Tuesday, September 18, 2012

Mortgage Spreads

This is a quick look at Canadian 5-year mortgage spreads. I am not a financial analyst or anything, but here are the data using some basic calculations. Here are the mortgage rates: the posted rate, the "average" rate that includes discounts from posted, and the rate listed on RateHub that tracks the maximum discounted rate.

Mortgage rates are dependent upon the real rate of interest, inflation expectations, and an additional spread that includes the spread between risk-free and mortgage securities as well as servicer markups. I have graphed the three components (real rate, inflation, and additional spread) of the 5-year average mortgage rate below:
The inflation expectation is calculated by taking the difference between the long Government of Canada real return bond and the Government of Canada long bond. The real 5 year rate is calculated according to the Fisher equation, however I used the long breakeven rate (BER) and not the 5-year BER when calculating inflation expectations.

The "spread" has been increasing since the beginning of 2011. Recent reduced mortgage rates seem to be attributable to lower real rates and lowered inflation expectations. By these calculations, the real spread from risk-free has been higher than before the 2008 recession.


Unknown said...

So, does this mean a) the lenders are making more money on the spread b) the lenders are expecting a significantly higher risk of default on these mortgages, or a combination of both factors?

jesse said...

@Unknown I don't know but the same phenomenon has existed in the US too, with the so-called "primary-secondary" spread wider than it was in the past. I'm betting at least part of it is margin, at least that's what some recent earnings reports are telling me...

As I mentioned in the post there are roughly two components to the "spread", one is the spread between risk-free (GoC bond) and the security (say a Canada Mortgage Bond, covered bond, or other mortgage-backed security) and then the spread the servicer (e.g. your bank) gets. Both will get a share of that spread.

ratedKG said...

Got an important point here: "reduced mortgage rates seem to be attributable to lower real rates and lowered inflation expectations." I can't agree more.