Take an interest in bonds to understand mortgage rates

January 2009
(with excerpts from the National Post)

Mortgages are often the biggest loan for most Canadians. Yet, they can be the hardest to understand. Why do mortgage rates move the way they do? Why don't the rates march in lock step with other interest rates? The answer lies in bonds, though maybe not in the way you think it does.

How do mortgage rates even work? When the Bank of Canada lowers the 'target' for the overnight rate, it's sending a signal for the the big banks to lower their prime lending rates. The banks, however, usually hold back for several hours, waiting to see who will drop their rates first. At the last cut, TD Bank was the first to lower their prime lending rate. And then the others followed within an hour.

If you had a variable-rate mortgage tied to prime, then your mortgage rate moved lower. But all other mortgage rates stayed put. Why is that? Is it because mortgages are actually financed through the bond market? No, not at all. Interest rates in the bond market influence fixed mortgage rates, because bonds yields help finance banks' expenses in holding these type of mortgages. But mortgages aren't financed through bonds.

So how are mortgages actually financed? Banks get their mortgage money the same way they get other money: they take in deposits from other products, such as bank accounts and GICs, and then loan out that money (for example, for mortgages) at a higher interest rate than they pay out. This 'spread' between the rates and is how banks make most of their money.

A bank will then put thousands of their mortgages together, repackage them as 'mortgage-backed securities,' and sell them to other institutions as a unit.

Since Canadian mortgages are typically backed by housing assets, mortgage-backed securities are seen as relatively safe investments (though the subprime variety were a disaster for the United States banks and markets). However, mortgages are still considered a riskier investment compared to bonds, because bonds are backed by the government, and mortgages are subject to default and early payouts. The banks actually use bond yields to finance their expenses (ordination, selling and services) of holding mortgages. That's why banks look at bond yields to set their fixed mortgage rates.

How do government bonds affect fixed-rate mortgages? The bond market is made up of traders sitting at terminals in the world's financial capitals. The bond market is much bigger than the stock market, and in many ways, more important, since it affects day-to-day interest rates. So, when the banks want to set their mortgage rates, they look at the yield, or interest rate, that the government bonds are currently paying.

"Say the interest rate yield on a 5-year Government of Canada bond is 3%," states Brendan Calder, adjunct professor at the University of Toronto's Rotman School of Management. "The banks then have to set a rate high enough to cover all the costs of origination, selling and servicing of their mortgages.

"They still have to be competitive with other lenders," he continues, "so they'll set the 5-year mortgage rate at 7%, but then discount it on a person-by-person basis to around 4.75%."

Before his academic career, Mr. Calder was president of CIBC mortgages, and before that — one of the people who actually set up the mortgage-backed securities business during the 1980s. So he knows a thing or two about how these rates work.

"So, if you want to know where mortgage rates are heading, watch the yields on government bonds. That's what mortgage brokers do," states Mr. Calder.

Big banks set the trend. According to the Bank of Canada, Canadians have borrowed a total of $879-billion against their houses. "That includes residential mortgages and lines of credit secured against housing," says Jeremy Harrison, a spokesman for the Bank of Canada in Ottawa.

Just about half of mortgages, or $487-billion, are held by the chartered banks, so they set the trend. The next biggest lenders are credit unions, which have $110-billion in mortgages outstanding, which is nothing to sneeze at, but still considerably less of the market share compared to the big banks.

Banks didn't always dominate the mortgage business. Until changes to the Bank Act in 1967, banks were not even allowed to lend mortgages. Back then, trust companies dominated the business.

"Ever since, the market dominance of the banks in the mortgage business has continued to grow," says Mr. Calder.

So what's the mortgage moral of this rate story? Keeping abreast of the government bond yields will help you understand how fixed mortgage rates fluctuate, and will help you stay informed on the influences and trends.

Or, even better, talk to us. We can help with great advice on rates and mortgages, and where we think the market is headed. Plus, we'll provide your best rate possible, to save thousands on your mortgage.