From The New York Times
November 12, 1999
Year 2000 Insurance Is Hot on Wall Street, but Not a Sign of Fear
By JONATHAN FUERBRINGER
Year 2000 insurance has been the hottest-selling item on Wall Street recently. And its popularity is one reason investors are less concerned than they were a few months ago about possible disruptions in business and trading when computers make the internal change to the new year.
To help ensure that cash will be readily available even if the changeover disrupts the financial system, the Federal Reserve Bank of New York has been holding weekly auctions of options that will guarantee the availability of billions of dollars from Dec. 23 to Jan 12.
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THE
Y2K
PROBLEM
Index of Articles
What does the Y2K issue say about our increasing reliance on technology?
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In just four weeks, the Fed has sold $306 billion of the options and has at least three more auctions planned. The amount paid for the insurance so far is just $4.9 million, a small price in markets where trillions are traded.
Other barometers also indicate that institutional and individual investors have been somewhat reassured leading up to the Century Date Change -- the Federal Reserve's preferred nomenclature for what is commonly referred to as the Y2K problem. Because of a design problem that may render computers unable to recognize "00" as 2000 when the new year rolls in, patchwork efforts have been made across all types of business and government, but the real test will come on Jan. 1.
Many Fed analysts had suggested this summer that central bank policy makers would not even consider raising short-term interest rates in November because higher rates could intensify any problems at the end of the year.
But that view has changed. "Fears have subsided," said Bruce Steinberg, the chief economist of Merrill Lynch, who is now expecting a rate increase when the Fed meets on Tuesday.
Though risky securities usually command a higher yield than Treasury securities, which are backed by the government, the differences in those yields grew earlier this year. Recently, however, those spreads have narrowed, indicating that investors are willing to take on more risk even as the year draws to a close.
Stock prices, meanwhile, have continued to rise. Consumers are still buying big-ticket items, like automobiles. Mutual fund flows hint of no significant Year 2000 concern. And the fund company T. Rowe Price found in a recent survey that only one in 10 of its fund customers expected to alter investment strategy because of such concerns.
There was a rush this summer to buy the first six-month Treasury bills that mature in January 2000, so that proceeds could be invested after Jan. 1, but no rush this fall when the first three-month Treasury bills maturing in 2000 became available.
Investors have also taken advantage of opportunities created by the heightened concern earlier this year. Paul DeRosa, a partner at Mount Lucas Management, an asset management company in Princeton, N.J., bought mortgage-backed securities in early August when the spread between these securities and Treasuries was abnormally wide. The wide spread reflected, in part, a preference for Treasury securities, which would be much easier to buy and sell than mortgage-backed securities in a crisis.
The spread has since narrowed, bringing DeRosa a profit.
Even Edward J. Yardeni, the chief economist at Deutsche Bank Securities who has long warned of a Year 2000 recession because of the date change, is moderating his view.
"It doesn't look as though Y2K will slow down consumer demand as much as I thought," Yardeni said, adding that he would have to revise upward his fourth-quarter United States growth forecast, which has been just one-half percent.
"I probably will be one of the happiest people on the planet if nothing happens, since I'm worrying so much about it," he said. Still, he added that he had been "quite surprised by the increasing complacency."
Alan Greenspan, chairman of the Federal Reserve, says that intense preparations for the Year 2000 are paying off. "The good news," he said in a speech last month, "is that evidence is becoming more persuasive that our electronic infrastructure will be ready for the Century Date Change. The public's understanding of the degree of our Y2K readiness also has grown, and fears of widespread disruptions around the C.D.C. appear to be waning, though we are not as yet home free."
Whether the additional money is needed or not, the Fed's insurance program, which was announced in October, is doing at least part of its job. "It adds a level of comfort to the environment," said Paul Scheufele, managing director for liability management at Credit Suisse First Boston.
The insurance, sold through primary dealers in the Treasury market, is intended to assure that cash is available to keep fixed-income markets working smoothly, even in case of computer problems.
Primary dealers are the center of the repo market, where securities, like Treasuries, are traded for cash to meet the short-term needs of Wall Street firms, banks, mutual funds, hedge funds and corporations. The cash can be borrowed for as short a period as overnight and is a major means of financing the bets made in the fixed-income market. If Year 2000 problems send repo interest rates soaring, this market could dry up, with damaging ripples through the entire fixed-income market.
Primary dealers say the option insurance costs $15,000 to $30,000 per billion dollars, depending on the week covered. The most expensive is for the week beginning on Thursday, Dec. 30, which includes the turn of the year. The options are also available for the week before and the week after. An option gives the dealer access to its face value in cash in exchange for securities as collateral. The interest rate is 1.5 percentage points over whatever the target rate is then for federal funds, now 5.25 percent.
The insurance would help if mutual funds or corporations suddenly had trouble borrowing. A mutual fund might need money to cover withdrawals at the end of the year, while a corporation might need money to cover a dividend payment.
"It insures that if we need cash, we would have the ability to get it," said David Sylvester, who runs the Stagecoach and Norwest Advantage money market funds for Wells Capital Management, a unit of Wells Fargo.
If a settlement problem arose in the repo market, making it more difficult for cash to move through the system, Scheufele said, the insurance options could be exercised to provide the funds.
Fear of the unknown could also make primary dealers reluctant to lend at the end of the year.
But with this insurance, primary dealers know their maximum cost of borrowing -- 1.5 percentage points over the federal funds rate target.
"I am more comfortable lending out over the year end to my customers," Scheufele said.
Most important, primary dealers, who borrow heavily themselves to make their bets, will have the cash they need. Without this source of cash they might be forced to sell holdings, from Treasuries to mortgage-backed securities, to meet their obligations. Such dumping could prompt a marketwide selloff, cause panic among many investors and lead to gridlock in the fixed-income markets. It happened in 1998 after Russia defaulted on its debt and a major hedge fund nearly collapsed. The Federal Reserve ultimately cut its short-term interest rate three-quarters of a percentage point to ease the strain on the virtually frozen bond market.
The idea of the program, said Joe Blauvelt, the managing director responsible for the finance desk at J. P. Morgan Securities, is for the Fed to "gauge what kind of trading volatility people expect and then alleviate some of that pressure by offering more of the insurance options to the dealers." This is why the Fed has expanded the program from five auctions to seven and why the amount offered has increased with each auction.
But the stampede for the options is not a sign of pervasive fear, just another relatively inexpensive precaution.
"This is a no-brainer," Blauvelt said. "We are buying insurance in case the repo market goes away."
It is also good for job security, added Paul Thomas, head of government securities sales and trading at Merrill Lynch. "Knowing that this insurance was available, an individual cannot afford to walk into his boss's office at the end of the year and say we can't get cash," he said.
Among the signs of continued concern is a buildup in business inventories. Manufacturing inventories shot up in October, according to the National Association of Purchasing Management, indicating that executives are worried about getting deliveries of products early in the new year. At 51.1, the index reading in October was the first over 50 since November 1988.
And while some Year 2000 fears from last summer are easing, some new ones are turning up.
Money market fund managers were worried last summer about having enough cash to meet withdrawals near the end of the year. Now, they may have too much cash.
Sylvester, the fund manager, said it was now possible that money will pour into the bigger funds in December from midsize companies and local governments with cash on hand.
So he will need places to invest his extra cash. And he has already made arrangements with primary dealers, who are willing to do so because they expect the Fed insurance program to help keep the repo market working smoothly.
Copyright 1999 The New York Times Company
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