Rate Reflections

Some odds and ends from the week’s mortgage rate action…

The Misleading Core…

One can be forgiven for wondering why the BoC cut the overnight rate ¼ point on Wednesday when its official “core” inflation measure is above target.

As it turns out, core inflation (which has stubbornly risen to 2.3%) doesn’t tell the whole story. Governor Stephen Poloz believes the “underlying trend” is actually much lower at 1.50% to 1.70%. “The Bank of Canada tries to strip out transitory factors in determining the underlying trend,” explains DLC Chief Economist Dr. Sherry Cooper. The biggest transitory factor at the moment is the boost in import (input) prices caused by our plunging loonie.

“But this is not inflation,” she explains. “Inflation isn’t a one-shot increase in prices. It’s an ongoing spiral up in prices.”

Don’t get too hung up on the BoC’s 2% inflation guideline either, Dr. Cooper cautions. “Inflation targets aren’t meant to be binding without judgment,” especially with the “R word” looming.

The DoF may tap the brakes again

Seven years of mortgage rules can’t keep the major markets down. Debt levels and home prices continue deviating from incomes, despite the Department of Finance’s efforts.

With this week’s cut and record real estate numbers, things have gotten interesting. When you get heads of real estate companies joining the BoC’s chorus about housing vulnerability, you can rest assured that policy-makers are on high alert.

The last thing rule-makers want is a housing calamity. The second-last thing they want is to be seen as not being proactive before a housing calamity. For that reason, the odds that tighter mortgage guidelines are on the way have just leaped.

TD’s Gambit

TD was ready for the rate cut. It announced a 10 bps reduction in its prime rate just 12 minutes after the BoC’s statement. It seemingly wanted to set the trend and perhaps get out in front of consumer backlash from banks withholding part of the quarter-point cut.

TD’s move would have been well played, had the other Big 5 matched its rate. But they didn’t. RBC, the biggest kahuna in Canadian mortgages, decided to trump TD’s less generous rate and drop prime by an extra 5 bps to 2.70%. “They just wanted to make TD look bad,” said one capital markets source.

Not to lose face (and business) over a 5-bps-rate difference, TD quickly relented and matched 2.70%. Being first to announce prime rate entails a lot more reputational risk than it used to.

The Banks Stole My 10 Beeps

About 1 in 4 mortgagors has a variable rate. And they choose variables because they expect to receive every basis point of BoC rate cuts.

But big banks haven’t been in a giving mood lately. They’ve passed along only 60% of the benefit of the last two rate cuts. This latest “spread pocketing” has driven the prime – overnight difference up to 220 bps, 45 bps higher than in 2008.

Here’s a look at how the prime – overnight spread has been creeping up.

But why?

RBC cited this as its reasoning for passing along only 60% of the rate cut:

“Our decision is consistent with the rate adjustment that we made in January when the Bank of Canada previously lowered their rate. It is meant to balance the interests of our clients who are always top of mind, with the costs that we incur to provide our products and services.”

What bank critics don’t acknowledge is that

  • Every single year, shareholders demand to be fed with a steady diet of earnings and dividend growth.
  • Banks have a minimum target spread they need to earn between what they lend and borrow at.
  • The Bank of Canada’s rate cut instantly shrinks lender spreads on variables—partly because banks fund much of their variable-rate book from deposits. They can’t really lower those deposit rates since they’re already near/at zero. Banks feel they have little choice (if they want to maintain spreads) but to pass along only a fraction of the rate cuts.
  • Adding fuel to the fire is that variable-rate MBS spreads have been steadily inflating this year—i.e., it’s getting relatively more expensive to fund variable rate mortgages using mortgage-backed securities.
  • On top of that, funding costs have risen on other parts of their mortgage book, thanks in part to widening swap spreads.

The interesting part is that this time around, you can barely hear any consumer outcry in the media—compared to when the banks last pocketed some spread in January. And that’s just the way banks like it.

Coming Up Next for Rates

The markets are pricing in a fair probability of another BoC cut on September 9, 2015. By then, the Bank of Canada will have data confirming if Canada is in a technical recession, more visibility on oil prices, as well as two more employment and inflation reports.

If the BoC lowers another quarter point, there’s a good chance that banks will again hold back some of the cut.

As for fixed rates, 5-year yields have been in a clear downtrend and the 0.55% record low is just 15 bps away. If yields makes a new low, fixed rates will do the same. But the same margin concerns that kept banks from lowering prime ¼ point will also keep the average 5-year fixed – bond yield spread closer to 165 bps than the 135 bps of old. In other words, we may not see overly generous fixed-rate discounting for some time.

  1. So, every time the Government “interfered” with the real estate market by forcing stricter lending requirements etc … it was met from the Broker community with harsh criticism to the effect that the Government was going to create a collapse instead of a “soft landing.” In Toronto, the real estate associations never shut up about how the Toronto land transfer tax was stopping buyers from buying and hurting the market. However, after seven years of “interference” my question is — How ridiculously out of control would the market have been if they didn’t take every single measure they took. In fact, the real question might have been all along whether they should have done more and NOT less. It shows how bias a huge portion of the broker community is in skewing the discussion in their best interest only.

    JD

    1. John, There’s no question that regulatory intervention was not overkill. That’s an easy observation in retrospect. Three to seven years ago, however, the future wasn’t so obvious. The concern at the time was that the onslaught of financing restrictions would over-decelerate the market. Housing was, and continues to be, a vital contributor to the Canadian economy. It’s health warranted an even greater level of concern back in 2010-2011 when the country was coming out of recession.

      On your last point, it would be rash to paint the broker community with one brush. Maritz surveys showed that many brokers supported the Finance Department’s rules. It would also be inappropriate to suggest brokers’ policy concerns were purely for self-interest. The vast majority of Canadians had (have) an economic interest in avoiding a housing collapse. Brokers were naturally more vocal at the time because they had a front-row perspective on what was actually happening in the mortgage market.

  2. While I’m still new to this business, I must say this seems to have been an interesting year so far. If the 5-year yields continue their downward trend and rates do decline, what do you envision as the next step for the DoF?

    Do you think they will go after minimum down payments first? Or are there other measures you expect them to employ first?

    1. Hi Ryan, One key area of concern with policymakers has been mortgagors with higher debt ratios and lower equity. I wouldn’t be surprised to see new guidelines somehow related to that — assuming they don’t just boost the minimum down payment.

  3. Hi Rob,

    Your musings are enjoyable reading as always.

    The list of bank excuses for not shifting prime the full 25bp remains pretty unconvincing. I for one think that there isn’t any moral distinction between a broker fudging a client’s application and the banks’ practices with respect to Prime. The broker would rightfully be punished. The banks get to bump their executives bonuses. Just because you can get away with something, doesn’t make it right.

    The other piece of the puzzle that makes the failure of banks to pass through prime rate decreases that much more egregious, is that rate discounts relative to prime have diminished as well. Whatever happened to Prime -100bp?

    It will be interesting to see what happens when the Bank of Canada finally does start increasing rates. Perhaps the big banks will finally provoke a meaningful level of adverse publicity if they try to raise Prime by a full 25bp. It wouldn’t be surprising if they try…..

    1. Thanks Matt,

      As Fox News likes to say: we report; you decide.

      First National’s Jason Ellis encapsulated this issue succinctly:

      “I know many of you will call this a money grab by the banks, but the truth is, regulatory capital and liquidity rules, combined wider credit spreads and reduced liquidity generally have structurally changed things since the liquidity crisis. I don’t like paying [banks] any more than you do, but try to keep these things in perspective…it’s not a conspiracy.”

      Link

      The above is in addition to the fact that lenders have not been able to reduce their cost of short-term funds enough to offset a 25 bps BoC overnight cut.

      On the discount, you’re right that it’s about a tenth of a percent or so skimpier than in 2010-11. It should probably be noted, however, that prime – 1.00% has never been an industry-wide going rate. It was typically a promotional bought down rate offered by very few providers when the going rates were closer to prime – 0.85%. At the moment, some of those same providers are selling low-frills variables at prime – 0.90% or better.

      Cheers…

      1. Hi Rob,

        Jason isn’t exactly a unbiased observer, given where he sits….

        It would be interesting to see him quantify each of the rationales for wider mortgage margins that he’s provided. I doubt that they would aggregate to anything close to the levels that we’re now seeing.

        Given that insured mortgages are 0% risk weighted, and conventional mortgages have a model based risk weight that varies slightly by bank, but is very low as well, the regulatory capital explanation seems quite weak. Perhaps the leverage ratio can serve as a partial explanation, but even there, I’m unconvinced.

        With respect to the liquidity rules, almost all of the bite is on the capital markets side. The flow through of liquidity rules to mortgage pricing is oblique at best.

        Further, using the liquidity rules and capital rules as an explanation of the failure to pass through Prime changes well after the liquidity rules and capital rules had been announced seems odd- any pass through of costs should have already occurred by the time the unmatched rate changes occurred.

        With respect to credit spreads, if you actually look at CMB spreads over the historical period back to October 2010 on Bloomberg relative to the swap rate (which is arguably the best indicator of credit spreads when looking at variable rate mortgages), current spreads are below the average during that period, and have only changed modestly during 2015.

        There probably isn’t a conspiracy, but there is a market dominated by a small number of large players, consumers who are at a informational disadvantage and are readily manipulated by sophisticated financial institutions, and a whole lot of banks that are reporting significant economic profits (ie profits that hypothetically shouldn’t even occur) from their Canadian retail operations, while crying poor to the media….

        1. Hi Matt,

          We quote Jason because he’s a straight shooter who’s very well respected. Regardless of who you hear it from, deposit costs, capital requirements, MBS liquidity, credit spreads, etc. have all directly or indirectly affected mortgage pricing. Have they impacted lenders so much that they can’t pass along a quarter point BoC cut. Absolutely not. But they have indeed impacted margins and, given that lenders aren’t a charity, they do explain some of the spread pocketing that’s going on. One can debate how much each factor contributes to higher rates (which is beyond the scope here), but not the fact that each factor does contribute.

          All that said, it’s good to poke and prod the establishment on pricing. I wish more people did it. So my thanks to you for the comments…

  4. Hi Rob,

    One other observation that I think is pertinent- in the US, the national average rate as reported by FNMA in the primary market for 5/1 ARMs (the closest equivalent to our 5 year product, but with better prepayment features, on the whole) is 2.97% (source: http://www.freddiemac.com/pmms/). The 5 year US Treasury is 84bp wide of the 5 year Canada, and FNMA guarantee fees, are approx. 60bp annualized (http://www.fhfa.gov/AboutUs/Reports/ReportDocuments/GFeeReport6302015.pdf). What’s wrong with the Canadian market that spreads are so wide relative to costs compared to the US? This comes down to a question of what a fair profit is to make on a nearly risk free product (nearly risk free to the bank at least- whether taking out an insured mortgage with 5% down is risk free for the consumer is a different story…) The market mechanism has pretty clearly broken down in some way- the kind of profits that the banks are making off of their mortgage customers doesn’t seem to fit anything close to an efficient market view of the world.

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