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Variable-rate Discounts Under Pressure

The days of extra-plump variable-rate discounts may be numbered.

A handful of lenders began trimming their variable-rate mortgage (VRM) discounts this week. They’ve gone from prime minus 0.75% (the average market rate) to prime minus 0.65%, or even prime minus 0.50% in some cases.

To most, these changes have seemingly sprung out of nowhere. Few expected rising VRM rates before the Bank of Canada resumed tightening. Unfortunately, it’s happening now and it’s beginning to smell of a trend.

So far, four of the top 10 broker lenders have reduced discounts, and others are considering following suit.

Here’s a look at what’s behind it…

In very simple terms, it seems variable-rate mortgages have basically stopped being profitable for a lot of lenders. We spoke with three lender executives for this story. Two said they were actually losing money on every variable they write. One lender was basically breaking even.

Narrow spreads are the culprits. (The “spread” is basically the rate you get as a customer minus the lender’s base cost to fund your mortgage).

Spreads are so poor that at least one lender is reportedly calling existing variable-rate clients and offering fixed rates well under the market as an incentive to lock in.

Paradigm Quest’s John Bordignon says, “Adjustable rate mortgages have been priced too low and as banks are getting their fill of ARMs, they need to get margins back in line to what they really need to make.”

The basic math is straightforward.

Take a typical VRM that’s priced at prime minus 0.75%. Then consider that a lender’s base cost on a variable is typically the 30-day bankers’ acceptance (BA) yield, or a close substitute like the overnight rate. The 30-day BA is 1.20% at the moment, leaving many lenders with a gross spread of just 105 basis points (2.25% – 1.20%). Most lenders need that margin at roughly 120-130 bps.

Lenders must then account for a variety of costs, including but not limited to the following:

  • Overhead, marketing and administrative expenses
  • Personnel costs
    • Including underwriters, fulfilment staff, sales support, customer service, etc.
  • Bank rep or broker commission
    • This is a big one. In Australia (which in many ways is an analogue to Canada’s mortgage market), lenders slashed sales compensation when VRM spreads collapsed. In Canada, lenders prefer to cut the interest rate than disincentivize their distribution channels.
  • Capital/risk/liquidity premiums
    • There are risks and opportunity costs when lenders, or investors, fund a mortgage from their balance sheet. These risks (and some of the tools lenders use to deal with them, like interest rate swaps) are material costs that must be built into a lender’s rate model. These costs can be significantly higher for non-deposit-taking institutions (aka., “monoline lenders) and smaller banks & trustco’s.
  • Rate risk
    • Lenders don’t hedge VRMs like they hedge fixed rates. Yet, bankers’ acceptance rates can and do jump before prime rate does, which cuts lender revenue further.
  • Early payout
    • It wouldn’t be as bad for lenders if people stayed in variables for a full five years, but the average duration is only about three years. That means lenders often have just three years to recoup the above costs (barring customer refinances or conversions–which lenders don’t always factor into cost models).

One relatively new phenomenon helping to boost rates are the IFRS (International Financial Reporting Standards). Global banking initiatives like IFRS are compelling lenders to increase the capital they must set aside, and that’s expensive. This expense is now filtering down to consumers.

One high-level bank exec we talked to called IFRS the “most significant shift in the mortgage business in decades.” He suggests IFRS is having a visible pricing affect and will “impact the willingness of lenders to lend” at deeply discounted rates.

John Bordignon adds, “The market is slowly adjusting via increased spreads to take into account the extra margin required to absorb the increase in capital because of IFRS.”

Banks have been making almost nothing on variables for a while now says another treasury markets veteran, George Hugh. Discount reduction on VRMs “should have happened a year ago,” he says. “Banks were calling [breakeven VRMs] a marketing cost” and using them as bait to cross-sell people on higher-yielding products, like credit cards, loans, credit lines, etc.”

That kind of pricing can’t last forever, states Hugh. He sees prime – 0.50% as more sustainable long-term. “People have to remember, it’s shareholders who set (mortgage) rates,” he says, and shareholders demand a return on equity.

Once prime rate eventually does start climbing, it could create even further spread compression. At that time, lenders will likely have to start paying more competitive savings rates (which may translate into higher mortgage funding costs according to one source). In turn, that could put additional pressure on VRM margins.

How things shake out from here remains to be seen.

In the near-term, more lenders will certainly follow the pack and reduce their own VRM discounts. How long those price increases stick is anyone’s guess. Lenders have sometimes been known to raise rates, and later relent when the market doesn’t follow, or when they start losing share.

There is at least a hint of positive news in all of this. Lest you think lenders are totally collusive, be assured that certain lenders with good liquidity may still keep prime – 0.75% rates or better, even if only a promo basis.

To be safe, though, you should call a mortgage professional soon if you’re dreaming of prime – 0.80% or more. There’s no way to know for sure, but there is at least the potential that those kind of rates could vanish…relatively soon.

Oh yeah, and for the eternal optimists hoping the banks will “give back” the 1/4% they failed to pass along after the Bank of Canada’s December 2008 rate cut, forget about it…

Sidebar:  The rate changes discussed here do not affect existing variable-rate holders.

Rob McLister, CMT