First National Financial LP

Jason Ellis on current market volatility

  • First National Financial LP

On March 10, 2020, Jason Ellis, President and Chief Operating Officer of First National, met over breakfast with mortgage broker professionals from the Greater Toronto Area to discuss the state of the economy and the mortgage industry against a backdrop of extreme volatility in global stock markets and lower bond yields driven by plunging oil prices and the impact of COVID-19. Here are some of Jason’s observations and answers to audience questions.

For the first time ever, the entire yield curve is below 1%. As a sign of the times, 30-year bonds are trading as low as 75 basis points and the Bank of Canada dropped its overnight rate 50 basis points (to 1.25%) last week. Monetary policy may help calm the markets temporarily but unfortunately it can’t put people back to work or fix supply chains.  Further intervention is probable.

Some economists are forecasting the Bank of Canada to drop the overnight rate by another 75-100 basis points. A future decline of this magnitude may happen quickly. Some analysts are predicting as much as a 100 basis point drop over the Bank’s next two meetings on April 15th and June 3rd. It is entirely feasible that the Bank could accelerate its plans with an emergency meeting and move faster as the U.S. Fed did in February.

Despite the troubling issues facing the Canadian economy, money – including into asset-back commercial paper – is still flowing. There is no liquidity crisis today – only a crisis of confidence with respect to economic growth – and this makes the situation significantly different than it was in the days of the financial crisis in 2007-2008. Nonetheless, credit spreads have widened but two-way trading is still happening. 

Toward the end of the financial crisis, the Big Banks did not match the Bank of Canada’s moves. Last week they passed along all 50 basis points.  At this stage it’s difficult to predict how the Banks may adjust their Prime rates relative to further Bank of Canada cuts to the overnight rate. It’s also not yet clear what the government may desire. The additional cash flow resulting from lower mortgage and personal finance debt service could add some resilience to the economy, but household debt is already at elevated levels. 

Cost of funds for the Canadian banks has widened.  One of the benchmarks for funding costs is ‘bail-in’ bank debt.  TD issued new 5-year debt earlier this week at GoC’s +145 compared to GoC’s +80 just several weeks ago. This may make the banks less inclined to drop mortgage rates as they strive to maintain margins. Non-bank lenders face similar spread pressures when considering mortgage rates. For instance, NHA MBS and CMB spreads are trading wider too.

Lower interest rates are a good thing for borrowers, but an abrupt decline in rates is a significant challenge to lenders. A precipitous decline in rates experienced over the past few days is what keeps many lenders awake at night because lower rates lead to float downs in existing mortgage commitments and affect margins. Our commitment is to the borrower first, but the asymmetrical nature of the residential mortgage commitment is a tricky and expensive proposition to hedge, especially with this kind of volatility.

It’s necessary for lenders to show patience in responding to rapid Bond movements when setting mortgage rates. The reason why lenders are reluctant to drop mortgage rates too swiftly is volatility. After touching intra-day lows of just 30 basis points on Monday, 5-year bonds bounced back to about 60 basis points this morning (March 10, 2020). 

Positive or negative mark-to-market impacts on short bond positions that First National carries means the company either pays now to earn later or earns now and pays later. With the recent rate decline, the mark-to-market impact on mortgage commitment hedges creates a pay now and earn the money back over five years scenario, ideally with wider net interest margins to offset hedge losses today. 

Because of how quickly mortgage coupons have fallen, the recent change in the Government’s mortgage stress test calculation may make a difference at the margin.  Given that banks may be slower to drop their posted rates than their ‘best rates’, the new calculation for the stress test may actually provide greater relief than initially expected. The generic bank posted rate is still 5.19% but the new stress test rate may be as low as 4.50% by the end of this week.  This could translate into significant additional buying power for some borrowers.

Bank economists have reduced their GDP forecasts meaning the Canadian economy is not likely to recover too quickly. It could take as long as a year to run through the downward impact of pressures like lower economic productivity, depressed oil prices and COVID-19. And while bond rates will likely stay low for a while, they aren’t likely to stay quite this low once the shock wears off. 

The breadth and depth of its funding model creates strength and stability for First National. The Company funds about 50% of its mortgages through securitization (MBS, Canada Mortgage Bonds, asset-backed commercial paper) and 50% through a wide variety of large balance-sheet mortgage investor partners. These investors continue to demonstrate a strong appetite for quality mortgage assets against a backdrop of strong deposit bases and asset growth plans.