Discounts off of Prime. (Variable rate mortgages)

In layman’s terms, what is happening?

Adjustable Rate Mortgages are typically priced according to the current 30-day Banker Acceptances (BA), which are a very common short-term money market investment, guaranteed by the banks. A lender funding adjustable/variable rate mortgages would typically borrow money through a 30-day Banker’s Acceptance. The lender is then responsible for paying the yield (rate of return) to the investor who purchased the BA. This yield is the cost of funding mortgages (“Cost of Funds”) to the lender.

So, what’s happening to the BA yields?

This is where the story has become interesting over the past few months.
The failure of the U.S. subprime market worried money-market investors. In Canada, investors began to sell off investments creating a strain on the market. Those who remained demanded higher yields from the BA market as no one was sure as to how much of these BA’s were used to finance U.S. subprime mortgages, or subprime mortgages here in Canada or other risky ventures. Everyone was asking the same thing: What’s the risk exposure? A classic example of the market overreacting.

The resulting increase in BA yields increased the cost of funds for lenders who want to finance their Adjustable Rate Mortgages. Essentially it’s costing lenders much more money now to finance ARMs than it did 60 days ago.

The following is a comparison of 30-day Banker’s Acceptance yields over the past 60 days:

July 17, 2007: 4.54%
August 3, 2007: 4.60%
August 14, 2007: 4.75%
August 17, 2007: 4.92%
September 11, 2007: 4.98%
September 17, 2007: 5.04%

*Source: Bank of Canada (www.bank-banque-canada.ca)

So, in 60 days we’ve seen the yield on 30 day BA increase 50 bps.

Now consider the interest rate earned by the lenders on an ARM at Prime - .90%. Today that interest rate is 5.35%. When you compare this to the current Cost of Funds at 5.04%, which doesn’t include overhead, profit margin (or any origination fees paid to mortgage originators), one can see that it’s only a matter of time before prices for ARMs need to change.

How long will this continue?

Are we seeing the end of the days of Prime - .90%? Perhaps for a while, until the money markets settle down.
The silver lining in all this is that due to Canada’s continued economic expansion and the reality of an $80+ barrel of oil, our longer term bonds are in high demand. As a result, we might see some interest rate decreases on the fixed rate products.