How the Lowest Rates Cause Banks Headaches

For years now, policy-makers have been reining in government backing of the mortgage market, ostensibly to “reduce taxpayer risk.”

Meanwhile, the riskiest mortgages in the prime owner-occupied market get the best mortgage rates.

A “high-ratio” default insured borrower with only 5% down, for example, can fetch 5-year fixed rates at 3.29% or less.

Yet, an uninsured borrower with four times the equity has to pay 25 basis points more, about 3.54% today.

Uninsured mortgages have rate premiums because they are more expensive for lenders. The reason is beyond the scope of this article, but most lenders do need to charge more for them.

Unified Pricing at the Banks

To get the best insured mortgage rates, one must look to non-bank lenders. Big banks are simply less inclined to advertise lower rates for high-ratio mortgages.

For one thing, major banks prefer unified pricing (i.e., one rate per term). It’s just simpler, for both customers and the bank. Banks don’t want five different rates (that depend on the borrower’s loan-to-value) for a 5-year fixed mortgage.

Furthermore, banks are cognizant that regulators see deep discounts on high-ratio mortgages as inconsistent with “risk-based pricing.” The thinking is that banks should charge more when risk is greater, and not rely on government-backed default insurance to “underprice” low-equity mortgages.

Meanwhile, bank competitors offer rock-bottom high-ratio pricing all the time. Mortgage finance companies (MFCs), which distribute through mortgage brokers, currently price high-ratio mortgages ~20 bps below average bank rates. Smart consumers gravitate to those bargain lenders and/or use such rates as negotiating leverage (thereby depressing industry profit margins), and that ticks the banks off.

Could this change?

The funny thing is, banks are mainly the ones funding those MFCs. Banks are essentially enabling their competition. In fact, we’re still seeing new lenders coming to market and buying market share with aggressive rates, using bank conduits for funding.

It’s fair to wonder how long this can last. Last year, BMO surprised analysts, saying it had “scaled back participation in the third-party mortgage market.” The bank said, “…The economics are getting tricky to rationalize from a return on equity perspective given the other places we could be deploying capital….We like our propriety [mortgage] channels best.”

Could waning bank support for their competitors be a long-term trend in the making?

Watch the Next Few Years

Banks will keep funding third-party lenders for the foreseeable future. For one thing, banks crave the virtually risk-free mortgage assets third-party lenders originate. Most such mortgages are default insured and backstopped by the federal government (which the government intentionally supports to foster beneficial competition for the banks).

To the extent banks can’t originate enough mortgages on their own, they have to buy them. In some cases, banks simply don’t want to commit to huge outlays to grow their sales channels, knowing that hundreds of other lenders and brokers could (in aggregate) out-market them.

Moreover, buying/funding competitors’ mortgages can generate decent revenue. That could be even truer in the medium-term if banks move as a herd to boost their yields (i.e., increase their wholesale rates, or pay competitors less for their mortgages).

Lastly, banks don’t let MFCs compete with them in all segments of the market. The big boys keep the best funding for themselves. There’s a reason you don’t see smaller lenders with great uninsured 1- to 4-year fixed rates and HELOCs. These products are more capital intensive and expensive to fund. In a market that’s growing more competitive and shifting online, banks will reserve their limited “balance sheet funding” for proprietary distribution (i.e., for mortgages sold via their mortgage specialists, branch reps and online channels).

Consumer Impact

As consumers flock to rate comparison sites, it’s getting harder to make money in the mortgage business. Banks can no longer rely on uniformed consumers.

To offset falling interest margins, the easiest thing banks could do is cut the funding of their competitors—either that, or increase competitors’ costs. In time, we believe they will do one and/or the other.

The resulting cost to consumers will depend on:

1. Whether other capital providers come to market to fund bank competitors (perhaps large foreign institutions?)
2. How aggressively banks decide to compete online
   • Successful online distribution demands lower advertised rates, but banks are developing their online channels very slowly, so as not to alienate and cannibalize their costly sales forces.
3. How aggressive non-bank lenders become in selling online
   • There are lenders planning new online-only mortgage processes as we speak — no brokers, no commissioned sales reps, just call centres, cheap rates and efficient online approvals. How many more such models will follow? Lots…

The mortgage industry is constantly in flux. Regardless of whether banks make it harder on their competitors or not, new online business models will keep rates low for consumers. That’s the good news.

Now let’s watch the spreads between insured and uninsured mortgages, and between big bank and broker rates, and see if we’re right.