If you’re a student of the industry, it’s fun to learn about the inner workings of the mortgage business. So we try to chat with different people and get different perspectives.
Recently, we had our first chance to speak with John Vogel. John is Chairman of MyNext Mortgage, our firm’s (Mortgage Architects’) proprietary lender.
John has a somewhat unique view on the world thanks to his background in the fixed income markets. Prior to helping launch MyNext Mortgage, John created, sold, and traded various fixed income products for over 20 years. He’s worked on the fixed income desks at major Canadian and international banks in New York, Toronto and London, England.
In this first of a two-part interview, we speak with John about lending spreads, interest rate risk and more….
CMT: John, thanks for being with us. We’ve been seeing some remarkably low fixed mortgage rates in Canada, relative to bond yields. Earlier this year, banks were pricing 5-year terms as low as 1.09% above 5-year bond yields—which is well below average. What’s behind all this deep discounting?
John: Essentially, Canadian banks have too much money. Though the Canadian financial system escaped the worst of the global financial crisis, our central bank and ministry of finance have lowered short term rates to rock bottom levels…and purchased over $60 billion of mortgage product from the major banks–at a time when mortgage demand is relatively moderate. In order to replace sold mortgages, banks have become aggressive on rates.
Another reason you’ve seen aggressive pricing is because of the steep yield curve. If a bank lends at 4.5%, for example, and borrows for the first 2.5 years at 2%, it will earn a 250 basis point spread for the first 2.5 years. Breakeven for the next 2.5 years is 7%. [In other words, the cost of funds could rise to roughly 7% and banks would still basically break even on that mortgage]. This is how central banks help commercial banks around the world repair their balance sheets…through interest earnings.
CMT: So banks are routinely funding 5-year mortgages with short-term money?
John: Yes, this is something they have always done but it is more compelling with a steep yield curve and with low rates that are expected to remain constant for some time. If you examine the notes in bank earnings reports, it’s referred to as “interest rate gap management.”
CMT: How do variable-rate mortgages compare with fixed mortgages, profit-wise? Do banks make more money on fixed mortgages or variables?
John: Generally speaking, banks would make more money on a 5-year fixed than a variable because they can hedge easier to lock in a profit. With our steep yield curve, if a 5-year fixed mortgage is funded with short rates, it can generate significant income and short-term profits.
Banks often show aggressive rates on variables as a ‘teaser.’ It is the bank’s hope that clients will move from a short term or variable mortgage and lock-in to a 5-year…because once you ‘own’ the client with a variable, leaving is a hassle for them.
In practice, most variable mortgages are held for a relatively short term, particularly in a rising rate market.
CMT: How are things different for banks and non-bank lenders?
John: Non-bank lenders often do not have a balance sheet and have to sell or securitize their mortgages. They cannot take the interest-rate risk or benefit from the steep curve–the way the majors and balance sheet lenders are today.
Non-bank lenders are getting squeezed because they are forced to match the majors (who are benefiting from the steep curve and government support in buying their mortgages).
CMT: Should bank shareholders be concerned about this “risk” that banks are taking?
John: No. Banks are getting paid for the risk they’re taking. Regulators speak with banks and monitor them on regular basis. Banks are taking this risk because central banks are confirming low rates will remain. Central banks transmit to the marketplace their intentions to raise interest rates well before they actually do. Banks respond accordingly by hedging out this risk at that time.
CMT: Interesting. On the topic of central banks, how much would you say the U.S. influences Canada’s mortgage rate market?
John: Canada’s interest rate policy is closely linked to the U.S. Our steep yield curve is something we’ve inherited from America, where banks are in far more trouble. Heavy U.S. treasury issuance and future inflationary expectations are helping keep their curve steep. U.S. authorities are essentially giving American banks increased income from the steep (yield) curve. As a result, Canada’s rates are probably lower than they should be given our relative economic health.
CMT: Would you say that Canada is definitely not independent when it comes to monetary policy and interest rates?
John: Some may argue otherwise, but I don’t think Canada can have an independent monetary policy given our integration with, and dependence on, the US. It is impossible for our economy—which is 1/10 size of the U.S.–to have full independence.
All Canadian bond traders watch U.S. data more closely than similar Canadian economic releases.
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