John Greenwood
Financial Post
February 17, 2011 - 4:51 pm Updated 6:27pm ET Why do mortgage rates rise quickly but fall like molasses? That's the question posed by an article in the latest issue of the Bank of Canada Review, and it's a good one. The report, by Jason Allen of the central bank's financial stability department, notes that the big banks that dominate the market tend to adjust interest rates faster when they're on the way up than they do when rates are falling. While it come as no surprise to borrowers that such is the case, the article draws an interesting conclusion: That such behavior by banks and other lenders may have broader implications for Canada's monetary policy, and that the central bank may want to take this into account when it comes time to plot strategy. The report comes on the heels of a decision by the federal government to tighten mortgage rules as a way to head off a potential real estate bubble. All the major lenders in this country tend to offer the same types of mortgage products, credit cards and other services, and in fact Canadians tend to treat their bank as a "one stop shop" where they buy a majority of their financial services, according Mr. Allen. Leaving aside the issue of whether this is a healthy situation, the author concludes that the mortgage market is "consistent with a model where consumers have different preferences and skills when shopping and bargaining for a mortgage and where lenders maximize profits based on observing these preferences and skills." Simply put, borrowers are often complacent and end up paying more than they should. One of the quirks of the industry in Canada is the prevalence of mortgages with terms of five-years or less, even though the loans amortize over as much as 40 years, according to the article. Citing a recent study by John Kiff, a senior financial sector expert at the International Monetary Fund, it notes that Americans, by contrast, tend to opt for longer term mortgages than do Canadians, and they have a much broader choice. The benefit of longer terms is that they provide the borrower with better protection against the risk of rising interest rates. If a loan is amortized over 25 years, the best way for the creditor to ensure he can always make the payments is to take a 25-year term. Some economists refer to five-year products as "balloon mortgages" because of the possibility that the payments may suddenly shoot up at the end of the term.
Borrowers are also left vulnerable to "roll-over risk," that the lender may be unwilling to renew the loan at any price. According to Mr. Kiff, the main reason 10- and 20-year mortgages aren't more common in Canada is because financial service providers consider them uneconomical.
Whenever banks make home loans they generally protect themselves from the risk that the customer may pay the money back early by including strict repayment penalties. But current regulations put strict limits on such penalties. "So the banks have this wall at five years," Mr. Kiff said in an interview. Bottom line: Lenders can't charge what they feel they need to charge so they don't offer longer term mortgages at an affordable price. Mr. Kiff, who previously worked at the Bank of Canada, said Canadians would be better served if there was more choice of longer term mortgages. The IMF recently recommended that the federal government change the rules around mortgages so that lenders are able to provide broader product choice without unnecessary limits on how they charge for products. What needs to happen is "at least, let the market determine where the rates should be," he said. "What [mortgage] works best depends on the borrower, on the borrower's own personal situation."
| 
