Big banks hold key to new mortgage rules
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.
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 Bank of Canada 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 Dunning, an economist who just published an 18-page report on the mortgage rule changes and how they might affect the market. Dunning said he thinks the mortgage rule changes could dramatically slow the economy.
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,” a spokesperson for the Canadian Banker’s Association said.
The Bank of Canada says “the typical rate is calculated by taking the rate most often offered by the six large banks, or the rate closest to the average. But Dunning said 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 said.
No one is suggesting the big six would 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, as penalties for breaking a mortgage are calculated based on the posted rate.
Vince Gaetano, a principal at brokerage firm Monster Mortgage, said the impact on the penalties will ensure 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,” Gaetano said.
“They want that discount to be as high as it can be because it’s reflected in the penalty.”
The penalty for breaking a mortgage is the greater of three months’ interest, or what is called the IRD, the interest rate differential.
Here’s an example: Gaetano said if a client had a five-year fixedrate 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 vicepresident at Moody’s Investors Service, said the posted rate at the banks hasn’t moved much in the marketplace for months. “I think there is a sensitivity around mortgage growth,” Mercer said, adding that policy-makers are likely to give banks a slap on the wrist for anything that promotes a lower rate environment right now.