December 01, 2011
Variable Discounts Turn to Premiums
Prime + 0.10% (i.e., 3.10%) is an interesting number. A few months ago consumers thought that fat variable-rate discounts were here to stay. Variables above prime will now come as a shock to some people.
The banks are well aware of that. They know that pricing above prime impacts consumer psychology.
They could have priced at prime. Spreads are not that horrendous. But pricing above prime makes more of an impact. It makes higher-profit fixed rates more appealing and it mentally prepares consumers for potentially higher VRM premiums down the road.
That said, banks are not just arbitrarily sticking it to borrowers. Far and away, the main reason variable rates are worsening is that banks' costs are rising.
At the moment, there are multiple factors at play:
- Higher risk premiums are compressing margins.
- We have Europe to thank for the that.
- The TED spread, a measure of interbank credit risk, just made a new 2½ year high. As volatility increases, banks have to factor that into their funding models.
- Another reflection of risk is the most recent floating rate Canada Mortgage Bond (which some lenders use to fund variable-rate mortgages). It was issued at a 15 basis point premium over the prior issue in August.
- Margin balancing is an underlying bank motive.
- Banks have publicly stated their desire to even out margins between profitable fixed rates and low-margin variables, and they’re slowly doing just that.
- Back in September, RBC Bank exec David McKay put it this way: “…Given the dislocation between fixed and variable, the very, very thin margins (of variables), we felt we needed to move prices up in our variable rate book.”
- New regulations (e.g., IFRS) have boosted the amount of capital required for mortgage lending.
- That has lowered the return on capital for mortgages, and thus influenced rates higher.
- Status Quo for prime rate doesn't help margins.
- Lenders partly rely on deposits (that money rotting in your chequing and savings accounts) to fund VRMs.
- Demand deposit rates rise slower than prime rate. So, when prime goes up, some lenders get wider margins temporarily.
- When expectations changed three months ago to suggest that prime rate will fall or stay flat (instead of rise like expected), it was bad news for some deposit-taking lenders. That’s because they now have no spread improvement to look forward to in the near-to-medium term.
- MBABC President Geoff Parkin says that until recently, “lenders have been prepared to accept low (VRM) profit margins with the knowledge that, as the prime rate inevitably rises, so too will their profit on variable mortgages.” As it turns out, the inevitable is taking longer than the market expected.
Rob McLister, CMT