If the Bank of Canada was permitted to do so, would it tighten home lending standards?

There’s reason to wonder. The central bank said on Tuesday that it expects record household debt levels to keep rising.
 

In one way, that’s good. With Europe’s economy likely in recession and China’s red-hot economy cooling to a more sustainable pace, domestic spending will continue to help Canada push through the current turbulence.
 

But it seems the Bank of Canada would be willing to forgo yet more debt-fuelled spending.
 

Policy makers made no mention of household debt in their previous statement. That’s significant. Governor Mark Carney and his deputies have expressed concern about household debt in speeches, and they have made note of the risk in formal reports on the financial system. Now, policy makers are discussing Canadians’ extreme debt levels in terms of setting policy for the broader economy. The threat level, as far as the Bank of Canada is concerned, is rising.
 

The prediction that household debt levels will continue to rise is an admission that Canadians are paying closer attention to the central bank’s actions, rather than its words. Mr. Carney’s increasingly severe warnings about the perils of debt last year apparently were no match for the once-in-a-lifetime allure of incredibly low mortgage rates.
 

This is why some academics argue that central banks should be given more power to fine-tune their policies.
 

Aside from public warnings, the Bank of Canada’s only direct means to influence consumer behaviour is to raise interest rates. But doing so now would be a mistake because companies need to be encouraged to borrow and invest. Higher interest rates also would inflate the value of the dollar, which would cripple Canadian exporters that the Bank of Canada already considers to be broadly uncompetitive.
 

It could be argued that the commercial banks should act more responsibly. Don’t count on it. Just as consumers have a powerful incentive to borrow, the banks have a powerful incentive to lend. It’s mostly risk-free lending because the mortgages are insured by Canada Mortgage and Housing Corp. (CMHC). And no lender driven by the profit motive is going to turn down that opportunity unless it is forced to by the government. Just listen to Toronto-Dominion Bank chief executive officer Ed Clark:
 

“The reality is it’s not like we don’t offer 25-year amortization mortgages or 20-year amortization mortgages. People can pick their amortization periods. But if you offer them more choice, overwhelmingly they will choose the longer period, and so the question, is would one bank say, ‘Well, I don’t care what you want; we’re going to only offer 20-year amortization mortgages,’ while everyone else offers a 30-year amortization? We know what would happen – TD would no longer be issuing mortgages and everyone will go across the street. That’s what the public has said by the way they act.”
 

Mr. Clark made the comments during a discussion with former Bank of Canada Governor David Dodge last month in Toronto. (The event was a semi-private affair for clients.
 

Underlying the Bank of Canada’s concern, Mr. Clark has said publicly that the maximum amortization period for home loans should be lowered to 25 years and that Ottawa should implement a qualifying rate, which would lower the default risk when official borrowing rates eventually rise.
 

The reason for doing so is to avoid the day when households realize en masse that they are overextended and must retrench. When this happens, the normal incentives to borrow and spend are ignored. In the U.S., consumers can get 30-year mortgages at rates of about 4 per cent – and they deduct the interest payments against their taxes. Yet half of TD’s U.S. customers are choosing 15-year home loans, a sign that the recession has had a significant effect on consumer behaviour. That helps explain why the recovery has been so torturous. “That’s what we don’t want to go into, is where we get that collapse and then we have to dig our way out of it,” Mr. Clark said at the December event.
 

Mr. Dodge explained the limits on the Bank of Canada’s ability to deal with the issue on its own. He said low interest rates are necessary for the broader economy, but not for housing. However, it’s CMHC and the Finance Department that sets the rules for housing. As with the public, the Bank of Canada can only sound the alarm. Action will depend on whether the politicians agree.
 

“This is a very judicious balancing act, and unfortunately it’s the Bank of Canada on one side that does the monetary policy, and Canada Mortgage and the Department of Finance on the other side that does the regulation,” Mr. Dodge said. “And that really does require much closer policy co-ordination between the three parties.”

All across the country, mortgage specialists and brokers are busy fielding calls from people who’ve just heard about this week’s record low mortgage rates.
 

Bank of Montreal made the biggest splash by announcing a five-year fixed-rate mortgage of 2.99 per cent – the lowest advertised rate for such a popular mortgage term by any major Canadian bank, ever.
 

Yes, there are more restrictions than usual attached to this mortgage and it’s supposedly just a two-week promotion.
 

But other big lenders – like the Royal Bank – have already begun to match BMO’s offer. TD Canada Trust and Scotiabank now have a similar interest rate for four-year fixed-rate mortgages and TD this week lowered its six-year fixed rate mortgage to 3.79 per cent – a drop of more than a full percentage point. It also lowered its seven-year mortgage by almost a full percentage point to 3.99 per cent.
 

So what’s driving all these rate plunges at the chartered banks?
 

One element is that bond yields have been plunging recently, so market watchers say it’s not too surprising to see other rates drop, too, a reflection of there being more cash in the system.
 

“Mortgage rate declines have actually been lagging behind falling bond yields, driven by global economic uncertainty,” says John Andrew, a real estate expert and professor at Queen’s University’s School of Urban and Regional Planning. So what we are seeing here is a bit of catch up on the part of mortgage rates.
 

It is the bond market that is the bigger driver of longer-term fixed mortgage rates, not the Bank of Canada’s overnight rate, which directly affects variable mortgage rates and other floating loan rates.
 

With stock markets shaky and volatility reigning in the currency and commodity markets, nervous investors have been stuffing money into safe Canadian bonds – driving up prices and driving down yields.
 

The other reason cited by the experts is competition. “The first few months of the year are typically slower for the mortgage market,” says Mark Kocaurek, the chief lending officer at ING Direct Canada.
 

In a commentary earlier this week for RateSupermarket.ca, he wrote that he expected lenders would lower fixed rates “over the short term in order to win more business.” A couple of days later, they did just that.
 

Time to break your mortgage?
So if you belong to one of the estimated three million Canadian households that currently have a fixed-rate mortgage, you’re probably wondering whether it’s worth trying to get in on this super-low mortgage-rate action.
 

The bottom line from the experts: it depends.
 

For one thing, there’s the penalty you pay if you do want to make a change.
 

The cheapest fixed-rate mortgages are closed mortgages – meaning that you can’t escape the interest rate you agreed to pay for five years unless you pay the lender compensation for the interest it would lose by letting you switch from a higher interest rate mortgage to a lower one.
 

There are two main variables that determine the prepayment penalty to get out of a fixed-rate mortgage early:

• The difference between your higher-rate mortgage and the current mortgage rate, known as the interest rate differential penalty; and
• The amount of time remaining in your mortgage’s term. The longer the time, the bigger the penalty.

It’s a complicated calculation – made all the more so because financial institutions have different ways of calculating penalties.
 

Some base their calculation of interest rate differentials on the posted rate (the current posted rate for a fixed five-year mortgage, for example, is 5.29 per cent – far above the actual 2.99 per cent lenders are now charging.) Some lenders, though, use their discounted rates to do the calculation.
 
 

If you want to switch, the only way to know for sure whether you’d be further ahead is to ask your current lender how much it would charge to release you early from your mortgage.
 

Once you have that figure, it’s a relatively easy matter for any independent mortgage broker to figure out whether it’s worth your while to make the switch. Will the added costs of the prepayment penalty, and other costs that might be involved, be covered by the much lower payments over the next five years?
 

A good broker can also explore other alternatives to lessen the blow. For instance, some lenders eager to build market share may offer incentives that would cover much of the penalty.
 

By the way, those penalties can be huge.
 

“Fixed rates are attractive to people because they want to avoid risk, but one of the biggest risks you can have is the interest rate differential (IRD) penalty,” says Aaron Vaillancourt, principal broker at Centum Engage Mortgages in Toronto.
 

“The penalty can be as much as the realtor fees,” he says, sometimes even more. Vaillancourt says he has one client with a $290,000 mortgage who is facing an IRD penalty of $32,000.
 

There’s no question that low mortgage rates are great for first-time buyers or others whose mortgages are now just coming up for renewal.
 

But some economists warn that these low rates will do nothing to keep a lid on what’s been called an “overheated” real estate market in a few Canadian cities.
 

Others point out that the added restrictions on some of these 2.99 per cent mortgages – such as no amortizations longer than 25 years – will help to keep out the barely-qualified.
 

What there’s no debate about is that low rates have already saved Canadian borrowers billions of dollars.
 

The Canadian Association of Accredited Mortgage Professionals estimated recently that the 1.35 million mortgage holders who renewed their mortgages in the past year saved an average of $2,000 a year in interest costs – or $2.7 billion a year in total.
 

The Facts
 

In this case, the Plaintiffs were husband and wife and were also the parents of two young children. They purchased a property in Bracebridge with the intention of using it as their residence. Upon purchasing the property, the Plaintiffs became aware that it was common knowledge that a person convicted under the child pornography provisions of the Criminal Code lived across the street from them.
 

Had the Plaintiffs known of this fact, they would not have purchased the property. As such, the Plaintiffs brought an action against the Sellers and their agent for failing to disclose this fact, which they were aware. The Plaintiffs argued in part that the fact was a latent defect such that it should have been disclosed to them.
 

The Arguments
 

The Defendants brought a motion to dismiss the Plaintiffs claim arguing that “it is plain and obvious that the fact that the person lives across the street was convicted of child pornography (1) is not a latent defect because it was common knowledge in the neighborhood, and could have been discovered on reasonable inquiry, and (2) in any event, the plaintiffs have not pleaded that such fact creates a risk of physical harm or danger to the inhabitants.”
 

The Plaintiffs in turn, argued that the courts seem to be broadening the doctrine of latent defects as evidenced by Swayze v. Robertson. In Swayze, the court held that a latent defect is one which is not readily apparent on a routine inspection. The Plaintiffs argued that in their case, similarly to Swayze, the criminal record of the neighbour could not be ascertained from a routine inspection. The plaintiffs further highlighted that the intended use of the property – as a home for the family which included young children- was known to the defendants and that the particular criminal record of the neighbour was a defect given the intended use.
 

Also, the Plaintiffs advanced that their case is similar to Sevidal v. Chopra in which liability was found in relation to risk not on the property itself, and not a structural problem. Similarly, in this case, the risk (the neighbour) “is not on the property but presents a potential danger to the children of the purchasers of the property.”
 

The Decision
 

The Defendants’ motion was pursuant to Rule 21.01(1)(b) of the Rules of Civil Procedure which states that “a party may move before a judge, . . . (b) to strike out a pleading on the ground that it discloses no reasonable cause of action or defence.”
 

While the court recognized that the plaintiffs’ claim is novel and raised policy issues (including the protection of children), the court concluded that it was not plain and obvious that the plaintiffs’ action was certain to fail and thus, the court dismissed the defendants’ motion.
 

The Moral
 

This case will likely never proceed to trial, as such uncertainty will continue to surround the subject of stigmatized properties in Ontario. In wake of this decision, agents and sellers should err on the side of caution when dealing with stigmatized properties and disclose such information especially when there is a potential danger posed to the potential purchasers.

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