Unusual Times

Normal isn't what it used to be in the mortgage market.

Normally you'd expect to see a nice discount off prime rate on a new variable-rate mortgage.

Normally you'd see 5-year fixed rates closer to 4.00% given today's bond yields--instead of 5.50%.

My, how things have changed.  Today's mortgage shoppers are finding themselves having to deal with the "now."

"It will be a while before we see a variable-rate discount [again]," CIBC Senior Economist Benjamin Tal told us yesterday.  "I think the new normal will be prime, or prime minus 0.25."

That is today's reality.  For anything to change, the capital market may have to step back, reassess Canada's housing outlook and global credit conditions, and be comfortable that Canada's low default rates are a good enough reason to reduce risk premiums.

Back to the Future

What does the future hold for interest rates?  It's a question mortgage planners get almost every day.  As always, any answer is usually just a educated guess because no one knows what economic news will hit next.

For what it's worth, though, the crystal ball seems a tiny bit less hazy at the moment.  Most analysts feel strongly that rates are coming down--at least in the short term.

Here is a small sampling of recent rate commentary:

• CMHC says: "Mortgage rates are expected to be relatively stable throughout the last quarter of this year, remaining within 25-50 basis points of their current levels. Posted mortgage rates will decrease slightly in the first half of
  2009 as the cost of credit to financial institutions eases. Rising bond yields, however, will nudge mortgage rates
  marginally higher in the latter half of 2009."
• The Bank of Canada says:  "Some further monetary stimulus" (i.e. rate cuts) "will likely be required to achieve the 2% inflation target over the medium term."
• According to CEP, credit market traders are pricing in a 100% chance of a 1/4% cut and a 53% chance of a 1/2% cut by year-end.
• Many economists also expect a 1/4% to 1/2% cut at the BoC's December 9 meeting.

Why are rates coming down?  One reason, according to TD economist Pascal Gauthier, is because the U.S. economy may "record its worst performance in decades, retreating by around 3% in Q4, with the Canadian economy mirroring this performance with a 2.5-3.0% decline, the worst since 1991." 

Moreover, the Bank of Canada's worst enemy--inflation--is currently no longer a clear and present danger to our economy.

So What Do You Do Now

All of this means there is "good news and other news," says InYourBestInterest.ca's Hank Cunningham.

"For those who already have a variable rate mortgage floating below prime, they are sitting pretty as the Bank of Canada may lower the Bank Rate an additional 50 basis points before Christmas." Cunningham advises further, "Those with existing floaters, hang on. They will save a lot of money as prime rate will fall."

It's not so pretty for new borrowers Hank says: "For those taking out a mortgage, the banks are now asking for a floating rate well over prime, hoping to get borrowers into a fixed loan."

"With credit conditions thawing in ever-so-glacial a fashion, those borrowers should be patient," feels Cunningham.  "Borrowers have to cross all their appendages and hope that spreads from Canada yields to fixed rate mortgages narrow by the time they wish to fix. Even if prime stabilizes, it would be best to wait as long as possible, until there is relief on the fixed rate side. It would be expensive to fix today."

Watching the Rate Markets

If you're into market timing (we're not), patience may be help.  The LIBOR rate--the rate at which international banks borrow from each other--fell for a 14th straight day yesterday.  Cunningham says "signs [now] abound of a thaw in the credit crunch."

For rate watchers, the key data point for variable-rate costs has typically been the yield on 30-day bankers' acceptances.  For fixed rates it's been the 5-year government of Canada bond yield.  More specifically:  

• the spread between prime and bankers' acceptance yields (for short-term variable rate forecasting); and,
• the spread between 5-year mortgage rates and 5-year Canada bond yields (for short-term fixed rate forecasting).

Today, however, those above metrics don't tell the whole story according to Mr. Tal.  Tal says the prime-BA spread is not currently the best indicator of variable-rate cost of funds.  "The liquidity premium is what counts at this point, and it's not publicly available."

That liquidity premium is basically extra "juice" that investors are demanding to fund variable-rate mortgages.  Right now it's about 40-50 basis points (0.40% to 0.50%) according to one capital markets analyst we spoke to.  It used to be just a few basis points over bankers' acceptance yields.  Now, however, "it's a difficult market to issue bankers' acceptances," he says.

Spreads Still Wide

Over the last 10 years, lenders have typically had a 1.68% spread on variable-rate mortgages.  This spread approximates their revenue margin.  As of late, that spread has shrunk to 0.9%.  That means very few variable-rate lenders are making money after expenses by offering variables at prime rate.

The lenders that can scratch out a profit (mostly banks and trust companies) are those with alternative funding sources, like customer deposits.  Other traditional funding sources, like bankers' acceptances and commercial paper, are very difficult to issue at good prices these days.  And the Canada Mortgage Bond program (a critical source of fixed-rate mortgage capital) simply doesn't have the frequency or volume of issuances to fund enough variable-rate mortgages.

As for fixed-rate mortgages, they're a similar story.  Spreads between discounted 5-year fixed rates and the 5-year bond yield (which correlates to fixed-rate capital costs) are 140% wider than normal.  Typically they'd be 125 basis points says the analyst we spoke to.  Now they're 300 basis points.

Will all this credit market mess sort itself out?  Absolutely, but it may take time. 

For now, if you're in the market for a new mortgage, find a good mortgage professional who can look through all this fog and help you set a proper course.  Good advice in markets like these will save you a lot more than a few basis points.