Mortgage rates, car loans hit by credit crunch

As the global financial crisis continues, many companies and consumer faceanapparent economic paradox.

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

OnWednesday, five central banks the U.S. Federal Reserve Board, the Bank of Canada, the Bank of England, theEuropean Central Bank andSweden's Riksbank all cut their near-term borrowing rates by half of a percentage point.

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

The governmentbanks are trying toreduce borrowing costs for other financial institutionsand repair the increasingly illiquid capital markets around the globe.

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

Canada's central bank rate hasset its target for overnight lendingat2.5 per cent while the U.S. Federal Reserve's fed funds rate now is pegged at 1.5 per cent.

Atalmost the same time, however, the TD Bank hiked what it charges onvariable-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 centat 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 areincreasing the interest rates they charge on long-termlending.

Thedivergence between what central banks want to happen and what is in factoccurring in lending markets highlights the difference between short- and long-term interest rates.

Quicker cash, lower cost

Short-term interest ratesrefer to the amount charged for lending money fora few hours, days or months alwaysless than a year.

For instance, with its well-followed monetary policy decisions, the U.S. Federal Reserve is changingtherate that onebankcharges another institutionto borrow usually for a few hours, not days excess cash deposited at one of the Fed's regionalbanks.

Therate on this type of near-maturity moneyis wherecentral bank cutspack the biggest monetary punch.

Thus, when people talk about interest rate reductionsaffecting borrowing charges, they arereferringintentionally or not to the market forcash 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 lendersto obtaintheir dollarsfor a month.

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

The cost of the same short-term money jumps, however, as soon aslenders look atcommercial 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 thesame time period.

In the current environment, lenders face the real possibility that the company to whom they havegiven cash maynot 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 whenthe money is lent for longer periods.

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

That relationship should not come as any surprise.

After all, the bank or other lenders aremaking 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 theinterest 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 themoney for 20 years, however, the rate jumped to 6.17 per cent, a bigspike in the cost of securing this cash for two decades.

In the chart, the longer the maturity period forthese 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 cashthat thebank or otherinstitutions will use to cover their lending.

Suppose, for instance, TD wants to lend ahome buyer$100,000 to be repaid within 20 years.The bank will head into themoney market tosecure $100,000tocover the mortgage loan for the next two decades.

So, the higher interest rate the bank charges is partly explained bythe 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 lesswillingto doleoutdollars.They are now increasingly worriedthat borrowers will not be around to repay the money in the near future.

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

Oneclosely watched indicator is just howtight theworld 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 centThursday, a steep decline from Wednesday's 6.87 per cent.

But, back in quieter times, therate stoodat 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 wellbe at an evenhigher interest ratethan the Libor, meaning the cost of a newmortgage or car loan if you can get one is movingup.