As the year passes its halfway mark, nothing has been popping up on mortgage players' radar screens more than Y2K concerns.
In conversations on the Street, in investment houses across the country and in conference rooms around the world, there has been a great deal of conjecture and planning regarding whether this issue will impact the mortgage market adversely.
"Y2K will have to be an issue on everybody's table, because it is going to affect issuance and impact liquidity," said Dale Westhoff, a vice president at Bear, Stearns & Co. "There is a good chance that investors will take their chips off the table. There is also an expectation of less demand, and some weakness in the market as we move to the fourth quarter. People are just getting very skittish."
Though all predictions are, of course, speculative, and there is no uniform opinion circulating, there does seem to be a unanimous feeling that considerations of Y2K compliance and of investment strategies must be at the top of everyone's list of priorities - whether they are an investor or an issuer.
"Just from a risk-premium vantage point, we could have some liquidity concerns over the next couple of months," said Stephen L'Heureux, vice president at AEW Capital Management. "There could be a speculative surge in terms of cautionary flows to more liquid assets towards year-end, [in anticipation of Y2K]."
The technical aspect of the issue is also causing some alarm in the market. From a technical standpoint, lack of Y2K system readiness by an MBS originator and servicer could result in steep asset quality deterioration, incorrect cash flow allocations and delayed or missed payments on outstanding transactions, according to Nehal Farooqi, an analyst at Moody's Investors Service.
Other problems for investors, says Farooqi, may stem from an MBS servicer's system failure, which could lead to an inaccurate or premature allocation of funds.
"We are viewing Y2K as an event risk though it can be construed like a credit risk if there is a disruption in any of the cash flows," Farooqi said. "Even if MBS servicers or investors feel they are ready, their outside interactions with other lenders could cause some kind of malfunction.
"This would further impact cash flows, causing even more problems."
There is currently no uniform definition of what it means to be Y2K-compliant - or ready, Farooqi added. Because of this, he says, it is extremely difficult to gauge who has done what and how far along companies are in their Y2K preparedness.
'98 All Over Again?
Technical issues aside, the main question revolves around what steps investors are going to take as the fourth quarter approaches.
"I think it is going to be very much a replay of 1998, when most players had effectively closed off their books by the first week of December, and only had purely discretionary actions left to do in December," said Michael Youngblood, managing director of real estate at Banc of America Securities. "I think that investors expect probably by Thanksgiving to be essentially positioned as they want to be for December 31."
Additionally, Youngblood says that more investors will be positioned to take advantage of distress sales and to bargain shop by the year's end.
"I expect an exaggeration of 1998 behavior, but nothing more radical than that," he said.
However, other market insiders doubt that the Y2K crunch will mimic the year-end 1998. While some say that it will be similar to last year, there seems to be fewer leveraged players out in the market now, making this year's economic ruptures resound with far less magnitude.
"Unless both Argentina and China devalues sometime soon, I doubt that it will be on the same level as last year," said AEW's L'Heureux. "There is certainly going to be a jump towards acquiring higher quality assets due to Y2K, in case something happens, but there is just less leverage out there compared to last year."
While there is always a liquidity crunch at the year's end, the crunch for this year might be more pronounced, sources say. Therefore, raising a portfolio's liquidity seems to be the most popular option for investors - and cheap paper is the way to do it.
"Y2K has been a major concern for us," said Stephen R. Cianci, vice president and portfolio manager of the Philadelphia-based Delaware Management Company Inc. "The way we've tried to manage it is to raise liquidity and look for possible dislocations in the market as we get closer to the end of the third quarter and the beginning of the fourth. We're looking for some great opportunities to buy some cheap paper."
Is the Cup Half Full or Half Empty?
Another way of looking at Y2K is to view it as a buying opportunity, said Westhoff.
"If there is real weakness in the market, investors may take advantage of this," Westhoff noted. "This may make the impact of Y2K relatively short-lived. My take is that it is going to be a weak fourth quarter, and liquidity will be impacted, but it may turn out to be a buying opportunity, since many companies have prepared a long time for it."
In fact, the risk involved with investors' switching to more liquid assets is that they might miss one of the strongest rallies of the century, says L'Heureux.
For instance, many international markets view the U.S. as a safe haven for Y2K uncertainty.
"So all of the capital flows to the U.S.," L'Heureux added. "We at AEW are monitoring the situation carefully, but we believe there will be some bumps before year-end which may create some nice opportunities."
CMBS May Slow
Commercial mortgage-backed securities are expected to post active volume in the current quarter, but the fourth quarter could possibly see a slowdown resulting from concerns over Y2K problems, according to a report issued last week by Moody's Investors Service.
According to AEW's L'Heureux, the majority of CMBS bond holders have no idea what percentage of their borrowers in a pool are Y2K compliant, which is a dangerous predicament.
This situation may lead to lawsuits, such as if a hotel has been booked for New Year's Eve for many months in an area that cannot deal with a power outage, L'Heureux said.
"Still, this would be an isolated incident. Overall, I don't think it will have much of a material impact on CMBS," he added.
Despite Y2K concerns, CMBS volume for this year is projected to total $60 billion, 25% less than last year's level.
The deals this year have become smaller, but credit has improved, according to Moody's.
"The trend toward smaller deals is largely the result of declining conduit origination volumes and the desire of issuers to turn over their inventory more rapidly," said Tad Philipp, a Moody's managing director.
The second quarter of 1999 saw a decline in the percentages of loans that have a loan-to-value ratio greater than 100%.
Further, more single-asset CMBS deals are coming to market. - AT/ES
