The consequences of political stupidity

“Papandreou’s move also exposes the fatal flaw of grand plans for a political or fiscal union to support the euro: the “people,” not governments, remain the real sovereign. Governments may sign treaties and make solemn commitments to subordinate their fiscal policy to the wishes of the EU as a whole (or to be more precise, to the wishes of Germany and the European Central Bank); but, in the end, the people may reject any adjustment program that “Brussels” (meaning Berlin and Frankfurt) might want to impose.” (An except from “The Revolt of the Debtors” by Daniel Gros, Director of the Center for European Policy Studies, in an op-ed on Project Syndicate, November 3, 2011)

We are about to witness a major credit crisis unfold yet again. This time, the culprit isn’t inflated housing values or sub-prime mortgages. No, this crisis is a lot more political than it is financial.

At the center of the crisis we find Greece, a small peripheral nation that has long lived beyond its means. As Greece is a member of the European Monetary Union (otherwise known as the Eurozone), a community of nations who share the same currency, it finds itself in a rather remarkable predicament of having to rely on other Eurozone members to bail it out so that it won’t default on its obligations to bond holders — many of which are Europe’s biggest banks.

The governments of Germany and France, who are major contributors to a stability fund — the EFSF — that provides the bailout payment stream to Greece and other peripheral nations, are demanding that in exchange for a bailout, the Greek government must institute a series of deep austerity cuts that have so far proven to be quite useless in solving Greece’s economic woes. Until now, the austerity measures demanded by France and Germany have been passed by the Greek parliament despite huge public opposition. It appears, however, that you can’t keep the electorate quiet for long.

Following last week’s summit where European leaders have agreed tentatively to expand the existing 400 billion Euros European Financial Stability Facility by an additional 1 trillion Euros, Greek prime minister George Papandreou surprised officials this past Monday by announcing he would hold a public referendum on the additional austerity cuts demanded by France and Germany in exchange for an 8 billion Euros payment so that Greece could pay its bondholders in December. According to Papandreou, the referendum is necessary so that the Greek electorate can decide if they would like to remain in the Eurozone. European leaders were blindsided by the decision. In an emergency summit that took place yesterday in Cannes, the leaders of France and Germany gave Greece an ultimatum: pass the austerity cuts that we demand without a referendum or go bankrupt.

“The EU remains a collection of sovereign states, and it therefore cannot send an army or a police force to enforce its pacts or collect debt. Any country can leave the EU – and, of course, the eurozone – when the burden of its obligations becomes too onerous.”

European officials are being quite cavalier with their attitude towards Greece. While no one is denying that Greece has serious financial issues that must be addressed, the quick solutions that European leaders are seeking to alleviate the markets are non-existent. The austerity cuts that have been demanded by France and Germany are not necessarily designed to help Greece but rather please the electorate back home. Both the French and German public believe, and understandably so, that they should not foot the bill to bail out a small country that has been reckless with its finances for years. Germany’s Chancellor Angela Merkel and France’s President Sarkozy understand very well that if they don’t take a tough line with Greece, they would pay a heavy political price when they run for elections.

“As long as member states remain fully sovereign, investors cannot be assured that if the eurozone breaks up, some states will not simply refuse to pay – or will not refuse to pay for the others.“

The ramifications of a Greek default would be felt across the Eurozone. Whether European officials admit it or not, Greece is the one in the driver’s seat. Greece could very well refuse the bailout, default on its obligations to bond holders, and bring back the Dragma. If anything, many economists have argued that defaulting on its debt would actually be helpful to Greece in getting back on track. However, the consequences of a Greek default for the Eurozone as a whole would be enormously challenging. The exposure that French and Italian banks have to Greek bonds means that these banks would have to be recapitalized quickly to offset the losses.

Another by-product of a Greek default is that bond yields of troubled European economies such as Spain and Italy would surge, making it almost impossible for these nations to borrow money through the bond markets. The cracks are already starting to appear; the yield on 10-year Italian bonds reached a Euro-era high of 6.40% earlier today. Once the yield approaches 7%, it is generally recognized that borrowing costs at such high levels are unsustainable.

In the worst case scenario, the EFSF would now be tasked with bailing out Spain and possibly Italy. Greece found itself in exactly the same predicament early in the crisis, as did Portugal and Ireland. And what’s even more troubling is that while the European Central Bank has been buying Italian bonds in an effort to lower the yield, the yield has actually continued to rise as investors lose confidence in the ability of European officials to resolve the crisis. Today’s .25% rate cut by the ECB effectively signals that Europe is about to enter into major crisis mode.

The approach taken by European officials is quite baffling. Three years ago at the peak of the sub-prime crisis, U.S. Treasury Secretary Hank Paulson effectively gave a blank cheque to the banks and successfully prevented a collapse of the banking system. While we can argue about the merits of giving the banks so much capital, in the end it stabilized the financial system. While the monetary system of the Eurozone is very different from the U.S., what we need are bold thinkers at a time where the world’s banking system is once again at risk.  The questions were asked later because U.S. officials understood that if they didn’t act quickly, a collapse of the banking system would lead to the collapse of not only the U.S. economy but the world’s economy as the credit markets dry up and consumers empty out their bank accounts.

One has to wonder why European officials aren’t thinking along the same lines given the calamity that’s ahead of them. Instead of providing Greece with the money it needs and signaling to the markets that Europe has the financial resources and political willpower to take care of its own problems, leaders have opted to engage in a game of chicken. This is a strategy that’s going to fail and drag everyone else along for the ride.

Tax-deductible mortgages: is now the best time to invest?

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”

A popular quote by Warren Buffett, CEO of Berkshire Hathaway and legendary value investor.

Over the past few months I have noticed more people calling me up about tax-deductible mortgages, the so-called Smith Maneuver. Investors, particularly those with a long-term horizon, are looking for a cheap source of capital as stock valuations, especially high quality value stocks, are hitting very attractive multiples as a result of all the volatility we have seen in the markets over the past few months. We’re at a point where borrowing to invest in the financial markets can be a very lucrative proposition for the right individual. The reasons behind this logic are:

• Interest rates are poised to remain low for at least another year and possibly longer as the world’s largest economies shift into slower growth
• Inflation so far remains well-anchored which means that central banks are unlikely to proceed with dramatic rate increases
• Housing prices in large metropolitan areas such as Vancouver and Toronto remain on solid footing
• Stock valuations of large blue chip companies, both in Canada and abroad, have reached very attractive valuation levels

With a tax-deductible mortgage, the client essentially taps into a home equity line of credit (HELOC) to borrow funds which are then used for investment purposes. The interest costs paid by the client to borrow the funds are tax-deductible as long as the funds are used to purchase qualified investments as defined by the Canada Revenue Agency (CRA). Note: interest on borrowed money to make an RRSP contribution is not tax-deductible.

The main attraction of this strategy, aside from the fact that the interest is tax-deductible, is that a HELOC provides a cheap source of capital. Unsecured loans from the bank or credit union are priced at about 8% to 10%. Personal lines of credit are priced at the institution’s prime rate (currently 3%) + 5% to 7%, effectively the same rate as a typical loan. At such high rates, there’s no logic in borrowing the money to invest unless you’re very confident that your investment can yield a much higher return than the cost of borrowing (highly unlikely at these rates). In contrast, our lowest HELOC rate at the moment is prime + .25% or 3.25%. That’s twice less than the price of an unsecured loan or line of credit. Moreover, a HELOC can be set up with numerous positions to offset interest rate risk. For example, a portion of the balance can be set up as a floating (variable) rate while the other portion can be set up as a fixed rate. There are many HELOC options available so it’s important to pick one that:

• Provides you with the maximum amount of flexibility in terms of access to capital
• Be structured in a way that reflects your level of risk aversion

That’s the borrowing component.

Next, you will need to set up a portfolio or investment strategy on how to use the funds. For this strategy, I highly recommend the services of a fee-only adviser. I recommend their services for two reasons:

1) They set up a personalized financial plan that revolves around your objectives and risk tolerance

2) Fee-based planners are generally not compensated through commissions from mutual fund companies. As such, they can structure a portfolio using low-cost investment vehicles such ETFs and individual stocks

Most fee-only planners have at least a Certified Financial Planner designation (CFP) and some carry additional designations such as Certified Investment Manager (CIM) through the Canadian Securities Institute and in some cases even a Chartered Financial Analyst (CFA) awarded by the CFA Institute. Simply put, fee-only planners are highly accredited individuals with a wealth of experience. The typical client includes executives, business owners, high-net-worth individuals, and charitable foundations. While some fee-based planners require that clients have a sizable portfolio to become a client, there are fee-based planners who are willing to accept clients with smaller portfolios.

In terms of choosing the right investment approach, it is important to talk with your financial planner about your objectives and risk tolerances. It would be helpful to perform a stress test so that you can become aware of your personal level of risk aversion. You’d be surprised how often investors have no clue about the true meaning of risk. While some financial planners may only ask a few generalized questions, I personally recommend taking the investor questionnaire provided by the Vanguard Group who pioneered low-cost index funds and passive ETFs. It is one of the better stress tests available out there for individual investors. In order to maximize the efficiency of a tax-deductible mortgage, it is important to choose investments that are tax efficient. Mutual funds that have high turnover ratios, for example, can trigger a series of taxable events that can erode your returns and offset the tax deduction.

Once your investment plan is implemented, it is important to keep in touch with your adviser (or rather your adviser should be keeping in touch with you) on a regular basis. If any life-changing events have taken place (new baby, marital breakdown, loss of income, etc.), make sure your adviser becomes aware of it so that appropriate adjustments can be made if necessary.

There are risks associated with borrowing to invest

First, the projected rate of return may change negatively and the value of your investments can drop. Even if the value of your portfolio drops, you are still liable for the HELOC payments. Second, by tapping into a HELOC, you are leveraging the equity you have built up in your home. Should the value of your home decrease for any reason, you may find yourself underwater with your mortgage. Third, if you decide to float the rate on the revolving position, the rate may change at any time. Remember, lenders control line of credit rate by adding an increment on their prime rate. Unlike a variable rate mortgage where the spread is locked, HELOC spreads are not locked and can be increased by the lender with minimal notice. Fourth, the lender may also collapse the HELOC facility altogether (highly unlikely but the risk is there) and you will be liable for any amount owing on the HELOC. Fifth, in some cases it may actually be more worthwhile to prepay the mortgage and build wealth through equity instead of borrowing to invest in a highly volatile market environment.

Putting the amount of risk involved in perspective, it’s crucial for clients and their financial planner to run a series of “what if” scenarios to determine whether the client is suitable for this strategy. As I have said previously, for the right individual with a very long-term investment horizon this can represent a good opportunity to diversify their nest egg and buy into the markets when valuations of many high quality equities are quite low. Other individuals, however, would be better paying off debt.

To summarize the steps of putting together a tax-deductible mortgage:

1) Pick the right HELOC product

2) Pick the right financial planner

3) Define your objectives clearly using multiple time horizons (short, medium, and long-term goals) and understand your personal level of risk

If you would like to consult with us about a tax-deductible mortgage, feel free to send me an email. We work with independent fee-only planners who specialize in low-cost investing and we have preferential pricing from lenders for individuals who are interested in implementing this strategy. We work together with financial planners to find the most suitable product and ensure that the mortgage plan remains in sync with your financial plan.

Final note: this post is not meant to be construed as blanket advice. Always consult with a qualified investment adviser before making any investment decisions. Investing in the markets always carries a risk including total loss of principal.

Quick note about mortgage rates

In light of the fact that bond yields have surged by as much as 35bp over the past 3 weeks or so, some lenders have decided to raise their interest rates. The increases are effective as of tonight (Friday) but some are holding out until early next week.

My suggestion is if you’re in the market for a fixed rate mortgage and your closing is coming up soon, have your Mortgage Adviser secure a rate hold over the next 2 business days. So far, only discounted rates are affected but posted rates may increase as well come next week.

We may also see lenders withdraw some of their quick-close (30 to 60 days) promotional rates.

Moneyville’s flawed logic on variable rate mortgages

This morning I stumbled upon a new article on Moneyville that discusses the reasons to choose a variable rate mortgage. A particular point that stood out in the intro is ” Now may be the time to go variable.”

Really?

Given that the spread between a 5-year fixed and a 5-year variable is now less than half a percent, I personally would have a serious problem with giving blanket advice like that.

Another point in the article that I found rather interesting:

“Although the central bank rate has not changed much over the past year — and is not expected to soon — lenders have been narrowing the gap between the two rates. That means it’s a good time to consider a variable mortgage before the gap gets even smaller.“

I hate to be the bearer of bad news but some lenders have wiped their decrement to prime entirely while others are very close to following the same route. In fact, some of the major banks are already advertising a 5-year variable at prime plus as opposed to prime minus. Even if one gets their lender to make a rate discretion, the savings over the institution’s posted rate would be rather small at today’s rates. The only consumers who are at a clear advantage right now are those who locked the decrement to prime a few weeks ago when prime – .75% or lower was available plentifully. Consumers who have not locked the decrement to prime while rates were low would be paying a premium that reflects the increased volatility in the credit markets.

While lenders are increasing their variable rates, bond yields have reached historical lows and this turned the advantage, at least in some instances, to a fixed rate mortgage. For example, a 2-year fixed is currently priced at 2.49% or prime – .50%. A 4-year fixed is priced just under 3%, less than prime rate in fact. Considering that the Bank of Canada doesn’t have much headroom to cut its benchmark rate anyway (it’s currently at 1% and while the economy is currently experiencing slower growth, there’s broad consensus among analysts that further rate cuts will not happen unless things really take a turn for the worst), I personally don’t think the case for variable is as clear cut as presented in the article.

Borrowers who opt for a variable rate mortgage would likely stick with variable rates and bet that rates would decrease in the future. However, even if the Bank of Canada decreases its benchmark rate, there’s a  possibility, in the midst of another credit crisis, that financial institutions may not pass on the full savings to the consumer (a practice that’s actually quite common in Europe). When the Bank of Canada cut its benchmark rate to nearly zero during the 2008/2009 financial crisis, the banks were initially reluctant to pass the full cut to consumers.

If the debt crisis in Europe morphs into another international credit crisis, and certainly there are indications that the interbank lending market is already feeling the pressure, variable rates could actually increase in the short-term. Even if prime remains static, lenders can change the pricing with an added increment/decrement (obviously consumers who locked the spread won’t be affected). Remember when variable mortgage rates went from prime – .90% to prime + 1% at the peak of the crisis? As long as the economy remains anemic and the European debt crisis remains unsolved, investors would likely not rush into more risky asset classes. They will leave their money in government bonds and this would keep yields low, making fixed rates more attractive in the short-term. Of course, this is merely a hypothesis. But looking at current economic indicators, it appears that we are entering a period of stagnant growth and investors would likely be pursuing a more conservative strategy.

The article presents a quick payment computation based on a 5-year fixed at 3.20% and a 5-year variable at 2.60% (prime – .40%) to show how a consumer can save “$2,700 annually on a $450,000 mortgage.” Wise consumers should take such examples with a grain of salt.

First, we have no way to know what variables were used to reach this result. What is the amortization? What are the payment terms? How is the interest rate on the variable mortgage compounded? What are the homeowner’s objectives as far as prepayments? After all, small prepayments spread throughout the year offer noticeable savings in the long term. Did the borrower consider keeping the payment amount the same as the fixed rate while capitalizing on the lower variable rate? This would magnify the savings in the short term.

Second, it’s nonsensical to assume that variable rates will remain the same for 5 years and devise a mortgage strategy based on such projections.Variable rates haven’t been steady when the Bank of Canada’s benchmark rate was nearly at zero during times of economic distress. When the economy emerges from a slump into resilient growth, the benchmark rate can fluctuate even more as the Bank of Canada would tweaks interest rates to ensure that they don’t impede growth or overstimulate the economy. As its benchmark rate is currently at only 1%, the only tweaks from here are upwards. Unless the author has a crystal ball that sees the economy remaining in the same state for five years, the example presented in the article, which doesn’t even take the borrower’s risk profile into account, is highly flawed.

Regarding the five reasons about why variable mortgages are a win over fixed rates:

1) Variable mortgages are historically cheaper: While it’s true that variable rates have historically paid off the mortgage faster and with less interest, an economist for the same bank quoted in the article as a reference actually said in a recent interview with Rob Mclister of CMT that in the long run, “borrowers won’t see the same advantage to variable rates as they have in the past 25 years”.

2) Variable rates are near historical lows: Actually, the historical lows were reached back in 2009. Consumers who locked in a variable rate mortgage at prime – .90% just before the financial crisis erupted paid an interest rate of as little as 1.40% as the Bank of Canada lowered its benchmark rate to nearly zero and prime decreased in tandem. As mentioned previously, today’s 5-year variable rate is priced close to 3% and with some lenders it’s priced just over 3%. Hence, while today’s variable rates are still competitive at 3% to their historical range, they are not at historical lows.

3) Variable rate penalties are typically lower: That’s correct. However, some lenders (though not many) charge an IRD to discharge a variable rate mortgage and some banks actually charge a renewal fee on variable mortgages which erode some of the rate savings. Moreover, some institutions register variable mortgages as collateral charge which would result in additional legal expenses to transfer-out the mortgage in the future. So while the penalties would be lower, it’s far more beneficial to look at the overall costs as opposed to just the penalties.

4) You can lock in at any time: While it’s true that most lenders offer this option, there are a couple of limitations. First, almost no lender guarantees the lowest discounted fixed rate upon conversion. In fact, only two lenders guarantee it and actually put it in writing in the current commitment and neither one is a major bank. Food for thought: what’s the point of converting to a fixed rate if you’re going to pay posted or “special offer” rate? The fact that most consumers would be paying a higher fixed rate upon conversion than other consumers who are taking out a mortgage at the same time means that it’s not exactly a free conversion after all. Second, there is a minimum fixed term with all lenders that you must commit to upon conversion (usually 3 years) if you wish to avoid penalties and discharge fees. Third, most lenders don’t allow a blend with a variable rate mortgage.

5) “You start saving right away. Because of the current spread between fixed and variable rates, the savings are immediate. Even if interest rates rise, the increase would have to be big enough to wipe out the savings reaped at the beginning of the mortgage.”: I’m still laughing at this one, especially since most lenders are now at or nearly prime and given that some fixed mortgage terms are actually priced lower than current variable rates. In fact, today’s 5-year fixed rates are inching closer to 3%. With a risk premium of 20bp to lock the rate for 5 years, even variable rate evangelists such as myself would have no hesitation recommending a 5-year fixed as long as the mortgage is planned properly and the homeowner is aware of the fees to discharge the mortgage before the term matures.

With a proper mortgage planning strategy, you can save money with a variable rate but it’s important to understand the limitations. The Moneyville article, in my opinion, shows exactly how not to pick a variable rate mortgage and the logic used in the article is quite flawed based on today’s circumstances.

Economy is frail, interest rates remain low, borrowers are more confused than ever

Welcome back, Ted. Four years ago, as the US interbank market came under stress, financiers learnt about the Ted spread – the gap between three-month Libor interbank rates and US Treasury bill yields. Usually negligible, the spread rises when banks start to lose faith in each other’s ability to repay loans. A great measure of trust, or lack of it, among banks, it is ignored at all times other than during crises.

Source: Financial Times, “European banks: Ted spread”, September 13, 2011

It’s a tough job being an economist these days. With so much volatility in the markets it’s virtually impossible to make the right call. Just a year ago economists were forecasting that prime rate would be nearly 5% by the end of this year. With a looming debt crisis emerging from Europe, weak recovery in the U.S., and now signs that even the Canadian economy is slowing down, it appears that low interest rates are here to stay as central bankers desperately try to keep the world’s largest economies from slipping into another recession.

Operation Twist is already under way south of the border, which entails the Federal Reserve selling short-term bonds and buying long-term bonds/Treasury bills with the proceeds, all in effort to lower the yield of long-term bonds and push (sic) investors to invest in riskier asset classes. In his latest Economic Monitor report (September 2011), Dundee Wealth chief economist Dr. Martin Murenbeeld predicts that another round of quantitative easing by the Federal Reserve is all but inevitable.

It can also be argued that it’s not exactly the best of times to be a banker. Major financial institutions around the world are not only slashing their workforce by tens of thousands of employees but are also forced to contend with higher capital costs as the credit markets start to price the contagion in Europe. Banks must also restructure so that they meet the new capital reserve requirements under Basel III.

In the midst of all the fiasco are confused mortgage borrowers who have seen fixed rates being slashed to levels not seen in more than 50 years while at the same time variable rate mortgages have actually increased in price. “Should I take fixed or variable?” is a rather common question these days given that the difference between a 5-year fixed and a 5-year variable rate has been reduced to, on a fully discounted basis, as little as 25 bps. In particular, attractive offerings can be found in shorter maturities such a 3-year fixed rate for 2.59% and a 4-year fixed rate for just under 3%.

Let’s quickly analyze what’s behind today’s low rates. Fixed rates move in tandem with the bond markets. As nervous investors take shelter in the safety of government bonds, the yield that these bonds pay decreases. As a result, fixed mortgage rates head down. Variable rates for the most part are based on short-term fluctuations in the financial markets and priced based on the lender’s “prime” lending rate, which itself is partially based on the Bank of Canada’s target rate. The factors that would cause variable rates to move upwards include an increase by the Bank of Canada to its benchmark rate (which would see lenders increase their prime rate) as well as an increase in funding costs in the interbank lending market.

Interbank lending rates are priced based on the level of volatility in the credit markets. Whenever the credit markets come under stress [i.e. an increase in price of credit default swaps (CDS) and a higher T.E.D. spread], such as  when major European banks are exposed to the bonds of peripheral Eurozone countries of questionable solvency, the cost of funds for financial institutions increases.

Three years ago, at the peak of the financial meltdown in October 2008, we have already seen how nasty the credit markets can react when banks are unsure about just how much crap there is on the balance sheet of other banks. Banks become reluctant to lend to one another, cheap credit (liquidity) becomes quite expensive, and the credit markets go into hibernation, pushing the entire economy into an initial shock followed by a long slump.

This is essentially the threat we are facing today. In a research note released yesterday, Wells Fargo strategist Gina Martin Adams warns equity investors to “tread lightly” as the T.E.D. spread more than doubled over the last three months. According to Martin Adams, the performance of the equity markets has yet to factor the increased volatility in the credit markets. The chart I have prepared below shows the T.E.D. spread compared to the performance of the S&P500 and S&P/TSX Composite indexes over the last 6 months.

Source: Bloomberg (click to enlarge)

As we can see, the T.E.D. spread starts increasing in mid-August and continues to show a steady climb throughout September and October while both the S&P and TSX remain relatively flat for the same period. It can be argued that the predominant factor behind the increase in the T.E.D. spread is Europe’s sovereign debt crisis spreading from small peripheral economies to global powerhouses such as Italy, Spain, and even France. In an effort to prevent further contagion, smaller European banks and credit unions have been merged with one another while larger financial institutions such as Dexia, which has significant operations in Belgium and France, have been nationalized and are in the process of being broken up. The disturbing part about the Dexia break up is that here was a major bank that passed the European Banking Authority’s “stress test” with flying colours just three months earlier.

The tests have proved to be meaningless even quicker than they were in 2010 when Ireland’s banks were given a clean bill of health, only to be bailed out four months later. In July, 2011 the EBA had been reckoning that the capital shortfall of the banks that failed was just €2.5bn. Now the markets reckon that the hole is more like €300bn.

Source: The Guardian, “How did Europe’s bank stress tests give Dexia a clean bill of health?”, October 5, 2011

So where does all this leave Canadians are pondering what to do with their mortgage? While I have heard various solutions from other Mortgage Advisers justifying why consumers should pick one mortgage rate over the other, there really is no right or wrong answer. Variable rates in Canada have increased in tandem with the level of volatility in the credit markets. Back in July, a 5-year variable rate was available for prime – .75% or less (2.25% based on the current prime rate). Fast forward to today where some lenders are pricing their 5-year variable at prime + .10%. It has been a stunning reversal of fortunes. Borrowers who didn’t lock the spread just a few short weeks ago will now pay nearly 1% more. With the Bank of Canada not likely to raise interest rates for some time (if anything, if things get worse we may actually see a rate cut), lenders have adopted a pricing strategy to push borrowers who are in the process of securing a mortgage out of variable rates and into short-term fixed rates. My guess is that short-term fixed rates have been scaled back as a retention strategy to entice those who need a mortgage now to lock-in and wait to see if variable rates would drop again in the future.

While some economists have said that this may be the end of prime minus mortgages, they said the same thing at the peak of credit crisis back in 2008 and early 2009 when variable mortgage rates and HELOCs spiked. It turns out that as the markets returned to some degree of normalcy, the credit crisis subsided, volatility dropped, and banks were once again offering variable rates at pre-crisis decrements. There’s absolutely no indication that variable rates won’t subside again. We may indeed be entering another prolonged credit crisis that will keep short-term borrowing rates elevated. But as past nuisances proved, the markets would eventually correct themselves and sanity will prevail. As of right now, the advantage is certainly tilted towards fixed rates, especially 4- and 5-year rates that are available at 2.99% and 3.29% to 3.34% respectively. Consumers who have traditionally opted for a variable rate mortgage should not feel compelled to secure a fixed rate if they believe that rates would drop in the future. The Bank of Canada may cut its target rate further, although given that its rate is presently at 1.00%, there isn’t much room to cut further and I don’t see the Bank of Canada lowering its benchmark rate to nearly zero like the Federal Reserve did.

Even though the spread between fixed rates and variable rates is very thin, a mortgage must still be structured based on the needs and goals of the applicant and not the most convenient option for the lender. While both fixed and variable rates remain competitive, variable rates would likely remain elevated until some of the volatility subsides. The only thing that can alleviate some of the pressure from the markets is for European regulators to come up with a permanent solution to the crisis instead of merely deferring the issue until there’s greater consensus among Eurozone members. At the present time, sadly, this doesn’t appear to be happening.

Another credit crisis is about to begin

The muddle-through approach to the eurozone crisis has failed to resolve the fundamental problems of economic and competitiveness divergence within the union. If this continues the euro will move towards disorderly debt workouts, and eventually a break-up of the monetary union itself, as some of the weaker members crash out.

Nuriel “Dr. Doom” Roubini, Financial Times, June 13, 2011

Hang on to your hats as this is going to be a wild ride. Earlier this year I wrote about how variable mortgage rates would increase as a result of a potential credit crisis starting in Europe and gradually spreading through the international banking system. And guess what? Over the last six weeks, variable mortgage rates went from prime – .90% (2.10% based on prime at 3%) to prime – .30% (2.80% based on current rates). It has been a stunning reversal that coincided with the Federal Reserve announcing, for the first time in its history, that it would be keeping its funds rate at nearly zero until 2013. As most lenders forecast that prime would be at over 4% by the end of this year, they left the decrement to prime low given how competitive the mortgage market has been and the housing market remains resilient even in the face of another economic slowdown. But with the Bank of Canada poised to leave interest rates low are for the foreseeable future, lenders reacted by narrowing the discount to prime.

While the subject of the European debt crisis has been in the headlines for some time now, it is important to look at the origins of the last credit credit crisis that unfolded 3 years ago to see if we can find some commonality. That crisis was the result of a housing bubble and fraudulent lending practices in the U.S. and the collapse of the securitization market through which every Joe Schmoe in the world ended up owning some piece of real estate in the U.S. While mortgage fraud isn’t exactly the source of this new crisis, the way things are currently developing is jarringly similar to how the last credit crisis formed.

The crisis we are seeing now is not back by toxic real estate but rather toxic debt of heavily indebted sovereign nations and the exposure that European banks, and indeed international banks, have to the bonds of these peripheral states. The Eurozone can be broken down into the “haves” and “have nots”. The “haves” are the rich superpowers such as France and Germany while the “have nots” are the smaller peripheral states such as Greece, Ireland, Portugal, and arguably Spain, a major country that has relied heavily on the construction boom in the recent decade and which is currently experiencing an estimated 20% unemployment rate.

The rescue plan, in its simplest form, calls for the richer states, notably France and Germany, to bail out their little Euro brothers or else risk that their own banks be exposed to the toxic bonds of peripheral states and the eventuality of governments having to take over the banks. In an effort to prevent the contagion from spreading to the richer states, European regulators have crafted the European Financial Stability Facility (EFSF), which is essentially a large bailout fund. The European Central Bank (ECB) has also facilitated some reprieve by purchasing the bonds of peripheral states, providing additional liquidity and keeping borrowing costs low. While the EFSF could certainly help countries with a smaller economic footprint such as Greece and Portugal with their finances in the short-term, it doesn’t address long-term issues nor is it big enough to support the likes of Spain and even Italy which has seen its own bond yields spike, making it more expensive to borrow through the bond markets, and credit rating slashed. Should a full-blown crisis spread to countries such as Spain and Italy, and some analysts are arguing that the contagion already spread there and it’s only a matter of time before it manifests itself into an even bigger problem, the EFSF in its current form would not be sufficient to calm the markets.

The last few years have been quite challenging for European banks. Several banks have already been bailed out and taken over by governments. Smaller banks were consolidated with larger banks to prevent a collapse of the banking system. “Rogue” (interesting word) traders have cost banks such as France’s SocGen and most recently Switzerland’s UBS billions of Euros in casino-style losses. As of this morning, the trading of shares of Belgium’s largest bank, Dexia, have been halted due to fears that it is heavily exposed to losses holding the bonds of peripheral states. Suffice to say the markets are quite sensitive to bad news coming from European banks. Since these banks are heavily exposed to the bonds of peripheral states, investors and indeed the banking community as a whole are keeping a watchful eye.

But the problem isn’t merely financial. It is also largely politically charged. The electorate in countries like France and Germany are heavily opposed to bailing out nations they see as fiscally irresponsible. Thus far, the solutions put together by regulators have kicked the can down the road instead of tackling the problem head on. Political innuendos are preventing Eurozone members from confronting the crisis as a united front despite any illusions that this is what they’re currently doing.

Let there be no mistake: should nations such as Greece, Ireland, or Portugal default on their debt because of their inability to raise money through the bond markets, the ramifications would be felt across the Eurozone and every member state would ultimately pay the price. The politicians know this very well but for the time being they decided on a course of action that merely buys time. To soothe the electorate’s objection to any taxpayer-funded bailout, the richer states embarked on a carrot-and-stick approach. In exchange for deep, enormously unpopular austerity measures which have so far failed to deliver any tangible results, heavily indebted nations would receive periodic transfers so that they won’t default on their debt.

This approach is flawed and it’s only a matter of time before the house of cards falls down. When it does end up collapsing, and I personally believe it would collapse eventually, the aftershocks would be felt across the world. Banks will be reluctent to lend to one another because, just as in the last crisis, no one will have any idea about the exposure of other banks to toxic sovereign debt. The bond markets clearly believe that Greece is on the verge of defaulting (sharply inverted yield curve). Once the debt crisis reaches the point of no return, the credit markets will come to a halt yet again. The only problem is that governments and central bankers are largely out of ammunition in terms of solving another large-scale crisis. As things stand now, most Europeans banks, big and small, are exposed to peripheral bonds. So things are getting quite interesting.

Tic toc… Will U.S. debt stalemate spill over into Canada?

Most analysts agree that a default by the U.S. on its debt obligations will not only spell disaster for the U.S. but send shock waves around the world. The problem is that we don’t necessarily need an actual default to have the financial markets spiral out of control.

As the August 2nd deadline looms, it’s becoming quite apparent that both sides of the political spectrum are too far apart to facilitate an agreement to raise the debt ceiling. While we can reserve judgment on who to blame for the stalemate — if you ask me, the Republicans are a bunch of selfish twits who are playing political Russian roulette — let there be no doubt that both developed and developing markets, including Canada where the economy is on much more solid footing than many other economies, will be dragged along for the ride.

The ultimate consequence

Investors may get wary of holding government debt altogether. It’s bad enough that the U.S. crisis is aligned with another bond crisis happening on the other side of the Atlantic. In the eyes of investors and financial institutions, if U.S. treasuries, which are regarded as the safest bonds in the world, all of a sudden pose a risk of default, then surely nothing else is safe. The end result is wide spread panic in the financial markets that some argue could end up being worst than the hit the markets took in the fall of 2008 (the collapse of Lehman Brothers).

The price of gold is already reflecting the anxiety of the markets. Currently at $1,600 an ounce, gold may very well shoot up in the coming days. But investors should remain realistic about what they can do with gold. After all, it’s not as if the world is about to return to the gold standard and people can’t exactly pay for basic necessities with a bar of gold. The Swiss franc is also trading at record highs due to the fact that Switzerland’s central bank holds a higher proportion of its reserves in gold than most other central banks, hence providing investors with a dual hedge.

Credit markets coming to a halt

While the average person on the street thinks nothing of the looming crisis, most people are unaware of how extensively U.S. treasuries are used as collateral in the repo market. A credit downgrade or default of U.S. debt could cripple the credit system as a whole as financial institutions would have to look to other forms of collateral to borrow money from each other.

Canadian Dollar surges

As Canada’s economy remains in far better shape than most OECD nations, it’s logical that investors would move their money into currencies that are more stable than the USD. It’s no coincidence that the CDN$ is trading at a 3-year high against the greenback. A handful of other currencies, such as the Australian dollar and Swedish krona, are also trading at record highs.

Bond yields (and possibly mortgage rates) spike

It’s a simple process: when your credit rating is downgraded, you should expect to pay higher interest rates (and post more collateral) to borrow money. While short-term bonds in the U.S. could very well see a spike in the yield, medium- and long-term bonds would likely not be affected as severely. Bond yields across the world could do two things: spike along with those of the U.S. as investors get wary of government debt altogether (and in Canada’s case, as we remain heavily leveraged to what’s happening with the U.S. economy, investors may perceive Canada to be a higher risk) or decrease further as a result of capital in-flows (investors shifting their money out of U.S. treasuries and into other currencies).

As you can see there are a lot of unknowns. After all, should events go down the negative path, this will be the first default for the U.S. since its founding. Let’s hope that things won’t escalate out of control. But if they do, this crisis will definitely be written about in the history books for many years to come. And for once at least it would be an entertaining afternoon with Maria Bartiromo! Get the popcorn ready…

Inflation nation

Statistics Canada’s CPI report was released earlier this morning. And to everyone’s surprise, inflation has been relatively tame in the month of June. Headline inflation was 3.1% (compared to 3.7% in May) while the core inflation rate, which strips out the eight most volatile items including food and energy prices and is rate the Bank of Canada looks at closely, fell to 1.3% (compared to 1.6% in May). While headline inflation remains elevated at over 3%, the core rate remains well below the Bank of Canada’s target rate of 2%. The latest inflation numbers, in contrast to May’s numbers, have led some to speculate that the Bank of Canada now has additional headroom to postpone any rate increases as inflation, despite the constant deviation in recent months, doesn’t appear to be of significant concern.

Should borrowers rejoice that low interest rates are here to stay? Not so fast, according to CIBC chief economist Avery Shenfeld. In his weekly insight, Mr. Shenfeld writes that Bank of Canada policy “is steered by where all-items inflation would be 12-18 months out if rates were held at the status quo. In that outlook, the Bank places a lot of emphasis on its forward projection for the degree of slack in the economy.” In other words, despite a strong recovery, the Canadian economy currently has excess slack which will be gradually absorbed in the coming year. With the economy projected to grow at a healthy pace, consumer prices are expected to increase and as a result interest rates would increase in tandem.

But there are external factors that can throw things off track. Economic recovery in the U.S remains anemic at best while Europe is desperately trying to quell a sovereign debt crisis that in recent weeks threatened even non-peripheral members. These are the “headwinds” that Bank of Canada Governor Mark Carney keeps referring to. While European leaders are worried about a bond crisis spreading to economic powerhouses, there’s an inherent risk that the damage could spread beyond Europe and especially if American politicians can’t reach an agreement to raise the debt ceiling by the August 2nd deadline. A default by some European states combined with a possible default (at worst) or a credit downgrade (at best) of U.S. debt may very well drag Canada’s economy along for a bumpy ride.

But for the time being, even with higher inflation, Canada’s economy continues to fire on all cylinders and the current value of the Canadian dollar against other leading currencies is certainly showing that this sentiment is shared by investors around the world. Should things subside in Europe and the U.S. start to show strong signs of a true economic recovery (interestingly enough, PIMCO’s Bill Gross wrote an op-ed in the Financial Times this week that talks about how a lower growth rate is  the “new normal” for nations that are heavily indebted),  the direction of interest rates here is Canada is certainly looking more upward than the status quo. The best advice for consumers at this point is use the time rates are low to pay down debt and not get deeper into debt.

Mortgage rates on the increase

Finally back. After a little vacation from blogging it’s nice getting back to the routine.

Kicking off the comeback is the news that fixed mortgage rates are on the increase. Most of the major banks have announced increases of .10 to 15% (10 to 15 bps) on most of their fixed maturities. This is the result of surging Canada bond yields with some maturities surging by more than 30 bps over the past ten days.

It’s no coincidence that bond yields have surged the same week as the CPI report released by Statistics Canada revealed an increase in inflation in the month of May. Headline inflation rose to 3.7% while core increased to 1.8%. While the headline figure was expected as a result of higher food and energy prices, the jump in core inflation, which strips out volatile items such as food and energy and the rate that the Bank of Canada looks at closely when determining its interest rate policy, is what surprised many analysts.

While 1.8% is still within the Bank’s target range of 2% to 3%, there’s some concern for inflationary pressure down the road. This is leading some investors to speculate that the Bank of Canada may end up raising interest rates sooner than expected. While it’s unlikely that rates would be increased at the Bank’s July 19th meeting, if core inflation continues to increase in June and July, we may certainly see rate increases come September.

With that said, there’s quite a bit of headwind that offers the Bank of Canada with some flexibility to keep rates at current levels. A weak U.S. economy, sovereign debt problems plaguing much of Europe, and a slowdown in growth in emerging markets may very well spill over and slow down economic growth in Canada. Moreover, while a higher Canadian dollar can certainly cause problems for exporters, so far the valuation has been anchored in the range of $1.02 to $1.04 against the greenback, a far cry from $1.10 we have seen two years ago. With the valuation of the CAD$ remaining at reasonable levels, the Bank of Canada will probably not risk raising rates especially as the Canadian economy remains heavily leveraged towards the U.S. and it’s only a matter of time before growth in Canada begins to moderate.

All these factors combined may very well keep the Bank of Canada from moving aggressively to raise interest rates. All in all, good news for borrowers, bad news for savers.

It will take a few days to determine the final rates in light of the fact that posted rates have been increased. If we go based on current margins and today’s effective yield of 2.27% on a 5-year Canada bond, a fully discounted 5-year fixed should be in the 3.7% range while a 120 days rate hold would be priced about 10 bps higher. Some lenders may offer a slightly lower rate if you’re closing within 30 days.   These rates are clearly much more attractive than the rather insulting “special offer” 5-year rate the banks are offering at 4.35% based on 5.54% posted rate.

Inflation? What inflation?

Statistics Canada released April’s CPI data this morning. The results are somewhat relieving, in fact:

• Inflation remained at 3.3% year-over-year
• Core inflation, which factors out volatile items such as food and energy, declined to 1.6% from 1.7% last month

It’s quite possible that the figures will be somewhat worse for May as fuel prices are higher this month than in April and last week many Canadian cities recorded the highest gas prices in history.

But volatile items aside, it’s clear that Canada is not suffering a chronic case of inflation, unlike many developing countries such as India, China, Brazil, and as of last month, even the Eurozone saw prices increase to 4.5% year-over-year following a small (25 bp) rate increase by the European Central Bank.

Unsurprisingly, energy prices posted the biggest increase – over 17% year over year and 5.5% higher than the month of March. The report noted that high gasoline prices were affecting all the provinces with price increases ranging from 19% in PEI to over 30% in Ontario. Specifically, gasoline prices increased by 26% compared to last April and the cost of transportation increased by 8.3%, which is the largest yearly gain since September 2005.

The increase in transportation costs is attributed to higher gasoline prices, higher premiums for auto insurance, and higher airfare costs.

Food prices have moderate in certain areas. Bakery and meat items posted the biggest gains while prices for fresh produce rose but at a much lower pace than in March.

In Ontario, consumer prices increased by 3.6% year-over-year.

What does this means for consumer borrowing rates?

With the core inflation rate remaining below the Bank of Canada’s 2% to 3% target range, the Bank of Canada has some leeway with leaving the rates where they are. Despite high oil prices and a weak U.S. dollar, the Canadian dollar has not broken through the $1.10 point despite earlier forecasts by some economists. The Canadian dollar is currently trading under $1.03.

With the Federal Reserve in no hurry to raise interest rates and the U.S. economy showing little signs of gaining traction towards solid growth as a result of a ballooning deficit, weak housing market, and stubbornly high unemployment, the Bank of Canada may be able hold its target rate for the rest of the summer and arguably into early fall.