What a difference a year makes – or a day for that matter.

2008 was a roller coaster ride for both the general economy and the real estate market, both commercial and residential, and had everyone asking – Where is the bottom? What started out as a US housing market correction became a global financial crisis in a matter of months, through the repackaging of risk. How exactly did we get here, and where are we headed?

Financial failures of “too big to fail” banks, insurers and automakers – who’s next?

The collapse of Bear Stearns early in 2008 was echoed later in the year by the rapid downfall and federal intervention to shore up Fannie Mae and Freddie Mac, the cornerstones of the residential mortgage market in the US. Fannie Mae and Freddie Mac combined own or guarantee almost half of the $12 trillion US mortgage market. The downfall of Lehman Brothers, the rescue of Merrill Lynch by Bank of America, the rescue of Wachovia by Wells Fargo, the seizure of Washington Mutual (the nation’s largest savings and loan) subsequently acquired by JPMorgan Chase, the federal bailout of AIG (the world’s largest insurance company) and backstopping of Citigroup pointed to tumultuous times in the US financial market, which were felt around the globe. European governments stepped in with major bank bailouts of their own to keep the financial system operating.

Wall Street hit a five year low in the latter part of 2008 as the wild ride continued. Recession fears battered the stock markets of both industrialized and emerging markets. Prospects of the beleaguered “Big Three” North American automakers requiring federal bailouts to stay afloat only added to the fear and misery. US automakers initially asked for a $25 billion lifeline, while the Canadian subsidiaries looked to secure $3.5 billion. In Canada alone, the “Big Three” directly employs roughly 28,000 workers. If you include the spin-off or indirect jobs related to the auto sector that number grows significantly. Failure of the automobile industry has implications for the industrial real estate market and general economy, particularly in Ontario, which is highly leveraged to this sector.

Following the lead of quick European government action to backstop banks in the UK and Ireland, the US Treasury Department’s $700 billion Troubled Assets Relief Program (TARP) came into law in October 2008 in response to the financial crisis plaguing Wall Street. The intent of TARP was to take illiquid assets, such as mortgages in default, off the books of lenders. By November 2008, the Treasury Department had changed its plans, allocating roughly $250 billion from the bailout fund for direct injection into banks through purchase of their stocks, while a restructured agreement with AIG would see the creation of a facility to unwind some of that firm’s more toxic structured products, including both credit default swaps (CDS) and the collateralized debt obligations (CDOs) that these CDS backed.

The Canadian government stepped up in October as well as a precaution, creating the Insured Mortgage Purchase Program (IMPP) to support the country’s credit markets. Under this program, Canada Mortgage and Housing Corporation (CMHC) would purchase securities comprised of pools of insured residential mortgages from Canadian financial institutions. Initially, the commitment was for $25 billion and this was subsequently increased to $75 billion as of mid-November.

Offsetting all of this downward economic pressure were significant interest rate cuts, which were the name of the game in 2008. The Bank of Canada dropped the target for the overnight rate a full 275 basis points to 1.5%, a fifty year low, over the course of the year. The most aggressive cuts came in the fall, where two rate cuts took place for a combined 75 basis point drop in October and an additional 75 basis point drop came in December. Canada was not alone in cutting interest rates. On October 8th, there was a coordinated monetary policy action by a number of industrialized countries to address the global financial crisis. This involved a 50 basis point rate cut by the US Federal Reserve, Bank of England, European Central Bank and the Bank of Canada. Interest rates in the UK reached World War II lows by the end of the year. Further cuts are expected in 2009, as central banks looks to stimulate growth through expansionary monetary policy. However, if these rate cuts are not working what else do governments have in their arsenal to get credit flowing through the system again? If liquidity is not solving the problem the bigger question is can we live through the pain until the de-leveraging is over?

Is there an end in sight to the never-ending wave of write downs and corporate failures? While the pace of financial failures appears to be abating, it is still too early to assess the effectiveness of these various actions by US and European governments. In the US, watch the Federal Reserve’s flow of funds data for tell-tale signs of a stabilization or increase in bank lending activity.

Soaring dollar and commodities – is the party over?

After soaring to an unprecedented US$1.10 in November 2007, the Canadian dollar flirted with parity for most of 2008 before pulling back in October and hovering in the US$0.80 range for the balance of the year. This provided some relief to Canadian manufacturers who have been struggling with the combined effect of a high dollar and soaring commodity prices. The Canadian dollar was not alone in its decline in relation to the US dollar as almost all of the most actively traded currencies, except for the Japanese Yen, felt similar downward pressure as investors fled to the safety of US Treasury Bills.

Along with the pullback in currency values, 2008 saw a dramatic rise and fall in the commodities market. A mixture of rapidly growing demand for energy in still booming economies, such as India and China, a decline in the number of oil discoveries being made, political instability in top oil exporting countries, and to a degree investor speculation have all played a role in the rapid rise of energy prices. Crude oil prices peaked at $147 per barrel in July 2008 putting a strain on both consumers and manufacturers and fuelling inflationary fears. With slowing global demand for oil through the balance of 2008, prices declined by roughly $100 and left everyone wondering how low they could go. What was good for the consumer was bad for oil producers and energy investment and will be particularly bad for the province of Alberta, which has been recording stellar growth as a result of its resource wealth, as well as Newfoundland & Labrador. Falling prices and financing constraints resulted in projects being delayed or cancelled in the global oil producing markets, including Canada’s oil sands where roughly $40 billion in new oil sands spending has been deferred.

What will happen in 2009 and beyond? Global oil supply has not grown in three years and current per barrel prices are not conducive to large scale investment. Supply will fall but what of demand? Demand from emerging markets is only going to continue to grow and any pick-up in global economic growth will push oil prices higher and perhaps eventually to new record highs, as history has shown the peak of one cycle often becomes the trough of the next.

Given that almost all of Canada’s crude oil exports are to the US, additional key statistics to watch include US crude oil consumption, US highway miles driven, and new vehicle sales. While all these figures are down at the moment, it is currently unclear how much of the decline is a result of the general economic downturn (an effect which could be short-lived) and how much of it reflects the recently recorded highs in oil prices. After oil prices spiked thirty years ago, Americans became energy-misers for much of the following decade, resulting in a sustained period of weak oil demand and prices. If Americans repeat this pattern, the negative implications for Canadian energy exports could last well beyond 2009. If SUV sales recover, highway miles driven rise, and US oil consumption turns up combined with a pick-up in global demand, then Canada’s energy industries can breathe a collective sigh of relief.

Job cuts – the tip of the iceberg?

Job losses in the US were felt throughout 2008. Some might say the only sectors poised to see job increases are government, health care, and debt collectors. All told, the US economy lost 1.9 million jobs over the course of 2008 with huge impacts for consumer confidence, retail spending and investment. While the cuts have yet to approach the levels seen in many recent US downturns (2.7 million jobs were lost between 2001 and 2003, while 2.8 million jobs were lost in the 1981-1982 recession), the rate of job loss increased dramatically in the final months of 2008, with continued losses expected through the first half of 2009.

In contrast, the labour market remained relatively strong in Canada with employment and wage gains throughout most of 2008 – but how long will this last? While there have been months where job losses have occurred over the past years, the net annual job gains have been consistently positive since 1993. While job losses were experienced at the end of 2008, they were not enough to offset gains earlier in the year. However, with employment taking its largest monthly decline since 1982 in the month of November, down 70,600 jobs, this set the tone for things to come in 2009. Once again these losses were not across the board with Ontario taking the brunt of the decline.

Overall employment growth is forecast to be flat in 2009 with the manufacturing sector continuing to struggle, and the other sectors feeling the squeeze of soft global economic conditions. A softening housing market will put a dent in the creation of construction jobs, which have underpinned a large part of overall employment growth over the past couple of years. With the unsettling financial market, the outlook is not rosy for job creation in that sector either. However, the unemployment rate remains near historic lows at 6.3% and even with softening employment activity in 2009 it is forecast to remain below the historical average.

Consumers and businesses tightening their belts – will exchange rates help?

Fears of a global recession sent consumer confidence on a downward spiral across the globe in the fall of 2008. With consumers retrenching, the outlook for buoyant retail sales growth comes into question. Less spending by consumers leads to less consumer goods being manufactured, which leads to more job cuts, which continues the vicious cycle. While softening oil prices may have a positive impact on consumers’ disposable income, the fact that many have had their net worth substantially diminished on the stock market, have lost their job, and in the case of the US have gone into foreclosure on their homes, does not leave much to be confident about. Consumers in Canada, however, have more to be confident about as they are typically less overleveraged than their American counterparts and, as mentioned above, employment and income gains have been stronger. Despite this, consumers are showing signs of concern, as confidence dropped to its lowest level in nearly two decades according to the Conference Board of Canada.

It is not just consumers tightening their belts. Non-residential business investment is forecast to decline though 2009. With financing a concern, many capital projects are being put temporarily on hold until market conditions settle. With a softening of the Canadian dollar, now would be a great time for reinvestment in equipment, machinery and productivity enhancing ventures on behalf of Canadian companies, but as the stock market continues its roller coaster ride, many companies are being forced into profit protection mode instead.

In this regard, the declining value of the Canadian dollar may turn out to be a boon: if exchange rates against the US dollar remain near current levels or fall further, both retail sales and business investment could benefit.

So what of the beleaguered housing market, where all the troubles began?

Construction starts have plummeted, existing home sales have stabilized, and subprime lending activity has all but disappeared in the US, but prices have yet to hit a bottom. Different data sources estimate that home prices have fallen anywhere from 10% (FHFA) to 20% (Case-Shiller), with additional price declines of 10% expected. Why do prices continue to fall and thwart housing market stability? The main problem is increased foreclosure activity and the dumping of foreclosed properties back onto the market by lenders, thus continuing the vicious cycle of house price depreciation.

There have been three distinct waves of foreclosure activity in the US. The first wave, led by flippers and speculators, began in late 2006. The second, dominated by households with resetting ARM and subprime “teaser” mortgage rates, led activity in 2007-2008. The current and third wave, however, is mostly economic, a reflection of job losses. The two preceding waves of activity, coupled with the supply of unsold new homes and bank-owned existing homes, have created a housing market so weak many newly unemployed households cannot sell their homes to stave off foreclosure, as they might have during a more “typical” recession. If US job losses continue in 2009, foreclosure rates will remain high, unless the new Obama administration forces lenders to make large-scale and dramatic loan modifications. Such an action, however, may not be necessary. It is important to remember that, despite all the talk of the housing market woes, less than 4% of US residential mortgages were seriously delinquent as of the end of the third quarter of 2008.

The fundamentals remain more solid for the Canadian housing market; however, most housing experts believe the boom is over. The good news for Canada is that the exposure to the subprime market or foreclosure activity is minimal in comparison to that of the US. Furthermore, US housing weakness has been concentrated in areas far from the US-Canadian border, with California, Arizona, Nevada and Florida accounting for more than half of foreclosure activity. The comparative economic and housing stability in markets in the US Northeast and Pacific Northwest regions, which have strong linkages with the biggest Canadian markets, is encouraging.

In addition, Canadian price appreciation can be more explained by economic fundamentals than pure speculation as seen in the price appreciation in the US as well as countries like the UK and Ireland.

Nonetheless, housing starts in Canada began to cool towards the end of 2008, a trend that is likely to continue through 2009 as the market re-aligns with demographic demand. Housing starts are forecast to dip below the 200,000 unit mark in 2009 for the first time in eight years. Overall resale activity also trended downwards, roughly 16% lower than 2007 with prices down 9.9% according to CREA. This trend is not generalized across the country, as markets that had become overheated are experiencing a cooling off, while other markets are still experiencing increased sales, starts and pricing.

However, a strong seller’s market is starting to give way to a buyer’s market and this is expected to persist throughout 2009. The question remains will it be as long and as deep a correction as that experienced in the US and other markets across the globe?