Mortgage rates, car loans hit by credit crunch

As the global financial crisis continues, many companies and consumer face an apparent economic paradox.

While central banks in many industrialized countries chop short-term interest rates to boost economic growth, what it costs to borrow money to buy a house or a car will likely rise in the coming months.

On Wednesday, five central banks — the U.S. Federal Reserve Board, the Bank of Canada, the Bank of England, the European Central Bank and Sweden's Riksbank — all cut their near-term borrowing rates by half of a percentage point.

That followed Tuesday's breathtaking reduction of one full percentage point by the Reserve Bank of Australia.

The government banks are trying to reduce borrowing costs for other financial institutions and repair the increasingly illiquid capital markets around the globe.

"Interbank lending is essentially frozen," federal Finance Minister Jim Flaherty said Thursday in Ottawa.

Canada's central bank rate has set its target for overnight lending at 2.5 per cent while the U.S. Federal Reserve's fed funds rate now is pegged at 1.5 per cent.

At almost the same time, however, the TD Bank hiked what it charges on variable-rate mortgages, a move many analysts expect to be mimicked by other banks.

In fact, on Wednesday, the rate on a one-year open, or flexible, mortgage rose to 8.8 per cent at TD and 8.5 per cent at Royal Bank of Canada.

Thus, while central banks are trying to stimulate economies by reducing some borrowing costs, banks are increasing the interest rates they charge on long-term lending.

The divergence between what central banks want to happen and what is in fact occurring in lending markets highlights the difference between short- and long-term interest rates. 

Quicker cash, lower cost

Short-term interest rates refer to the amount charged for lending money for a few hours, days or months — always less than a year.

For instance, with its well-followed monetary policy decisions, the U.S. Federal Reserve is changing the rate that one bank charges another institution to borrow — usually for a few hours, not days — excess cash deposited at one of the Fed's regional banks. 

The rate on this type of near-maturity money is where central bank cuts pack the biggest monetary punch.

Thus, when people talk about interest rate reductions affecting borrowing charges, they are referring — intentionally or not — to the market for cash with a near-term maturity attached.

Corporate risk

Even in the short-tem market, however, not all money is created equal.

Take a one-month treasury bill. The interest rate on this instrument is what the government gives lenders to obtain their dollars for a month.

Right now, the T-bill interest rate is 0.5 per cent in Canada, according to the Bank of Canada. The low rate reflects the fact that the government will be able to repay this money.

The cost of the same short-term money jumps, however, as soon as lenders look at commercial companies.

For instance, the rate on one-month corporate paper stands at 3.73 per cent, or seven times what the government will pay for money for the same time period.

In the current environment, lenders face the real possibility that the company to whom they have given cash may not be able to repay the funds within a month.

The higher interest rate reflects that risk.

In addition, interest rates are normally higher on bonds and other financial instruments when the money is lent for longer periods.

Essentially, it costs more to borrow cash for a year than it does for a month, five years more than one year, and so on.

That relationship should not come as any surprise. 

After all, the bank or other lenders are making a guess at future inflation rates and whether the person or company borrowing the cash will still be around to repay the money in a couple of years.

That higher risk of bankruptcy, known as a risk premium, is reflected in the interest rate for these instruments.

For example, in September, the yield — a proxy for interest rate — on a corporate bond due in 24 months stood at 3.99 per cent. 

If the company borrowed the money for 20 years, however, the rate jumped to 6.17 per cent, a big spike in the cost of securing this cash for two decades.

In the chart, the longer the maturity period for these Canadian government bonds, the higher the interest that is paid.

It is this relationship that partly explains TD's mortgage hike. 

Mortgage matching

Historically, companies that lend money to home purchasers try to match up the terms of the mortgage with the terms of the cash that the bank or other institutions will use to cover their lending.

Suppose, for instance, TD wants to lend a home buyer $100,000 to be repaid within 20 years. The bank will head into the money market to secure $100,000 to cover the mortgage loan for the next two decades.

So, the higher interest rate the bank charges is partly explained by the longer period that person borrows the cash.

Borrowing suffers

Tim Hockey, president of TD Canada Trust, calls the present situation  "continued market turmoil." Many investors call it "financial Armageddon." 

By whatever name, however, the problems faced by global banking and other lending institutions staying fiscally solvent is also weighing on individuals' borrowing.

"The availability of credit is a concern," Flaherty said.

Since the financial meltdown began in earnest in September, lenders are much less willing to dole out dollars. They are now increasingly worried that borrowers will not be around to repay the money in the near future.

Thus, like any other market, as the supply of available cash dries up, the cost of that money in the form on higher interest rates jumps as well.

One closely watched indicator is just how tight the world credit markets are getting is the Libor rate — an international measure of what the banks charge each other to lend money.

The Libor rate for overnight lending, measured by the British Banking Association, fell to 5.03 per cent Thursday, a steep decline from Wednesday's 6.87 per cent.

But, back in quieter times, the rate stood at a fraction of its current level.

For example, on Dec. 1, 2007, the overnight Libor rate was just 2.1 per cent.

Any money that Canada's chartered banks borrow might well be at an even higher interest rate than the Libor, meaning the cost of a new mortgage or car loan — if you can get one — is moving up.