Financial Update

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Take an interest in bonds to understand mortgage rates

Fred Langan, Financial Post Published: Saturday, November 22, 2008

Mortgages are the biggest loan in just about everyone's life. And 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?

When the Bank of Canada lowers interest rates the big banks usually play chicken for several hours waiting to see who will drop rates first. At the last cut, the TD Bank was the first to lower prime. The others followed within the 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? One pat answer is mortgage rates don't move with prime because mortgages are financed in the bond market.

Not true. Interest rates in the bond market influence mortgage rates, but that isn't where the money for mortgages comes from.

Banks get their mortgage money the same way they get other money: they take in deposits from bank accounts, GICs, etc., and then loan out the money at a higher rate. The difference, or the spread, is how commercial banks make most of their money.

The banks then put thousands of those mortgages together and repackage them as "mortgage-backed securities." These are sold to other institutions as a unit.

Since Canadian first mortgages are typically backed by housing assets, mortgage-backed securities here are seen as pretty safe investments, though the subprime variety were a disaster in the United States.

Here's where bonds come in: The bond market is made up of traders sitting at terminals in the world's financial capitals. The market is much bigger than the stock market and in many ways more important since it affects day-today interest rates.

When then banks want to set mortgage rates, they look at the yield, or interest rate, the bond is paying.

"Say the interest rate yield on a five-year government of Canada bond is 3%. The banks then have to set a rate high enough to cover all their costs of origination, selling and servicing the mortgage. They still have to be competitive with other lenders, so they set the five-year mortgage rate at 7%, but then discount on a person-by-person basis to around 5.5%" says Brendan Calder, now an adjunct professor at the Rotman School of Management at the University of Toronto. Before his academic career he was president of CIBC mortgages and before that, one of the people who set up the mortgage-backed securities business in the 1980s.
"So, if you want to know where mortgage rates are heading, watch the yields on government of Canada bonds," says Mr. Calder. "That's what mortgage brokers do."

Canadians have borrowed a total of $879-billion against their houses, according to the Bank of Canada.

"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 the mortgages, or $487-billion, are held by the chartered banks. The next biggest lenders are credit unions, which have $110-billion in mortgages outstanding. But the big banks set the trend.

Banks didn't always dominate the mortgage business. Until changes to the Bank Act in 1967, banks were not allowed to lend mortgages. Back then, trust companies dominated the business.
"The market dominance of the banks in the mortgage business has continued to grow," says Mr. Calder.

-Fred Langan is host of CBC News Business.