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.