Variable Discounts Turn to Premiums

rising-variable-ratesIn the last few days, RBC and Scotiabank have eliminated their advertised variable-rate discounts.

They’re now promoting variable mortgages at prime + 0.10%, twenty basis points more than their previous “special offers.”

Prime + 0.10% (i.e., 3.10%) is an interesting number. A few months ago consumers thought that fat variable-rate discounts were here to stay. Variables above prime will now come as a shock to some people.

The banks are well aware of that. They know that pricing above prime impacts consumer psychology.

They could have priced at prime. Spreads are not that horrendous. But pricing above prime makes more of an impact. It makes higher-profit fixed rates more appealing and it mentally prepares consumers for potentially higher VRM premiums down the road.

That said, banks are not just arbitrarily sticking it to borrowers. The main reason variable rates are worsening is that banks’ costs are rising, and they want to recoup those costs.

At the moment, there are multiple factors at play:

  • Higher risk premiums are compressing margins.
    • We have Europe to thank for the that.
    • The TED spread, a measure of interbank credit risk, just made a new 2½ year high. As volatility increases, banks have to factor that into their funding models.
    • Another reflection of risk is the most recent floating rate Canada Mortgage Bond (which some lenders use to fund variable-rate mortgages). It was issued at a 15 basis point premium over the prior issue in August.
  • Margin balancing is an underlying bank motive.
    • Banks have publicly stated their desire to even out margins between profitable fixed rates and low-margin variables, and they’re slowly doing just that.
    • Back in September, RBC Bank exec David McKay put it this way: “…Given the dislocation between fixed and variable, the very, very thin margins (of variables), we felt we needed to move prices up in our variable rate book.”
  • New regulations (e.g., IFRS) have boosted the amount of capital required for mortgage lending.
    • That has lowered the return on capital for mortgages, and thus influenced rates higher.
  • Status Quo for prime rate doesn’t help margins.
    • Lenders partly rely on deposits (that money rotting in your chequing and savings accounts) to fund VRMs.
    • Demand deposit rates rise slower than prime rate. So, when prime goes up, some lenders get wider margins temporarily.
    • When expectations changed three months ago to suggest that prime rate will fall or stay flat (instead of rise like expected), it was bad news for some deposit-taking lenders. That’s because they now have no spread improvement to look forward to in the near-to-medium term.
    • MBABC President Geoff Parkin says that until recently, “lenders have been prepared to accept low (VRM) profit margins with the knowledge that, as the prime rate inevitably rises, so too will their profit on variable mortgages.” As it turns out, the inevitable is taking longer than the market expected.

Rob McLister, CMT

  1. With the gap narrowing between the 5 year fixed and that of the VRM now being offered by major players like RBC I can not see any favor in selling a client a VRM with less than 20bps in difference during these uncertain times.
    Mind you I still and probably temporarly have access to a VRM much lower than RBC P-.10(3.10) but for how much longer will that last?

  2. This is probably about 20% due to cost changes and 80% profit driven. Remember that M&A activity, IPO’s and now even consumer lending have seen significant slowdown over the last 4 years – banks are under an enormous amount of pressure to maintain and grow dividends in what is beginning to look like a horrible market for growing capital.
    In Canada our near-complete dependence on this Big 5 oligopoly has led to extremely efficient consumer pricing during boom times. There is a flip side as we are now seeing, and will continue to see.

  3. As long as the BoC rate stays below 1-2%, even at Prime + 0.1, the rate is not that bad.
    In general I believe Anyone that can’t afford to pay 5% interest on their mortgage shouldn’t get a house probably.
    and with fixed rates around and below 3%, who really cares what variables are ?

  4. Ok I think I am bit confused. Why I heard people keep saying when the variable rate goes up (as the result of prime goes up) some people on variable can no longer afford their mortgage payment? I thought you still pay same amount of payment each month but just it takes longer to pay back your mortgage? Of course not that when the variable goes too high that your payment can no longer cover the interest…I understand in that case your payment has to go up…

  5. Arthur,
    Many clients opt for a “variable” payment option, so that the payments are based on the interest rate today and so if the Prime rate rises, so too do the payments.
    Some lenders offer a “fixed” payment option where you make payments based on a higher rate (so today, more principal per payment). Even these payments change if your payment doesn’t cover at least the interest portion (or in some cases the minimum principal and interest portion).

  6. Hi John, CMT has multiple sources, not just the banks. Job #1 is to share the facts as we know them and advocate for consumers, always and without exception. I recognize that folks aren’t usually bent on giving banks the benefit of the doubt, and that’s people’s choice to make.

  7. Banks obviously want more profit from variables but don’t discount the cost aspect. MBS spreads are climbing and banks just had IFRS take effect in November.

  8. ‘TD Bank profit up 58% to $1.5B”
    Any cent profit of a bank is a cent out of the economy. More banks profit, less better economy is.

  9. “Any cent profit of a bank is a cent out of the economy. More banks profit, less better economy is”.
    Ah…Ignorance! Anybody who makes such a statement is obviously out of touch with how the financial system works…including liquidity and cost of funds for banks to fund mortgages. Bash the banks if you wish, instead of celebrating the advantages we enjoy by having what is recognized as the world’s best banking system. Take a look at the European debt crisis and what’s been going on in USA, and we should be thanking our lucky stars that we (so far) have a solid banking sector and consumers can borrow at such low rates. Maybe next credit crunch Hugh will have something else to rant about.

  10. Dave, you seem to be a bank employee :).
    The low rates we have are not because our banks were less greedy, but because the government controlled them.
    And US have lower rates than us, what will you say about that ? Their banking system is better than ours according to your thinking.
    Banks (some greedy people in them) don’t think about people or economy. If they have a chance, they will take every cent out of your pockets.
    It’s good we have government regulation and more it’s on it’s way.

  11. Record profits indeed. The Big 5 are driven by only factors profit and share price. well they should be. after all any business has the same motivation. The only “evil” if you will,is that they accomplish this at the expense of their clients not from a partnership. There is so much data that shows that variable products save borrowers 1000’s in interest and many years. Naturally the banks you their weight to sway borrowers to choose a fixed rate. NO one has ever accused a bank of altruism. We as brokers need to better educate the public and the public needs to wake up. Their is only factor which drives which will force a bank change, LESS PROFIT.

  12. Thanks for the explanation Rob. I have repeatedly heard that cost of funding is going up and no one else really could explain it to me. We see bond yields low and so on the surface it would seem that cost of funding is not getting higher. I realize the bonds yields are related to fixed rate mortgages and prime rate to variables but it’s good to know some of the other factors that affect variable mortgage rates.

  13. Actually, Dave, Canada’s banking system is not as bulletproof as everybody thinks.
    During the financial meltdown of 2008 and early 2009, Canada’s banks did in fact receive a small bailout, err, let’s just call it a “support facility” from the federal government who allowed them to dump some $75 billion of MBS to alleviate pressure from their balance sheet.
    Of course, it was nowhere near the scale of bailouts that were happening in Europe and the U.S. where whole banks were effectively nationalized (especially Britain). But if people think that the banks in Canada never twitched in the face of a financial crisis, they are grossly mistaken.
    Don’t forget that some Canadian banks lost billions of dollars in bets on the U.S. housing market and a few of them are now being taken to court by investors who lost money through MBS. Should the courts side with the investors, or if the banks end up settling the allegations out of court, the big banks may have to fork over a few billions more.
    So it’s nice that our banks have had very good consecutive quarters for the last 18 months because that pile of cash they’ve been earning would come very handy should another credit crisis unfold.
    At the end of the day they are susceptible to global events as everybody else.
    Observer actually brought up a good point about why the banks came out reasonably well out of the recession. Prudent underwriting did play some role but ultimately it is government regulations that prevented the banks from making riskier bets. If you recall, RBC lost its triple-A rating last year precisely because of its exposure to the capital markets/investment banking business.

  14. At what point in time do you think the banks will finally pass on the additional .25% reduction to their prime rates which they failed to match when the Bank of Canada reduced the bank rate .75% on December 11, 2008 – the banks eventually only follwed with a .50% reduction to their prime rates?

  15. I don’t understand… my bank’s prime has been at BoC rate + 200 bps since before 2008.
    Was it standard pre-2008 to have prime at BoC rate + 175, or some other increment?

  16. Interesting post. As you know, in the most overpriced markets in the country (small town and big city British Columbia) most of the mortgages originated in the past two years have been VRM, and buyers have been stretching even with those low rates. A 20 bps increase in mortgage rate doesn’t seem like a lot, but it amounts to an 8% increase in monthly payments for a couple of twenty-something kids who own an $800K Vancouver condo (of which there are far, far too many). You can already see the MOI’s mounting out there and this change is just going to add to the avalanche of listings in the spring.

  17. Changing the rate differential from prime only affects new mortgages, though. A VRM contract is for a fixed bps spread from prime, negotiated at the beginning of the contract.
    I completely agree about the pending problems for these markets, though. I’m in one of those markets myself (in much better circumstances, luckily) and it annoys me to no end that I had to purchase amongst thousands of “shill bidders”.

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