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Mortgage Rate Spreads Explode

We’re in one of the most unusual mortgage periods in recent history.

You might have noticed that lenders have all been lowering their rates lately, but only by peanuts (0.05% to 0.10%).

Meanwhile, 5-year bond yields (on which most fixed mortgage rates are based) have plummeted to 3.75%.  That’s almost the lowest they’ve been in two years!

It’s a paradox explained by fear.

Thanks to the U.S. subprime crisis, the quality of most non-government debt has been brought into question.  As we noted last week, this has led to an abnormal risk premium being built into mortgage lending.

As a result, lenders are being forced to pay skittish investors more for the mortgage capital they lend to you and me.  How much more?  A lot more.  The most since the recession of 1980-81!

The chart below shows mortgage spreads since 1980.  The spread shown is the average 5-year posted mortgage rate minus the 5-year bond yield.

Today’s spread is 3.62.  The typical spread since 2000 has been 2.50.

Canadian Mortgage Interest Rate Spreads
When comparing discounted mortgage rates versus the 5-year bond, the spread is even wider–over 2%!

Incidentally, the last few times mortgage spreads were this wide our economy went into recession.

Lets also not forget that variable rate spreads and “swap rates” (swaps are used by lenders to switch fixed-rate mortgage payments to variable rate payments) are, or have recently been, at multi-year extremes.

When will things return to normal?  It could be several quarters say some industry observers.  For one thing, the fear is being stoked by U.S mortgage defaults, and those might not peak until the spring.

Second, home sales are still booming in many parts of Canada.  Mortgage demand is therefore “extraordinarily good,” says TD’s David Fallon, and “continues to defy gravity.”

Scotiabank’s Aron Gamel says, “If we are going to see rate relief on the mortgage side, it will come later rather than sooner, and that means probably some time in the late winter or early spring of 2008 at the earliest.”
Ed. Note:  We’d like to thank the Bank of Canada for the rate data used in this story.