Why TD and BMO mortgage rate cuts are late in coming

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Amid the fears of excess housing market exuberance reignited by Tuesday's mortgage rate cuts by the Bank of Montreal and Toronto-Dominion Bank, one question isn't being asked: Are mortgage rates actually too high?

From the bond market's perspective, these rate reductions were, in fact, long overdue. Five-year fixed mortgage rates have drifted far away from a key benchmark over the past six months.

Five-year mortgage rates typically track the yield on the Government of Canada five-year bond. Housing analysts often use the yield on five-year sovereign debt as a simplified proxy for a bank's blended funding costs, though there are a number of other dynamics, and a variety of funding sources used by lenders, that complicate the picture. The difference between the two can be viewed as the bank's margin on this offering. Since 2009, the spread between average discounted five-year fixed rates – what borrowers actually transact at – and the five-year Government of Canada bond yield has averaged 1.5 per cent.

The correlation coefficient between the two is 0.83, suggesting there is a strong tendency for these rates to move in the same direction.

Following the Bank of Canada's surprise rate cut in January, which prompted markets to price in a high likelihood of additional easing in the future, the spread between the five-year Government of Canada bond and average discounted fixed-mortgage rates of the same maturity expanded to its widest level since the recession.

This widening spread, on its own, indicates that originations of five-year fixed mortgages, the dominant product in the market, are more profitable for the banks than they have been in recent years.

Other factors, such as hedging programs and new capital requirements, make it difficult to get a perfect read on a bank's cost of capital and the profitability of these mortgages.

"If we ballpark added funding expenses, such as higher securitization costs, regulatory costs, capital requirements, transactional insurance fees and bulk insurance costs, at 10 to 15 basis points, then today's five-year fixed margins are still fatter than they have been over the past three spring markets," said Robert McLister, founder of RateSpy.com.

Falling yields and a flattening curve have long been the bane of the banks, and big bank executives have often cited fierce competition in the residential mortgage market, both amongst the banks and from monoline lenders as well as credit unions.

But this above-average spread is a boon for net interest margins.

So while these rate reductions may appear to be a public "volume over margins" strategy, BMO and TD's moves allow the banks to have their cake and eat it, too.

However, the reality of the matter is that many transactions have already occurred at rates well below 3 per cent.

"Most of the banks already offer better rates than this, on a discretionary basis, for well-qualified borrowers," Mr. McLister said. "This type of deal has been in the market for weeks from the Big Six banks – in fact, with even better products available."

Recently, average discounted mortgage rates have proceeded to fall (to 2.59 per cent, 20 basis points below BMO's posted offer) while Canadian government bond yields have been pulled higher. The Bank of Canada's neutral outlook on rates and the looming commencement of a tightening phase south of the border, which has seen Canada import higher yields from the United States, has fostered this weakness in sovereign debt.

Critics of the banks, such as the late, former finance minister Jim Flaherty, would contend that slashing rates demonstrates lenders' propensity to "race to the bottom," as they are largely sheltered from losses thanks to the prevalence of government-backed mortgage insurance.

This still-wide spread between mortgage rates and bond yields suggests that banks have not been overeager in their desire to boost market share and lure borrowers, and that there may be more room for further rate reductions should yields stay low.