Weekend Post

Some thoughts on key events and reports of the last couple days:

Bank of Canada Raises Rates

These rates hikes were mostly symbolic to continue the narrative that "Canada rulz" as opposed to meeting inflation targets. Given these recent hikes, current low level of inflation, unwinding fiscal stimulus and weakening housing market I think the BoC will be under their 2% mandate for awhile.


inflation table


RBC Affordability

Carrying costs in Calgary appear reasonable in RBC's housing affordability report. It is important to note this report looks at monthly payments so the 5-year fixed rate being at historic lows masks absolute price level. However, local affordability is benefiting from a more modest price bounce compared to other centers and continued wage growth.

Although the report downplays the risk of a crash it's not exactly a strong reassurance.

While we agree that housing prices are currently historically elevated, we do not believe that any major slump will necessarily ensue.

Canada Mortgage Trends, report


Labour Market Survey

Another mixed report. While employment increased by 36,000 the unemployment rate also increased as more people entered the workforce.

• Good news: Full time up 80,000, part time down 44,000.

• Bad news: Private sector employment down 40,000 while public sector up 58,000 and self employment up 18,000.

• Statistical glitch - Last month there was a reported loss of 65,000 in educational services while this month there was a gain of 68,000.

Statscan report


Edmonton New Construction Update(again)

More single family homes being built in the face of a weak resale market. A glut is forming in this segment as an increasing level of construction will not be easily absorbed.

Edmonton Real Estate Blog - report

Easy money for Canadian Lenders

This post will take a look at some ways banks and lenders are taking in some easy money in Canada.

1. The 5-year fixed corral

Right now there is a fairly hefty premium built into 5-year fixed mortgages and with the new qualifying rules it is the only option available to marginal buyers. If buyers choose a variable mortgage or a short fixed term they have to qualify for the posted 5-year rate. This rate now appears to be arbitrarily high compared to 5-year government bonds and this will move buyers towards fixed mortgages.

Even the spread on the discount rates appears elevated. Lenders are moving marginal buyers into fixed rate mortgages and collecting wider margins for it.

See the chart below to compare the fixed 5-year mortgage to the 5-year government bond. Before the financial crisis (2000-2006) the posted mortgage averaged 2.42% higher than the benchmark bond. The premium has been above 3% for about a month.



Read the article from Canadian Mortgage Trends about this situation.

It makes one curious about the logic that went into the final decision. Is there a real threat of sustained 4.35%+ higher rates? Or did the powers that be set the bar overly high to herd people into 5-year fixed mortgages—which just happen to be more profitable?

Maybe the latter is just too cynical a thought…

My opinion is that the restrictions to variable mortgages is a good thing and should be applied to discount 5-year fixed mortgages to avoid this problem.

2. Prime rate premium remains elevated well after financial crisis subsides.

Must be nice to collect an additional 0.25% off indebted Canadians, which the banks are doing since the prime rate remains inflated long after the financial crisis faded away. Normally the prime rate tracked the Bank of Canada's overnight target rate with a 1.75% premium. However back in 2008 they decided to withhold part of the central bank's rate cut. See article: Canadian consumers shortchanged on rate cut.

"Continuing market turmoil has steadily driven up the cost of borrowing for financial institutions. This makes it challenging to match the Bank of Canada rate cut at this time,"

Tim Hockey, president and chief executive of Toronto-Dominion Bank, said.

The prime rate remains 2% above the overnight rate even now the crisis is over (from the bank's perspective). See article: TD TD Bank blows away analyst estimates as Q1 profit soars to $1.3 billion

TORONTO - Toronto-Dominion Bank (TSX:TD) continued a string of big-profit announcements from Canada's largest banks Thursday, posting first-quarter results that handily blew away analyst estimates for both earnings and revenue.

The bank's net income rose to $1.3 billion in the quarter, essentially doubling the $653 million it earned a year earlier, helped by record earnings from its domestic banking operations.

It joined CIBC (TSX:CM) and Bank of Montreal (TSX:BMO) in beating Bay Street estimates, with only Royal Bank (TSX:RY) falling slightly short of expectations even as it posted a $1.5-billion profit.

To illustrate this additional 0.25% premium see the chart below with the BOC rate, prime rate and difference between them. There were the occasional spikes resulting from a small delay to move the prime rate, but this is the first sustained difference going back 10 years.



3. The renewal trap.

Canadian mortgages are typically renewed every 5 years or less. With the recent mortgage changes to decrease amortization from 40 to 35 years, require 5% down and qualify on 5-year posted rate (not to mention future price decreases) there will be borrowers who fail to qualify at renewal. Since a change in lender requires requalification while renewal does not, borrowers have no choice but to renew at the rate given to them. Good deal for lenders who can set price arbitrarily. Another unintended consequence of loose lending. Again, from Canadian Mortgage Trends:

The kicker is that you can’t change lenders at renewal without requalifying. Therefore, if you don’t have 20% equity at maturity you could be stuck in another 5-year fixed mortgage (possibly at your existing lender’s “rack rate”). If you instead want to switch to a variable or 1-4 year fixed term, your debt ratios will have to fit under the much stricter government guidelines at that time.

Do low interest rates help or hurt?

Low interest rate reduce carrying costs during the initial mortgage term and saves the borrower some amount of money. One concern is the effect of the low interest rate of the purchase price itself, potentially reducing or even reversing the benefit of the initial rate. This post will take a look at a hypothetical condo purchase in Edmonton and the amount saved on interest rates and/or lost due to inflated valuations.

Low interest rate purchase

Consider a 891 sq. ft, 2 bed / 2 bath condo in South Edmonton suburb of Ellerslie. The asking price is $199,000.


With $19,900 down the initial mortgage balance is $179,100. The mortgage is as follows assuming a 5-year fixed rate of 4.10% and 25 year amortization.

2009 Purchase price: $199,000
Down payment: $19,900
Initial balance: $179,100
Rate: 4.1%
Monthly payments: $951.84
2014 Balance: $156,184

Rent for two years and purchase with higher rates

Compare this to waiting for two years and taking out a 5-year fixed at 7.10% at three different prices. One will be a market crash of 30%, one only 10% and another with zero appreciation. In each of these cases there will be some gain on the down payment and some difference between the cost of renting and owning.

If we expect to use this down payment in 2 years its not going to be put at huge risk. Lets go with 3%. After two years the down payment grows to $21,112

Even with these low interest rates there is a small premium to own. First assume this apartment rents for $1200 including utilities. An owner will need to add $270 for condo fees, $50 for power and $120 taxes. So the monthly savings renting is ($952+$270+$50+$120)-$1200 = $192. After two years that adds up to $4,608. So total down payment is $25,720 after two years in each of the wait cases.

Wait case #1: 30% decrease

After a brutal decline the purchase price of an equivalent condo decreases to $139,930. I am comparing the balance after 3 years to have this case line up in time with the one that bought immediately. The mortgage terms are as follows:

2011 Purchase price: $139,930
Down Payment: $25,720
Initial balance: $114,210
Rate: 7.1%
Monthly payments: $807.01
2014 Balance: $108,578

This case shows that low interest rates are not enough to offset a market crash (duh!). Not even close as both monthly payments for the initial term and final mortgage balance after 5 years have elapsed are lower. Amount lost on difference in monthly payments over three years is $5,213 and the difference in mortgage balance is an additional $47,606. Total lost buying with low interest rates before a 30% crash: $52,819.

Wait case #2: 10% decline

The purchase price of an equivalent condo is $179,100 with the following mortgage terms:

2011 Purchase Price: $179,100
Down Payment: $25,720
Initial balance: $153,380
Rate: 7.1%
Monthly payments: $1083.79
2014 Balance: $145,816

In this case the reduction in payments with low interest rates($4,750) is not enough to offset the higher mortgage balance at the end of the term (-$10,368). Total lost buying with low interest rates before a 10% correction:$5,618.

Wait case #3: No appreciation

The purchase price of an equivalent house remains at $199,000 with the following mortgage terms:

2011 Purchase Price: $199,000
Down Payment: $25,720
Initial Balance: $173,280
Rate: 7.1%
Monthly payment: $1224.40
2014 Balance: $164,735

This case shows in absence of any price decline, the amount low interest rates benefit the original purchaser. The amount save on payments due to low interest rates for the three years the mortgage terms overlap is $9,812 and the balance is $8,551 less. Total gained by buying with low interest rates $18,363.

Low interest rates save the buyers money if we assume no, or only a minor market correction once rates increase.