A very interesting Monthly Indicators report from CIBC World Markets this month. For two reasons, one the Mortgage strategy of providing a 12 month teaser period for consumers at a heavily discounted rate with the option to convert into potentially lower fixed "Floor" rates in 12 months continues to be a very viable strategy. Secondly, Benjamin Tal wrote a very interesting article on "Exotic Mortgages" and the fact that US $2 Trillion will have rate resets in the coming 24 months……the largest reset in US history.
First off, the forecast over the next 12 months is for Prime to go down 100 bps over the next 12 months and for long term bond yields to decrease by 60 bps.
If a customer takes a Standard ARM and closes in December 2006, the Floor rate is P-1.20 for 12 months. If I follow CIBC World Market predictions the average rate the customer would pay over that 12 months is 4.20% (starting at 4.70% and dropping to 3.70%). If they lock into a 5 year fixed at the end of the teaser and the forecasting holds true, they should obtain a Floor Rate of about 4.69% (60 bps lower than today's Floor Rate) in Dec 2007. Therefore the average rate over 6 years would be 4.60%.....not bad for 6 years if the forecasting holds true.
The reason Prime forecasting has been increased to a drop of 100 bps is the fact that the slowing of the US economy and all the forecasting of a slow down south of the border has not impacted the Canadian dollar as much as it usually does. This is because the US economy used to routinely account for 30% of global GDP growth and now it only accounts for half that much. Far less then that, when it comes to global demand of most commodities, so the US no longer has as much of an impact on the global economy as it once did. The combination of a high exchange rate and a retrenching US consumer, has the potential to turn a mid-cycle slowdown in the US economy into something a lot uglier in Canada and particularly in Ontario, which has North America's largest auto production. If commodity prices don't fall steeply, it will take the Bank of Canada interest rate settings to bring the Canadian dollar down to a favorable level to combat the economic downturn ahead.
How Painful Will Mortgage Rate Resets Be?
The upcoming mortgage rate reset in the US mortgage market will see $2 Trillion of mortgage debt being adjusted upward. The Fed funds rate has risen 425 bps and American households mortgage rates are up only 30 bps on average. This is because a majority of ARMs were given teasers and not 3 or 12 months like here in Canada, but two or even three years. For most of these loans, the teaser period is now ending and it's "payback time". This is a credit quality issue because the recent surge in ARM activity concentrated on high risk borrowers and exotic mortgages such as Interest Only and Negative Amortization Option ARMs. Many of these high risk borrowers had little or no equity to begin with and may have a modest price correction to deal with on top. The mortgage delinquency rate is already on the rise in the US.
The US financial sector is heavily exposed to the real estate market, with home loans and mortgages representing 40% of total loans and leases. The most significant impact may be felt in the MBS Market where non-agency (private) issuance has been rising much faster than MBS issuance from agencies like Fannie Mae. Non-agency issuance has doubled to more than US$1 Trillion in just the past few years and its percentage in the MBS Market has risen from 25% in 2000 to more than half today. The strong increase in private issuance coincided with the sub prime boom. Current non-agency/agency MBS spreads have not yet reflected in the credit quality of non-agencies, but the prediction is that this will change soon.
