How the Mortgage Market Works
In Canada, mortgage rates are set by the major financial
institutions, in a “follow-the-leader” manner, with one of them, usually a
major bank, taking the “leader” role. All major financial institutions earn a
large part of their income on the “spread”, which is the difference between
loan/ mortgage rates they charge to borrowers and the rates they pay to
depositors/ investors for an equivalent term.
In this section, the basic “cause and effect” factors
behind these mortgage rate movements are discussed in greater depth.
How the Bond Market Affects Mortgage Rates
The Government of Canada, and all major nations, finance
their activities and accumulated deficits, by issuing “bonds”. In the US they
are known as “Treasuries” and in the UK “Gilts”. The duration and interest rate
paid on new issues of these bonds depends upon the financial strategy of the
Government in power. The accumulated outstanding amounts of these bond issues,
past and present, is known as “the National Debt”. New issues are constantly
required either to refinance maturing issues or finance current Government
deficits, and a bond (say in $100,000 denominations) is considered a “commodity”
by the market. Like every other commodity, its’ price can go up or down.
A new bond issue may set a “coupon” rate of interest at
current market, say $100 million at 5.8% for an issue of 5-year duration. If
this issue is made coincident with an economic or political event which drives
down its’ value (say an unexpected “Yes” vote in a Quebec referendum), the
effect on interest rates is immediate. The individual $100,000 denomination
bond may fall in value to $95,000, thus yielding a significantly higher return
for the buyer at the lower price. The combined “yield” of interest and capital
gains sets the new base market rate for wholesale funds. Any financial
institution seeking funds from these same investors, for example to correct an
imbalance in deposit and loan commitments, will have to pay this yield plus a
small “premium over Canada’s” to secure them.
Investors who buy and sell these Government securities in
large quantities, such as multinational corporations, pension funds and the
like, weigh many factors, including the currency value and economic prospects
of Canadian and other competing nations’ issues. They then determine what price
they’ll pay for Government of Canada Bonds. The price they’ll pay immediately
defines the base market rate for wholesale funds. Every day, trends in this
rate are watched closely by all Financial Institutions, in order to be in a
position to adjust their rates on deposits and loans if require
All Canadian mortgage lenders are acutely aware that
their current or potential retail depositors can choose to put their money into
none of the financial institutions GIC’s in a rising rate market, and instead
buy other “fixed income securities” such as bonds, which yield a higher rate
because they adjust immediately to market changes. They can even switch.
Therefore, in the truest sense of the word, the mortgage
lending institutions are competing with other markets for the investor’s money.
If a bank doesn’t attract enough depositors to fund all the mortgages, they’ll
have to go where their depositors go – the money market – to make up the
difference….and there, they pay the going rate! their funds into the stock
market if this is performing relatively better.
How Market Changes can Affect Mortgage
Decisions
The single biggest dilemma for Canadian mortgage
borrowers since 1992 has been whether or not to lock in to a long term mortgage
or stay ‘short’. History has shown that, overall, it might have been better to
stick with a short term or variable rate mortgage. That, however, is 20/20
hindsight, and many who locked in their mortgage at 6.75% in March of 1994 and
then watched as rates zoomed through the roof when constitutional discord
ravaged the Canadian dollar, would argue that they got the better of the deal.
It remains to be seen what the next decade will hold. Let’s consider a few of
the dynamics directly affecting rates, and then see how personal mortgage
decisions might be affected.
It is clear to see that accuracy in interest rate
prediction can only be judged after all the world’s political and economic
events have worked their way through the bond market over a period of time. One
of the brightest analysts in Canada predicted a cataclysmic National Debt for
Canada by the turn of the century, even suggesting that the International
Monetary Fund (IMF) would have to place controls over the Canadian currency and
foreign borrowings in order to stabilize the situation. Interest rates were
confidently predicted by some to be heading back to double digits by the year
2000.
And yet, following severe damage control by the Bank of
Canada in the late 1980’s and early 90’s, through draconian monetary policies,
combined with fiscal restraint and heavy cutbacks by the Federal Government,
Canada’s financial house appears to be in order, paving the way for stable
growth with a well controlled interest rate market.
In Canada, the threat of Quebec separation continues to
be the ‘wild card’ which could tip the balance in terms of whether the Canadian
dollar once again undergoes a prolonged attack. This would force the Bank of
Canada to once again defend the dollar by driving up short-term rates and
causing Canadian Bonds to be heavily discounted in the market. This would in
turn drive up long term rates as explained in the previous section.
This leads us to the conclusion that there are three
basic strategies that Canadians could follow given the current state of the
market. Each is represented by a “risk tolerance” on the part of borrowers:
- Stay
‘short’ with a 6 month convertible or variable rate mortgage, watching for
indications that a long lasting upheaval warrants either a long-term
lock-in or a ‘hedging’ strategy. This approach is for the
‘risk-taker’, or the borrower who can easily absorb significant rate hikes
and is prepared to live with a reasonable average over the long haul.
- ‘Hedge’
your bets by either taking a protected variable rate mortgage with a
ceiling at the current, 3 year posted rates; or a split-term mortgage with
terms varying from 6 months to 5 years, in amounts which suit your risk
tolerance level. This strategy is the best for those that are cautious and
possibly vulnerable to significant rate increases in the near term…or
simply partners with different risk tolerances!
- Lock in now, after negotiating your best long term rate – as long as 10 years from some lenders. This dispels all concerns about the direction of the market, and gives the risk- averse borrower an opportunity to reduce their mortgage balance significantly before they are once again exposed to interest rate risk.
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