchase agreement transactions.  Guidelines and a  questionnaire have been developed for use by Federal Reserve examiners in monitoring more effectively securities servicing and securities lending activities at the banks.  The Federal Reserve  is sharing those supervisory tools with the other Federal bank regulatory agencies.  THE DRYSDALE CASE 1.  •  Investigation. The four months that have passed since the Drysdale  Government Securities, Inc. (Drysdale GSI) default have not been sufficient to determine all the details about how the firm came to do what it did.  However, it is believed that the main facts are  known about the methods and strategy that permitted a small securities firm to involve a large number of market participants in a major market misadventure.  Less clear is an answer to the  question of precisely how the firm managed to lose such a large sum of money in a short time, although informed and plausible conjectures can be made. As noted earlier, the firm was not a primary Government securities dealer reporting to the Federal Reserve.  Such records  of Drysdale GSI as have been made available to the Federal Reserve are unsatisfactory.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  They consist mainly of incomplete trans-  _  A  9  -  -  actions data that must be laboriously pieced together to show even a murky picture of the operations that Drysdale GSI was engaged in during the months preceding its demise.  The failure of Drysdale  GSI to either maintain or disclose adequate position records or income and expense accounts will probably continue to obscure the details of the trading strategy which generated the massive exposure that characterized the firm's activity. The known records of Drysdale GSI were obtained by Chase Manhattan Bank when it assumed the remains of the securities firm. The records were placed in the custody of Milbank, Tweed, Hadley & McCloy, the law firm retained by the bank to investigate Chase's involvement with Drysdale GSI.  Thee law firm subsequently retained  the accounting firm of Peat, Marwick, Mitchell & Co. to analyze the accounting records received from Drysdale GSI.  The Securities  and Exchange Commission has subpoenaed pertinent records of market participants associated with Drysdale GSI and the records of Drysdale Securities. also investigating.  The District Attorney for New York County is The Federal Reserve has not sought to  duplicate the ongoing analyses and investigations referred to above, but plans to use the results of these investigations in its own continuing review of the causes and implications of the Drysdale failure.  In addition, the Federal Reserve has used its  bank supervisory authority to pursue an investigation of the circumstances of the default.  The examination of the available  information is not complete and it is too early to indicate all the conclusions that may be drawn from the record.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  One point that is not yet clearly established is whether  -  , -1S-  Drysdale GSI incurred trading or operating losses sufficient to cause the default or whether fraudulent actions contributed to the firm's failure to meet its obligations.  The Securities and  Exchange Commission is pursuing an investigation to determine if fraudulent conduct was a major cause of the default, and the District Attorney for New York County is conducting a criminal investigation.  Also not yet clear is the time span over which the  losses occurred.  2.  Conditions Which Permitted the Default to Occur. A combination of practices existed in the market for  .. . Government securities which permitted Drysdale GSI to exploit vulnerabilities.  No inddual market practice could be  considered necessarily irresponsible or irrational by itself, but each had potential flaws when manipulated and combined with other practices.  In particular, the market was vulnerable because some  participants were not sensitive to or aware of the exposure to which they were subject.  The amount of business offered by  Drysdale may have distorted judgements regarding the potential risks.  The discretion which participants usually exercise when  choosing business associates may have been weakened by the prospect I f profitable transactions. Exercising discretion was made more difficult by the nature of the transactions.  The major risks developed in a  business which was considered low in risk, i.e., lending of securities.  Securities dealers, in the course of making markets,  often sell securities short.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  That is, they sell securities they  .  -11-  do not own.  In itself, this can be an entirely normal and  appropriate activity.  To make delivery of securities sold short,  dealers borrow securities either through a loan collateralized by other securities or through a temporary purchase known as a reverse repurchase agreement.  Dealers also enter into repurchase  ageeements, in which they sell and then subsequently repurchase securities. The temporary transfer of securities through loans, repurchase agreements, and reverse repurchase agreements is one of the most active market operations.  Statistics are not available  regarding the daily volume of transactions but dealers who report positions to the Federal Reserve indicated that at the time of Drysdale's default they had outstanding about $103 billion of Government securities sold under repurchase agreements. The size of the market has nurtured a number of firms which act as brokers or finders.  These firms bring lenders and  borrowers into contact and provide the service of locating lenders of specific securities.  The service eliminates the need to  canvass the market and can save dealers much time and money. Another important service sometimes provided is anonymity.  Dealers  may want to avoid direct contact with other dealers because their transactions would indicate the positions they are taking. Consequently, they often prefer to mask their actions through a broker or finder.  The term "blind" brokering is frequently used  to describe the activity of not disclosing the names of the participants in a transaction.  In some cases a participant may  know the names of all the clients of a broker but not the name of   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -12-  the client that was party to a specific transaction.  In any  event, participants could be dealing "blindly" in that the completion of the transaction will depend on the performance of an uniS.ntified party.  In the case of nonperformance the dealer  could look to the broker but the ability and the obligation of the broker to provide compensation may be open to question. Before the Drysdale default the lender of coupon -bearing securities under a repurchase agreement generally did not receive as part of the payment the value of the interest that had accrued on the current coupon.  A coupon-bearing security that was nearing  a coupon payment date was consequently worth much more than was realized by the lender of securities.  This practice developed  because the repurchase agreement was devised by dealers as a way of financing their securities inventories.  Generally, the  securities were financed with major financial or non-financial corporations.  Such lenders of funds had strong credit positions  and would only provide dealers with financing if it was sufficiently collateralized.  The interest that had accrued on  coupon-bearing securities was not paid to the dealers because it formed an additional margin of protection as well as simplified calculations.  There was little question about the dealer  receg the interest when due.  After dealers became borrowers  of securities and, in effect, lenders of funds the practice continued even though the logic for the practice had changed.  In  S ther words, the institutions which were strong credits now provided the dealers with the same protection they had been afforded when the roles were reversed.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  However, in some cases the  -13-  recipients of the protection were not as financially reliable. The growth of the market in recent years increased the possibility that an unreliable borrower of securities would misuse the system that had evolved in the market.  3.  Drysdale's Operations. Drysdale Securities Inc. was a broker -dealer registered  with the Securities and Exchange Commission and a regulated member of the New York Stock Exchange.  The firm was founded as a  partnership in 1889 but in 1975 the ownership changed and a corporate form was adopted.  The new owners expanded the  activities of the firm and it became active in the market for U.S. Government securities in the spring of 1981. Reports filed with the New York Stock Exchange reveal that securities borrowed rose from modest levels to about $750 million in May of 1981 and climbed above the billion level in the next month's report.  Ownership equity in the firm was listed as  $2.8 million at that time.  Securities borrowed rose to $1.3  billion in July but then were reported around the $900 million level in the reports for August to October 1981.  The month-end  report for November 1981 showed securities borrowed of $2.1 billion with ownership equity of only $5.1 million.  During this  period Drysdale Securities, Inc. indicated in its reports to the New York Stock Exchange that its business in U.S. Government securities was one of borrowing and lending securities essentially as a broker.  The reports filed with the New York Stock Exchange  did not indicate that the securities borrowed and lent were   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -14-  supporting long and short positions in U.S. Government securities.  On the other hand, Government securities dealers  reportedly knew the firm as a relatively aggressive trader of U.S. Treasury securities during 1981, one that was taking large long and short positions. The large position in borrowed and lent securities maintained by Drysdale Securities, Inc. made it difficult for the firm to satisfy the New York Stock Exchange's minimum capital requirements.  Apparently for that reason Drysdale Securities, Inc.  formed an affiliate titled Drysdale Government Securities Inc. This enabled it to insulate its Government securities activities from the application of the New York Stock Exchange capital adequacy regulations.  The affiliate opened on February 1, 1982  with a stated capital of $20.8 million, including subordinated debt of $10.3 million, common stock of $5.5 million, and preferred stock of $5 million.  The preferred shares were issued to Drysdale  Securities, Inc. in exchange for operating assets and related liabilities said to have a net fair value of $5 million.  Whether  the opening capital was impaired or deficient in some way has not been determined.  The opening capital position was audited by a  well-known accounting firm but the report did not include a balance sheet showing the firm's assets and liabilities. As early as June 1981, even before the formation of Drysdale Government Securities, Inc. some of the Federal Reserve statistical reports showed noticeable increases in trading volume which turned out, on inquiry, to have been generated by Drysdale Securities, Inc.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Over the next several months the Drysdale name  ]  -15-  was heard intermittently by Federal Reserve officials as an active market participant.  In addition, the officials noted that tenders  received at sales of Treasury debt included bids submitted by dealers for Drysdale, sometimes for large amounts.  The Federal  Reserve made inquiries of other dealers about the activity noted, including the large auction bids, and took the occasion to point out to dealers submitting bids on behalf of others that they have a responsibility for their customer's bids. Shortly before the default the Federal Reserve met with two Drysdale GSI officials who had inquired about qualifying for reporting to the Federal Reserve.  The default occurred, however,  before more was learned through direct contact.  The indirect flow  of information received through the reporting dealers suggested that the dealer community was displaying a growing reluctance to deal with Drysdale GSI because its activity did not seem consistent with its resources.  It may be noted that some dealer  firms seemed to be considerably more tolerant than others in continuing to deal with a firm of questionable financial soundness relative to its scale of activity and exposure. The impetus behind the new activity in Government securities, initially at Drysdale Securities and then after February 1982 at Drysdale GSI, was apparently a trader who had been previously employed by several securities firms.  He was known as  a technician who traded securities using sophisticated yield curve analysis, charting techniques, and computer technology.  His basic  trading strategy evidently used a computer program to uncover market relationships that were likely to change.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  That is, the  Wow  -16-  programs were supposed to identify situations in which the price of one maturity or range of maturities was likely to rise or fall relative to the price of another maturity or range of maturities. Accordingly, one or more securities were purchased and other securities were sold short on the expectation that the spread between the prices at which the securities were bought and sold would change favorably.  That strategy required the arrangement of  repurchase agreements to finance the purchase of securities and acquiring securities using cash provided by the delivery of the securities sold short. The strategy that apparently was the foundation of Drysdale GSI's activity in the market for U.S. Government securities is widely practiced.  Where the maturities of the  securities traded are approximately equal, the risk tends to be low because the position is hedged to some extent.  Nevertheless,  the risk can increase significantly as the maturities of the long and short positions diverge and the assumptions supporting the strategy grow more tenuous.  An unanticipated change in spread  relationships can cause major trading losses.  Even modest price  changes can result in severe problems for a slimly capitalized operation when a multi-billion dollar position is maintained. A sizeable position of this character is also subject to loss or gain resulting from the need to finance and borrow securities.  The income accruing to a trader from the securities  purchased is often close to the cost of financing the securities. In addition, the income received when securities are purchased under a reverse repurchase agreement is often close to the expense   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -17-  of meeting the interest that accrues on the securities owed. However, if the cash flow from the financing arrangements is not favorable, the drain on the firm's funds can be a problem. Possibly the very size of Drysdale's operations may have helped drive up its financing costs.  At the same time, the very large  short positions it established may well have increased the vulnerability and cost of maintaining the short positions.  An  inefficient accounting system -- by failing to reveal problems -could have compounded the potential for losses. With the benefit of hindsight two questions can be raised about the firm's activities:  (1) how did a firm with such modest  capital develop multi-billion dollar positions in securities? and (2) what kind of trading strategy involved such large short and long positions? related.  The answers to these questions appear inter-  Using the convention of the repurchase agreement market,  the firm apparently borrowed securities against cash for the purpose of making short sales that generated surplus cash essentially from the accrued interest on the securities involved. With the capital thus generated, the firm could then provide margin on securities it bought outright and financed with lenders on repurchase agreements.  The firm's trading strategy evidently  involved taking very large long positions in issues whose yields were expected to decline relative to the yields on issues the firm sold short in another maturity sector.  If yields moved as  expected, the potential gains were very large, but the risks from adverse movements were commensurately large.  Comments -- after  the firm's collapse -- from market participants who observed   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -13Drysdale GSI's activity during the February-May 1982 period suggest that the firm's transactions seemed less astute than in previous months and the strategy that appeared to be motivating the transactions often did not seem logical.  Market participants  noted that the transactions seemed to be more openly speculative. Rather than carefully closing both short and long poons simultaneously as a cautious arbitrageur would do, Drysdale GSI reportedly often left either the short or long position open. Such activity would offer greater profit potential if the direction of interest rate movements was accurately predicted but would also expose the position to greater loss. A striking feature of the transactions in the firm's final few weeks was that they reportedly appeared directed at raising working capital rather than realizing normal arbitrage opportunities.  Coupon securj.ties sold short would usually be  issues nearing a coupon payment date and, therefore, the proceeds of the sale would include a sizeable amount of accrued interest. The securities required to make delivery could then be obtained for a lesser amount of funds than was being received from the short sale because coupon-bearing securities purchased under a reverse repurchase agreement did not entail payment for the accrued coupon interest.  To increase the cash flow it appears  that securities were at times sold for immediate delivery when arranging an arbitrage but the purchase would be arranged for delivery and payment the next day.  This suggests that the  cumulative losses were large and that the firm was having difficulty keeping abreast of its cash obligations. The difference between receipts and payments was in excess of $160 million on May 17,  .Sn that day the semi-  annual coupon payments on a sizeable am5unt 5f the securities  -19-  borrowed by Drysdale GSI were due, and it was required by market practice to pass payment of the interest to the owners of the securities.  Drysdale stated it was unable to make payment of the  interest on the securities it had borrowed.  At that time Drysdale  GSI had a gross short position in Treasury securities of about $3.9 billion and a gross long position of about $2.4 billion. Evidence of positions in other securities has not come to light.  4.  Relationships With NYC Banks Drysdale GSI had banking relationships in New York with  Chase Manhattan Bank, N.A. (Chase), Manufacturers Hanover Trust Company (MHTCo), the United States Trust Company (U.S. Trust) and Chemical Bank (Chemical).  Based on volume, Chase was Drysdale  GSI's primary channel for acquiring and financing securities, with MHTCo and U.S. Trust also functioning in this capacity, but to a lesser extent.  Chemical was Drysdale GSI's clearing bank and as  part of that relationship frequently provided overdraft accommodations and overnight clearance loans. In the wake of Drysdale GSI's collapse on May 17, 1982, the Federal Reserve Bank of New York initiated special examinations of these four New York City banks.  These examinations  included inspections and analyses of:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - the adequacy and effectiveness of bank operating systems; - the adequacy of credit evaluation techniques and the banks' perception and control of risk; - the effectiveness of internal controls and audit  -20-  procedures with respect to fee-based and "off-balance-sheet" operations; - and the adequacy of current supervisory and examination techniques used by the Federal supervisory agencies.  Intermediary Banks Chase, MHTCo and U.S. Trust acted as intermediaries between the lender and borrower in "blind" transactions, wherein the name of the principal borrowing Government securities was not disclosed by the intermediary to the lender.  These securities  pass-through transactions initially were not monitored by the banks with respect to position because they were apparently felt to be essentially risk free.  The banks perceived their role as  being no more than a conduit for delivery and settlement of securities and payments and saw themselves in a fee-based relationship, not in a principal or credit relationship. Chase had dealt with Drysdale Securities for a number of years, dating back to the days when it was still a partnership. Throughout this period it appears that Chase and Drysdale Securities maintained a mutually beneficial relationship.  The  mid-1981 period, when Drysdale Securities became involved with repurchase transactions on a large scale, seems to coincide with Buttonwood Management Corp. (Buttonwood) becoming its finder.  The  function of a finder is to bring together both borrowers and lenders of securities.  By the time that Drysdale GSI was formed  on January 29, 1982 and commenced business on February 1, its   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  o  -21-  position in reverse repurchase agreements alone at Chase had risen to $1.7 billion.  By May 17, Chase's total intermediary position  w ith Drysdale GSI had increased to $4.1 billion (consisting of $900 million of repos and $3.2 billion of reverse repos). Manufacturers Hanover Trust Co. (MHTCo) acted as intermediary for Drysdale GSI in effecting repos and reverse repos w ith Government securities dealers.  This relationship was  established through Buttonwood, which had previously done business w ith MHTCo in the Securities Lending Department.  MHTCo had not  had a relationship with Drysdale prior to the establishment of Drysdale GSI.  The first Drysdale GSI securities transactions at  MHTCo commenced February 3, 1982.  MHTCo's position with Drysdale  GSI reached a high point of $2.7 billion ($1.8 billion of repos and $900 million reverse repos) on April 21, 1982.  The bank's  position with Drysdale GSI declined somewhat by May 17, 1982, to $2.2 billion ($1.5 billion of repos and $700 million of reverse repos). U.S. Trust had engaged in securities lending activities since 1972, primarily corporate issues from existing customer trust accounts when specifically authorized by these customers. In 1981, U.S. Trust began pass-through activities involving U.S. Government securities and, through Buttonwood, took Drysdale Securities on as a customer. By late January 1982, U.S. Trust's pass-through outstandings with Drysdale Securities totaled about $700 million. At this time, management of the Brokers Loan Department of the bank became concerned about this concentration of activity with   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -22-  one customer and the fact that there was no indication in the documentation of these transactions with third parties that anyone other than U.S. Trust was involved.  The bank concluded that,  under this arrangement, it could be considered primarily liable for the total value (including interest) of the transactions. Based upon this assessment of potential liability, aggregate outstandings to Drysdale Securities far exceeded the bank's established customer lending limit.  U.S. Trust, in effect, came  to view its relationship with Drysdale as a credit relationship that not only exceeded its lending limit, but also was undercollateralized and had not met other standard credit tests. The bank informed Drysdale Securities of its concerns and began working down its position.  Although some new pass-through  transactions with Drysdale GSI were entered into after January, the bank's overall outstandings with the firm were declining.  By  May 17, U.S. Trust's aggregate outstandings involving Drysdale GSI amounted to $38.8 million.  U.S. Trust was able to purchase  securities in the market at a price that enabled the liquidation of Drysdale contracts without loss.  U.S. Trust had assessed the  potential risks in its Drysdale relationships and had nearly completed an orderly winding down of these relationships. Chase and MHTCo experienced significant losses as a result of their Drysdale relationships.  On May 19, Drysdale GSI  assigned the title, rights and interests of virtually all of its property to Chase.  The bank agreed to make payments of  approximately $178 million to third parties to cover interest due on securities delivered to Drysdale GSI including the $160 million   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -23-  due May 17.  Chase further agreed to meet other obligations  related to trading activities of Drysdale GSI.  On winding down  the Drysdale GSI position which it had assumed, Chase incurred an additional loss of approximately $107 million.  In total, Chase's  Drysdale-related losses totaled $285 million before taxes and $117 million net after tax.  After unwinding of its Drysdale GSI  position, MHTCo recorded a before-tax loss of $22 million, and a net after-tax loss of $9 million. Chase and MHTCo had apparently viewed the securities lending activities as having little, if any, risk since the securities involved were U.S. Governments and since collateral (generally 102% of the market value), either in the form of cash or securities of equivalent value was required.  However, in line  with market practice, these calculations did not take account of accrued interest.  Because collateral margins were seen as  adequate, no records were maintained of potential liabilities arising from accrued interest. Systems used by the two banks focused on the accurate and timely processing of each transaction and did not provide for a regular monitoring of overall customer activity and positions. Transactions at both banks were initiated on the basis of telephone authorizations.  No written authorizations were required nor were  verifications received from customers.  Operating controls centered  on a proof of each day's transactions. Internal audit programs at Chase and MHTCo provided for annual audits focusing on the accurate processing of the transactions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Audits did not provide management with insights into the  -24-  potential liabilities accruing from the actives.  External  audits by accounting firms relied heavily on reviews conducted by internal auditors. The banks' income from securities lending activities was derived from a standard fee of 1/2 of 1 percent per annum of the principal amount of the securities involved.  The fee, which was  factored into the settlement price of the securities, was collected at the maturity of the transaction.  These activities  represented a sizeable income source for both Chase and MHTCo. Growth in volume at Chase may have been encouraged by a volume-based incentive program for Secures Lending Department personnel.  In 1981, the additional compensation arising from this  program generally ranged from 10 to 20 percent of departmental salaries; however, two key officers handling the Drysdale account received bonuses equal to their annual salaries. The banks acted promptly to deal with the internal weaknesses revealed by the failure of DrysdaleChase immediately ceased all securities lending activities.  The  emplI yment of all Chase officers who were directly responsible for these activities has been terminated, either voluntarily or involuntarily. In addition, Chase retained the services of the firm of Milbank, Tweed, Hadley and McCloy to conduct a complete inve gation of the bank's relationships with Drysdale Securities and Drysdale GSI.  This investigation is focusing on breakdowns in  operational controls and reporting mechanisms which permitted the Drysdale exposure to reach a large size, and is expected to   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -25-  develop recommendations for changes in operating practices and controls to forestall the recurrence of similar situations in the FJI4.U. MHTCo also temporarily suspended securities lending and repurchase transactions as a result of the Drysdale experience.  A  review of such actives is being made by senior operations and credit officers, as well as by outside counsel, to determine what operational and control changes are needed before securities lending can be resumed.  Also, the bank's General Auditor has been  reviewing securities lending operations and is expected to present recommendations to improve controls and practices in these activities shortly.  Clearing Banks Chemical provided clearing and related services for Drysdale, but was not involved as an intermediary in that firm's securities borrowing and lending actives.  Drysdale & Co., a  I. rtnership, became a customer of Chemical in January 1928.  In  December 1975, following its acquisition, the company was incS rporated as Drysdale Securities Corporation.  In early 1981,  Drysdale Securities began its Government securities actives. The transactions were moderate in size and cleared through an account in Chemical's Custody Department.  In August 1981, when  the volume of activity had increased substantially, Drysdale Securities was requested to open a brokers clearance account for this activity since the Custody Department was not equipped to handle the volume.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -26-  When Drysdale GSI began operations in February, Chemical established clearing facilities in the Brokers Clearance Department.  A short time later the bank also established an overnight  lI. n facility.  On occasion, the bank would also grant overdraft  accommodation to Drysdale GSI, although no line was established. The overnight loans were fully secured by the market value of the underlyinI securities.  These loans would occur when payments for  securities from third parties were either delayed or not made on the trade date.  Chemical would finance this securities position  until payment could be received the next I. The daily processing of the Drysdale GSI actives passed theough the hands of many of the bank's officers.  The frequency,  size and volume of the transactions alerted many of the officers that problems could develop quickly in this account.  The Vice  President and account officer for Drysdale GSI from the bank's Wall Street Division became concerned when Drysdale GSI began to run sizeable overdrafts.  Drysdale GSI was cautioned several times  early in the relationship that Chemical felt uncomfortable in financing overdrafts at high levels, and subsequently they moderated in both size and frequency. Drysdale GSI was placed on a "special watch list" at Chemical in March 1982, and on April 16 was requested to terminate its activities at the bank and find banking relationships elsewhere.  Chemical granted Drysdale GSI time to find another clearing  bank; however, the firm collapsed before a change could be effected.  During this period, the Brokers Clearance Department  prepared daily volume figures for Drysdale GSI and reported them   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -27-  to the Drysdale GSI account officer.  On May 17, Drysdale GSI had  an overdraft of $3.6 million and borrowings of $215 million, with collateral value of securities totaling $218 million. the firm's operating account were $1.7 million.  Balances in  Chemical took  possession of the collateral on hand and the balance in the operating account on May 17.  Chemical experienced no losses  directly from its activities with Drysdale GSI because the liquidation of collateral more than covered the bank's position. Securities clearance services, similar to those provided by Chemical to Drysdale, were also reviewed by the Federal Reserve Bank of New York at a number of other clearing banks.  Such  reviews were undertaken on-site at Chase and MHTCo, and in meetings and discussions with management of Marine Midland Bank, N.A. (Marine), Bradford Trust Company (Bradford), Bankers Trust Company (Bankers Trust), The Bank of New York, Morgan Guaranty Trust Company and Irving Trust Company.  Marine and Bradford  served as clearing banks for Comark and Bankers Trust served in the same capacity for Lombard-Wall. The review revealed that policies and procedures in effect with respect to the banks' securities clearing operations are basically sound and are generally being adhered to.  The three  banks clearing for Drysdale and Comark suffered no losses as a result of the problems of those firms.  Nor did Bankers Trust  incur a loss as a result of clearing for Lombard-Wall.  However,  the review also noted that on occasion there has been some weakness in monitoring efforts, particularly as they relate to volume increases and related credit extensions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  There was also  -28-  need in some instances for more rigorous procedures in determining whether to act as clearing agent for marginal firms. anS other  The Drysdale  dents, however, have motivated the clearing banks to  correct these deficiencies.  They contemplate increased selectivity  in establishing new clearing arrangements; agreements presently in use are being screened by counsel for adequacy of protective covenants, and operating policies and procedures are being reviewed to assure that sound control measures are in place.  Increased  surveillance of clearance activities is also planned from both the internal and external auditors.  5.  Chronology of the Drysdale Failure The Federal Reserve first became aware of a potentially  serious problem in the Government securities market relative to Drysdale GSI when the Chairman of the Chase Manhattan Bank called the President of the Federal Reserve Bank of New York on Monday, May 17, and in his absence arranged a meeting with a few of the Bank's senior officers.  At that meeting, at 2:30 on Monday  afternoon, two senior Chase officials described the extent of the problem and identified Drysdale as its source.  Chase suggested  that the Federal Reserve call a meeting of major market participants who were owed interest payments by Drysdale, where Chase would propose joint action to resolve the problem. After discussion with high level Federal Reserve S fficials, the Federal Reserve Bank of New York agreed to a meeting on its premises, to which Chase would invite officials of the firms that it identified as being significantly involved in this   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -29-  situation.  The meeting was held at 6 p.m. Monday.  An officer of  the Federal Reserve said at the start of the meeting that the Federal Reserve had a concern with the potential market consequences of the problem and had agreed to the meeting in order to learn more about the situation, but was not taking a position on any proposal that Chase might advance.  Chase invited the  participants at the meeting to join with Chase in an arrangement for the orderly liquidation of positions held by Drysdale and to provide funds for interest payments.  After giving the dealers the  opportunity to consider its proposal overnight, Chase reconvened the group early the following morning at its premises.  No arrange-  ment was reached because of a difference over who should bear the immediate loss. During the evening on Monday and early on Tuesday, meetings were held in Washington and New York among Federal Reserve officials to explore the potential problems for the Government securities market and actions which might be taken to deal with any secondary repercussions.  The Federal Reserve  informed officials in the Treasury Department, the Securities and Exchange Commission, the Comptroller of the Currency, and other agencies about the problem and contacted market participants to learn more about the problem. Rumors of the situation had spread on Monday afternoon, contributing to a substantial decline in Government securities prices.  The market opened on Tuesday in a rather apprehensive and  uncertain mood.  By mid -morning Tuesday, Chase had confirmed its  involvement with Drysdale in a public announcement which referred   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -3I -  to $160 million in interest payments due on securities borrowed by that firm which had not been made.  As awareness of the problem  I- came widespread, other market participants became unwng to do business or settle transactions with Drysdale.  The Federal  Reserve.also became aware by midmorning that Manufacturers Hanover had not received nearly $30 million in interest payments due on securities borrowed by Drysdale.  The United States Trust Company  also appeared involved on a smaller scale. Beginning Tuesday morning, the Federal Reserve had people working with Drysdale's books and records, such as they were, trying to develop a picture of Drysdale's financial affairs.  By  mid -day Tuesday the market uncertainty about clearing and financing arrangements seemed to be building.  There was concern that  investors and traders would draw away from the markets because of uncertainty about the magnitude of the problem, and that major securities firms would be threatened with losses that could jeopardize their ability to function.  At an afternoon meeting  with the 12 New York Clearing House banks, the Federal Reserve told the banks that it was watching the Drysdale situation closely and stated that the Discount Window stood ready to assist commercial banks in dealing with unusual liquidity problems arising from the situation.  Since there was some concern that the  Drysdale matter might impede the flow of securities and related payments through the market, the Federal Reserve said that it would extend the day's deadlines for its securities and funds transfer systems to allow time for the smooth completion of the I.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  work.  After the meeting with the banks, the same message  -31 --  was conveyed by telephone to the primary dealers who report to the Federal Reserve.  During that call, each dealer was asked to keep  the Federal Reserve informed about its exposure in the Drysdale situation. During the rest of the day, Federal Reserve officials had discussions with senior officials of Chase and Manufacturers Hanover reviewing the options for a resolution of the situation, to reduce or eliminate the uncertainty, and restore more normal conditions in the Government securities market.  At the same time,  market pressures were building for Chase and Manufacturers to take action to deal with the problem.  While the decision could only be  made by the banks involved, after considering legal and business factors, it seemed likely that a decision to pay interest would have a calming effect.  The market performed fairly well on  Tuesday with little net price change on the day though the background mood remained tense and apprehensive. At 8:45 a.m. on Wednesday, Manufacturers Hanover announced that it would pay $29.3 million interest due its customers on account of securities borrowed by Drysdale and would complete the securities transactions it had executed for Drysdale. In response to press inquiries regarding the announcement by Manufacturers Hanover, the Federal Reserve said that it regarded it as an encouraging and constructive development that should help to reassure the markets. At 10:15 a.m., United States Trust Company announced it was making interest payments involved in the Drysdale situation to its customers and that this action would not have a material   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  -32-  effect on its financial condition. Chase also announced, at 11:45 a.m., that it would pay interest due on securities involved in the Drysdale situation.  It  also announced an agreement with Drysdale to liquidate securities positions held by Drysdale which had been processed by Chase. Market apprehension had greatly diminished by midday Wednesday, following the announcements by the banks.  Prices  recovered that afternoon -- although a number of questions still remained as to how the unwinding process would be carried out.  To  assist that process, the Federal Reserve temporarily liberalized its rules regarding the lending of securities from the Federal Reserve's portfolio.  For many years, the Federal Reserve has  loaned dealers securities needed to avoid delivery failures. Securities are loaned under stringent conditions which discourage dealers from borrowing when alternatives exist.  The lending  facility's purpose is to avoid mechanical blockages in the market's delivery process which could impede the marketing of Treasury securities.  Ordinarily, the Federal Reserve does not  lend securities for delivery against short sales and sets modest limits on the amounts loaned.  Because the Drysdale default  threatened a severe disruption to the orderly functioning of the market, the Federal Reserve temporarily allowed firms to borrow securities to make deliveries against short sales and lifted the restrictions on amounts that could be borrowed.  As usual, the  firms borrowing the securities were required to pledge securities of slightly greater value.  The amount of securities loaned reached  a high of $2.0 billion on May 25, and then dropped to about $200   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  <  -33-  million in early June after the temporary liberalization of rules expired.  (See Attachment I)  THE COMARK AND LOMBARD-WALL CASES The closing of Comark and the bankruptcy of Lombard-Wall, Inc. and one of its subsidiaries were subsequent event s which also disturbed the markets.  Neither problem had the same degree of  impact as Drysdale but both reinforced the market's cauti on and spurred the re-examination of practices and standards, and the need for increased surveillance of dealer activities.  The Lombard -Wall  receivership was of particular interest because it raised basic questions about the nature of repurchase agreements. Comark was a securities dealer headquartered in Newport Beach, California, which had been organized in 1977 as a limit ed partnership with $15.7 million of paid-in capital.  In July 1981  the firm expressed interest in reporting position and volume statistics to the Federal Reserve.  In such cases the Federal  Reserve typically accepts reports on an informal basis.  If the  informal reports indicate over a number of months that the firm conducts a substantial business and is a major market maker, and if a review of the financial condition of the firm and its personnel shows its condition to be satisfactory, the Federal Reserve will add the firm to the list of those reporting to it as a primary dealer.  Comark began reporting its trading activity informally in  November 1981.  Data indicated the firm maintained moderate  positions in shorter term Treasury securities and a repurchase position which was not unusual in size.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  However, the reports  -34-  indicated the firm was not a significant market maker, and up-to-date balance sheet and income information were not provided.  Accordingly, the firm was not added to the Federal  Reserve's list of reporting dealers. The immediate cause of Comark's withdrawal from the market was the decision of the Marine Midland Bank, which cleared securities for Comark, to terminate the relationship.  The bank's  action occurred because it believed that Comark had used as collateral for its own borrowings from Marine, securities that were owned by its customers and had been left with Co mark in custody.  Comark admitted that its accounting system had fallen  intS disarray after it was automated several months before.  It  maintained that its lack of control resulted in the dispute with the clearing bank. To protect its position, Marine Midland sold the securities which had collateralized its loan to Comark, thereby liquidating the loan.  It suspended clearing Comark's transactions,  but resumed for a time on a secured, and closely monitored, basis after receg representations from Comark that it would be able to provide additional capital.  When the bank subsequently  concluded that the prospects for this injection were uncertain, it suspended operations again.  Comark, at this point, had insuf-  ent liquid assets to enable it to meet customer demands for the return of the securities owned by them.  Comark consequently  withS rew from the market and reportedly has been in the process of attempting to obtain additional capital from its limited partners to satisfy unsettled claims of its customers amounting to $16.6   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -35-  million.  As a securities dealer headquartered in California,  Co mark is licensed and regulated by that State's Department of Corporations. Lombard-Wall, Inc. was a dealer organized in 1970 by a I. nk holding company.  It was purchased in 1976 by several of its  officials aided by outside financing.  The problem which forced  Lombard -Wall into the bankruptcy court was its maintenance of much larger arbitrage positions than its capital could support.  When  prices declined on the securities it had sold under long-term repurchase arrangements to state and local governments, it had to come up with additional capital to replenish the margin of collateral held by these customers.  It obtained the additional  working capital through undercollateralizing funds supplied by other customers and by taking sizeable margins from customers who were selling Lombard-Wall securities under repurchase agreements to replenish their liquidity.  Lombard-Wall's clearing I.  Bankers Trust Company, became concerned about the firm's capital position and asked the firm to find another clearing I. When it was unable to IS so, Lombard -Wall filed for bankruptcy. A major part of Lombard -Wall's business was the temporary investment of construction funds on behalf of numerous state and local authorities.  By and large, these funds were adequately  cI llateralized with holdings of Government securities.  But to  provide the margin of extra collateral needed for these arrangements, Lombard-Wall was raising working capital through transactions with other customers.  Certain customers placing  funds in repurchase agreements with Lombard-Wall, notably the New   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -36-  York State Dormitory Authority, received securities having considerably less value than the money invested in this way. Other customers, notably a group of thrift institutions, sold securities to the firm under repurchase agreements, receiving cash of less value than the securities.  Lombard -Wall's underlying  capital position had long been thin in relation to its activity. While it expected the various long-term reinvestment arrangements with state and local authorities to be profitable over the life of its contracts, Lombard-Wall had an increasing need for working capital when the value of securities sold under these contracts declined in value. Wall's problems.  The demise of Drysdale accentuated Lombard-  Some of the thrifts terminated repurchase  agreements with Lombard -Wall and in the process reduced the firm's working capital. Another of the firm's major activities wa money market instruments.  dealing in  From 1975 to 1981 the Federal Reserve  transacted business in bankers acceptances with Lombard-Wall.  The  firm was not a dealer that reported transactions and positions in U.S. Government securities.  In the fall of 1981 the Federal  Reserve became dissatisfied with its inability to obtain financial information from the firm and in November 1981 it discontinued dealing in acceptances with Lombard -Wall.  Discussions with the  firm at the time indicated that Lombard-Wall had sizeable paper losses from positions in securities which it held on an arbitrage basis.  Shortly afterward, during late 1981 and early 1982, the  Federal Reserve Bank of New York, because of concern with situations like Lombard -Wall, sought to put potential repurchase   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -37-  agreement customers on notice that they should be aware of the financial strength of their counterparties when undertaking such transactions.  Discussion among Federal financial institution  supervisors led to the dissemination of an advisory circular on April 21, 1982.  The circular called attention to the possibility  that parties selling securities under repurchase agreements were sometimes in the position of parting with securities of considerably greater value than the amount of funds they were temporarily acquiring and that, in such circumstances, they should be looking to the basic strength of their counterparties in the transactions to assure fulfillment of contractual obligations.  (A  copy of this circular is appended as Attachment II.) It was not until March 1982 that Lombard -Wall was able to reach an agreement with an accounting firm over the treatment of the firm's position.  The long delay in publishing a financial  statement caused concern among some customersand the firm reduced the scale of its activity.  The statement that was eventually  published did not satisfy all the firm's customers.  Bankers Trust  Company, which cleared Government securities for the firm, terminated the relationship.  When the firm was unable to  establish a new clearing arrangement with another bank, it sought the protection of the court.  It filed a voluntary bankruptcy  petition under Chapter 11 of the Bankruptcy Code on August 12, 1982.  Its president was appointed receiver by the court as a  debtor in possession.  Most customers, who had either purchased or  sold securities to Lombard -Wall under repurchase agreements, were forced to wait while the court decided how to deal with the case.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -38-  For the customers that had not received adequate security value for their repurchase agreements, there was hope that potent ial losses could be reduced by an orderly disposition of the firm's assets.  The firm was estimated to have negative capital of about  $25 million on the day it filed under Chapter 11.  Subsequent  interest rate declines appear to have raised the prices of securities owned by Lombard -Wall sufficiently to reduce the net loss appreciably.  The net capital position of the firm on a  liquidation basis is still not clear. The inability of the firm's customers to use either their funds or securities has had a detrimental effect on confid ence in the market for repurchase agreements.  In particular, market  participants have sought to learn whether the court would conclusively decide if a repurchase agreement is a loan or a securities transaction.  The findings of the court are expected to  have a major effect on the market.  With this in mind, the Federal  Reserve Bank of New York filed an amicus curiae brief which the court accepted for consideration.  The Federal Reserve Bank  submitted, as a matter of public policy, that a repurchase agreement should be characterized as a purchase and sale transaction. It said that, if the court characterizes a repurchase agreement as a secured loan, this characterization could have an adverse impact on the Federal Reserve's ability to conduct domestic monetary policy effectively, and to invest dollar deposits of foreign central banks efficiently.  Moreover, such a characterization  could also increase the cost of financing the public debt of the United States.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -3S -  CONSEQUENCES FOR THE MARKET 1.  Market Behavior In the period that followed the Drysdale default,  borrowers, lenders, and traders in Government securities have scrutinized their customers and procedures in order to identify potential problems and if possible avoid them.  Since Drysdale GSI  was a little-known firm with a fairly short history, quite a few firms began to tighten their credit standards by ceasing to do business with small or relatively new firms.  Because repurchase  agreements and reverse repurchase agreements were at the heart of the problem, there was a tendency for market participants to restrict their activities in that area.  Inally, this took the  form of a more selective choice of trading partners and a preference for overnight agreements as opposed to term agreements running for several days or weeks.  These developments probably  contributed to some temporary reduction in the liquidity of the secondary market in Treasury securities because of the restraints these actions placed on the abty of securities firms to finance their long positions or maintain short positions. Trading activity in the marketGovernment securities was active in the immediate aftermath of the Drysdale situation.  Daily volume shown by reporting dealers in the latter  I.rt of May rose to about $33 billion compared to an average of $29 bon over the period from April 1 to mid -May.  However, the  market's liquidity appeared to diminish in early June.  Activity  dropped in various sectors, including trading with customers and trading among dealers.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  In the atmosphere of increased sensitivity,  -40-  participants voiced concerns about other firms, speculating about their profitability or their overall financial health.  Most firms  survived the intensified scrutiny of their condition but, as discussed, one trading firm, Comark, voluntarily liquidated its business in June, and a second, Lombard -Wall, filed for bankruptcy in August.  Trading volume increased in the latter half of June  and through August as the market's concerns abated and a sharp decline in interest rates prompted increased activity.  (See  Attachment III.) Interest rate movements also indicate that the Treasury market's behavior was orderly after the Drysdale default occurred. Rates on Treasury bills declined after the prompt resolution of the interest payment problem.  Because of the heightened concern  about credit quality, market participants' preference shifted toward shorter -term securities, toward those securities with the lowest default risk, and toward those securities with the greatest marketability. Three- and six-month bill rates were around 12 1/4 percent before the Drysdale default was known.  These rates  dropped to around 11 1/2 percent by Thursday, May 20, and showed little overall trend over the rest of the month.  The rate  decreases on Treasury bills in late May were larger than those on comparable private debt instruments such as CDs and commercial paper.  The rate spread narrowed in early June, but widened over  most of the month when short-term rates generally rose. The Drysdale problem did not appear to have a significant impact on the demand for the Treasury's debt at auction.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The  -41-  total amount of tenders for three- and six-month bills sold weekly averaged about 280 percent of the amount of bills offered in the interval from April 1 to May 17, and declined only modestly to about 250 percent in the remainder of May and in June. in the bill auctions remained strong.  The bidding  The difference between the  average rate and the highest rate accepted in the weekly auctions remained well within the range of recent experience.  The  experience in auctions of Treasury notes was similar. As regards open market operations, while the Federal Reserve was prepared to act forcefully if the orderly functioning of the market required it, open market operations were not substantially affected by the Drysdale situation.  The bank  reserve objectives that determine operations were not changed because of Drysdale.  However, in moving to supply the reserves  called for by reserve objectives, the Federal Reserve acted slightly earlier than usual on the day the default became public. By late June and on into the summer, the sluggish growth of narrow money supply relative to Federal Reserve target paths tended to produce a more accommodative availability of reserves and lower interest rates, developments which made it easier for market participants to cope with the post-Drysdale apprehensions.  2.  Repurchase Agreements There was a sizeable decline in the volume of repurchase  agreements and reverse repurchase agreements of reporting dealers immediately following the Drysdale default.  The total amount of  repurchase agreements reported to the Federal Reserve by reporting   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -42-  dealers fell from about $103 billion on May 12 to about $87 billion in mid-June, with slightly more than one-third of the drop taking place in the first week of that period, the week when the Drysdale default occurred.  In the same period, reverse repurchase  agreements fell from about $78 billion to a low of approximately $61 billion, with nearly one-half of the decline coming in the first week. expanded.  Since mid-June, however, these arrangements have  Repurchase agreements rose to $100 billion the week  before Lombard -Wall filed for bankruptcy and reverse repurchase agreements climbed to $80 billion.  After the bankruptcy,  repurchase agreements declined slightly.  (See Attachment IV.)  Reports suggest that some dealers have had to pay higher rates than others on their repurchase agreements since the Drysdale default.  However, the extent of this was not particularly large.  The spread between the high and low rates at which dealers reported they were financing their inventories widened from about 1/8 or 1/4 of a percentage point to about 1/2 of a percentage point.  In  June, the average spread between high and low returned to normal, although some strongly capitalized dealers report that their financing rates have remained below normal, particularly since the Lombard-Wall bankruptcy.  REGULATORY AND SUPERVISORY TOOLS The market for U.S. Government securities has relied for many years on informal surveillance or monitoring rather than formal regulation to preserve its integrity.  The only Federal  securities laws which apply to the market for U.S. Government   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  -43-  securities are the anti-fraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934.  The traditional  exemption of U.S. Government securities from broader application Sf the Federal securities laws reflects several factors.  In  S. rticular, the issuance of Government securities does not require regulation and the trading of Government securities has typically been an activity of a relatively small number of dealers and institutions that have not been deemed to require the protection of regulation.  The participation of individuals has grown but  their interests have been considered to be protected by the anti-fraud provisions of Federal securities laws. Self-policing by market participants, including the Federal Reserve and the Treasury, has been adequate in the past to insure that the market functioned well with only occasional problems.  Broadly speaking, the  ..Svee  securities market  has met the needs of the Treasury, the Federal Reserve, and many thousands of other participants, functioning in a flexible and adaptable manner without formal regulation. Self-policing by market participants will require more discipline in the future.  One of the most difficult aspects of  self-policing will continue to be the need for dealers to resist dealing with firms whose activity or exposure seems excessive in rSlation to capital.  There is also a need to ensure that  customers are adequately protected in their repurchase and reverse repurchase transactions with dealers.  Recent events in the market  have demonstrated to dealers that pursuit of short-term profit opportunities in disregard 5f high standards of prudent behavior   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  .  . -44-  and market integrity can damage the dealer's own longer-term interest, as well as the public interest. While the Federal Reserve has no statutory authority over the Government securities market, given the importance of this market to the Treasury, to the Federal Reserve for monetary policy purposes, and to the nation's financial structure in general, the Federal Reserve has felt an obligation to encourage sound market practices and high standards.  Accordingly, the Federal Reserve  has for decades exercised informal surveillance in the market. The Federal Reserve's surveillance has been related to its own market operations as well as its activities as fiscal agent of the Treasury.  Purchases and sales for its own account • are conducted through a group of dealers who must demonstrate a willingness and capability to make markets as well as their L.ElL.I4Iu.tI-f.  These dealers and those who aspire to a  relationship with the Federal Reserve must report their securities positions and transaction volume with considerable detail and frequency, including a number of daily reports. report on their financial performance each month.  The dealers also Frequent  telephone and face-to-face interviews with the dealers provide a flow of information on market conditions and other significant developments.  Many of the dealers are commercial banks or  registered dealers in regulated securities and, consequently, fall under the scrutiny of Federal or state bank examiners or self-regulatory organizations with legislated powers.  The  dealers, through trade associations, also set standards and review practices.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -45-  To be sure, the available tools for monitoring dealer performance have limitations, but it is not clear that more formal, widely applicable, regulatory authority would yield net benefits to the public.  One limitation in the present system is  that only a few dozen dealers (this does include all the major ones) are under the Federal Reserve's direct scrutiny.  Other  firms are not required to report to supervisory authorities as long as they deal only in U.S. Government securities or other items exempt from regulation such as certain money market instruments.  However, it would be very difficult for a firm to  I-.l in the market on a large scale without coming in substantial contact with one or more of the primary dealers reporting to the Federal Reserve.  Thus, to some degree, the Federal Reserve can  look to the primary reporting dealers to provide information on siS nificant developments involving nonreporting firms. Another limitation is the lack of formal regulatory authority to deal with the practices and standards of nonregulated participants.  The Federal Reserve does have considerable  influence, however, over current or prospective dealers with whom it conducts market transactions, or who are listed as "reporting dealers."  Indirectly, moreover, the Federal Reserve can exert  some influence over a wider group of market participants by monitoring the standards exercised by the primary dealers with which it does trade, in turn encouraging those primary dealers to require high standards of their customers.  By setting a  gh  road" example, the primary reporting dealers can encourage market participants to demand comparably high standards of other dealers   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -46-  with which they may do business. The question of whether a self-regulatory approach to the Government securities market, monitored by the Federal Reserve, best serves the public interest, cannot be answered in the abstract but only on the basis of carefully evaluated experience.  The  recent outcropping of failures of a few non-reporting dealers who traded in Government securities does not by itself justify a hasty move to more encompassing and formalized regulatory structure--any more than the absence of such disturbances for a number of years preceding Drysdale should have been cause for complacency.  At a  minimum, recent events have indicated a need for a more active and forceful Federal Reserve presence in its monitoring role, and the .  steps undertaken or planned in this connection are summarized below.  Whether it is necessary or desirable to go beyond this  general approach--perh.aps to request Congressional authorization for an appropriately supervised self-regulatory organization--can best be determined in the light of future experience.  STEPS TO IMPROVE THE GOVERNMENT SECURITIES MARKET In the aftermath of the Drysdale failure, the Federal Reserve has taken a number of steps to promote improved practices in the Government securities market and strengthen its monitoring of developments in that market.  Where appropriate, the steps have  been taken in cooperation with the Association of Primary Dealers in Government Securities, as well as with the cooperation of individual reporting dealers.  Through these joint efforts, there  has been a new sense of determination that self-regulation,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -47-  monitored by the Fed, can be made more effective. A natural initial focus of attention has been the move to recognize accrued interest when valuing securities involved in repurchase agreements and reverse repurchase agreements.  The  absence of such recognition of accrued interest -- together with the practice of blind brokering -- permitted Drysdale to abuse a market pricing convention and raise large amounts of working capital from unwitting counterparties.  The changeover was endorsed  in principle early in the summer by the Primary Dealer Association, and also by President Solomon of the Federal Reserve Bank of New York in a letter to heads of dealer firms.  The Federal Reserve  changed its own accounting practices for repurchase agreements in early August to include accrued interest -- not for its own protection, as this was satisfactory both before and after the change, but to lead the way for dealers and others to make that change.  Later in August, reporting dealers were individually  surveyed to determine the feasibility of setting an early OctS.•rget date to change this accounting practice with other customers as well.  After determining that such a date was indeed feasible,  the Federal Reserve wrote to each reporting dealer on August 27 to say that the desired change should be completed by October 4, 1982 (See Attachment V). Earlier in the summer, the Federal Reserve also made a change in the way that its reverse repurchase agreements are calculated.  The change did not involve accrued interest, as these  transactions are always done in Treasury bills, which do not carry coupons, but the change did entail moving to a technique that   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -48-  ensured a closer correspondence between the value of the securities and amount of money in the transaction. In recent months, senior officers of the Federal Reserve Bank of New York have attended a number of meetings of the Primary Dealer Association at which discussions focused on market practices.  On June 23, President Solomon met with the Executive  Committee of the Association and outlined the Federal Reserve's intention to work closely with the dealer community to improve practices in the Government securities market, taking the initiative where it was deemed appropriate.  A few weeks after the  June 23 meeting, President Solomon wrote each of the primary dealers, indicating the general direction in which the Bank is moving in the effort to strengthen the mechanisms of the market. The letter, which is appended to this report (see Attachement VI) referred to a number of topics that are receiving the attention of the Federal Reserve.  Among the topics discussed were capital  adequacy, adequate and timely financial reports, "when-issued" trading (i.e., trading in not-yet-issued securities for forward delivery), and the practices pertaining to repurchase agreement valuations referred to above. On August 19, the Federal Reserve Bank of New York announced the appointment of a senior officer to head a strengthened unit at the Bank devoted to market surveillance.  The  newly appointed senior vice president has had broad experience in Government securities in the private sector, as well as at the Federal Reserve and the U.S. Treasury.  At least for the time  being, it is planned that this unit will be modest in size,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  N  . -49-  comprised of a professional staff of about six or eight, although it will also be able to draw on other resources of the Bank. Among the early concerns of this unit are the review of standards of capital adequacy of primary reporting dealers, and of other dealer or trading account operations expecting to command the confidence of their trading partners.  It is expected that  these standards will be thoroughly discussed with the dealer community as they are being developed.  Another subject for early  attention is the potential problem of credit exposure created by lengthy periods of "when-issued" trading.  In such trading, since  no money changes hands until delivery, commitments made for delivery as long as two or three weeks later may entail sizeable gains or losses which can engender concern about the viability of one's counterparty.  The organized futures exchanges deal with  this problem through a mark-to-market mechanism run by the exchange, and something similar to this would be one of the options to be considered.  The problem is much less severe in  trading for delivery the same day, or the next business day, since price changes are likely to be less in that time and the shorter time interval offers a smaller window of vulnerability. In time, the new surveillance unit will also consider whether the reports on the positions and transaction volume should be extended to a broadened group of dealers.  If more widespread  reporting is deemed desirable, it is to be hoped that the basis of reporting could still remain voluntary.  This could prove feasible  because many firms would prefer to cooperate with a voluntary system, provided it is not too onerous, rather than be forced to   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -50-  comply with a mandated system. Sound banking practices seemed to have been overlooked in some instances in the banks' securities lending relationships with Drysdale GSI.  Since the banks followed what was then the standard  industry practice of taking collateral equivalent only to the market value of the underlying securities involved in the passthrough transactions, they were exposed to the extent of any accrued interest that would have to be paid to the owner of the securities on settlement or coupon payment dates.  Some of the  banks did not have procedures in place which would permit them to appropriately respond to sharply increased levels of activity and heavy concentration of the business in one customer, Drysdale. The banks' procedures and internal audit and control mechanisms did not serve to alert managements to the risks being incurred. The banks' securities clearance activities were handled more prudently, but there were some deficiencies in these activities as well. The problems of Drysdale and other Government securities firms have made clear the need for the banks to take a closer look at the management of fee-based customer relationships.  The banks  have all initiated internal reviews of the adequacy of their systems, and credit controls and audit programs as a result of the recent failures.  Steps are underway at the banks involved which  should correct the deficiencies which led to the problems and lead to safer and sounder relationships. In addition, the procedures that the Federal Reserve uses in examining securities servicing and securities lending activities   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -51-  by banks have also been significantly strengthened in light of recent events.  Guidelines and a questionnaire have been developed  to assist field examiners in assessing bank risk exposure and controls with respect to such activities and those tools are being shared with other Federal bank supervisory agencies.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  # ATTACHMENT #1  FEDERAL RESERVE SYSTEM SECURITIES LENDING OPERATIONS (CLOSING LOAN BALANCE, PAR VALUE IN MILLIONS OF DOLLARS) 1982  2000  -  1500  _  1000  500   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  A  _  MMIIMUMM1111111111 11111111111111111111111111111 _ III till I lt I 11.11111111111111111  10 19 28 APRIL  7  1.6 25 MAY  3  11.1 ILL11111t tali 1 i Lui hill 11111lllilililliLliiitimiiti  12 21 30 JUNE  -  9  18 27 JULY  5  14 23  fluGusT   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ATTACHMENT #II  FEDERAL RESERVE BANK OF NEW YORK  April 21, 1982  RETAIL AND WHOLESALE REPURCHASE AGREEMENTS To the Chief Executive Officer of Each State Member Bunk in the Second Federal Reserve District:  The usage by banking organizations for funding purposes of repurchase agreements involving U.S. government or agency securities has increased dramatically over the past several months.  Although to date there have been few problems  associated with this activity, we believe that it is appropriate to bring to your attention some considerations to reinforce your awareness of the need to proceed cautiously in offering these instruments. With respect to retail repurchase agreements (retail repos), bank management should bear in mind that in some cases it is dealing with customers who do not normally engage in large denomination, money market transactions.  In addition,  because of the complex nature of retail repos and the possibility that retail repos may be confused with insured deposits by the general public, all material facts of a retail repo transaction should be disclosed to the customer.  As you are probably aware, the  Securities and Exchange Commission has taken the position that the antifraud provisions of Federal securities laws apply to the sale of retail repos, and these instruments may be further subject  to various State securities laws.  Banking  organizations engaging in or planning to engage in the sale of retail repos are urged to consult and obtain the opinion of legal counsel competent in the field of securities laws to determine what constitutes sufficient disclosure to customers as well as to ensure compliance with the antifraud and other applicable provisions of Federal and State securities laws.  - 2The face of all retail repurchase agreements should state conspicuously and in bold-face type that "the obligation is not a deposit and is not insured by the Federal Deposit Insurance Corporation," and care should be taken to avoid the potenti al misrepresentation that retail repos are guaranteed by the U.S. govern ment.  In  addition to ensuring that retail repos are not misconstrued as insured deposits, we believe that, at a minimum, the following information concerning retail repos should be communicated to customers:  1.  The nature and terms of retail repos, including interest rates paid, maturities and any prepayment fees.  2.  A description of and approximate market value of the underlying security or fractional interest thereof collateralizing the agreements.  3.  A statement that the interest paid on a retail repo is not necessarily related to the yield on the underlying collateral.  4.  A statement that the bank will pay at maturity a fixed amount, including interest on the purchase price, regardless of any fluctuation in the market value of the underlying collateral.  5.  A statement that general banking assets will most likely be used to satisfy the bank's obligation rather than proceeds from the sale of the underlying security.  6.  A statement that the market value of the collateral could depreciate before the maturity of the agreement, thus making the investor an unsecured creditor of the bank for the difference between the repurchase price of the retail repo and the market value of the underlying collateral.  7.  Information advising the customer whether he or she has a perfected lien on the underlying collateral under state law, and whether it is being held by an independent trustee or custodian. If the customer does not have a perfected security interest, the legal consequences, including the possibility of becoming an unsecured general creditor, should be described.  8.  Appropriate information regarding the bank and its financial condition.  If the retail repo agreement itself does not include all material disclosures, the face of the agreement s- hould make specific reference to other documents provided to the customer containing sufficient material disclosures. Care should also be taken with respect to the advertising and marketing of retail repos.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  All advertisements, announcements, and solicitations for retail repos  •  3 should state that they are not deposits of the issuing bank and are not insured by the FDIC. Advertisements and other documents provided to the customers that refer to the underlying U.S. Government or agency obligations securing retail repos should disclose sufficient information to avoid the potential misrepresentation that retail repos are guaranteed by the U.S. government. As a matter of prudent banking practice and in order to provide a cushion of protection for indivic'uals who purchase retail repos, the market value of the underlying security should be equal to or exceed the purchase price of the retail repo at the time of issuance. In addition, in order to avoid the potential for conflicts of interest, a bank should not sell its retail repos to its own trust department or to trust agency accounts over which it or any affiliate has investment discretion. Since both retail and large denomination wholesale repurchase agreements are in many respects equivalent to short-term borrowings at market rates of interest, banks engaging in repurchase agreements should carefully evaluate their interest rate risk exposure at various maturity levels, formulate policy objectives in light of the institution's entire asset and liability mix, and adopt procedures to control mismat ches between assets and liabilities. The degree to which a bank borrows through repurchase agreements also should be analyzed with respect to its liquidity needs, and contin gency plans should provide for alternate sources of funds in the event of a run-off of repurchase agreement liabilities. Bank management also should be aware of certain considerations and potential risks associated with wholesale repurchase agreements entered into in large volume with institutional investors and/or brokers.  If the value of the underlying  securities exceeds the price at which the repurchase agreement was sold, the bank could be exposed to the risk of loss in the event that the buyer is unable to perfor m and return the securities. The possibility of this occurring would obviously increase if   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  4 tution or broker with which the the securities are physically transferred to the insti over, if the securities are not bank has entered into the repurchase agreement. More of a significant write-off to the returned, the bank could be exposed to the possi5ility the price at which the securities extent that the book value of the securities exceeds For this reason, banks should were originally sold under the repurchase agreement. the financial condition of those obtain sufficient financial information on and analyze repurchase transactions. institutions and brokers with whom they engage in review each bank's internal Federal Reserve examiners will be asked to derations discussed above. procedures and practices for consistency with the consi  ANTHONY M. SOLOMON. President.  All'ACIIMENT III  GROSS DEALER IMMEDIATE TRANSACTIONS IN U.S. GOVERNMENT AND FEDERAL AGENCY SECURITIES (DAILY TRANSACTIONS, PAR VALUE IN BILLIONS OF DOLLARS) 1982  80  70  60  L_  50  -  40  30  I  V  i  I  I  1  V- I  L  20  10 •   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  _  ..............m.........mmmu 1 10 19 28 7 16 25 3 12 21 30 9 18 27 5 11 23 APRIL  MAY  JUNE  JULY  AUGUST  •  ATTACHMENT #IV Dealer Financin91/ (Wednesday outstanding, billions of dollars) Reverse Repurchase Agreements Total  Matched Book  /  / Balancel  1982 5/12  78.3  51.4  26.9  5/19 5/26 6/2 6/9 6/16 6/23 6/30 7/7 7/14 7/21 7/28 8/4 8/11 8/18 8/25 9/1  70.7 67.3 65.0 63.9 61.4 66.1 70.9 69.8 68.1 71.6 76.6 80.4 77.4 79.8 81.8 81.5  48.2 44.3 42.6 41.2 41.0 44.1 47.5 46.8 46.3 49.0 51.5 53.8 53.5 52.0 53.1 52.1  22.5 23.0 22.4 22.7 20.4 22.0 23.4 23.0 21.8 22.6 25.1 26.6 23.9 27.8 28.7 29.4  Repurchase Agreements Total  / Matched Booka  1982  Balance-/  5/12  103.0  53.1  49.9  5/19 5/26 6/2 6/9 6/16 6/23 6/30 7/7 7/14 7/21 7/28 8/4 8/11 8/18 8/25 9/1  96.9 92.6 91.6 89.4 86.5 87.7 90.0 90.1 88.9 91.6 99.3 100.0 99.1 97.9 98.9 97.5  49.5 44.5 42.7 42.2 40.9 44.0 47.8 46.8 47.2 50.2 52.6 54.0 51.8 51.1 52.1 51.0  47.4 48.1 48.9 47.2 45.6 43.7 42.2 43.3 41.7 41.4 46.7 46.0 47.3 46.8 46.8 46.5  / i Includes agreements collateralized by Treasuries, Agencies and other money market instruments in terms of actual money borrowed or lent. a /Under a matched book arrangement relourchase agreements are roughly matched with reverse repurchase agreements. 3/ - Balance represents securities obtained to cover short positions or securities inventory being financed,  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ATTACHMENT #V  FEDERAL RESERVE BANK OF NEW YORK NEW YORK, N.Y. 10045 AREA CODE 212 791-54.83  PETER D. STERNLIGHT EXECUTIVE  VICE  PPESIOIENT  August 27, 1982  In my letter to reporting Government securities dealers of June 18, 1982, I expressed our strong support for the practice of including accrued interest in valuing Government securities used in repurchase agreements. I believe it represents an improved market practice that will help avoid undesirable differences between the market value of securities and the related payments in repurchase and reverse repurchase transactions. In replying to my June 18 letter, nearly all of the reporting dealer firms endorsed this proposal, as has the Association of Primary Dealers. Adoption of this practice was also encouraged in the July 29, 1982 letter from President Solomon of this Bank to chief executives of all the dealer firms. As you are aware, in the Federal Reserve's repurchase agreements, for its own or customer accounts, interest is now included in the calculation of the value of the securities. We adopted this practice at the beginning of August in part to encourage other market participants to incorporate this procedure in repurchase agreements with other customers. We have experienced little difficulty in processing our own repurchase agreements with dealers using the new procedure. In fact, while we had been prepared to revert to manual accounting procedures if necessary, our staff was able to accomplish the necessary programming changes in time to retain automated handling. We have become concerned recently with a bogging down in the momentum toward making this widely endorsed change the general practice in the market. Accordingly, Trading Desk officers have had conversations with each of the dealers in the last couple of days, and suggested that for those who have not made the change already, the new Procedure be implemented no later than the beginning of October. Virtually every dealer indicated that this was feasible.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  a.  AP FEDERAL RESERVE BANK OF NEW  YORK  2  Against that background, we now firmly and confidently expect each of the reporting Government securities dealers to value repurchase agreement securities with accrued interest taken into account, starting no later than Monday, October 4, 1982. This should apply generally to repurchase agreements and reverse repurchase agreements in Government securities with all custom ers. We believe that customers will want to cooperate with a change widely endorsed by the responsible dealer community and the Federal Reserve as being consistent with sound market practice Exceptions, such as where state or local government regulations impede the change, should be rare, and it should be possible to overcome these exceptions--once the underlying rationale for the change is explained to these customers. We do understand that this changeover may require extra efforts from your staff, perhaps involving temporary substitution of manual for automated processing. But we emphasize that your cooperation is important--not only in achieving this desirable change in a particular market practice, but also in demonstrating that members of the primary reporting dealer community can recognize a need and take appropriate action in the interest of improving the market's integrity.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Sincerely,  Peter D. Sternlight  ATTACHMENT  #VI  FEDERAL RESERVE BANK OF NEW YORK NEW YORK, N.Y. 10045 AREA CODE 212 791-6173  ANTHONY M. SOLOMON Pecalocmr   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  July 29, 1982  In a meeting held at this Bank with the Executive Committee of the Association of Primary Dealers in Government Securities on June 23, 1982, I emphasized this Bank's intention to initiate mutual discussions of how to improve practices in the Government securities market. This letter, which is being sent to each of the primary dealers, outlines the general direction in which we plan to proceed in strengthening the mechanisms of this market. In the wake of recent developments, we attach even greater importance to the adequacy of a dealer's capital as a suitable safeguard to those parties with whom it transacts business. Along those lines, we are consulting with individual dealer firms regarding the capital prudently required of a dealer firm, in relation to its scale of operations and positions, as well as protection for its customers. We believe it is also appropriate for the Association of Primary Dealers to review their standard for the minimum capital requirements of primary dealers and we expect to discuss this with the Association's leadership. Consistent with the need to maintain appropriate capital, dealers should also provide timely audited financial information and regular financial reports so their customers will be able to make informed credit judgments about them. Of course, we expect reporting dealers to keep the Federal Reserve fully and promptly informed about their financial situations.  FLDERAL RESERVE BANK OF NEW YORK  2  July 29, 1982  As a start in developing stricter standards of market practice, Peter Sternlight and his colleagues in open market operations are working closely with the dealer community in encouraging all participants to recognize the value of accrued coupon interest when pricing repurchase agreement collateral. The Federal Reserve's trading desk has informed dealers that, beginning in August, the valuation of collateral for repurchase agreements executed by us will include accrued interest. We will further examine practices pertaining to repurchase agreements and expect reporting dealers to ensure that risks to both .the dealer and customer are held to a minimum. This will mean appropriate margg, frequent marking to market, and timely correction of collateral deencies or excesses. A dealer's willingness and ability to make markets, as attested in part by the volume of its trading activity, will remain one of the important standards for being a reporting dealer. Participation in auctions of Treasury debt and in Federal Reserve open market operations will also serve as signcant measures of a dealer's market making activityt Equally important, a primary dealer is expected to serve a broad spectrum of responsible market participants beyond a narrow group of professional traders. Moreover, every dealer should have adequate credit information about each customer, .which would reduce the potential for market participants, custSmers as well as dealers, to engage in excessive speculation..   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  At the June 23 meeting we also discussed the need to establish a more prudent system of dealing with the risks of "when-issued" trading. Recognizing that there ar.e differences of view within the dealer community, we are considering with the Dealer Association various approaches toward establishing a mechanism for minimizing credit exposures in "when-issued" transactions. In addon, in our view, dealers must also assess their potential exaosure when dealing through brokers and be sure they understand without question whether they, their customers, or the brokers are agents or principals in cSmmitments. The Federal Reserve does not seek to discourage innovation in the market but every dealer is expected to engage in new businesses or trading strategies only after thoroughly reviewing the risks and appropriateness of the activity. Transactions which threaten the reputation or integrity of the dealer or the market should be avoided. It is expected that reporting dealers will open their records to the Federal Reserve on request. Further, --ch reporting dealer has an obligation to inform us of  FEDERAL RESERVE UANK OF NEW YORK   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  July 29, 1982  3  situations which suggest potential problems for themselves or for the market. The Federal Reserve will be monitoring all of the areas noted in this letter -- including capital positions, market making, RP practices, credit procedures -in evaluating a dealer's reporting and trading relationship with the Federal Reserve. Chairman Volcker and I believe that cooperative efforts by the Federal Reserve and the dealer community to improve practices of the market can preserve and enhance the reputation for integrity and professionalism that has been the hallmark of the market for U. S. Government securities. We are confident that through your dedicated efforts the efficiency, vitality, and integrity of the market can be sustained and elevated to an even higher plane. Sincerely,  Anthony M. Solomon  Nag   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  September 24, 1982  The Honorable Gene Chappie House of Representatives Washington, D. C. 20515 Dear Mr. Chappie: Thank you for your letter of September 1 concerning the interstate and competitive implications of the application by Citicorp to acquire Fidelity Savings and Loan Association of San Francisco, California. The Board is giving very careful consideration to the issues you have mentioned, and your views on these issues will be made part of the record in this case. We very much appreciate having the benefit of your views on this matter. Sincerely,  Donald J. Winn Assistant to the Board MAG:vcd (#V-214) bcc:  Ms. Gadziala Mr. Bradfield (Log 330) Mr. Mattingly Mrs. Mallardi'-Legal Files (2)  Action assigne-1 Mr. BradfieH GENE CHAPPIE isv Dvriescr. CALM:IONIA le  IMASKINOTON OPINC11 1730 Leeiswowni Hang OrrIcz BUILDING WASHIrarrom D.C. 20515 (202) 225-3075  COMMITTEE ON AGRICULTURE  Congresz of the Anitebslotattc; 3k)OUf‘t of tpregentatiba  MACON M ITTCES COTTON. RICE, AND SUGAR roRESTS. FAMILY FARMS. AND ENERGY  it  'DOMESTIC MARKETING, CONSUMER REL.ATIONS, AND NUTRITION   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  DISTRICT 270 Ewirr AIrm ItTitErr CHICO, CALIFONNIA 95925 (915) 1193-11363  '141  20515  rra September 1, 1982  O  The Honorable Paul Volcker Chairman, Federal Reserve Board 20th and Constitution Ave., NW Washington, D.C. 20551 Dear Mr. Chairman: I would like to take this opportunity to express my concern over the impending acquisition of the Fidelity Savings and Loan Association of San Francisco by Citicorp of New York.  This acquisition was recently approved by the Federal Home Loan Bank Board and, as you are aware, must next receive the approval of the Federal Reserve Board. I am concerned that Citicorp's takeover of Fidelity might undermine interstate banking restrictions and weaken independent banks. The issue deserves careful study and I believe that if these restrictions are to be loosened, it should be done through the legislative process. I strongly urge the Federal Reserve Board to give close and careful scrutiny to this proposed acquisition while keeping in mind its nationwide repercussions. Thank you for your kind attention to this matter.  GENE CHAPPIE Member of Congress GC:WBh cc: The Honorable Fernand J. St. Germain Weldon Barton   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  September 24, 1932  The Honorable John J. LaFalce House of Representatives Washington, D. C. 20515 Dear Mr. LaFalce: Thank you for your letter of September 17 urging prompt Board action on the application by Citicorp to acquire Fidelity Savings and Loan Association of San Francisco, California. Your comments will be made part of the record on this case and will be considered by the Board in acting on Citicorp's application. We very much appreciate having the benefit of your views on this matter. Sincerely,  Donald J. Winn Assistant to the Board  MAG:vcd (V-216) bcc:  Ms. Gadziala Mr. Bradfield (Log 329) Mr. Mattingly Mrs. Mallardi-/ Legal Files (2)  Action assigned Mr. Bradfield; info copy to Mr. Ryan 2447 RAYBURN BUILDING WASHINGTON, D.C. 20515 (202) 225-3231  JOHN 'J. LAFALCE 361- 4 DISTRICT, NEW YORK COM PATTEE•g;N BANKING, eINANCE AND URBAN AFFAIRS COMMITTEE ON SMALL BUSINESS  Congre55 of tic Elniteb btatefs 3Doute of ReprefSentatibet  CHAIRMAN: SUBCOMMITTEE ON GENERAL OVERSIGHT   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Ularsbington, ri.e. 20515  FEDERAL BUILDING BUFFALO, NEW YORK  14202  (716) 846-4056  MAIN POST OFFICE BUILDING NIAGARA FALLS, NEW YORK 14302 (716) 284-9976  September 17, 1982  The Honorable Paul Volcker Chairman Board of Governors of the Federal Reserve 20th Street and Constitution Avenue, N.W. Washington, D.C. 20551 Dear Mr. Chairman: I write to indicate my belief that it would be in the public's interest to have a prompt Board action with regard to Citicorp's application to acquire Fidelity Savings of San Francisco. This matter has already been pending for a long time. The first round of bidding began in April and was concluded in the later spring with Citicorp the apparent high bidder. For various reasons, there followed a second round of bidding, which began in July and ended last month, with Citicorp again the apparent high bidder. This extensive bidding process would certainly seem to be adequate to protect the interests of other potential bidders, and further delay would only seem to be inconsistent with the public interest insofar as it could mean added cost because of Fidelity's loss of key employees, deposits, and general position in the California marketplace. Moreover, I know of no compelling legal reason for any further delay. The Scioto decision would seem to resolve any lingering doubt whether a bank holding company can permissibly acquire a thrift, at least under certain circumstances. It would seem that approval of the proposed application would not contravene either the Douglas or McFadden Acts. Additionally, as a principal sponsor of the House-passed "Regulators' Bill" and upon a review of the applicable provisions found in S. 2879, it would seem to me that the bidding procedures above would certainly comply with those now under consideration by Congress. Nor would equity suggest an objection to the subject application. California based thrifts have made acquisitions in New York; New York based thrifts have made out-of-state acquisitions. Such "near-banks"   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The Honorable Paul Volcker September 17, 1982 Page two as Merrill Lynch and Sears do an interstate business. All of these compete with commercial banks and bank holding companies. I see no reason why commercial banks and bank holding companies should not be afforded similar competitive abilities. To conclude, whatever disposition the Board makes on the merits, I respectfully urge that it be done promptly out of fairness to the parties and in the overriding public interest, for all the reasons discussed above. S' cerely,  HN J. LaFALCE Member of Congress JJL:w   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  September 15, 1982  Dear Walter: It was with great sadness that .  I learned of  Please accept my condolences and know that your many friends and admirers share your loss. Sincerely,  The Honorable Walter E. Fauntroy House of Representatives Washington, D. C. 20515  WRM:vcd bcc:  Mrs. Mallardi (2)   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  September 15, 1982  The Honorable Henry S. Reuss Chairman Joint Economic Committee Washington, D. C. 20510 Dear Chairman Reuss: Enclosed is a copy of a report on foreign exchange operations by the Treasury and the Feder.41 Reserve covering the period from February 1982 through July 1982. The report will be printed in the September issue of the Federal Reserve Bulletin. It is being released to the press for use in tomorrow morning's newspapers. Copies of the report are also being sent to the Chairmen of other interested Committees. Additional copies are enclosed for the use of members and staff of your Committee. Sincerely,  Enclosures  (30 copies)  Identical letters to Chrmn. Jake Cam, Senate Bkg., 20 copies Chrmn. St Germain, House Bkg., 50 copies  JRC:vcd bcc: Mrs. Mallardi (2) 1./—   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  September 15, 1982  The Honorable John Heinz Chairman Subcommittee on International Finance and Monetary Policy Committee on Banking, Housing and Urban Affairs United States Senate Washington, D. C. 20510 Dear Chairman Heinz: exchange Enclosed is a copy of a report on foreign Reserve covering operations by the Treasury and the Federal 1982. The report the period from February 1982 through July the Federal Reserve will be printed in the September issue of ss for use in Bulletin. It is being released to the pre tomorrow morning's newspapers. Sincerely,  Enclosure JRC:vcd bcc: Mrs. Mallardi (2) Identical letters also sent to those on attached list  Chrmn. John Heinz tary Policy Subcmte. on International Finance and Mone irs Committee on Banking, Housing and Urban Affa  William Proxmire Ranking Minority Member Policy Subcmte. on International Finance and Monetary Committee on Banking, Housing and Urban Affairs  House Chrmn. Jerry M. Patterson and Finance Subcmte. on International Development, Institutions Committee on Banking, Finance and Urban Affairs  Thomas B. Evans Ranking Minority Member ions and Finance Subcmte. on International Development, Institut Committee on Banking, Finance and Urban Affairs  JEC Vice Chrmn. Roger W. Jepsen House side--sent to main offc.) Clarence J. Brown (ranking minority of JEC, te side--sent to main offc.) Lloyd Bentsen (ranking minority of JEC, Sena   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  .1  011.• t  BOARD OF GOVERNORS OF THE  FEDERAL RESERVE SYSTEM WASHINGTON. O. C. 20551  it4L • • .• •  September 13, 1982  The Honorable Andy Ireland House of Representatives Washington, D.C. 20515 Dear Mr. Ireland: Thank you for your letter on behalf of your constituent, Mr. Gordan R. Allison, Sr., submitting a plan that seeks to stabilize interest rates and to assure the availability of credit for home mortgages and other purpo ses. Under this plan, interest rates on savings accounts at finan cial institutions--the only permissible type of account--woul d apparently be pegged to an auction rate for Treasury secur ities. The institutions would make loans within a structure of rates set by law or regulation. Up to some minimum rate of interest, earnings on savings would be tax-free. At rates highe r than the tax-free limit, taxation would be progressive with respe ct to the level of rates, and part of the tax proceeds would be used to subsidize the lending institutions should high rates on savings cause lending to be unprofitable at the legal ly set maximums. While the plan has some interesting features, it would involve a far deeper intrusion of government into the control of interest rates and credit flows than ever befor e permitted. Such centralized management would represent a sharp reversal of the course toward freer operation of finan cial markets set by the Congress in the Depository Insti tutions Deregulation and Monetary Control Act of 1980. In general, the Board subscribes to the principle underlying the Monetary Control Act that resources are deplo yed most efficiently and equitably when credit markets are allow ed to function with as much freedom as possible. Although your constituent describes his plan as preserving market freedoms, several aspects of the plan are decidedly restrictive-particularly the limited choice of savings instruments and associated yields available to individuals. The discussion of the plan provides no assurance that the limited outlets for savings could attract sufficient funds to satisfy the demand for credit at whatever interest rates would be stipu lated for loans.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The Honorable Andy Ireland Page Two  Further, while your constituent proposes a modest degree of variation in interest rates among different types of loans, the plan largely ignores the considerable cost differentials that may exist among loans that differ by size, collateral, cost of origination, or other aspects. The complexity of incorporating such differences in cost into the yield structuie is one reason that market determination of interest rates channels the flow of credit much more proficiently than would government rate-setting. I hope you will find these comments to be helpful. Please let me know if I can be of further assistance. Sincerely, (Signed) Donald 1. WINO Donald J. Winn Assistant to the Board  1 4;‘)  CAL:RMF:JLK:CO:pjt (#V-202) bcc: Mr. Luckett Mr. Fisher XXXXXKX Mr. Kichline Mrs. Mallardi   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Action assigned Mr. Kichline WINTER HAVEN, FLORIDA 33883 120 WEST CENTRAL AVENUE P.O. Box 9447  am DISTRICT. FLORIDA  WASHINGTON OFFICE. 1124 LONGWOR TH HOt.”-.1- OFFICE BUILDING WASHINGTON. O.C. 20515  Congrea4 of tbe Ziniteb Otatt5  (202) 225-5015  PouSe of ikeprelentatibe5 Ellassbinaton, n.e. 20515  COMMITTEES  (813) 299-4041, 299-5120 DRADEI'ION. FLORIDA 3352.6 1101 6TH AVENUE WEST P.O. Box 1220 (813) 746-0766. 748-1388 SARASOTA, FLORIDA 33578 2002 RINGLING BLVD.. RM. 238  FOREIGN AFFAIRS  P.O. Box 1029 (813) 366-4896  SMALL BUSINESS  LAKELAND, FLORIDA 33803 2015 SOUTH Fj..125IDA AVENUE  CHAIRMAN. SUBCOMMITTEE ON SPECIAL SMALL BUSINESS PROBLEMS  (8* 687-83443687-8195 t  August 19, 1982  :73 rt"! C-7-1 73  Mr. Paul A. Volcker Chairman Federal Reserve System Twentieth St. & Constitution Ave., NW Washington, D.C. 20551 Dear Mr. Chairman: I would like to submit, on behalf of my constituent, Mr. Gordon R. Allison, Sr., a proposal for alleviating high interest rates and the volatility on the mortgage market. I would greatly appreciate your reviewing Mr. Allison's 1  solution.  I await your evaluation and would like to thank you  in advance for your kind consideration in this matter. Best regards.  Sincer91  API:cma enclosure  r.)  7) C LO   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  FLORIDA OFFICES:  ANDY IRELAND  I ,)  s  f •  ••  r•Y  r• .•  _  •  LD  .•••• Ton"  CD CD  '11  •  ' ••"•••••,.  ( .7„ ? i  L. 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(Kika) de la Garza House of Representatives 20515 Washington, D.C. Dear Mr. de la Garza: Thank you for your inquiry requesting comments by U.S. officials to calm fears that the United States might freeze bank deposits of Mexican nationals held in U.S. banks.  I enclose copies of the Treasury  releases of August 26 and September 3 on this subject. I would hope and expect that these statements would put an end to those rumors. Sincerely, S/Paul A. Volcker  Enclosures  RG:CO:pjt (/V-206) bcc: Mr. Gemmill frv<i (c,)   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ti  )0 1 h  •  trl  ( )1 I rm  1 rn:3:  CD  J  n  it (1) :11" (1) 0 1 1 1 (1)  (to ti  ni  O rt :j 0 I-1 P. 0 11, 11) ri-  • 11 1 it (1 .1 1-. ())  rt  p) 0 Ft,  O  1  X (1) 1-0 Pp (U  ;1 !  t_, tn  • L‹  -  1 1 1 .1 to UI  Ph 1 M 1 (D /11 al rD ti !  O P--.1 Ih LT I  INA  rt. 0 3  •  %.<  13  7 CD  0ti  rt  3  A  P.  11111-115  ‘. sigrzTrimv,  epartment of the Treasury • Washington, D.C. • Telephone 56G-FOR IMMEDIATE RELEASE SeDtember 3, 1982  CONTACT:  Marlin Fitzwater (202)566-5252  Mexican Banking Rumor  There is absolutely no truth to the rumors which are circulating in some areas that the Government of the United States will direct American banks to disclose to Mexican authorities the identities of Mexican citizens who own accounts in U.S. financial institutions.  4   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  et.)ARC rocigI  cts t313i  1911 SEP  r )7!tt  —7sqp 9:02 *** MESSAGE REC12 *** n li 1) OFFICE OfEccit 14E DC BD ED RES cil,AllotiAN MSG DONE *** *** MESSAGE REC13 *** :74 PIPED RES BD DC 1-022787A246 09/03/82 IIU INFOMASTER ars IPMWGWD WSH P EST 03812 09-03 0238FED RES BD DC WX 7108229235 -017965C246002 09/03/82 CS IPMUAWA WSH 12002 NL GOVT BUWASHINGTON DC 56 09-03 2041: EDT MS HON PAUL A VOKCKER OF GOVERNORS HAIRMAN OF THE BOARD SYSTEM RESERVE :11F THE FEDERAL OTH AND CONSTITUTION AVE NORTHWEST ASHINGTON DC 20551 IZATION MEXICAN BANKS AND BECAUSE OF S RESULT OF NATIONAL N MESSAGE, SOME PRESIDENT IN STATE OF UNIO EMARKS MADE BY MEXICAN ITUT U.S. FEEL NEED FOR COMMENTS BY OUTH TEXAS BANKING INST S IONS T FREEZE BANK DEPOSITS FEAR THAT U.S. MIGHWILL FFICIALS TO CALM ANY HELD APPRECIATE U.S. BANKS. MEXICAN NATIONALS REQUINEST. PLEASE ADVISE. NY CONSIDERATION THIS l il E KIKA DE LA GARZA MEMBER OF CONGRESS 1/338 EST 637 EST 11 RES BD DC :111ED ItG DONE *** *44   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  7tG20  4  September 10, 1982 The Honorable Bill Lowery House of Representative, Washington, D.C. 20515 Dear Mr. Lowery* Thank you for your lettel of August 20 concerning the application of Citicorp to acquire Fiaality Federal Savings and Loan Association of n Francisco, California. Your letter notes the pending Congressional consideration of the se-called Begulators Dill, the financial situation of Fidelity, and the legal issues surrounding the Board's authority to approve bank bolding ceMplay aequisition of savings and loan institutions. our letter also suggests • 30-40 day delay in the taking of the Board's . decision on the Citieerp epplication. We have very carefully considered your letter and, in particular, the request of interested parties fee a rescheduling of the hearing on this issue originally set for September 1 in Washington and September 4 in San Francisco. We also considered that Chairman Pratt has requested emergency action on the Citicorp application in view of the financial condition of Fidelity Federal Savings and Loan. Taking these factors into account, we decided to postpone the hearings on the Citicorp application until September 8, 1982 in Washington and September 9, 1982 in San Francisco. These bearings have now been held and all interested parties have had a full opportunity to present their views. The full transcript of the hearings is available to the members of the Board and the staff is now analyzing the comments made at the hearings as well as all other information relevant to the application and will Submit this analysis to the Board for its consideration. With respect to the time of the Board's consideratien of the application, we will have to evaluate the comments made at the hearings in Washington and San Francisco both urging Board action on the application and requesting a delay based on same of the considerations which you have outlined as well as other factors. The Beard will also have to consider that Chairman Pratt has emphasised that Fidelity Federal Ravings and Loan is in a precarious condition and that its financial situation has continued to erode, thus continuing to raise the potential costs to the FSLIC of placing this institution on a firm and sustainable footing for the future. The considerations that you and Chairman Pratt raised will, of count*, be important elements in the Board's evaluation of both the timing and substance of its actions. We will, of course, keep you informed of the results of the Board's deliberations.) boos Wolfe (2) Bradfield   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  MAttinalV  Sincerely,  ••••••••  ' • ov G0vk- •.  •.  .•‘•• •co •0 --n  BOARD OF GOVERNORS OF THE  FEDERAL RESERVE SYSTEM WASHINGTON, D. E. 20551  .RALRE.s .• • •.. •  September 10, 1982  PAUL A. VOLCKER CHAIRMAN  The Honorable Bill Bradley United States Senate Washington, D.C. 20510 Dear Bill: Following our recent conversation, I wanted to put in writing for you some of my thoughts on the bill introduced by Senator Robert Byrd that would have the Federal Reserve set interest rate targets. As you know, the bill would require us to establish "yearly targets for positive real short-term interest rates, consistent with historic levels" along with our annual growth targets for money and credit. It is surrounded by "balanced" or innocuous-sounding language about inflation and unemployment. But I don't think there is any real doubt about the way the markets would read it, or about how it would work toward changing the "independence" of the Fed. My concerns essentially involve questions of confidence in our comwitment to an anti-inflationary program, the intrusion of short-term political considerations into monetary policy, and substantial practical problems of implementation. The context in which these bills have been introduced leads directly to an interpretation that the message is to force interest rates down. I don't question the legitimacy of debate on monetary policy, and well understand urgings that, in today's circumstances, attention should not be focused wholly on the money supply. I have testified as much, and it comes down to a matter of degree and judgment. But legislation to attempt to direct interest rates will be perceived, among other things, as setting up the mechanism for accelerating money growth to accommodate, for instance, large budget deficits ahead. Given everything we've learned in the past decade and a half of inflationary experience, there is little reason to doubt that an effort to stabilize interest rates through thick and thin would be counterproductive, and perhaps, within a very short period of time. Expectations of higher inflation to come would lead to higher interest rates, not lower ones. Let me repeat the point I've made repeatedly--I would be delighted to see interest rates much lower (even after the recent declines) but on a sustained basis. It does not serve much purpose to attempt to do so in a way which results in short-lived relief followed by a disspirting back-up in interest rates.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The Honorable Bill Bradley Page Two  For the longer term, passage of such a bill, without real hearings or debate around the country, would clearly suggest a pattern of intensified political (and partisan?) pressures on the Fed. The House version is transparent in mandating Presidential comment on every Fed decision. Recognition that adoption of the approach in these bills will interfere with the traditional institutional arrangements governing the nation's central bank can hardly be conducive to the confidence and stability that is our common goal. The bill also presents substantial practical difficulties and ambiguities. Targeting quantity (money) and price (interest rate) simultaneously is inherently difficult--if not impossible--in the complex economic and financial system we have. We can't escape that in the real world, but setting forth specific targets in both areas will hardly contribute to confidence in the Federal Reserve's ability to set and steer a predictable course. We will continually be in a posture of explaining and altering money and interest rate targets, or both, and eroding the sense of consistency that is a valuable component of monetary policy. The conflicts cannot be resolved by sticking to interest rate targets and effectively eliminating money targets. If we have learned anything in the past two or three decades, it is that interest rate behavior can be quite unpredictable, depending as it does on domestic and worldwide credit demands, savings behavior, and the very fragile attitudes of investors and borrowers. This element of unpredictability has recently been well illustrated by the experience of a widely respected market analyst, who, though not alone in this, had to make an unusually sharp turnabout in his interest rate forecast. Money or credit targets alone, especially if too rigidly interpreted, can of course have problems, too. But I have to remind you that not too many years ago Congress was enthusiastic in that direction and contributed to the barrage of comment and criticism when we "missed" a little, often for reasons that (then and now) seemed to me preeminently sensible. Beware of overly simple targets: Real interest rates are about as uncertain as nominal rates, at least in the "short run" of a quarter, or year, or more. They depend on how the public--investors, businesses, consumers-sees prospects for inflation over the period ahead. There is very little, if any objective technique for the Federal Reserve to use in determining "real" interest rates on the basis of lenders' and borrowers' subjective forecasts of future inflation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The Honorable Bill Bradley Page Three  What we do know is a measure of real interest rates is sensitive to what measure of inflation or what measure of interest rates is used, and that, historically, short-run fluctuations are substantial. The enclosed chart, for example, tracing the Treasury bill rate minus the C.P.I. shows the sharp variations in "real" interest rates covering the time span from the 1930's to the present, and other charts reflect the sensitivity to definition. Related to these observations are the problems created as a "target," because of its visibility, becomes a "peg." If the Federal Reserve chose to maintain a rate on one type of targeted credit instrument, that rate would soon get out of line with others. If too low in relation to economic circumstances, market participants would shift into other investments that would yield a higher rate more consistent with price expectations, and borrowers would have to finance at that higher rate if they were to find lenders. Thus, attempts to hold a nominal rate would be self-defeating and the money created in the attempt to hold the rate would add to inflation. We had extreme experiences with that kind of thing after the war, and the milder attempt to hold down the prime rate in 1971-1972, partly by jawboning, is almost unanimously, in hindsight, thought to be a mistake. As you well know, the Federal Reserve fully recognizes its status as a creature of the Congress and is accountable to Congress through a variety of means, including prominently the semi-annual reports and appearances before the Banking Committees You probably share the feeling that somehow more and better information can be brought to bear. All I can say is that we already provide a multiple of what most other central banks do, and we don't try to hide. What I suppose we do do is avoid explicitness about the future when we don't know enough to be explicit, and where it is counterproductive to say more than we know or imply "commitments" when we should be flexible. At any rate, it seems to me that legislation and practice provide all the reporting vehicles needed, and if they can be improved, that's a human problem for us and for the Congress. Come to the Banking Committee and question us! In view of all these considerations--immediate effects on market confidence in our commitment to sound monetary policy, alteration in the institutional arrangements assuring insulation of the central bank from transitory political considerations and a host of practical shortcomings--I would hope that there would be no serious consideration of this legislation before hearings are held with full opportunity for deliberation, discussion, and clarification of these complex issues by the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The Honorable Bill Bradley Page Four  appropriate Congressional committees and by the public. In that framework, I suspect the proposals will be rejected, but whether that judgment is right or wrong, they should not be adopted now. Sin  rely,  Enclosure   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Lyitt/V  /(zudiA_fto  P14  P.44.‘ aPAtit  Z7f  comm ITTEES:  BF:ADLEY NEW JERSEY  FINANCE ENERGY AND NATURAL RESOURCES  'Unita)Ziafez Zertate  SPECIAL COMMITTEE ON AGING  WASHINGTON, D.C. 20510  August 19, 1982  Honorable Paul A. Volcker Chairman Federal Reserve System 20th and Constitution Ave., N.W. Washington, D.C. 20551  ; 1.  C:3 Or)  Dear Mr. Chair a For more than a year, with Poland on the brink of financial default, the Western world has become sharply aware of the potential risks posed by our lending to members of the Soviet bloc. But the debate surrounding East-West economic relations has eclipsed an equally important message of the Polish debt crisis -- the world financial system may be vulnerable to the possible repercussions of a sizeable sovereign default. The prospect of losing even a part of the estimated $27 billion in Western assets held as loans to Poland, should spur the governments of the major financial powers to plan collectively for contingencies. A contingency program should spell out possible scenarios following a Polish default and trace, step-by-step, how the system can be expected to cope with each possible danger. Unfortunately, I fear that such an exercise would expose several points of vulnerability in the world financial system. Here are some of the factors that spur my concern: 1  the huge international debt incurred by Eastern European and Third World countries which are in precarious economic health;  2)  the shaky financial condons of many major international corporations;  3)  the chain reactions and systemic problems which will develop if one or more of these shaky players should start to fall, including breaks in bank lending lines; a race to call in loans; withdrawal of deposits from banks perceived as risky; and a rush of new deposits to "safe" currencies;   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  4,  • Honorable Paul A. Volcker - Page 2  4)  a failure to define lines of authority among central banks for crises in overseas affiliates and consortia banks, and to change domestic laws which would inhibit effective action in a liquidity or currency crisis;  5)  a lack of a mechanism to handle severe, system-wide foreign currency shortages.  My impression is that during a crisis spurred by these factors several gaps in the system could develop. At best, there is uncertainty about how existing institutions would perform to close them. A contingency program to increase certainty could play an important role. If my concerns are not warranted, I hope you will detail for me how we and our major allies would effectively protect Western banking systems, and hence economies, in a crisis. If no such plans exist, or if you lack confidence in them, then I urge you to undertake a study of this problem. Assuming that adequate protections do not currently exist, I would like to offer a few steps that might be considered. First, we could create a multilateral fund from which central banks could borrow, under agreed conditions, the foreign exchange they need to cover endangered banks. The fund would need authority to borrow from the central bank of the country whose foreign exchange was in high demand in order to relend to the central bank in need. Of course, the fund would have to set rigorous conditions to deter anything but emergency use. It appears to me that the International Monetary Fund would be the appropriate agency to administer this fund, but there are other possible candidates such as the Bank for International Settlements in Geneva. In connection with this proposal, I would like to know whether the lending of dollars in any amount by the Federal Reserve to the IMF or BIS for this purpose would require Congressional authorization. We might also consider creating a financial contingency program which could include (1) a formal agreement clarifying and reaffirming the 1974 central bankers Basle declaration on the allocation of lender of last resort responsibilities; (2) preparations to stabilize a vulnerable currency; and (3) preparations to coordinate the operations of the lender of last resort facilities of major industrialized nations.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -  4r  ' Honorable Paul A. Volcker - Page 3  These suggestions are at best partial solutions to difficult questions. I recognize that responses to the questions raised are not easily prepared. However, I know you appreciate that the matter is of great importance. While I do not intend to create undue public alarm. The desire to assure public confidence in a vulnerable financial system, will prove a shabby excuse if an uncontrollable crisis should develop. We must guarantee stability against any reasonable doubt. Equally important, allied threats to cut off credits to Poland would weigh more heavily with Poland's generals (and Soviet Politburo members) if they knew that our economies were braced against the potential repercussions of a default. Similarly, a contingency program is a prerequisite to a credible credit sanction policy. Without it, our hands are tied by our own economic vulnerability. I offer these comments and questions in a spirit of cooperation and in the belief that our country will be better off if we have a reliable framework for minimizing the vulnerability of the U.S. economy and U.S. security interests to the repercussions of large sovereign defaults. Because of the urgency of this problem, I would appreciate a timely response, at a minimum informing me of the progress b.6-irig made in preparing answers and, I hope, formulating a contingency program. 13,9mt wishes,  Bill Bradley  BB:afk   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  BOARD OF GOVERNORS OF THE  FEDERAL RESERVE SYSTEM  Office Correspondence To  Date August 26, 1982 Subject: Background for your lunch with  Chairman Volcker  Senator Bradley  From Robert F. Gemmi 1 1,-1'X'A ,  Senator Bradley has expressed concern about the level of exposure of the banking system to LDCs and to Eastern Europe, and about the lack of a mechanism to provide liquidity (and possibly bail -out) support in the event of a "default" by large borrowing countries.  The concerns are set forth in the attached  letter and in two speeches in the Congressional Record (attached). 1.  He proposes (page 2 of letter) a multilateral fund to provide foreign  exchange to central banks to be loaned to ibndangered banks."  The Eurocurrency  Committee (BIS) recently considered this issue, concluding that each central bank will provide liquidity assistance in its own currency and that commercial banks will convert these funds in exchange markets, as needed.  The Committee recognized  that such actions might add to the pressures in exchange markets that may already be occurring in a banking crisis, and the Committee noted (a) that it was important for authorities to stand ready to avoid disorderly markets, and (b) that facilities existed to supply funds to counter disruptions (swaps and EMS credit lines). 2.  Senator Bradley asks (letter, page 2) whether the Federal Reserve  could lend to the IMF or the BIS in connection with this proposal without Congressional authorization.  The question does not distinguish between loans outside  the BIS swap arrangement, which would require Congressional approval, and possible use of the BIS swap line. 3.  He recommends a formal agreement "clarifying and reaffirming the  1974 central bankers Basle declaration on the allocation of lender of last resort responsibilities."  This appears to confuse the 1974 (post-Herstatt) statement  regarding liquidity support (reproduced below) with the Concordat which, as Peter Cooke and others have noted, contains guidelines only with respect to supervision, and does not allocate responsibility for providing assistance.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  , .` -  0 1  ' v•\•••-  ..,-43)\-` ' %.  41   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  .e,‘-';'.‘•*-  -2-  Chairman Volcker  The recent Eurocurrency Committee review of liquidity support issues illustrates the difficulty of arriving at formal, detailed agreements.  The  Committee emphasized the role and responsibility of the parent commercial banks, and recognized that as central banks supply liquidity support to their parent banks, these banks may channel the funds to support foreign branches and in many cases also subsidiaries.  However, the Committee concluded (paragraph 4 of the  Committee report) "no advance undertaking on the part of central banks to provide support in a specific situation could be envisaged," referring, I believe, to support to banking offices operating outside the home country.  Assistance may be shared  by parent and host country authorities in the case of subsidiaries and joint ventures (and to a lesser degree in the case of branches).  In sum, assistance  would be provided on a case-by-case basis, rather that allocated by formula in advance. 4.  Senator Bradley (letter, page 3) argues that a contingency program  is needed "to guarantee stability against any reasonable doubt" and also as a "prerequisite to a credible credit sanction policy" against Eastern Europe. 5.  Senator Bradley has expressed concern about debt burdens of LDCs  and Eastern Europe, and about bank exposure to these countries. Staff estimates of gross external debts are as follows: Data in billions of dollars  Non-OPEC developing countries Eastern Europe (excluding Yugoslavia)  1975  1979  1981  160  360  500  35  75  85  Tables 1 and 2 give data on exposure of U.S. banks and other G-10 banks to these two groups of borrowers.  Debt to banks is currently about half of total  LDC debt. Table 3 gives sources of external financing of LDCs' current account deficits.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Table 1 Bank Claims on Selected Countries (billions) .  Country Non-OPEC Developing (Total)  December 1975 NonU.S. U.S. 1/ BanksBanks Total  December 1979 NonU.S. U.S. Banks Banks Total  December 1980 NonU.S. U.S. Banks Banks Total  December 1981 NonU.S. U.S. Banks Banks Total  34  29  63  59  96  156  73  121  193  90  140  230  Argentina  2  1  3  5  8  13  7  12  19  8  15  23  Brazil  8  7  15  14  23  37  16  27  43  18  32  50  Mexico  9  5  14  12  19  31  16  25  41  22  33  55  Korea  2  1  3  5  5  10  8  6  14  11  6  17  3  21  24  7  56  63  7  62  69  8  63  71  2/ Eastern Europe-  1/ 2/  Converted to BIS basis. Includes Yugoslavia.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Table 2  .  Concentration's of Lending to Developing Countries and Eastern Europe Relative to Capital for U.S. Banks (Percent)  December 1977  December 1979  December 1981  Nine Largest Banks Developing Countries (total) Argentina Brazil Mexico Korea Eastern Europe  156 9 40 32 12 25  161 10 39 27 17 21  208 19 43 41 21 19  105 5 28 29 6 16  116 10 26 24 14 17  150 15 29 36 16 11  54 3 14 18 2 8  59 5 14 14 2 7  74 6 15 23 6 6  Next Fifteen Banks Developing Countries (total) Argentina Brazil Mexico Korea Eastern Europe All Other U.S. Banks Developing Countries (total) Argentina Brazil Mexico Korea Eastern Europe  Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Country Exposure Lending Survey.  Table 3 Current Account Position and Financing of the Mon-OPEC Developing Countries ($ billions) Federal Reserves staff Projections 1975  1976  1977  1978  1979  1980  1981  1982  -38  -26  -21  -34  -52  -76  -87  -80  6  6  7  8  11  12  13  14  -32  -20  -14  -26  -41  -64  -74  -66  5  5  5  6  8  8  11  12  Public borrowing from official sources (excluding IMF)  11  9  11  12  14  18  18  19  6.  Borrowing from banks  15  16  10  24  37  40  42  33  7.  IMF credit (net)  2  2  1  3  7  8  8.  Miscellaneous and residual  -2  -1  -2  -4  -11  -7  -4  -4  9.  Net acccumulation (-) or reduction (+) in official reserves  1  -11  -10  -12  -8  2  0  -2  1.  Balance on Goods, Services and private transfers  2.  Public transfers  3.  current account  Financed by: 4. Direct investment 5.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  760  FEDERAL RESERVE BULLETIN E NOVEMBER 1974  should note, however, that while we have market, commercial banks can turn to central a general concern about undue dependence on banks in the event of liquidity difficulties resultunreliable sources of funds, the fears sometimes ing from any abrupt withdrawal of funds. The expressed that the banking system could be great bulk of the recycling involving U.S. banks threatened by a sudden withdrawal of OPEC has occurred through U.S. head offices or funds from some banks are exaggerated. Current foreign branches; the role of foreign subsidiaries practices in international commercial banking or consortia in which U.S. banks participate has provide a measure of liquidity to individual been minor. For instance, the assets of the banks facing an abrupt withdrawal of short-term foreign branches of U.S. banks are more than petro-dollar deposits. For example. were the ten times as large as those of subsidiaries and beneficial owners of petro-dollar deposits to consortia banks. Almost all of these foreign elect to withdraw their funds from some Ameribranches belong to U.S. banks that are members can banks and place them with banks of other of the Federal Reserve System. The Federal nationalities, the American banks would be Reserve is prepared. as a lender of last resort, faced with a need to finance their asset portfoto advance sufficient funds, suitably collatlios. At the same time as the American banks eralized, to assure the continued operation of were experiencing an outflow, banks of other any solvent and soundly managed member bank nationalities would be confronted with an inflow that may be experiencing temporary liquidity of funds since the owners of these funds would difficulties associated with the abrupt withhave to deposit them somewhere, or would have drawal of petro-dollar—or any other—deposits. to purchase other assets whose sellers would Similarly, the central bankers, who meet at then make deposits. The banks that had lost the Basle, issued a statement on September 9, inpetro-dollar deposits would be able to bid for rclu ding the following comment: funds from the banks that had received the large The Governors also had an exchange of and relatively sudden inflow of petro-dollar deviews on the problem of the lender of last posits in excess of the financing requirements resort in the Euro-markets. They recognized of their loan portfolios. As long as the outflows that it would not be practical to lay down do not seriously affect confidence in the ability in advance detailed rules and procedures for the provision of temporary liquidity. But of the banks in question. there could be a they were satisfied that means are available relatively smooth process as banks receiving the for that purpose and will be used if and when petro-dollar deposits redeposit them with those necessary. [ banks losing deposits. But the possibility of such deposit withdrawals can pose serious manI shall return to questions of emergency asagement problems, especially for all but the sistance later. largest banks. You have asked about the supervision of the A second and related source of liquidity to foreign activities, including the foreign banks that experience withdrawal of deposits is branches, of U.S. banks. The primary means the sale of assets. A bank that experienced a by which the overseas activities of U.S. banks withdrawal of its deposits could sell some of are evaluated are through examinations and reits asset portfolio to those banks that are exquired reporting. The examination process, periencing the deposit inflow. For the foreign which entails a- scrutiny of bank assets and branches of U.S. banks, and most major banks operational procedures. seeks to assure that that participate in the Euro-currency markets, practices are being followed which minimize a large proportion of the assets consist of claims risks to depositors' funds and insure that the on other banks of less than 1 -year maturity. In institution is a viable one, prudently managed. the event of liquidity pressures the foreign The concern here is primarily with solvency and branches of the banks losing deposits should be liquidity, both of which relate primarily to the able to liquidate these assets within a short type and quality of a bank's assets. The examiperiod of time. nation process also seeks to verify that applicaApart from their ability to refinance in the ble U.S. laws and regulations are being ob-  au'  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -  BILL BRADLEY  -  ODIAMMMES: FINANCE ENERGY AND  NEW -IKTSEY  NATURAL RESOURCES  'ZICT-tifeb ,Stafez Zenctfe  SPECIAL COMMITTEE ON AGING  WASHINGTON, D.C. 20510  r,  CD  L7 ' 1  Cm  August 19, 1982  -r.  c-) rrl CD ,3  r)  C-)  NJ --:::  c. - rn  -.,_.„,  Honorable Paul A. Volcker Chairman Federal Reserve System 20th and Constitution Ave., N.W. Washington, D.C. 20551  •••  --0 --...... ......  --f -)  ,r4  7-V . .  t.':- ,' . . -...  D ,. ,  CD  I.  Dear Mr. Chair4n:,,G? ( For more than a year, with Poland on the brink of financial default, the Western world has become sharply aware of the potential risks posed by our lending to members of the Soviet bloc. But the debate surrounding East-West economic relations has eclipsed an equally important message of the Polish debt crisis -- the world financial system may be vulnerable to the possible repercussions of a sizeable sovereign default. The prospect of losing even a part of the estimated $27 billion in Western assets held as loans to Poland, should spur the governments of the major financial powers to plan collectively for contingencies. A contingency program should spell out possible scenarios following a Polish default and trace, step-by-step, how the system can be expected to cope with each possible danger. Unfortunately, I fear that such an exercise would expose several points of vulnerability in the world financial system. Here are some of the factors that spur my concern: 1  the huge international debt incurred by Eastern European and Third World countries which are in precarious economic health;  2)  the shaky financial conditions of many major international corporations;  3)  the chain reactions and systemic problems which will develop if one or more of these shaky players should start to fall, including breaks in bank lending lines; a race to call in loans; withdrawal of deposits from banks perceived as risky; and a rush of new deposits to "safe" currencies;   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  f•-•^1  •_,  :--;" •• 1 :.? -_,-  'Honorable Paul A. Volcker - Page 2  4  a failure to define lines of authority among central banks for crises in overseas affiliates and consortia banks, and to change domestic laws which would inhibit effective action in a liquidity or currency crisis;  5)  a lack of a mechanism to handle severe, system-wide foreign currency shortages.  My impression is that during a crisis spurred by these factors several gaps in the system could develop. At best, there is uncertainty about how existing institutions would perform to close them. A contingency program to increase certainty could play an important role. If my concerns are not warranted, I hope you will detail for me how we and our major allies would effectively protect Western banking systems, and hence economies, in a crisis. If no such plans exist, or if you lack confidence in them, then I urge you to undertake a study of this problem. Assuming that adequate protections do not currently exist, I would like to offer a few steps that might be considered. First , we could create a multilateral fund from which central banks could borrow, under agreed conditions, the foreign exchange they need to cover endangered banks. The fund would need authority to borrow from the central bank of the country whose foreign excha nge was in high demand in order to relend to the central bank in need. Of course, the fund would have to set rigorous conditions to deter anything but emergency use. It appears to me that the International Monetary Fund would be the appropriate agency to administer this fund, but there are other possible candidates such as the Bank for International Settlements in Geneva. In connection with this proposal, I would like to know whether the lending of dollars in any amount by the Federal Reserve to the IMF or BIS for this purpose would require Congressional authorization. We might also consider creating a financial contingency program which could include (1) a formal agreement clarifying and reaffirming the 1974 central bankers Basle declaration on the allocation of lender of last resort responsibilities; (2) preparations to stabilize a vulnerable currency; and (3) prepa rations to coordinate the operations of the lender of last resort facil ities of major industrialized nations.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  'Honorable Paul A. Volcker - Page 3  These suggestions are at best partial solutions to difficult questions. I recognize that responses to the questions raised are not easily prepared. However, I know you appreciate that the matter is of great importance. While I do not intend to create undue public alarm. The desire to assure public confidence in a vulnerable financial system, will prove a shabby excuse if an uncontrollable crisis should develop. We must guarantee stability against any reasonable doubt. Equally important, allied threats to cut off credits to Poland would weigh more heavily with Poland's generals (and Soviet Politburo members) if they knew that our economies were braced against the potential repercussions of a default. Similarly, a contingency program is a prerequisite to a credible credit sanction policy. Without it, our hands are tied by our own economic vulnerability. I offer these comments and questions in a spirit of cooperation and in the belief that our country will be better off if we have a reliable framework for minimizing the vulnerability of the U.S. economy and U.S. security interests to the repercussions of large sovereign defaults. Because of the urgency of this problem, I would appreciate a timely response, at a minimum informing me of the progress be-int made in "preparinganswers and, I hope, formulating a contingency program. B0-st wishes, x , •  Bill Bradley  BB:afk   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  PAUL A. VOLCKER CHAIRMAN  September 10, 1982  The Honorable Jake Garn United States Senate Washington, D.C. 20510  V  Dear Senator Garn: Thank you -for the letter you and you r colleagues on the Senate Banking Committee sent me regarding the Federal Reserve':, proposal to modify the System's check processing and collection procedures. You have requested that the Board extend the period for public comment on the proposals for an additional 30 day s beyond the present closing date of September 20, 1982. After very car eful consideration of your request, for the reasons explained in this let ter I do not believe it would be desirable to delay Board considera tion of this matter further. The Reserve Banks did not initia lly plan to request public comment on the change in the presen tment schedule hours since this cha nge did not involve any modification to Federal Reserve regulations, but only the exorcise of rights availa ble to all presenting banks under the Uniform Commercial Code. How ever, the Reserve Banks initiated extensive discussions within the financial community over the past several mon ths and various elements of the pro posal were announced to the bankin g industry. As we came closer -to implement ation of the proposal, it became clear that there was sufficient concern in the banking industry that we should have a more formal commen t period. In doing this, we dec ided to go beyond the 30-day comment per iod typically provided by agenci es and provide for a comment period of 45 days in ordef to as_gure -a dequate time for presentation of views. In view of the fact that this pro posal has been under banking industry review for some time prior to the formal comment period, and that the com ment period was initially opened for 45 days, we feel it would be undesirable to add an additional 30 days to the delay of what has already become an extended process. In August the System began operat ing a reconfigured air charter system. As a result of a contin ued delay in considering the pro posal, the advantages of the modified System are not able to be utiliz ed to the fullest extent possible. Moreover, a delay will also adv ersely affect our longer run efforts to reduce and eliminate float. We are concerned that a substantial portion of increases in float we have experienced in recent wee ks are   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The Honocable Jake Garn  -2-  attributable to the delay in the Board's consideration of this mat ter. During the first several weeks of the delay in implementation, flo at increased approximately $500 fai llion. This has come down somewh at in recent weeks due to interim ope rational adjustments and we ; now attribute at least $100 million of increa sed daily float to the delay in consideration of the proposal. The cost impact of delay is man ifest not only in terms of increased float, but also as a result of lower revenues from check clearing. As you are aware, the MCA requires the Federal Res erve to recover its costs of providing a check clearing service to dep ository institutions. These earnings are turned over to the Treasury and represent an offset to the loss of Treasu ry revenues due to the phasein of the ne4 reserve requirements of the MCA. As part of the cost recovery effort, and in accordance wit h the pricing principles adopte d by the Board last year, the System planned to reprice its checks ser vice on an annual basis. However, the fee schedule for this service depends heavily upon the type and lev el of service that are to be provided by Reserve Banks. Until the noon presentment pro posal is considered by the Board, Reserve Banks will be una ble to implement revised fee sch edules for their check collection ser vices. Consequently, any add itional delay in the Board's consideration of this matter beyond the schedu led comment period would adversely affect -the Federal Reserve's ability to c,arry out the mandate of the MCA to. recover our costs of providing check collection services and thus sig nificantly reduce Treasury rev enues. I feel it is important, both in terms of the costs to the government and promotion of the efficiency of the paliments_me chanism-basic objectives of the MCA--t o make a prompt decision with respect to this matter. In making this decision, I can assure you that the Board will give careful con sideration to all of the views expressed in the comments. If public comment indicates there are ser ious problems with the current proposal, we will all the sooner be able to make the necessary changes. In any eve nt, we will continue an effect ive dialogue with the banking community on prompt and effective implem entation of the mandate of the MCA wit h the aim of promoting a more efficient and safer payments system that responds to the needs of both the providers and users of financial ser vices.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The lionorala Jake Garn  -3-  I appreciate the concern expressed by yourself and your colleagues; however, in view of the considerable industry knowledg e of the proposal and the ad3auate time provided for formal comment as well as the costs that will result because of added delays, we believe it is necessary for the Board to proceed expeditiously with consider ation of -this matter.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Sincerely,  Copies sent to Senators Riegle and Chafee  MB:mara (V-191) bcc:  Mrs.Mallardi (2) •••••  JAKE GARN, UTAH, CHAIRMAN JOIF44 TOWER, TEX. JOHN HEINZ, PA. WILLIAM L. ARMSTRONG, COLO. RICHARD G. LUGAR, WO. ALFONSE M. DAMATO, N.Y. JOHN H. CHAFEE, R.I. HARRISON "JACK" SCHMITT, N. MEX. NICHOLAS F. BRADY. N.J.  DONALD W. RIEGLE, JR., MICH. WILLIAM PROXMIRE. WIS. ALAN CRANSTON, CALIF. PAUL S. SARBANES, MD. CHRISTOPHER J. DODD, CONN. ALAN J. DIXON, ILL. JIM SASSER, TENN.  M. DANNY WALL, STAFF DIRECTOR ROBERT W. RUSSELL, MINORITY STAFF DIRECTOR   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  'Alenife  iafez -.Senate  COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS WASHINGTON, D.C. 20510  August 20, 198 / The Honorable Paul A. Volcker Chairman The Board of Governors of the Federal Reserve System 20th & C Streets, N.W. Room B2125 Washington, D.C. 20551 Dear Chairman Volcker: On July 27, we, along with four other colleagues on the Senate Committee on Banking, wrote you urging that the Board of Governors seek public comment on a proposal of the District Reserve Banks to establish a uniform nationwide presentment time for so-called city items presented throughout the national system for check clearing. The Board has issued a notice seeking public comment on this proposal, and we wish to commend you and your colleagues for having taken this action. Our purpose in writing today is to request that you extend the period for public comment for an additional thirty days beyond the present termination date of September 20, 1982. The letter of July 27 emphasized our judgment that the proposed rulemaking by the District Reserve Banks may have potentially far-reaching effects on the existing structure of our national payment system. This is so, in part, because the proposal would have the practical effect of vitiating many existing voluntary agreements of city clearing houses - agreements previously formally accepted by some of the District Reserve Banks. Because of the significance of the proposal, it seems well to take every reasonable step to assure that the public commentary presented to the Board is the product of careful and detailed analysis of the proposal's cost and other effects on existing operating procedures. Given the fact that the request for comment was issued at a time when many affected institutions are understaffed because of traditional vacation schedules, we believe that the quality of public  • .116111M  The Honorable Paul A. Volcker August 20, 1982 Page 2 lly improved by a thirty-day extension comment will be materia• of the comment period.  ..L.S.,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Jake Garn  • Donald W. Rie1eJ .  >  September 91 1982  The Honora'ole Walter E. Fauntroy Chairman Subcommittee on Domestic Aonetary Policy Committee on Ban%ing, Finance an Urban Affairs House of Representatives Washington, D.C. 20515 Dear Mr. Chairman: Thank you for your letter to Chairman Volcker of September 8, 1982, concerning Citicorp's application to acquire Fidelity Savings a and Loan Association of San Francisco. Since the letter refers to record matter that will come before the Boar:a it will be made part of the in this case an broug%t to the attention of Chairman Volcker and the application. other memberE of the Board at the time the Loard considers this We very much appreciate having your views concerning this matter. Sincerely, (signed) Michael Bradfield Michael Bradfield General Counsel  NiB:mam  FIB bcc:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Mr. Ryan V-208  C  E y  Action assigned Mr. Bradfield; info copy to Jack Ryan W 1.1-TE R  PARREN J. MITCHELL. MD. STEPHEN L. NEAL, N.C. DOUG BARP*RD, JR., GA. HL.•04Y S. Rt.USS. WIS. JAMES J. BLANCHARD, micH CARROLL HUBBARD, JR., Ky. BILL PATMAN, TEX.  U.S. HOUSE OF REPRESENTATIVES SUBCOMMITTEE ON DOMESTIC MONETARY POLICY  H2-179. ANNEX NO. 2 WASHINGTON. D.C. 20515 (202) 225-7315  OF THE  COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS NINETY—SEVENTH CONGRESS  WASHINGTON, D.C. 20515  September 8, 1982  r.-  r• •I  The Honorable Paul A. Volcker Chairman Board of Governors Federal Reserve System 20th & Constitution Avenue, N.W. Washington, D. C. 20551  7  Dear Paul: I just wanted to share with you some of the concerns I have regarding the continued delays of Citicorp's offer to acquire Fidelity Savings of San Francisco. While I am aware that the Board plans to consider this matter at hearings on September 8th or 9th, I wanted to be sure that you were aware of my own thoughts in this matter. The series of delays which have plagued the Fidelity transaction prolong the time for Fidelity to lose deposits and key personnel, which in turn could lower the value of Fidelity to any potential purchaser by millions of dollars -- a cost that would be borne by the FSLIC and, ultimately, the taxpayer. Additionally, I am concerned that delays could impart the belief that the regulatory and monetary authorities of this country are either incapable or unwilling to act thereby adding to the liquidity problems which will worsen the already fragile state of the economy. Finally, the series of delays involved in this situation and the costs involved could have a chilling effect on the incentive of out-ofstate institutions to bid in future situations. I am particularly concerned with the effect this could have on possible interstate activities involving regional banks and thrifts in and around the District of Columbia. While I am sure that Congress will provide further guidance on some of the questions which opponents of this acquisition have raised, I am not as sanguine about the time they have noted nor am I convinced that the guidance provided would have the regulatory authorities reach any different result. Furthermore, I would note that the bidding procedure used by the regulatory authorities, which have resulted in Citicorp's superior bid by over $140 million that will not have to be paid by   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  0  GEORGE HANSEN, IDAHO RON PAUL. TEX. BILL M000LLUM. FLA. BILL LOwERY, CALIF. ED WEBER, OHIO JAMES K. COYNE, PA.  E. FAUNTROY, D.C., CHAIRMAN  -11 3  '  Chairman Volcker  - 2 -  September 8, 1982  VI  either the taxpayer or through the use of contingent liability instruments or the insurance funds, are of the type which have broad support. If, therefore, the Board determines that the acquisition by a Citicorp of Fidelity meets all of the other prevailing regultory standards usually applied, I would urge that the Board direct forthwith the immediate approval of the application.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  With kindest personal regards. Sincerely yours,  Walter E. Fauntroy Chairman  or • Of GOv;•. .•'  BOARD OF GOVERNORS OF THE  FEDERAL RESERVE SYSTEM WASHINGTON, D. C. 20551  September 8, 1982  PAUL A. VOLCKER CHAIRMAN  The Honorable Benjamin S. Rosenthal Chairman Subcommittee on Commerce, Consumer and Monetary Affairs House of Representatives 20515 Washington, D.C. Dear Chairman Rosenthal: In your letter of August 13, you revised an earlier request for access by the Subcommittee staff to information contained in the Form F.R. 2068, Confidential Report of Operations, filed by the Hongkong and Shanghai Banking Corporation for calendar year 1981. You request access to those portions of the form providing financial statements of unconsolidated related companies, both majority- and minority-owned, in order (1) to review the adequacy of the Hongkong Shanghai Banking Corporation's compliance with the reporting requirement and the Federal Reserve's enforcement of the requirement, and (2) to review the basis on which the Hongkong and Shanghai Banking Corporation qualifies for exemption from the nonbanking prohibitions of the Bank Holding Company Act, as provided in section 211.23(b) of Regulation K. As I indicated in my letter to you of July 15, it is the Board's policy to afford the information provided in the F.R. 2068 the highest degree of confidentiality. To release this information in any manner would, in the Board's view, be damaging to the effective performance of its supervisory functions. Moreover, the information that you are now seeking will not effectively serve to meet the objectives stated in your August 13 letter. In particular, the information you seek from the F.R. 2068 will not serve to help assess whether the Hongkong and Shanghai Banking Corporation is a "qualifying foreign banking organization" under section 211.23(b) of Regulation K. The primary source for such data is the "Annual Report of Foreign Banking Organizations," Form F.R. Y-7. That form provides the information necessary to determine whether a foreign banking organization may engage in certain nonbanking activities as a "qualifying foreign banking organization" under section 211.23(b) of Regulation K. A copy of the most recent F.R. Y-7 filed by the Hongkong and Shanghai Banking Corporation has been forwarded to you under cover of my letter of July 15, and the data contained in that form demonstrates that the Hongkong and Shanghai Banking Corporation meets the two   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The Honorable Benjamin S. Rosenthal Page Two  criteria specified in section 211.23(b) for a qualifying foreign banking organization: more than half its worldwide business is banking (not taking into account its U.S. banking) and more than half its banking business is outside the United States. The F.R. Y-7 does not call for specific documentation supporting the data submitted, although the Board may request such information if it is deemed necessary. We believe that the data submitted by the Hongkong and Shanghai Banking Corporation in the F.R. Y-7 are accurate and complete, based on our general knowledge of the activities of the organization and the data previously submitted by the corporation. The data are fully consistent with earlier data received by the Board, including the data contained in my letter to you of January 14, 1980, on which the Board based its original determination that the corporation was a "foreign bank holding company" for purposes of 12 CFR § 225.4(g), the predecessor of section 211.23(b) of Regulation K. There is no evidence that there have been material changes in the character of the organization since that time. Moreover, the portions of the F.R. 2068 that you are currently seeking--the data required by pages 9 and 10 of the forms--will not effectively serve as a way of supplementing information in the F.R. Y-7 for purposes of determining whether the Hongkong and Shanghai Banking Corporation is a "qualifying foreign banking organization." Page 9 of the form asks for financial statements of unconsolidated majority-owned related companies. Page 10 of the form asks for summary financial information, consisting of data on total assets, stockholders' equity, and net income, on unconsolidated minority-owned related companies. The purpose of requiring the information on these pages is not to enable a determination of the foreign banking organization's qualification for exemptions under section 211.23(b) of Regulation K. The purpose is to assist in the assessment of the financial condition of the foreign banking organization by determining whether there are significant related companies that are not included in its consolidated financial statements.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  JIM WEAVER  ,,, 4TH DISTRICT, OREGON •  COM MITTEES  WASHINGTON OFFICE: LONGWORTH F-IOUSE OFFICE BUILDING  Chairman 4iscussing with 'Vice Chairman re who will testify-R&S to do statement  AGRICULTURE INTERIOR AND INSULAR AFFAIRS  WASHINGTON, D.C. 20515 (202) 225-6416  Congre555oftheanitebtate5  JOE RUTLEDGE ADMINISTRATIVE ASSISTANT  DISTRICT OFFICESFEDERAL BUILDING 211 Ep.sr 7TH AVENUE  jiptifSe of iltpre5entatibefi  EUGENE, OREGON  97401  (503) 687-6732  teafsbington, 13.C. 20515  FEDERAL BUILDING 333 WEST 8TH STREET M EDFORD, OREGON 97501 (503)779-2351  August 24, 1982  Mr. Paul A. Volcker Chairman Board of Governors of the Federal Reserve System 20th Street & Constitution Avenue, N.W. Washington, D.C. 20551  •••••• ••  Dear Chairman Volcker:  I do not believe that the Congress has fully explored the impact of this depression on housing's dependent industries, especially forest products. It is vital that Congress begin serious planning for the future of these two important sectors. Our long-term goal must be stable and adequate housing and timber production. The housing depression is severe and I believe that Congress' approach to it must be conducted with the forest products situation in mind. I have scheduled a hearing of the Forests Subcommittee for in 1301 Longworth House Tuesday, September 16, 1982, at 9Office BuilltistrTr"Tr=rinTwi 1 focus on the present state of the housing and forest products industries, their future, and the relationship between them. I respectfully request that you testify and present your views on the situation and on possible solutions. If you have any questions concerning the hearing or wish to testify please contact Kevin Kirchner at 225-0301 or Gordon Stoddard at 225-6416. Thank you. Sincerely,  1.42.sAtA WEAVER irman GS:el   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis
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