Why the latest mortgage war was months in the making

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Before it waded back into the market with deeply discounted mortgage rates last week, Bank of Montreal sought to give policy makers in Ottawa a heads-up that it was about to shake up the housing market again.

The bank had also spent months amassing a stockpile of cheap funding in the bond market to backstop the discounted mortgages, a strategy designed to ensure the cut-rate loans would not lose the bank money.

The parallel moves show the strategic manoeuvring that has gone on behind the scenes to set the stage for Canada's latest price war on mortgages. Most major lenders are now locked in battle, offering historic low rates.

After reports Ottawa was uncomfortable when the bank began offering record-low mortgage rates in January, amid ongoing warnings of household debt, BMO signalled another price cut was coming in an effort to explain its rationale, sources said.

That was before BMO's announcement last week that it would reintroduce five-year fixed rate mortgages at 2.99 per cent, after testing them in January, and 10-year mortgages at 3.99 per cent. The move cascaded through the sector, causing a flurry of price-matching by rival banks.

It has also spawned mudslinging between the country's biggest lenders. Royal Bank of Canada has taken out ads across the country to combat BMO's publicity push, pointing out fine-print restrictions on BMO's mortgage offers compared to its own. That prompted a flurry of rebuttal ads from BMO.

Meanwhile, CIBC has launched a cash-back campaign hoping to lure customers of other banks to switch lenders.

In an interview, Bank of Montreal chief executive officer Bill Downe said his bank took steps to ready itself for the attack on prices. "We were able to plan for that offer in a way that preserved our margins," Mr. Downe said.

The bank has been stockpiling cheaper funding in the bond market over months, which it planned to unleash in advance of the spring mortgage season. The move has left rival banks with little choice but to introduce comparable rates on a variety of offerings, even though some are facing unattractive margins.

Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Canadian Imperial Bank of Commerce and a host of others, including credit unions, have put similar mortgage promotions in the market, usually involving 4-year fixed rates and 30-year amortizations, as opposed to BMO's offer of 25-years and a five-year rate.

Mr. Downe would not comment on discussions BMO may have held with Ottawa. However, after reports that policy makers were uncomfortable when the bank began offering record-low mortgage rates in January, BMO is said to have signalled to Ottawa that another price cut was coming.

At a time when government and regulators are trying to warn Canadians about the perils of rising household debt levels, the bank's goal was to explain to policy makers that the discounts aren't risky or irresponsible from a lending perspective.

But market watchers suggest the reason behind BMO's high-profile push on mortgages is to regain market share the bank has lost since 2007, when it decided to stop using mortgage brokers.

BMO wanted to increase margins by bringing mortgage sales inside its branches, rather than use commissioned middlemen to sell the products. Branch sales also allow the bank to cross-sell customers on other products.

Since 2007, BMO has seen its market share on mortgages fall significantly, to about 6.5 per cent from more than 9 per cent as a result. In a $1.1-trillion mortgage market, that drop is worth billions to the loan book. It also comes at a time when profit margins have also shrunk, due to low interest rates, putting added strain on the balance sheet.

"You can see that [BMO]are really aggressive in the market right now. And at 2.99 per cent, their spreads are tight and getting tighter," said Robert McLister, a mortgage adviser in Vancouver and author of the Canadian Mortgage Trends blog. "So they're obviously trying to get their name in headlines and start to get their market share going in the right direction."

The drop in market share at BMO in the past four years is a key risk for CIBC, as it looks to potentially exit the mortgage broker channel in search of fatter margins. CIBC confirmed last week that it is looking to sell its FirstLine mortgage broker business to "put more emphasis on branch mortgage originations."

Analysts are now concerned that CIBC will see a significant drop in market if the strategy backfires. BMO, for example, grew its mortgage book 2 per cent in 2011, which was well behind its peers who used brokers to push more sales.

"The execution risk inherent to [CIBC's]bold decision to exit the mortgage broker distribution channel in Canada warrants a discount" on the stock price, National Bank Financial analyst Peter Routledge said in a research note.

At BMO, Mr. Downe said his bank has held talks with policy makers in Ottawa about the bank's strategy of promoting shorter amortizations, something Ottawa favours.

"For the past two years, we have been advocating publicly for shorter amortizations and we have shared this point of view with government," Mr. Downe said. "We have structured our offering based on maintaining margin," he said.

Bank of Montreal (BMO)

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