Is another round of mortgage wars on the way?

John Greenwood 

Renewed concern around the crisis in the eurozone has investors heading for the exits, and once again Canada is emerging as one of the biggest beneficiaries with rising demand pushing yields on even corporate bonds close to record lows.

But analysts warn the soaring popularity is a double-edged sword. Bank funding costs have tumbled as well, and that typically translates into falling mortgage rates which in turn drive increased consumer borrowing — the last thing Canada needs according to its policy makers.

‘In a world almost devoid of triple-A credit in the sovereign space, Canada is taking on a new importance’

“What you’re seeing is a tremendous flight to quality in the Canadian market,” said Ian Pollick, a fixed income strategist at RBC Capital Markets. “In a world almost devoid of triple-A credit in the sovereign space, Canada is taking on a new importance.”

The yield on Government of Canada five year bonds, a market benchmark, slipped to a record low of 1.84% on Wednesday. And where government bonds go, so go bonds issued by banks.

Bottom line: It now costs a whole lot less for a bank to borrow money than it has historically.
According to Mr. Pollick, five-year bonds issued by banks to fund their home loans are enjoying such high demand that their funding costs are lower today than they were in the so-calledmortgage wars of early February, “when we stated to see the 2.99% specials.”

Coming in the wake of repeated warnings from Bank of Canada Governor Mark Carney about the country’s excessive household debt levels, the mortgage wars drew criticism from Finance Minister Jim Flaherty, who made his concerns known directly to the banks.

Low interest rates especially after the financial crisis have created incentive for consumers to take on more debt and helped drive a run-up in housing prices across Canada, especially in Vancouver and Toronto. Economists worry that a rise in interest rates or unemployment could precipitate a serious housing correction with potentially disastrous consequences for consumers as well as the broader economy.

The federal government has taken a series of steps to try to cool the market, most recently by putting theCanada Mortgage and Housing Corp., the biggest provider of mortgage default insurance, directly under the control of the Office of the Superintendent of Financial Institutions. Earlier this spring OSFI announced proposals for tough new mortgage rules that will likely come into force before the end of the year.

Analysts say those efforts have already begun to have the desired effect, with a sharp deceleration in consumer loan growth in the first four months of the year.

But with bank funding costs now slumping again, some worry that it’s only a matter of time before phase two of the mortgage wars gets underway.

“The Canadian banks as a group have enjoyed very good access to wholesale funding since the crisis and borrow at spreads well inside those of their global peers,” said David Beattie, an analyst at credit rating agency Moody’s.

With yields where they are banks “can absolutely afford to cut mortgage rates again,” said another leading credit analyst who asked not to be named. “But factors such as “pressure from [the federal government] will probably lead them to hold off on more rate cuts — but anything’s possible.

Observers said the spread between Government of Canada bonds and bonds issued by banks has been up and down in recent years — they’re wider now that it was six weeks ago, before the eurozone flared up — but yields have come in so much that banks are still better off.