Banks cut rates

Royal Bank of Canada's Barbara Stymiest paused at midday yesterday in the midst of explaining the balancing act that's required to fund a major financial institution during a credit crisis.

The chief operating officer had been talking about the need to keep lending to customers at reasonable rates while at the same time maintaining a safe and sound bank.

A federal program announced hours earlier that would see up to $25-billion of mortgages taken off bank balance sheets would help the banks to a degree, but no bank had cut rates on the news.

"I bet you a beer some day that that's not likely to happen," Ms. Stymiest said.

Minutes later, an incessant BlackBerry brought the news: Toronto-Dominion Bank had cut rates. The COO left the room for a moment to tell her own team what move to make, and walked back in owing reporters a beer.

Not even the country's top bankers can predict the state of affairs in the industry today, where a flurry of market forces are changing the game by the minute.

In a series of announcements, Canada's banks reduced their prime lending rates yesterday afternoon.

The brinkmanship really began on Wednesday, when the Bank of Canada cut its key rate by half a percentage point, and each of the banks reduced their prime rates by only a quarter point, keeping half the savings.

Yesterday morning, Finance Minister Jim Flaherty moved to ease banks' borrowing costs by having the Canada Mortgage and Housing Corp., a government agency, buy up to $25-billion in mortgages over the next year.

"The Finance Department's move on mortgages is exactly what the government needed to do to lower the cost of funding to Canadian home buyers," said Tim Hockey, president of TD Canada Trust. "This will have a real and immediate benefit to the banks and to mortgage holders."

While TD was the first bank to lower rates yesterday, its 15-basis-point reduction was quickly trumped by Bank of Nova Scotia, which reduced its prime rate by a quarter point. Canadian Imperial Bank of Commerce also reduced by 15 basis points, while Bank of Montreal and RBC matched Scotiabank.

Competitive forces were at work as the banks each try to keep their domestic lending businesses strong. But they were difficult decisions to make.

Ms. Stymiest noted that the central bank's rate cut on Wednesday did not provide any more liquidity to the system.

The reduction in prime rates "gouge[d] the profitability of the Canadian banking system, and I'm not so sure that's a great thing to do at this point in time when safety and soundness and having enough capital" are so important, she said.

The Bank of Canada has already stepped into the market with $20-billion in loans to the banks to finance short-term lending, in addition to interest rate cuts and other measures to increase the banks' access to cash.

In an Ottawa news conference yesterday, Mr. Flaherty said Canada Mortgage and Housing Corp. would purchase $25-billion worth of CHMC-insured mortgages now held by the banks in order to help finance new lending.

Mr. Flaherty said the government has consulted the banks for months about steps it could take to ease the credit crunch, and was responding to their difficulty in raising funds for medium-term loans. "This is going to make loans and mortgages more available and more affordable for ordinary Canadians and businesses," he said.

The Finance Minister said the mortgage purchase does not represent a bailout of the banks. Rather, the government's CHMC will be purchasing "high-quality assets" that, in normal times, the banks would be able to use as collateral for borrowing in credit markets. The first tranche, expected to be $5-billion, will be bought at auction, scheduled for Oct. 17.

In contrast, he noted, U.S. and European governments have launched massive programs to buy non-performing loans and subprime mortgages from lenders in an effort to keep them afloat and to keep the credit system functioning.

Ottawa maintained that the plan will not cost taxpayers any money because the loans were already insured by Canada Mortgage and Housing Corp. The government will be earning an unspecified rate of return on the mortgages.

Mr. Flaherty said the government imposed no conditions on the banks in exchange for their $25-billion purchase plan, but that Ottawa expects they will use the additional liquidity to lower borrowing costs and increase the availability of credit.

However, some economists question whether the banks will boost their lending, or whether - after offering modest rate reductions - they will primarily use the federal money to improve their balance sheets and protect their shrinking profit margins.

"The banks are de-risking themselves. They're basically shutting down credit and they're laying low," Queen's University finance professor Louis Gagnon said in an interview.

"They're hoarding cash right now. That's why we don't see any of the liquidity that has been provided by the Bank of Canada or the Federal Reserve in the U.S."

While the federal action will provide some relief, Canadian corporate borrowers are finding themselves caught in a more fundamental credit squeeze between increasingly risk-averse banks and deteriorating business conditions, said Jayson Myers, president of the Canadian Manufacturers and Exporters association.

He said the market no longer knows how to value assets, including accounts receivable, that are typically used as collateral on lines of credit and other loans.

In a nutshell

The plan

The federal government, through Canada Mortgage and Housing Corp., will purchase $25-billion worth of CHMC-backed residential mortgages from banks and credit unions. The purchase will be conducted through an auction process at market prices. The first sale is scheduled for Oct. 16, and would amount to up to $5-billion.

The assets

The mortgages are considered "high-quality" assets that are not in arrears, and the government insists the program is not a bailout for Canadian banks, which remain sound.

The payoff

Ottawa expects to make money on the deal because it can borrow money to pay for the program at a considerably lower rate than what the mortgage holder pays.

The problem

The banks are finding it difficult and increasingly expensive to borrow to fund their own lending. Canadian banks have been paying a premium of almost three percentage points in attempts to roll over long-term debt recently - a huge spread that means big losses for the banks.

The solution

With the government program, they won't have to go to the bond market to roll over debt. They can do it through the new facility, and get Government of Canada bonds in return. This will increase their cash positions, hence increasing the availability and lowering the cost of mortgages and lines of credit.

The risk

The government will be taking on additional risk by encouraging the banks to issue more CHMC-insured mortgages while the housing market remains s shaky. There is also a concern that the banks are becoming overly risk-averse, and will unduly cut back on lending even though they have better access to funds.

(prepared by Shawn McCarthy and Andrew Willis and Tara Perkins /Globe & Mail)




The Canadian housing market

Mortgage debt has declined to about 30 per cent in Canada, while it has risen to a record 55 per cent in the U.S.

RATIO

U.S.
Q2 2008: 0.55

Canada
Q2 2008: 0.31

The share of mortgages in arrears remains near historic lows in Canada.

U.S.
Q2 2008: 4.5%

Canada
Q2 2008: 0.3%

(KATHRYN TAM/THE GLOBE AND MAIL; SOURCE: DEPARTMENT OF FINANCE)