Mortgages, markets, money and more
Should you lock in your mortgage?
The Globe and Mail
The perpetual question for people renewing or taking out new mortgages is whether to lock in to a fixed-rate mortgage, or go with a variable-rate mortgage under which the rate floats along with the prime rate used by the banks for top borrowers. Today, the choice has never been more complicated as a result of a credit crunch that has caused lenders to ratchet up borrowing costs for both consumers and businesses.
Example: Lenders of all types have been offering fixed-rate mortgages at rates that are inflated well beyond what they would be under normal circumstances, even after the usual discounts are applied. Meanwhile, discounts on variable-rate mortgages have all but disappeared at the dominant lenders, and at least one of the big banks, Toronto-Dominion, has added a rate premium of 1 percentage point to its variable-rate loan. Prime today is 4.75 per cent. Rather than follow the previous custom of offering a discount of 0.6 to 0.9 of a point or more off prime, TD is offering this kind of mortgage at prime plus a percentage point, or 5.75 per cent.
Fully discounted five-year mortgages (that’s what people usually choose if they go with a fixed rate) are running at about 5.45 per cent. That’s not a bad rate by historical standards, but here’s the thing: With the economy weakening, it’s widely thought that the Bank of Canada will start a declining rate trend that will push the prime rate lower. If that happens, borrowers with variable-rate mortgages will immediately benefit. Of course, people with variable-rate mortgages will be vulnerable when the economy rallies and interest rates start to move up again. But that could be a long time off. Bottom line, fixed-rate mortgages offer security in uncertain times at a fair price. Variable-rate mortgages, if you can still get one at prime, offer a chance to wring some personal benefit out of an economic slowdown that causes interest rates to fall.
What’s the worst-case scenario?
Apocalyptic scenarios are tempting, but this isn’t the Great Depression. Economists are close to universal in predicting a U.S. recession. France and Ireland are already in one. Canada’s growth is the slowest in almost two decades, and a couple of banks are predicting Canada’s gross domestic product is set to contract for at least two quarters in a row (the classic definition of a recession). But these won’t be severe contractions. For now, most economists predict sluggish growth in the world’s richest countries through most of next year. That’s because demand from China, India and other emerging markets, which give exporters somewhere to ship their goods, will buoy faltering commodity prices. Try to put those heady days of the last few years out of your mind, but there’s no need to stock up on canned goods and sell the family jewels just yet.
How is the Bank of Canada different from the U.S. Federal Reserve?
All major central banks share a mission as lender of last resort. They also seek to set the tone for the economy by raising or lowering benchmark lending rates. It’s how they perform this latter function that differentiates them. The Bank of Canada, like most major central banks, has a legislated mandate to keep a lid on inflation. In the Bank of Canada’s case, the mandate is to keep prices advancing about 2 per cent a year. The Governor, advised by five deputies on the Governing Council, sets the Bank of Canada’s overnight target for loans between banks at whatever level he deems necessary to achieve that goal.
The Fed has a slightly different mission. While it is charged with containing inflation, the Federal Open Market Committee also sets borrowing costs to promote full employment, economic growth and a sustainable pattern of international trade. The FOMC, the Fed’s equivalent of Canada’s Governing Council, also is a larger body, consisting of the Fed chairman, the six other members of the Board of Governors and five of the presidents of the Fed’s network of regional banks.
What is money?
Money represents stored value and is used to make transactions easier and assign value to goods and services. Prior to its introduction, people would barter for what they wanted. But problems inevitably arose: What if you wanted to get a shiny new axe from the vegetarian down the road, but all you had to trade was a side of beef? To get around such issues, money was created so that everyone could get their hands on what they wanted, regardless of what they had to offer in exchange. Currency, on the other hand, is the type of money everyone in the country agrees to use. Money can be virtually anything. Playing cards were used in New France from 1685 to 1728 after the colonial government ran out of livres.
What happened to gold as the basis of our currency?
The gold standard was a monetary system based on the idea that every bank note could be exchanged for shiny bars of gold. A country tied to the gold standard had to have enough of the precious metal to back the currency completely. Besides the challenges of finding gold and storing it safely once acquired, the gold standard limited a nation’s money supply to the amount of gold on hand even as the economy expanded, which made it difficult for governments to influence their economies.
The Globe and Mail
Canada first untethered its dollar from the gold standard at the onset of the First World War, as worried investors rushed to get their capital out of banks. This threatened the viability of the financial sector, because if the banks couldn’t meet their clients’ demand for gold they were required to close. Canada went back to the gold standard in 1926. It was abandoned for the last time in 1929, in favour of a currency backed by a government promise rather than an underlying commodity. The United States held on to the gold standard until 1971. With the U.S. no longer setting the value, other nations followed suit and the system is no longer in use.
What was behind the Federal Reserve’s plan to buy up commercial paper?
The central bank is stepping in as a buyer of last resort in the $1.6-trillion market for commercial paper. This is a form of short-term debt that thousands of companies use to finance their daily operations, including paying employees and buying supplies. The Fed hopes to kick-start this market and free up funds for corporations. The central bank said it was taking the action because money market mutual funds and other investors were loathe to buy commercial paper.
Ian Stannard, a currency strategist at BNP Paribas in London, described the move as “probably the first piece of news we’ve had that starts to address the underlying problem in the financial system. This is a very pro-active step and will be a huge help to getting things moving again.”
How effective will the Fed’s new measure be?
The historic move should unclog the market for these business IOUs, helping to insulate the real economy from the credit crunch. The hope is that, over time, private investors will feel confident enough to return to the market, allowing the Fed to withdraw. The catch is that the commercial paper market is just one piece of a massive and interconnected credit system that is no longer functioning, and the Fed can’t possibly nationalize it all. Douglas Porter, deputy chief economist at BMO Nesbitt Burns, said the central bank is putting itself even more into the “credit creation process” and taking on more risk as a result.
Will it work? “This welcome step should alleviate some of the pressure on companies which were finding even day-to-day operations difficult to manage … Still, the problems besetting the credit markets are so multi-dimensional that no move will be a single fix,” Mr. Porter said, noting the Fed wants to use every measure possible before cutting its benchmark Federal funds rate.
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