What if the government created brand new mortgage rules to keep a lid on expanding debt in Canada, but handed the keys to the vault to the six biggest banks in the country?
One of the key provisions of the tightened mortgages rules that kicked in Oct. 17 was a requirement that consumers qualify based on the posted rate.
Ottawa is demanding financial institutions use the Bank of Canada’s conventional five-year fixed posted rate, now at 4.64 per cent, to qualify consumers with government-backed loans. Previously, consumers locking in for five years or longer could use the rate on their contract — which could be as low as 1.95 per cent in today’s market — and qualify for a much larger loan, which some argued led to inflated housing prices.
But here’s the rub: That new higher rate, which is intended to create a buffer if rates rise, is ultimately set by Canada’s six largest banks because the BoC rate uses the mode (the most commonly occurring posted rate) of those banks. In theory, two banks changing their posted rate could drive qualification criteria up or down.
“You are putting the people affected by the policy basically in charge of keeping the policy,” said Will Dunnning, an economist, who just published an 18-page report on the various mortgage rule changes and how they might impact the market. Dunning thinks the mortgage rule changes could have a dramatic effect on the economy, slowing it.
The qualification rule doesn’t just hit consumers with down payments of less than 20 per cent, the minimum federal requirement to avoid costly mortgage default insurance: Consumers with a down payment of more than 20 per cent must also meet the rigid new standard of qualifying based on the posted rate if their loans are securitized in a program that is backed by the federal government.
“The setting of the posted mortgage interest rate is an individual business decision made by each bank based on a number of factors including the bank’s funding costs and competition in the marketplace,” said a spokesperson for the Canadian Banker’s Association.
The Bank of Canada says “the typical rate is calculated by taking the rate which is offered most often among the six large banks. If there is an instance in which the mode does not exist, the rate closest to the average (mean) is selected.”
Dunning says the posted rate is really an “artificial” number and past studies he’s done show virtually no mortgages are contracted at the rate. “There is not an obvious argument that the posted rate is the best possible rate for testing borrowers’ abilities to afford future payments,” Dunning added.
No one is suggesting the big six would ever collude to set the rate. And, they do have a powerful incentive, individually, to keep their rates higher, rather than lowering them to attract customers — namely, penalties for breaking a mortgage are calculated based on the posted rate.
Vince Gaetano, a principal at brokerage firm Monster Mortgage, says the impact on the penalties will ensure that banks will not lower rates to drive more customers through their doors.
“That posted rate is primarily for the penalty calculation and the discount off of the posted rate. They want that discount to be as high as it can be because it’s reflected in the penalty,” Gaetano said .
The penalty for breaking a mortgage is the greater of three months interest or what is called the IRD or interest rate differential.
Here’s an example: Gaetano says if a client had a five-year fixed-rate mortgage of 2.64 per cent, the posted rate was 4.64 per cent and the customer was 18 months into the contract with $400,000 outstanding, the penalty would be $400,000 multiplied by two per cent (the difference between the client’s rate and the posted rate) multiplied by 3.5 years.
“Under today’s system it’s very unlikely they’ll adjust (the posted rates). They’ve securitized most of the mortgages on their balance sheet. If one (mortgage) gets paid out, they have to replace it in the pool (of assets),” Gaetano said. “They’re on the hook for the interest to maturity and the investor in the (securitized program) expects to be paid.”
Conversely, down the road if banks have mortgages sitting on their books instead of securitizing them, and rates start to up, they will be incentivized to get rid of those mortgages and lower the IRD penalty, so they can put that money back into the marketplace at a higher rate.
Jason Mercer, an assistant vice-president at Moody’s Investors Service, notes the posted rate at the banks hasn’t moved much in the marketplace for months.
“I think there is a sensitivity around mortgage growth,” said Mercer, adding that policy makers are likely to give banks a slap on the wrist for anything that promotes a lower rate environment right now, so posted rate will likely stay put.