SIGNS POINT TO CREDIT CRUNCH RELIEF

January 16, 2008

A stream of subprime garbage may be pouring out of the financial sector, the stock market may be cratering and the U.S. consumer may be about to cave, but amid the gloom there is one bright spot: The credit crunch is rapidly easing.

Although a newspaper report on Wednesday suggested Canadian banks may not match an expected interest rate cut from the Bank of Canada next week because their own cost of borrowing has escalated -- their own cost of borrowing has in fact tumbled in recent weeks.

"We've seen a tremendous decline even in recent days in interbank rates," said Douglas Porter, deputy chief economist at BMO Capital Markets. "Quietly, they were declining fairly steadily last December, certainly heavily helped by the moves central banks undertook [to inject liquidity], partly as a natural course of events, but also to some extent because the interbank rates are pricing in further easing by the central banks."

Canada's interbank lending rate, or the rate commercial banks charge each other to borrow funds -- a key conduit of global financing -- has dropped to about 4.17% for three-month money from a peak of around 4.75% in late November.

Canadians have already felt the easing. In the past few days all of the big five banks cut mortgage rates by five basis points, bringing the posted five-year rate down to 7.49%.

It is true interbank lending rates had been extremely slow to fall. Banks all over the world, unsure of the extent of their subprime losses and facing mounting losses, were hoarding cash to help shore up capital.

But as the U.S. Federal Reserve slashed borrowing rates by 100 basis points and, along with other major central banks, injected hundreds of billions of dollars of liquidity into the money markets before Christmas, interbank rates gradually began to thaw.

The decline has picked up steam in recent days as the U.S. Federal Reserve indicated "substantiative" further easing was ahead. U.S. three-month interbank rates have plunged to 3.95% from more than 5% at their peak in November.

U.S. longer-term bond yields have also dropped and the easing has filtered through to U.S. homebuyers. Thirty-year mortgage rates have dropped to their lowest level in two years at 5.62%, prompting a surge in mortgage applications last week to their highest level since April, 2004.

Canadian banks have been slower to react but Canada's housing market has also displayed little of the weaknesses the U.S. market has. Also, the Bank of Canada has chopped its overnight lending rate by only 25 basis points to 4.25%.

In fact, Canadian banks continued to raise mortgage rates last year and began to offer fewer discounts. By December, the five-year posted rate hit 7.54%, the highest since 2001. The spread between five-year mortgage rate and the five-year government bond yield had widened to 356 basis points, the widest since the early 1980s housing downturn.

Ted Carmichael, chief Canadian economist at J.P. Morgan, added it is not unusual for commercial banks to delay chopping interest rates in response to a Bank of Canada rate cut as banks scramble to offset the cost of impeding defaults.

Indeed the spread between bank prime rates (the rates banks charge their best customers and to which floating-rate mortgages are linked) and the bank rate (the rate at which the Bank of Canada lends to commercial banks) widened in advance of or during recessions in 1974-75, 1980, 1981-82, and 1990, he said.

"As growth prospects deteriorated during these periods, credit risk rose and the spread between the prime rate and the BoC rate increased," Mr. Carmichael said in a note yesterday.

He said the tendency for credit spreads to widen as growth prospects wane is normal and does not "destabilize" monetary policy as the newspaper report suggested on Wednesday.

But if the central bank wants to lower rates faster, there is one easy solution - it can chop its policy rate more aggressively.

"The link between policy rates and these other rates is not broken," he said.

As noted, the commercial banks have already lowered mortgage rates in recent days, but Mr. Carmichael said the Bank of Canada should consider cutting interest rates a chunky 50 basis points at its announcement next week to jump-start the easy.

Mr. Porter agreed the bank could easily bring rates down.

"There's an easy solution for the Bank of Canada and that's basically to get more aggressive to achieve their goal but this may basically become a non-issue if interbank rates continue to tumble as they have," he said.

Financial Post