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In Canada, the only things that don’t seem to be falling these days are snow (at least in the Greater Toronto Area) and our mortgage rates.
China’s economic slowdown and the seemingly never-ending drop in the price of oil are combining to hammer the TSX, the Loonie, employment momentum, and consumer and business confidence. All of this has helped push five-year Government of Canada (GoC) bond yields from a high of 0.83% on December 17, down to 0.56% at last Friday’s close. One would normally assume that this twenty-seven basis point drop would cause five-year fixed mortgage rates to fall but that has not been the case lately. In fact, market five-year fixed rates have risen from 2.64% to 2.79% over that same period.
Meanwhile, market five-year variable-rate discounts have shrunk from prime minus 0.50% to 0.35% over this same period, and that is after our lenders had already padded their variable-rate spreads by passing on only fifteen basis points of the two quarter-point overnight-rate cuts by the Bank of Canada (BoC) in 2015.
At first glance, the question of why our mortgage rates are rising when the rates they are priced on are falling was answered when our federal finance department increased the cost of securitizing mortgages through the National Housing Act Mortgage-Backed Securities (NHA MBS) program, the primary funding source used by most residential-mortgage lenders (which I wrote about here).
But those added costs were estimated to be about twenty-five basis points and the spread between the GoC five-year bond yields and market five-year fixed rates has widened by much more than that. To wit, in mid-October 2015, the GoC five-year bond yield was 0.84% and market five-year fixed rates were about 2.54%, giving lenders a gross spread of about 170 basis points. Today, the GoC five-year bond yield is 0.56% and market five-year rates are closer to 2.79%, so gross spreads have now widened to about 223 basis points. This is well above its historical norm and well beyond the estimated increase in NHA MBS funding costs that lenders needed to build into their pricing.
In other words, lenders are widening their lending spreads well beyond what they need in order to maintain their existing profitability. Given that they are all doing this at the same time, there must be another explanation.
What’s going on?
When CMHC recently announced tighter down payment requirements and the department of finance announced increases to lender funding costs, the Office of the Superintendent of Financial Institutions (OSFI), Canada’s banking regulator, also issued an announcement that received far less publicity. On December 11, 2015, OSFI warned that it was considering requiring lenders to increase the allocation of capital that they hold on their balance sheets in relation to the size of their mortgage portfolios. This is money that the lender must keep in reserve as a buffer against housing-related losses and these increased capital requirements raise the cost of residential-mortgage lending. It is these higher costs, which cannot be fully quantified without more detail from OSFI, that have lenders increasing their spreads beyond what they need to recover the higher securitizaiton costs that I detailed in my previous post.
By hinting that capital requirements may be increased, OSFI is forcing lenders to re-evaluate the profitability of their residential-lending activities. Without a clear indication of the magnitude of these potential changes, lenders are using falling bond yields as an opportunity to increase their fixed-rate spreads in anticipation of higher capital costs to come.
On the variable-rate side, lenders chose not to fully pass on the BoC’s last two quarter-point cuts to its overnight rate and they are now shrinking their variable-rate discounts as well. This has led many market watchers to speculate that lenders might not drop their variable mortgage rates at all if the BoC decides to cut its overnight rate again when it meets this week.
None of this should come as a surprise to my regular readers. Our regulators remain concerned about our household debt levels and while they continue to make changes to our mortgage-underwriting guidelines, nothing will slow our housing markets as broadly, or as effectively, as higher borrowing rates. By adopting higher securitization charges and raising the spectre of increased capital requirements, our regulators have now managed to raise mortgage rates without increasing borrowing costs for the rest of the economy.
(The BoC has long resisted the urge to raise its overnight rate as a way to slow the housing market because of its effects on the rest of the economy. For example, raising the overnight rate would increase borrowing costs for businesses, making them less likely to invest in productivity improvements and expansion. And it would also boost the Loonie at a time when the BoC wants a cheaper dollar to help boost the competitiveness of our beleaguered export manufacturers.)
When we view the recent regulatory changes and OSFI’s vague references to possible increases in lender capital requirements in that light, the disconnect between the movements in our bond yields and the direction of our mortgage rates makes more sense.
Five-year GoC bond yields fell eight basis points last week, closing at 0.56% on Friday. Five-year fixed-rate mortgages are available in the 2.59% to 2.74% range (for now), and five-year fixed pre-approval rates are offered at rates as low as 2.79%.
Five-year variable-rate mortgages are available in the prime minus 0.45% to prime minus 0.30% range, which translates into rates of 2.25% to 2.40% using today’s prime rate of 2.70%.
The Bottom Line: In the strange times that we live in today, Canadian mortgage rate movements are no longer being determined in lockstep by changes in the benchmark rates on which they are priced. That’s because lenders are now using any drop in bond yields, or the BoC’s overnight rate, as an opportunity to widen their gross spreads in response to higher funding costs and in anticipation of increased capital-allocation requirements to come. We don’t have to like it, but at least now we can understand it.
David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog, Move Smartly, and on his own blog: integratedmortgageplanners.com/blog Email Dave
January 18, 2016Mortgage |