The subprime crisis developed into euro crisis

Paul Vieira, Financial Post ·     Angel Gurria is never short of words, or emotion. The secretary-general of the Organization for Economic Co-operation and Development will talk about almost anything economic-related, and do it with a passion that’s to be expected from a native of Mexico. Mr. Gurria, a former finance and foreign affairs minister in Mexico, has been head of the Paris think-tank since 2006, and has tried to provide a voice of reason during the economic crisis. In its most recent outlook, the OECD said developed economies should begin the process of budget-cutting and get debt levels back to more reasonable levels. And in Montreal this past week for the International Economic Forum of the Americas, the multi-lingual Mr. Gurria warned economies have a tough dilemma ahead: They have to maintain fiscal policies that lead to job creation, while at the same time get their own fiscal houses in order. Mr. Gurria talked to the Financial Post’s Paul Vieira in Montreal. This is an edited version of the interview:

Q Is the euro crisis the beginning of new woes, or did the crisis that broke in 2008 really end?

A You are absolutely correct. The euro crisis is just a different phase of the crisis. And just like the first manifestation of the crisis, this deals with overleverage. First it was overleverage of the banks and the stabilization of the financial system, plus the drop in government revenues due to recession, plus the increase in automatic stabilizers, plus stimulus spending. All this produced these exorbitant deficits and this mind-boggling accumulation of debt, which we would have just laughed at a few years ago of ever happening. The euro crisis is the same problem of overleverage, but has moved from the private sector to the public sector. This is just unsustainable and has to be fixed.

Q Any surprise by the drubbing in the markets, due mostly to Europe? And any shock at how intense it has been in such a short time?

A I think at some point in time, governments took the first decision to do whatever it takes. No more failures of banks. That has consequences. The second decision was to say, “We will go out and stimulate.” That was a deliberate, co-ordinated, co-operative type of decision, and something which we are seeing the consequences of now.

The first decision was linked to stabilizing the financial system. The second decision was a little bit different because, objectively, everyone went into some kind of stimulus, with China doing 15% of GDP, and the United States did something like 6%. The difference was the degree of response that the economies had. And then there was the result of the economy. And that’s when revenue drops, and you have to spend automatically [on unemployment benefits]. That was not planned. It is the result of a general economic situation. Countries were having enough trouble just with that, on top of digging into their pockets and going into deliberate deficit spending. And now we see the consequences.

Q The US$1-trillion rescue package from European policymakers was meant to calm markets and support the euro, but that has yet to materialize. What happened?

A It is going to. It was only on [Monday] night that European policymakers got it together in term of finalizing the conditions. The proposal has been going through legislatures. Germany got its passed two weeks ago, but some of the other countries have been circling the wagons because their parliaments were reticent. But let’s assume everyone chips in, and they are in. Then that’s done. Once the money is in place and ready to be triggered, it is going to produce a lot more peace of mind than it has right now.

There were a lot of skeptical voices out there because they did not see the package gelling. What they don’t understand is the way Europe works, or how things happen. They happen slowly, there’s always a little bumpiness, but it happens. And there was enough resolve. This is sorting itself out.

Q What topic, or topics, is going to dominate the G20 leaders summit in Toronto?

A In 2008, the G20 was focused on stabilizing the financial system, and avoiding a cataclysmic disaster. In 2009, it was about growth. This meeting in Toronto is going to be about a more balanced, more nuanced, more complex formula for growth. The balance has to do with the situation where you need to put an emphasis on growth but also on fiscal consolidation, or deficit adjustment. That balance, and the need to be looking at both sides, will be much more apparent now.

There is also a need for countries not to withdraw the stimulus just yet. The monetary tightening is something that is going to happen by next year. Countries have to roll out all the stimulus packages –some of them are finished, but some of them are still happening. So don’t interrupt until you are through with them. Finish the plan. And don’t start cutting the budget just yet, maybe start in 2011. Leaders need to, at the very least, strongly signal how they are going to address the deficit and debt issues. How are they are going to bring down the deficit to a manageable level, but ensure a soft landing. Then the ultimate issue is, whether markets will be more or less tolerant and patient

Maybe your mortgage needs a check-up Andy Holloway, Financial Post · 

While about 80% of Canadians visit a doctor at least once a year to help ensure they remain physically healthy, the number of people who check their financial health by regularly reviewing their mortgage is far less.

Plenty can change in someone’s life in a year, never mind during the standard five-year mortgage a lot of Canadians sign up for. A career change, kids, retirement or newfound money or it could be that such a major event is on the horizon. All can affect the type of mortgage that fits just right.

“A lot of people don’t like to face up to it but, doing an annual financial check-up is a very smart thing to do,” says Peter Aceto, CEO and president of Toronto-based ING Direct Canada. “Managing your financial lifestyle is just as important as managing your diet and exercise.”

Aceto says people often just wait for a renewal letter before they look at their mortgage, and even then they’ll likely send the contract back without considering if it is meeting their current needs because they feel changing providers or the terms is futile. But they should put just as much thought into a renewal or a review as they did when they signed the initial deal.

Kelvin Mangaroo, founder of RateSupermarket.ca, which compares mortgage rates and brokers across the country, agrees. “Canadian consumers tend to become complacent about their mortgage payments and they could be saving a lot of money.” He says home owners should annually review three main things: their current and expected future risk profile and net income as well as rates.

For example, the more adverse you become to risk, the less likely a variable mortgage will be right for you. Aside from comparing rates, Ratesupermarket.ca has a few other online tools that can help consumers figure if a change is a good thing, such as a mortgage calculator and a mortgage penalty calculator that will show how much you can expect to pay to break your existing mortgage. You can also sign up for e-mail alerts that tell you when rates change.

Rates are an obvious thing to pay attention to. If they’re going up, make sure you can make the higher monthly payment that may come at renewal time, or lock into a fixed rate if you’re on a variable. If rates are dropping below your existing rate, you might want to refinance or renew early.

“You’re making a commitment to be mortgage free in 25 years so you should have a longer term view of what interest rates will look like over that period, says Aceto. “Make sure you’re comfortable with them and comfortable making those payments.”

Even though banks are in the business of getting as much interest from you as they can, many will allow people to pay a lump sum of the principal on the mortgage’s anniversary and increase their monthly payments. An extra $100 a month on a standard $200,000 mortgage could save almost $18,000 in interest and shorten the amortization period by about four years, according to Aceto.

Paying down your mortgage faster may seemingly put a crimp into your future finances if something happens and you need the money — unlike, say, putting it into a tax-free savings account or other low-risk liquid investment. But many financial institutions have a re-advance clause that allows you to retrieve some of the money spent accelerating mortgage payments, says Peter Veselinovich, vice-president of banking and mortgage operations at Winnipeg-based Investors Group.

Of course, it may become more difficult to get those funds back if there is a dramatic downward change in housing values and you haven’t built up enough equity. But that’s where understanding your entire financial situation, not just your mortgage, can help. “Most of us don’t like to think about debt, says Veselinovich. “It’s just something that somehow comes up and ends up as part of our personal balance sheet and we make payments.”

Even something simple such as making renovations could affect the type of mortgage desired. For example, topping up or refinancing an existing mortgage can pay for renovations, providing you’re comfortable with a blended interest rate. If you’re buying a new home, you may be able to port your current mortgage. Or maybe you just want to consolidate higher-interest unsecured debt into your mortgage. “Rolling that into your mortgage can significantly save on interest costs and that will help you get out of debt sooner,” says Feisal Panjwani, a Surrey, B.C.-based broker with Feisal & Associates under the Invis Inc. umbrella.

A mortgage can also help you become more tax efficient if you’re thinking of investing in a business, buying a rental property or putting some money into mutual funds or the stock market. That’s because the interest paid on money borrowed on a principal property can be written off against revenue from those investments.

But the biggest reason for making changes to your mortgage mid-stream may be because it could be a lot easier to do something before your situation changes. “Making changes to your mortgage before you go into a new venture or before you retire would allow you to qualify much easier rather than waiting for your mortgage to come up for renewal,” says Panjwani.

The new face of debt

Andrew Allentuck, Financial Post · Friday, Jun. 11, 2010

For James Kennedy, a federal civil servant before he retired, and his wife, Jane, who retired from the Calgary civil service, the golden years have become a series of tough compromises. Both 59, they live in Qualicum Beach, B.C., a five-minute walk from the Strait of Georgia on Vancouver Island. They enjoy the mild weather, long walks on the beach and their beautiful home.

Trouble is, a lack of employment income combined with debt stalk the good times they thought they would have after they left their careers.

Their jobs paid them a total of about $100,000 per year. Today, as a result of too much house and the repairs it entails — repainting, new floors, new electrical circuits, new kitchen counters, custom French doors and other elegances — they carry a debt of almost $70,000, nearly twice their retirement income of $37,000 a year.

If they pay off the debt, James and Jane would face a cash shortage. They could do it, but it would wipe out all of their RRSPs and other retirement assets built up over their working lives. A tough choice.

“We used to think that our house would go up enough in price to cover our debts,” Mr. Kennedy explains. “But I don’t think you can rely on that.”

Their situation could be resolved by selling the house, yet they fear that having paid too much in renovations, even downsizing might leave them house broke — with a nice abode and nothing else.

“As I approach the age of 60, I don’t want to carry so much debt. There has to be an end to the debt. I want my mind to be clear that when we get our Canada Pension Plan and Old Age Security, we will be able to keep those benefits. We don’t want to go into our sunset years paying off our debts.”

See The Kennedys are not alone. A flurry of recent studies show a significant increase of retirees in debt. First was Investors Group, which said 62% plan to carry debt such as a mortgage into their golden years. Then Royal Bank of Canada came out with its Ipsos Reid poll, which found four in 10 Canadians retired with some form of debt, and one in four began retirement with a mortgage on their primary residence.

“More and more, Canadians are carrying debt into retirement,” said Lee Anne Davies, head of retirement strategies at RBC.

Just this week, BMO Financial Group noted less than half of Canadians 55 and over have a post-retirement income strategy in place and only a third have considered that they might outlive their savings.

It’s a new and dangerous trend.

Unlike their parents and grandparents, who remembered the Great Depression and regarded debt as a first step toward ruin, today’s retirees, especially Baby Boomers born between 1947 and 1966, grew up comfortable with owing others. Indeed, for many who grew up in the expansionary years of the 1960s, it was a normal and expected to have a credit card, fund a university education with loans, graduate to readily available mortgages and then to handy lines of credit from accommodative banks.

“Retirees, especially Boomers, are less averse to debt than their parents were,” says Peter Drake, vice president for retirement and economic research with Fidelity in Toronto. The contrast with earlier generations is stark, Mr. Drake adds. “They lived through a sustained period of strong economic growth and have adopted the idea that they will be well-off.”

Boomers have always had a major influence on consumer trends, and now they are changing the face of retirement as well.

“Boomers don’t have the same sense of saving for bad days that their parents had,” explains Charles Mossman, a finance professor at the Asper School of Business at the University of Manitoba. “When they retire, former workers, especially those who don’t have defined-benefit pensions that provide a guaranteed and sometimes even an indexed cash flow, wind up with more debt service charges than they can afford.”

According to a special report by The Office of the Superintendent of Bankruptcy that was released in 2008, 15.3% of all individual bankruptcies in Canada in 2003 were of individuals 55 and over, up from 6.9% in 1993. “Those over 65 are less likely to be able to recover economically and socially from the bankruptcy,” noted the OSB.

The risk of senior bankruptcy grows with age. A study for the Canadian Institute of Actuaries released June 2007, shows that longevity risk — the chance of living to a very ripe old age — poses the problem of running out of personal savings.

Given Canadians’ extending life expectancy — currently 78 for males, 83 for females — a person retiring at age 55 has a 40% chance of running out of personal savings by age 85 and a 90% chance of being flat broke by age 95. It should be noted the data shows that women, who outlive men on average and tend to have lower lifetime incomes, have even greater reason to fear poverty caused by longevity.

Compounding the longevity problem is the trend, promoted by some financial services companies, to early retirement. Remember Freedom 55? But retiring at that age means giving up what may be one’s most financially productive years. Indeed, if the average retiree has paid down most of his or her debts, and delays retirement to age 62, he or she can live in reasonable financial security, says demographer David Foot, an economist on the faculty of the University of Toronto and author of the 1996 bestseller Boom, Bust & Echo.

It would be wrong to label all debt foolish and all debtors in peril of financial catastrophe, argues Tina DiVito, head of retirement solutions at BMO Financial Group. “There is bad debt and good debt. Bad debt may be what one borrowed for a transitory pleasure, such as a vacation, after which the borrower has to pay high interest rates and gets no tax breaks.

“Good debt bears moderate rates of interest and is payable in a reasonable time period, perhaps as a part of an investment that makes interest tax-deductible,” Ms. DiVito says.

For good debt, consider the case of 61-year-old Montreal retiree Ioanna Jakus, who has maintained a mid-six figure investment portfolio while living on an after-tax income of less than $2,000 per month.

A former bank employee, she has a $10,000 line of credit with her stock broker. “I use the line to buy stocks and bonds,” she says. “I can deduct the interest I pay from my taxable income. My investments have been successful and have more than paid the cost of credit. What’s more, rates of interest are so low that borrowing to invest just makes sense for me.”

Not only has Ms. Jakus made intelligent use of credit, she has done so expertly, selecting low-risk GICs, bonds and blue-chip stocks with strong dividends. “I have always been motivated by the knowledge that only I can control my destiny,” she explains. “My husband and I paid off the mortgage — that was when interest rates were near 20% — and we never borrowed again for spending.

“Of course, I can clear my investment debt in a moment by using cash in one of my accounts. My philosophy has always been not to take risks that I cannot afford, especially when it comes to borrowing money.

“Nobody can look after me as well as I can,” she adds.

That’s a lesson a lot of retirees have yet to learn.

Carney plots cautious rate path

Jeremy Torobin Globe and Mail  

Mark Carney is taking a cautious approach to raising interest rates, weighing Canada’s powerful economic rebound against the uncertainty of an “increasingly uneven” recovery across the globe.

The Bank of Canada Governor became the first central banker in the Group of Seven to raise borrowing costs since the financial crisis and recession, increasing the benchmark overnight rate Tuesday by one-quarter of a percentage point to a still exceptionally low 0.5 per cent.

Policy makers will keep an eye on Europe’s troubles, and won’t move more aggressively than they see fit, the Bank of Canada suggested, even though the economy is rebounding rapidly and inflation will likely exceed its 2-per-cent target this year. Much like in 2008 when the U.S. financial crisis pulled Canada into recession, the country’s economic health depends in large part on policy makers in other countries successfully containing homemade problems.

“Interest rates are incredibly low, given the strength of the domestic economy, but the global story is where it’s at right now,” Eric Lascelles, chief economic strategist at TD Securities in Toronto, said in an interview. “The level of uncertainty suggests there’s not a lot of confidence in the forecasts.’’ The open-ended nature of the announcement sparked a fall in the Canadian dollar and yields on two-year government bonds as investors pulled back their bets on what they had expected might be a series of uninterrupted rate hikes going forward.

The Bank of Canada as suspected has raised its overnight rate by basis points and the banks will most likley follow by raising prime to

This means if you have a 400,000.00 mortgage your payment will increase by as much $60/monthly.

With every 25 basis point increase you can expect $12-$15 dollars per 100,000.00 in mortgage amount.

We expect prime to continue to rise in 2010 and 2011. For as long as interest rates have been recorded 88% of the time people pay less interest with a variable rate, when the right mortgage plan is in place. We recently helped a young family reduce there mortgage from 30 years to 18 years even placing into consideration the antisipated increases.

What would you do with that additional savings? Call 604-802-3983 or introduce us over an email at acalla@dominionlending.ca to someone that you truly care about to see how we can help you today!

Bank of Canada increases overnight rate target to 1/2 per cent and re-establishes normal functioning of the overnight market

OTTAWA – The Bank of Canada today announced that it is raising its target for the overnight rate by one-quarter of one percentage point to 1/2 per cent. The Bank Rate is correspondingly raised to 3/4 per cent and the deposit rate is kept at 1/4 per cent, thus re-establishing the normal operating band of 50 basis points for the overnight rate.

The global economic recovery is proceeding but is increasingly uneven across countries, with strong momentum in emerging market economies, some consolidation of the recovery in the United States, Japan and other industrialized economies, and the possibility of renewed weakness in Europe. The required rebalancing of global growth has not yet materialized.

In most advanced economies, the recovery remains heavily dependent on monetary and fiscal stimulus. In general, broad forces of household, bank, and sovereign deleveraging will add to the variability, and temper the pace, of global growth. Recent tensions in Europe are likely to result in higher borrowing costs and more rapid tightening of fiscal policy in some countries – an important downside risk identified in the April Monetary Policy Report (MPR). Thus far, the spillover into Canada from events in Europe has been limited to a modest fall in commodity prices and some tightening of financial conditions.

Activity in Canada is unfolding largely as expected. The economy grew by a robust 6.1 per cent in the first quarter, led by housing and consumer spending. Employment growth has resumed. Going forward, household spending is expected to decelerate to a pace more consistent with income growth. The anticipated pickup in business investment will be important for a more balanced recovery.

CPI inflation has been in line with the Bank’s April projections. The outlook for inflation reflects the combined influences of strong domestic demand, slowing wage growth, and overall excess supply.

In this context, the Bank has decided to raise the target for the overnight rate to 1/2 per cent and to re-establish the normal functioning of the overnight market.

This decision still leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in light of the significant excess supply in Canada, the strength of domestic spending, and the uneven global recovery.

Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.

Information note:
The next scheduled date for announcing the overnight rate target is 20 July 2010. A full update of the Bank’s outlook for the economy and inflation, including risks to the projection

 Enjoy your week

Angela Calla, AMP,Mortgage Expert
Host of “The Mortgage Show” on CKNW 980 Saturdays at 7pm
DLCBC Mortgage Group Ltd.Tel: 604-802-3983
Fax: 604-939-8795
Toll Free: 1-888-806-8080
Email: acalla@dominionlending.ca
Web: www.angelacalla.ca

For most of her life, 56-year-old Royal City resident Jackie Olds thought owning a home was nothing more than a pipe dream.

The market in the Lower Mainland was spinning out of control. There was no way she could ever afford to own, she couldn’t pay for those tricky, hidden costs. Or, so she thought.

“During my last experience trying to rent a place it was just a nightmare,” she said.

“Everything was overpriced and filthy. I went to this one apartment and lifted up the bread board and it was covered in bugs. I left in tears.”

Once the tears dried up, Olds decided to sit down and take a long look at her budget and see if she could manage the daunting jump into home ownership.

“It’s so scary, you just never feel like you know you can do it,” laughed Olds, now the owner of a condo in New Westminster’s Brow of the Hill neighbourhood.

“But, if you do your homework and you don’t rush in, it’s amazing.”

Soaring prices

While Vancouver has become a place where real estate watching has become a sport of sorts—seemingly never-ending fodder for dinner party and water cooler chatter—those hoping to break into the market can feel overwhelmed at times.

According to the Real Estate Board of Greater Vancouver, the average detached home on the west side of Vancouver currently sells for $1.7 million. On the east side of the city, a detached home goes for around $746,000; in Burnaby, it’s $791,000.

But according to realtor Adam Goss, there are still attractive options for the first-time home buyer who doesn’t make $200,000 a year. The key is to equip themselves with a few tools before making that uncertain leap.

Goss said first things first: understand your finances.

Know where you spend your money and then decide what expenses you’re willing to part with to own a home.

For most, owning a home is a sort of forced savings plan, Goss said, and it’s going to affect your lifestyle.

“I recommend seeking a mortgage pre-approval and working off the figures provided to determine where buyers feel financially comfortable and what will be manageable.”

Find a neighbourhood

From there, the question arises as to which neighbourhood to live in.

Each presents its unique set of real estate hallmarks—from the type of housing available, to the cost, to the amenities you’ll find there.

For example, New West’s Sapperton neighbourhood has a number of 30-year-old condos. These buildings are generally wood-frame with shared laundry areas. These aspects tend to lower the price of a condo, with one-bedroom suites typically in the $165,000 to $185,000 range. For a two-bedroom suite, buyers will be looking in the $200,000 range.

Similarly, New West’s Brow of the Hill—below Sixth Avenue and west of Sixth Street––offers little in the way of new product. The bulk of buyers interested in this area will be looking at 20-year-old wood-frame buildings with one-bedroom units going as low as $150,000.

“The great thing for new residents in New West is the door to this community is wide open,” said Goss.

“Although we do hold on to our history tightly, and people are attracted to that, there is also more of willingness for change and a move forward these days. There are some exciting projects on the go.”

SkyTrain factor

Next door in Burnaby, new construction abounds.

Just over two decades ago, the area around the Edmonds SkyTrain Station—now known as City in the Park—was dominated by forest and ravine, so the buildings there tend to be newer, concrete structures.

In-suite laundry, gyms, saunas and unobstructed views of the mountains are all available, and will affect the value of a unit. Recently sold two-bedroom units in the area have gone for around $280,000, but some have gone for as high as $349,000.

Over in Burnaby’s Metrotown neighbourhood, the city’s busiest area, the first-time buyer will find much of the same.

Recently sold condos have gone for as low as $308,000 for a two bedroom, and the $325,000 range is the average. Where Metrotown separates itself from other popular areas with first-time buyers is its proximity to the mall and the commercial centre of Burnaby. Location within that corridor, however, raises the value of a property, according to realtor Doris Gee.

“People still, of course, work in Downtown Vancouver so living around the SkyTrain in Burnaby just makes sense,” said Gee, who’s been specializing in Burnaby properties since 1989.

“This convenience of Burnaby has always been attractive for this market. And the option to save on a vehicle is important.”

Watch hidden costs

Demographically, the average first-time home buyer in B.C. is between the ages of 25 and 32 years old.

According to Angela Calla, a mortgage broker with Dominion Lending Systems and the host of CKNW’s Mortgage Show, 70 per cent of the province’s real estate purchases last year were first-time buyers.

“The average income we were seeing last year was $45,000, either combined or from one person,” said Calla.

“And a five per cent down payment was the average from that same demographic.”

Calla advises the rookie buyer to be aware of a few of the hidden expenses, such as closing and moving costs.

On a $250,000 home, Calla says, these expenses, coupled with the five per cent down payment, can run as high as $14,000.

And while the financial hoop jumping of home ownership will remain a painstaking inevitability for most, Goss believes the final decision to become a homeowner is always a personal one no matter what the numbers may say.

“You will always end up having the choice on where you will live,” he said. “You’re not being told where to look anymore. Realtors are here to educate you in every step of the process and show you the factors that can affect your purchase. But you will decipher what it is you want and whether you can do it.”

JUNE 1 HIKE IN QUESTION

By Claire Sibonney Reuters   The negative news has led many to question whether Bank of Canada will start raising rates from their current record lows on June 1.

Yields on overnight index swaps, which trade based on expectations for the Bank of Canada’s key policy rate, have fallen in recent weeks and on Wednesday indicated just a 51 percent chance of a June 1 rate increase.

On April 20, when the bank removed its conditional pledge to keep interest rates on hold until the end of June, the market priced in more than a 90 percent likelihood.

Currencies tend to strengthen as interest rates rise as higher rates often attract capital flows.

“Even with the ongoing uncertainty, the Canadian situation warrants a small move toward more normal rates so I wouldn’t unwind the forecast just yet,” said Craig Wright, chief economist at Royal Bank of Canada., whose bank was the last primary dealer to join the call for a June 1 move.

“We’re really just looking at a 25 basis point adjustment … tapping of the brakes rather than slamming them on.”

OTTAWA – Neither recession, global uncertainty nor growing joblessness appears to have stayed Canadians’ appetite for spending money they don’t have.

A new report by the Certified General Accountants Association of Canada shows that household debt in the country kept rising through the recession and peaked in December at $1.41 trillion.

That’s $41,740 on average per Canadian, or debt to income ratio of 144 per cent that is the worst among 20 advanced countries in the OECD.

“This report is another indication of Canadians’ readiness to consume today and pay later,” says association president Anthony Ariganello.

“The concern is do they understand the full cost of paying later?”

The Bank of Canada has also voiced similar concerns, with governor Mark Carney having repeatedly advised Canadians to ensure they will be able to meet their mortgage commitments once rates increase. Ottawa has put that cautionary principle into effect by stiffening the means test chartered banks must apply when issuing open-ended mortgages.

Most Canadians don’t yet share that concern. The accountants’ survey found that almost 60 per cent of Canadians whose debt had increased still felt they could manage it or take on more obligations.

But the accountants say many households could find themselves in difficulty when interest rates, as expected, begin to rise.

The report estimates that even a small two per cent increase in rates would mean that mid-income and higher income households would have to cut their outlays on non-essentials by between nine and 11 per cent.

The finding is similar to one reached by the Canadian Association of Accredited Mortgage Professionals in a survey results release Monday.

The survey showed that while Canadians appeared well positioned to absorb higher rates, there would be a significant number that would come under stress. The mortgage professionals estimated that 475,000 households would be challenged if mortgages rates rose to 5.25 per cent, and that 375,000 were already facing pressure paying their bills.

The most likely outcome for a debt squeeze is that households will stop spending on non-essentials, and that could ripple in a general slowing of economic growth.

Household spending, particularly in the housing sector, was a mainstay of the economy during the recession. But as interest rates grow, a bigger percentage of household income may need to be diverting into paying off debt, meaning less cash for other purchases, like autos, appliances, furniture and clothes.

BMO Capital Markets economist Sal Guatieri says that is the flip-side to the Bank of Canada’s decision to slash rates to historic lows during the recession.

“That’s why we did not experience a great recession,” he noted. “That was the intention all along of the Bank of Canada, to get people borrow and spend. The problem is if that continued, Canada eventually would have a debt problem.”

But that is why the central bank is preparing to reverse course and start increasing the cost of borrowing, he added.

Most analysts believe Carney will start moving on rates on June 1 with a small quarter-point hike.

Courtesy of the Financial Post

Andrew Allentuck, Financial Post  Published: Thursday, May 06, 2010

Taking on a mortgage is a big commitment. Every buyer who uses a mortgage has the choice of floating or going with a fixed rate that often costs a couple of percentage points higher per year. Today, for example, one can get variable rates at an average rate of 2.34% while five year closed rates average 5.27%, according to Fiscal Agents Financial Services Group in Oakville, Ontario. Negotiated rates can be lower.

If rates never changed very much, there would be no contest – the floating rate deal would win. But rates do rise and fall and therein lies the borrower’s dilemma.

Borrowers with kids and an aging car fear that their ability to pay interest rates twice or thrice the current floating rates are limited. “The test is liquidity and risk tolerance,” says Derek Moran, a registered financial planner who heads Smarter Financial Planning Ltd. in Kelowna, B.C. “People with ample liquidity can afford to take a chance on rising mortgage rates. It follows that those who lack liquidity feel some pressure to avoid drastic interest rate increases.”

The point is not merely academic, for Canada, in spite of recent mortgage rate increases, is still at a relatively low point of rates over the last four decades. “There is more room for rates to go up than down,” Moran points out.

The cost of making a decision to float or go fixed varies with the rate differences.

In 2008, Moshe Milevsky, Associate Professor of Finance at the Schulich School of Business at York University, and Brandon Walker, a research associate at the Individual Finance and Insurance Decisions Centre in Toronto, published a study that measured the direct and opportunity costs of going with either choice. “Over the long run, homeowners really do pay extra for fixed rate mortgages,” they concluded.

The reason is intuitive. Lenders do not want to take the chance that when they have to refinance a loan that they will be stuck paying more than they are getting.

Mismatching what they lend with the cost of what they borrow can cut their profits and even lead to insolvency. So lenders attach what amounts to an interest rate insurance fee and bundle that into the price of money they lend on fixed terms.

Milevsky and Walker confirmed this explanation. “The study showed that a positive Maturity Value of Savings [the value of investing the difference between floating and fixed mortgages in 91-day T-bills] was positive the majority of the time, so the homeowner saved by using a variable-rate mortgage.”

The amount of money that the homeowner can save by taking a chance on floating rates varied in the Milevsky and Walker study, depending on the time periods in question. But the average amount was impressive: $20,630 as of 2008. Put another way, floating allowed borrowers to cut the time it would take to pay off the mortgages by a year or more, in some cases as much as five years on 15-year amortizations.

Rational calculation and personal feeling are, of course, different things. A person with a fixed income and a great deal of debt may be reluctant to put a rate casino between himself and the lender and will therefore go with certainty, even at a high price.

It is also a matter of experience. “First time buyers tend to pay close attention to the cost of the mortgage,” says Laura Parsons, Areas Manager of Specialized Sales – which includes mortgages, for the BMO Financial Group in Calgary. For them, the appeal of locking in is relatively high. Their mortgages are new, the amounts they owe are higher than they would be 10 or 15 years in future when the mortgage is substantially reduced, and their incomes, often early in their adult lives, are lower than they will be in future.

“First time home buyers are net debtors and they don’t want to endanger their finances,” suggests Adrian Mastracci, a portfolio manager and financial planner who heads KCM Wealth Management Inc. in Vancouver.

There are other strategies that the buyer can use to provide some rate insurance without taking on what Milevsky and Walker have demonstrated as the high cost of peace of mind.

“The buyer can take a variable rate mortgage but set payments higher than the minimum required” says Parsons. “That could be at the 5 year closed rate, which would mean a faster paydown and growing asset security while still keeping the low cost of the variable rate mortgage. Faster paydown is itself cost insurance if interest rates do rise.”

Banks are nothing if not inventive in helping clients cope with the fixed versus floating dilemma. For example, TD Bank offers to give 5% of the amount borrowed on a five or six year fixed rate residential mortgage to the borrower. The program, aptly dubbed the “5% CashBack Mortgage,” implicitly acknowledges that fixed rate loans can be more costly than variable rate ones.

For its part, RBC has a RateCapper Mortgage that builds on the initial low cost of a variable rate mortgage but limits the cost if rates shoot up. On a five year mortgage, the borrower will never pay more than the capped rate and if the variable rate, based on the prime rate, drops below the RateCapper mortgage maximum, the interest rate charged to the borrower also drops. The plan is a compromise and spreads interest rate risk. Many other lenders allow borrowers to mix fixed and variable rates, thus accomplishing a similar goal.

Plan selection, it turns out, is gender-related. According to a BMO survey, men, 44% of the time, are more likely than women to choose a fixed rate mortgage than women, who make that choice only 28% of the time. Women, it turns out, tend to make the better choice, for as BMO’s analysis shows, “fixed rates were advantageous during only two periods – through the late 1970s and in the late 1980s, in both cases ahead of a period rising interest rates, as is the case now.”

So where are interest rates headed? The yield curve, a line that links interest rates for periods of time from 1 day to 30 years, implies that rates will rise, but not very much.

There is no sense that we are returning to a period of double digit rates. Moreover, there are deflationary forces at work, notes Patricia Croft, chief economist of RBC Global Asset Management in Toronto. “The present crisis in European finance and the potential fizzling out of the present recovery in North American capital markets could presage falling inflation and even disinflation – the subsidence of rising prices and interest rates,” she explains..

BMO forecasts that the rising Canadian dollar will put downward pressure on consumer prices, reflecting the fact that much of what Canadians eat and use is imported. Inflation could flare up, BMO’s economists say, but there is a balanced risk of declining prices. For now, the Bank of Canada is being very cautious in its interest rate management commitments. For those who are strapped for cash, personal circumstance may dictate the choice of a fixed rate. But for everyone else, the folly of trying to make interest rate predictions over a business cycle and to predict both the short term rates and the long term rates along the yield curve should be apparent. No promises, of course, but the odds of saving money are with borrowers who choose variable rate plans or those that emulate them.