On Friday afternoon, April 3, 2020, First National’s Jason Ellis, President and Chief Operating Officer, and Scott McKenzie, Senior Vice President of Residential Mortgages, participated in a special webinar dedicated to sharing insights into current conditions in Canada’s mortgage markets and efforts the company is making to assist mortgage brokers and their clients through this difficult time. Here are the key takeaways beginning with Jason’s synopsis of interest rate changes between January and March.
Bank debt, mortgage backed securities and asset-backed commercial paper were well bid and generally trading at relatively narrow spreads to open 2020. Toward the end of January 5-year Canada Bonds were trading around 1.5%, a 5-year fixed rate mortgage was approximately 2.89%, the Bank of Canada overnight rate was 1.75%, the prime rate was 3.95% and adjustable rate mortgages were generally offered at discounts to prime of as much as 1%.
As the reality of the pandemic began to play out, 5-year bond yields fell to as low as 35 basis points in intra-day trading and, with that, fixed mortgage rates also fell to as low as 2.39%. In March, the Bank of Canada cut rates by 50 basis points on three separate occasions.
The Bank of Canada’s overnight administered rate is now just 25 basis points, the lowest since the global financial crisis when the overnight rate was cut 425 basis points between December 2007 and May 2009.
The prime rate has followed the Bank of Canada rate lower, from 3.95% in January 2020 to 2.45% today. But fixed mortgage rates, which did drop briefly to 2.39%, have moved back up to 2.84% today, leaving them effectively unchanged despite the fact that underlying Government of Canada bond yields are 100 basis points lower.
There is a common misconception that 5-year fixed mortgage rates are inextricably linked to 5-year Government of Canada bond yields and that cuts to the Bank of Canada’s overnight rate always result in lower 5-year fixed mortgage coupons. Although the five-year Canada bond yield does act as the base from which other rates are set including 5-year mortgages, the reality is there is not a one-to-one relationship.
Today, spreads on bail-in funds Schedule I banks use to fund mortgages have increased and spreads on mortgage backed securities (“MBS”) that non-bank lenders like First National use for funding have also increased. Effectively, the traditional relationship between mortgage coupons and government yields has broken down and as a result, the coupon on mortgages is higher than it would be otherwise.
A similar phenomenon has taken place for adjustable rate mortgages which are traditionally thought of as being linked to the prime rate. Behind the prime rate, bank and non-bank cost of funds more closely follow the CDOR or the Canadian Dollar Offered Rate. CDOR is an index which references the market where asset backed commercial paper and Banker’s Acceptances (“BAs”) are generally traded. Normally there is a relationship between prime and CDOR that is predictable and stable. However, in this environment, bank clients are drawing down on their committed lending facilities. In order to meet demand for cash, banks are issuing Banker’s Acceptances. This supply of BAs has put pressure on the demand side and yields have increased. The normal relationship between CDOR and other rates like prime is now broken and lenders have been required to eliminate the discount from prime to normalize the relationship between mortgage coupons and the cost of funds. As it costs lenders more to borrow, they must charge more to lend.
Market data show that home purchases declined in the last two weeks of March, and while volume reductions are likely to continue, it’s not possible to predict by how much or for how long.
Government Responses
Because this is more of a main street problem than a Bay Street problem, the government’s response to these economic conditions has been extraordinary – faster and bigger than anything we have ever seen. Some of the responses include the re-introduction of the Insured Mortgage Purchase Program which was first used during the liquidity crisis. It began at $50 billion but was quickly upsized to $150 billion. The Canada Mortgage Bond program has been increased from $40 billion to $60 billion. And the Bank of Canada is now purchasing Canada Mortgage Bonds in the secondary market and has introduced both a Banker’s Acceptance purchase program and a Commercial Paper purchase program along with a Term Repo Purchase Facility with an expanded set of eligible collateral including MBS.
While the government is spending a great deal of money funding initiatives like the Insured Mortgage Purchase program, it is buying triple A-rated securities at extremely elevated spreads and financing those purchases through the issuance of risk-free government debt at materially lower yields. As a result, the government stands to earn significant net interest margin by providing this liquidity. This will ultimately help finance many of the government’s fiscal initiatives.
Despite all of these actions, including unprecedented help for consumers, the market response has been surprisingly muted. To be clear, the programs have been critical in providing liquidity and creating ceilings on spreads in BA, commercial paper and MBS markets. The programs have provided a critical stabilizing effect and spreads have narrowed from their widest levels. However, there is a long way to go before the markets return to anything close to normal conditions.
Mortgage Deferrals
Mortgage deferrals, when granted, continue to incur interest. The deferred interest from a deferred payment is capitalized to the principal of the mortgage at the prevailing coupon rate. Some market commentators have been unfairly critical of this approach. For clarity, mortgage payment deferrals are not financed by a government program. The financial burden falls on the mortgage lenders. Banks and non-bank lenders alike fund mortgages with other debt including covered bonds, deposit notes, commercial paper, and mortgage backed securities. The monthly interest and in some cases principal on these debt instruments must still be paid even while the payments on underlying mortgages are deferred.
At maturity, borrowers with an approved deferral of payment from First National will be offered a rate to renew and their mortgage will be rolled seamlessly into a new term. This should be comforting for those who find themselves in a renewal situation while facing temporary financial hardship related to COVID-19.
Borrowers will not be expected to repay the deferred interest at the time of renewal. Because the deferred interest is capitalized, it will be paid out over the remaining amortization period unless the mortgage is discharged at the end of the term.
If a borrower is granted a deferral by First National, the mortgage will not be reported as “in arrears.” Similarly, if a borrower misses a payment before being granted a deferral, that mortgage will also not be reported to credit rating agencies as “in arrears.”
Mortgage insurers have asked lenders to use deferrals as the way of helping borrowers facing issues rather than entertain other measures such as extending amortization periods.
Commitments, Closings and Refinancings
First National absolutely remains open for business from qualifying borrowers and continues to offer competitive insured and conventional mortgage rates for purchases and refinances.
For home purchasers who received commitment letters and then lost employment due to COVID-19, First National will do everything possible to advance those mortgages.
Even if employment has been disrupted by COVID-19, there is a high likelihood that borrowers who already have an outstanding commitment from First National on a refinancing will see their deals completed. Refinancing may become more difficult six weeks or two months from now if a borrower loses employment but First National will look at each refinancing on a case-by-case basis.
For new mortgage applications coming in now, whether a purchase or a refinancing, borrowers will need to be employed.
Appraisals, e-Signatures and AML
First National announced in March that it would accept modified full appraisals. This means appraisers will do an exterior inspection of the property, but an interior inspection is not required. Pictures of the interior will be provided by the homeowner or the listing agent to facilitate the completion of the report. So far, this modification has worked out well.
On e-signatures, First National is taking a purposeful approach recognizing that every province has a different system for registering a mortgage. First National looks to real estate lawyers to ensure the mortgage is registered properly so that there is an enforceable charge on title. If that can happen with an e-signature in the province of residence, First National is happy to accept it. First National has also allowed e-signatures to be used for its own documentation.
For AML and KYC requirements, First National is working on different ways of confirming the borrower’s identity and will resolve this through internal measures.
Underwriting and Mortgage Rates
Turnaround times for underwriting are now back to normal after being temporarily affected because of an overwhelming volume of borrower requests. First National’s work-at-home protocols did not disrupt workflows and have proven to be successful with almost 100% of the company’s workforce working remotely.
First National’s mortgage rates are competitive and will remain so.
It’s impossible to predict where mortgages rates will go, but assuming government programs in place perform as hoped, it is possible that six months from now, discounts to prime could return on adjustable rate mortgages. Fixed rate spreads could also recede, all things being equal.
It’s unlikely but not impossible to see negative interest rates in Canada. Although there has been some emergence of negative rates recently in the repo market, with prime still at 2.45%, it’s hard to imagine a scenario that would create negative mortgage rates.
Changes made in the prime rate are typically reflected in changes in the borrower’s coupon rate at the first of every month to simplify technical operations. While this is to the lender’s benefit currently, there have been times when prime moved up and the same delay benefited the borrower.
First National’s underwriting policies have not changed at this point with the exception of Excalibur where the maximum LTV on a refinance has been reduced to 75%. As the situation evolves, underwriting policies may change but generally every deal will be evaluated on its own merit in any case.
This situation is fluid and as conditions change, the team at First National is committed to keeping mortgage broker partners updated and stands ready to serve in any way we can.