ABSTRACT

And, how much did house prices fall during the last recession? Richard Blackwell digs into the economic crisis

FULL TEXT

As the global financial crisis plays out, Report on Business writer Richard Blackwell examines and explains the economic outlook and the turmoil in credit and stock markets. Here, we answer your questions daily, with the most recent at the top.

What is a "bear market rally"?

A bear market rally is a significant upward movement in stock prices, but within a long-term overall downtrend.

It's essentially the reverse of a "market correction," which is a short-term decline in stocks within an overall bull market.

Usually, bear market rallies and market corrections don't last very long, but they can shift markets by as much as 30 per cent or more, before the overall trend continues.

After the 1929 market crash, for instance, there were several substantial rallies, but after each one stock prices continued on a long downward trajectory. Several of those rallies saw indexes jump more than 10 per cent in one day.

The big question at the moment is whether the recent upturn in stocks, which has pushed prices up by about 20 per cent since the trough in November, is the beginning of a long-term trend, or just a bear market rally. Wednesday's 350-point drop on the S&P/TSX composite after six successive gains may provide a hint.

The disruption in European natural gas markets makes me wonder if the same thing could happen in Canada. Do we depend on foreign suppliers?

In Canada, almost all of our natural gas comes from domestic production, so it is very unlikely that any other country could disrupt our supply.

Most Canadian gas is produced in Alberta, Saskatchewan and British Columbia, with a small amount generated from offshore gas fields in Atlantic Canada. It is sent through hundreds of thousands of kilometres of pipelines to customers, including homeowners, industrial users and electrical power plants.

However, some of the gas consumed in Ontario is imported from the United States.

So we are essentially self-sufficient in gas?

Yes. It helps that Canada is the third-largest producer of natural gas in the world, after Russia and the United States. About half of what we produce is sold to customers in the United States.

What exactly is "quantitative easing"?

Quantitative easing involves a central bank pumping money into the financial system by buying up a variety of securities, including government debt, mortgages, commercial loans and stocks. By flooding the financial markets with cash, interest rates charged to a wide range of borrowers should be reduced.

With official interest rates in the United States close to zero already, quantitative easing is one of the few remaining tools that the Federal Reserve Board can use to try to get retail lending rates down and more money flowing to individual borrowers and small businesses.

Why is it called that?

The word "quantitative" refers to the money being pumped into the system, while "easing" means lowering rates. Essentially, cash is being used to reduce borrowing costs and expand lending, which differs from the Fed's usual route of lowering its benchmark interest rate.

Normally, pumping cash into an economy would boost inflation. But deflation, rather than inflation, is the key concern at the moment.

The term quantitative easing was first used in the 1990s to describe Japan's monetary policy at the time.

What is the difference between monetary policy and fiscal policy?

Monetary policy involves actions taken by agencies, such as central banks, to control the supply of money and shift interest rates.

At its most basic, lowering interest rates or adding to the money supply can help expand an economy in a period of weakness.

Tightening money supply and raising rates can slow economic activity and keep inflation in check during expansionist times.

Fiscal policy, on the other hand, involves government actions to alter taxation and spending levels. These moves can also have a substantial impact on the overall economy, as higher government spending or lower tax levels tend to give a boost to economic activity.

Royal LePage says house prices will drop 3 per cent this year in Canada. How much did prices fall during the last recession?

The problem with housing price statistics is that there are so many different ways to compile them.

But there is no question that at the start of the last recession in the early 1990s, house prices took a hit. According to the Canadian Real Estate Association, there was roughly a 3.5-per-cent fall in the average Canadian house price in 1990, compared with the previous year.

CREA numbers suggest there was a similar drop in prices in 2008 compared with 2007.

Some monthly comparisons show much bigger drops, however. Between November, 2007, and November, 2008, for instance, the average house price across the country dropped almost 10 per cent, according to CREA.

Individual markets showed even bigger swings.

Royal LePage's numbers suggest that house prices fell only 1.1 per cent in 2008. The company projects a 3-per-cent fall in prices in 2009.

Royal LePage president Phil Soper said the housing market is currently in better shape than in the early 1990s, as price increases have not overshot income gains to the same degree, and there has been less speculation in the market.

AUTO INDUSTRY

We've heard so much about the U.S. and Canadian governments' plans to bail out the North American auto industry. What has the Mexican government done?

The U.S. bailout package, amounting to $17.4-billion (U.S.) in loans to General Motors Corp. and Chrysler LLC, was announced in December.

Canada and Ontario responded with a commitment of $4-billion (Canadian) in emergency loans to the two companies' Canadian subsidiaries.

Mexican auto producers have asked their government for $3-billion (U.S.) in loans to spur vehicle sales. This money would provide financing for car dealers and buyers. The Mexican government has yet to respond.

Still, Mexico is likely to benefit from the U.S. bailout package because General Motors and Chrysler - along with Ford Motor Co. - build small, fuel-efficient cars there, and wage rates are very attractive to the auto makers.

CENTRAL BANKS

What is the difference between the U.S. Federal Reserve Board and the Department of the Treasury?

The Federal Reserve Board, often called the Fed, is the central bank of the United States. It has a similar role to the Bank of Canada, in that it sets interest rates and lends money to member banks.

It also regulates banks, a job that in Canada is performed mainly by the Office of the Superintendent of Financial Institutions. The Fed also manages the United States' cheque clearing system.

The Department of the Treasury is the arm of government that manages finances, much like Canada's Finance Department.

It collects taxes (a role performed in Canada by the Canada Revenue Agency), pays government bills, and manages federal government debt. The Treasury also prints paper currency and mints coins.

What is the purpose of countries having foreign currency reserves?

Foreign reserves usually include cash held in foreign currency, along with gold, and reserves set aside for the International Monetary Fund.

Holding foreign reserves gives a country flexibility in influencing the exchange rate of its own currency. If Japan wants to prop up the value of the yen, for example, it can sell some of its vast foreign reserve holdings to buy yen, a move that effectively increases demand for the currency, which will tend to increase its value.

(In recent years, the Japanese have been doing exactly the opposite. They have purchased billions of U.S. dollars and sold yen to try to slow the appreciation of the yen, which was hurting Japan's exports.)

What is "currency intervention?"

When a country doesn't think its currency has the right value compared with that of another nation, its government or central bank can make large purchases or sales of currency to try to right the imbalance.

For example, if country A wants to see its currency lower relative to country B, it will sell its own currency and buy large amounts of country B's currency. That would increase supply of the domestic currency and drive down demand, likely depressing its value.

What is a liquidity injection?

Central banks can use their financial clout to try to get money flowing to the banks and their customers. In a liquidity injection, they make money available for banks to borrow, although the financial institutions have to post securities as collateral to get it.

Where do central banks get the money for a liquidity injection?

The Bank of Canada has billions of dollars in assets, mostly held in very safe securities such as bonds and treasury bills. In essence, when it makes money available to commercial banks, it is temporarily swapping its safe securities for the riskier ones the banks are putting up as collateral.

Do interest rate cuts actually help boost the stock market?

In theory, they should. If an investor is trying to make a decision between putting money into a bond or a stock, he or she will look at the difference between the yield on the bond and the possible return on the stock. Bond yields should fall when interest rates go down, making stocks more attractive. Essentially, for a stock to compete for an investor's money, it doesn't need to offer as high a rate of return. However, bond yields do not always follow central bank interest rate cuts, and they haven't this time. Some very high-quality corporate bonds, for example, are offering huge yields compared with the stock market. While lower interest rates should also make corporate borrowing easier and thus lower costs and finance growth, that hasn't been happening either in the current credit crunch. On top of all this, worries over a recession or panic over falling stocks can trump any minor tweaking of interest rates.

COMMODITIES

Is the recent jump in oil prices directly related to the conflict in the Middle East?

It is impossible to pinpoint exactly what causes changes in oil prices, although the explosion of hostilities is certainly a factor in the jump in prices in recent days. Any conflict in the Middle East raises concerns about oil supplies from the region.

Over the weekend a military commander in Iran called for Islamic countries to cut oil supplies to countries that support Israel. While this was not taken seriously - and was dismissed outright by some sources at the Organization of Petroleum Exporting Countries - it does make some traders nervous.

Are there other things that are making prices swing so radically?

There are so many factors that go into energy prices that it is hard to figure which is most important. In addition to the conflict in Gaza, a dispute erupted on New Year's Day between Russia and the Ukraine over natural gas payments, and this has disrupted supplies to Europe, pushing up prices.

At the same time OPEC is in the process of instituting oil production cuts, and some analysts say a mildly optimistic mood in financial markets may presage higher oil demand. Those could also be reasons for higher prices.

Reports of a damaged oil pipeline in Nigeria have also raised some concerns about supplies from that country - yet another possible explanation for upward pressure on prices.

What does it cost to produce a single barrel of oil from the Alberta tar sands? At what price is it no longer profitable?

It varies, of course, depending on the project and a wide variety of factors.

But the Canadian Association of Petroleum Producers says the "all-in" cost of producing a barrel of oil sands oil is between $75 (U.S.) and $90 a barrel. That includes the cost of capital, operating expenses, royalties, taxes and a return on investment.

A recent report from Calgary-based investment dealer Peters & Co. estimated the prices needed to generate a 10-per-cent after-tax rate of return on new developments starting up in 2012. Peters said the threshold would be $60 per barrel for a SAGD (steam-assisted gravity drainage) project, $100 for an integrated oil sands mining project with an upgrader and $55 for a conventional mining project without upgrading.

Peters said long-term price trends should still support oil sand development, particularly if production costs can be reduced.

CREDIT MARKETS

What is the "money market," and why does it matter if it freezes?

The money market is made up short-term loans (generally of less than one year), such as certificates of deposit, commercial paper, banker's acceptances, and 30-day treasury bills. If the money market freezes up - in other words, no one wants to make short-term loans because they are worried about borrowers defaulting - companies cannot get the cash they need to pay staff, buy supplies or pay rent. Often companies need to borrow this money because they are waiting for revenue that may not arrive for a few days or weeks. But if they can't get short-term cash from the money markets, it can make day-to-day operations very difficult.

What is a credit default swap?

These were originally set up as a kind of insurance against bad debts. A holder would pay a series of "premiums," and in return would get a payout if a specified organization failed. It's the same idea as paying a life insurance premium, where the beneficiary gets a payout only if the specified person dies. Like life insurance, everything is in balance unless there is an epidemic and people start dying left and right. With more companies going under, or threatening to do so, firms that issued swaps are themselves in trouble. That's what happened to insurer AIG, which sold credit default swaps that protected investors against bond defaults. When bonds started defaulting, AIG itself was left vulnerable.

What is counterparty risk?

When you lend $20 to a friend, the counterparty risk is the chance that he or she won't pay you back. And it works the same way with corporations or financial institutions, although their measurement of risk is a little more sophisticated. If the counterparty risk is high, traders and banks won't lend money unless they get some solid collateral or loan guarantees, or they might just say "forget it."

Commercial paper is normally issued only by the most credit-worthy companies, providing them with short-term cash to run their day-to-day operations. Issuers almost always need to have a credit rating on their commercial paper, because the buyers want assurance that their money is very safe, and will be paid back quickly. But getting a credit rating is an expensive and time-consuming process that is conducted by bond-rating agencies. As a result, most commercial paper is issued only by large, stable companies, or entities such as utilities.

ECONOMY

Automotive CEOs say they will work for $1 a year. Who were the original "dollar-a-year men"?

Dollar-a-year-men were wealthy business executives - usually in the manufacturing sector - who were recruited by governments to help run crucial war-time production. They were paid nominal salaries to do crucial government work.

The term was first used in reference to men who went to Washington to help President Woodrow Wilson during the first World War. It was used again in World War II in both the United States and Canada.

In Ottawa, C.D. Howe, the "minister of everything" (who was actually minister of Munitions and Supply during the war) recruited dozens of these "buck-a-year men." They included John Wilson McConnell, the owner and publisher of the Montreal Star, H.R. MacMillan, founder of forestry company MacMillan Bloedel, and Henry Morgan, President of Morgan's department store in Montreal.

The Americans "stimulated" their economy by issuing cheques to millions of citizens this past spring. Has Canada ever done anything like that?

Canada has never sent cheques directly to its citizens to try to stimulate the economy. The closest thing to that took place early in 2006 when the Alberta government sent $400 "resource rebate cheques" to every resident of the province - the so-called Ralphbucks. In that case, the idea was to share an unbudgeted surplus, not an attempt to stimulate the economy.

Occasionally in the past, Ottawa has cut income tax rates retroactively at the end of a year, so that many people got tax refund cheques in the spring, but that's not quite the same thing.

Wouldn't this kind of direct payment be a good idea?

The problem with direct rebates, and even tax cuts, is that a lot of the money doesn't actually help the domestic economy. Many people save the money, pay down debt, or buy consumer goods that are made in other countries.

What exactly is a 'have-not' province?

The calculation of equalization payments - thus determining provinces' "have" or "have not" status - is complex.

There are about 33 economic criteria that go into the formula, and these are averaged over several years.

But the calculation is heavily weighted toward the provinces' abilities to raise tax revenues, including resource royalties.

So when prices of resources such as oil and gas go up, provinces rich in these commodities are more likely to be "have" provinces - those with economic well-being that is above the average for all the provinces.

Because the numbers are averaged over an extended period, the drop in oil prices in the past few months won't likely change the relative status of the provinces in 2009, keeping Newfoundland, Saskatchewan, Alberta and British Columbia as "have" provinces.

Is there a better way to measure the economic health of the provinces?

According to Dale Orr, chief economist at Global Insight Canada, most economists determine the relative health of provinces or countries by looking at per capita measures of real gross domestic product. On that score, Ontario is not a "have not" province, and would not likely be next year or for some time to come.

In 2007, Ontario's real GDP per capita was about 4 per cent more than the national average (according to data just released in the past few days). It is expected to stay about 3 per cent above average next year, even though it is set to begin collecting equalization payments.

And even with tougher times ahead for Ontario's manufacturing base, the GDP per capita measure in the province is expected to stay above the Canadian average at least until 2013.

What is the International Monetary Fund?

The IMF, established at the 1944 Bretton Woods conference, provides financial help to countries in serious economic trouble. It uses money gleaned from its 185 member countries.

Those funds, called quotas, vary depending on each country's size and strength. The U.S. has the biggest quota, at $58-billion. Canada's quota is about $10-billion. Countries keep the bulk of their IMF commitments in their own reserves at home, but they may be called on to provide cash when troubled members seek help.

Voting rights in the fund are proportional to quota. Rich nations also contribute to a separate emergency fund. The total quotas now amount to more than $350-billion, and the fund has about $20-billion in outstanding loans to more than 60 countries.

The IMF makes money on the spread between what it earns on its loans and what it pays in interest to countries that provide the funds. It uses that cash to pay administration costs.

I read that Saudi Arabia is already one of the largest contributors to the International Monetary Fund. How much does it give?

Saudi Arabia is indeed one of the largest contributors to the IMF, and as such it has a large number of votes at the organization. Saudi Arabia's "quota" - or the amount of credit it provides to the IMF - is just over $10-billion (U.S.), slightly more than Canada's quota of about $9.5-billion.

Since votes at the IMF are proportional to quota, that means Saudi Arabia has about 3.2 per cent of the votes, compared with Canada's 2.9 per cent.

That makes Saudi Arabia the sixth most powerful country within the 185 members of the IMF, beaten out only by the United States, Britain, Japan, Italy and France. The United States has the biggest quota (about $55-billion) and the largest number of votes (about 17 per cent of the total).

Member countries keep the bulk of their IMF commitments in their own reserves at home, but they may be called on to provide cash when troubled members seek help.

When the Canadian dollar took its recent dip, did it come close to its lowest point ever relative to the U.S. dollar?

The Canadian dollar bottomed out at 61.75 cents (U.S.) in January, 2002, so the fall to 77.59 cents on Oct. 27 was quite a way from that point. What was more unusual about the recent drop was the speed with which it occurred. The dollar tumbled more than 19 cents in the space of a month.

The Canadian dollar's highest point compared with the U.S. dollar, at least in modern times, came just last November, when it briefly nudged above $1.10. Way back, during the U.S. Civil War in the 1860s, the Canadian dollar reached $2.78.

Why do economists always say that the consumer is 70% of the economy? Isn't the consumer really 100% of the economy, since all business is just an intermediary activity that ultimately sells to the consumer?

In a broad sense, you are right that individual consumers ultimately make up the entire economy, said Doug Porter, deputy chief economist at BMO Nesbitt Burns. But the way economic activity is measured, there are different categories that make up the overall picture, he said. This includes government spending, residential construction, domestic business purchases and exports, along with consumer spending.

But Mr. Porter notes that the 70-per-cent number you are referring to actually applies only to the United States, "which is the real outlier compared to most of the rest of the world." Elsewhere, consumer spending makes up a much smaller proportion of the economy.

In Canada, consumer spending is about 55 per cent of the economy. The big difference between us and the Americans is that health care purchases are mainly made by government here, while in the United States most of that spending comes under the consumer category, because individuals write the cheques.

Government consumption makes up almost 20 per cent of the economy in Canada.

What provinces have run deficits in recent years?

Most provinces have had balanced budgets or surpluses for several years. The only exception is Prince Edward Island, which had a small deficit of $37-million in its 2007-08 fiscal year, and projected a $35-million shortfall for 2008-09.

The days of almost-universal provincial surpluses may be gone, however, because of the gloomy economic outlook. Ontario said Wednesday that it will now have a $500-million deficit in the current fiscal year because it does not want to cut health or education spending, even though its revenue is declining. That's a change in direction after three years of surpluses.

Alberta has been running surpluses for the longest period - it hasn't had a budget deficit in 15 years, thanks to its blossoming oil revenue. And Alberta is also the only province that has managed to completely eliminate its accumulated debt. That happened in 2004.

What is deficit financing?

It is the concept, first promoted by British economist John Maynard Keynes in the 1930s, that governments should be prepared to run deficits during tough times in order to stimulate the economy by increasing spending. It was not enough to let market forces deal with high unemployment, he said.

The idea was that budgets would be balanced over the course of an entire business cycle, as revenues would increase - and surpluses would replenish government coffers - when the good times returned.

The concept fell out of favour in the 1970s and 1980s, when many governments began to run large deficits on a regular basis and cumulative debt spiralled out of control. There was no Keynesian solution to "stagflation" - prolonged periods of inflation, low economic growth and high unemployment.

What is a recession?

The classic definition of a recession is a period when the economy shrinks for two consecutive quarters. But that is considered very rough and imprecise by most economists.

One of the problems with the simple definition of recession is that it doesn't take into account swings in the economy. If GDP shrinks in one quarter by 2 per cent, rises in the next by 0.5 per cent, then shrinks in the third by another 2 per cent, then the country is not in recession under the definition, although it very likely is, in reality.

On the other hand, two consecutive 0.2-per-cent drops would mean we're in recession, even if there was strong growth in earlier quarters. That's not very realistic either.

GDP numbers can also be skewed by population growth, which can disguise a possible recession. And they are often revised months after the fact, so that what initially looked like a recession might not actually have been one.

"We've had situations in history where a recession has been revised away, two years later," says Dale Orr, chief economist at Global Insight Canada.

Is there a better way to define recession?

Many economists prefer to do a much more complex analysis to determine whether a country is in a recession. What needs to be added into the equation, says Mr. Orr, is data on industrial production, consumer spending and labour markets.

In the United States, the National Bureau of Economic Research (NBER) takes these and other numbers into account to officially declare whether a recession has happened.

The NBER (or more specifically, the NBER's "business cycle dating committee") says that a recession is the period that begins just after the economy reaches a peak of activity, and ends as the economy reaches its trough. Sometimes NBER data show there is a recession, even if GDP hasn't declined for two quarters. That was the case in 2001, when the U.S. was deemed to be in recession even though there were no successive quarterly GDP declines. (Later revisions showed there were GDP declines in the first three quarters of 2001.)

How did the National Bureau of Economic Research figure out that the U.S. has been in a recession for a year?

The NBER doesn't use the usual definitions of a recession - two quarters of decline in gross domestic product. It instead looks for the peak of economic activity, by considering GDP and several other factors such as production, employment, consumption and real income.

When the peak is reached and the economy begins to decline significantly, that's when the recession has started, according to the group.

This often means that an official recession - or at least its duration - is not declared until it is well under way, or is even over. And it means that there can sometimes be a recession when there aren't two consecutive quarters of GDP decline. So far that's the case this time.

The recession will not be considered finished until the economy reaches its trough.

What is the NBER?

The NBER was founded in 1920 by a group of economists who wanted to study business cycles. It is a non-profit research organization with more than 1,000 university professors and researchers functioning as "associates," who study how the U.S. economy works. Since the 1960s it has been considered the official arbiter of when the U.S. is in recession.

The NBER's business cycle dating committee actually makes the decision to declare a recession. That key committee is currently composed of economists from Harvard, Stanford, MIT, Northwestern University, the University of California at Berkeley, and the Conference Board.

If I lose my job, that puts me personally in a recession, doesn't it?

There is an old joke (recently retold in the Economist) that says that when your neighbour loses her job, it is called an economic slowdown. When you lose your job, it is a recession. But when an economist loses his job, it becomes a depression.

What is a depression, anyway?

There doesn't seem to be any formal definition of a depression. But economists say it would involve a sharp drop in economic activity, as measured by GDP, over a prolonged period of more than two years. That shrinkage would also be accompanied by a rapidly rising unemployment rate and a severe drop in personal consumption. During the most bleak stretch of the Great Depression between August, 1929, and March, 1933, the U.S. economy shrank by 27 per cent, about 10 times as much as during the worst postwar recession.

Can a country go bankrupt?

Countries can't go bankrupt in the same way that companies do - closing their doors, sending everyone home, and having their remaining assets seized. But they can become insolvent if they default on their loans and don't repay the interest or principal.This has happened many times over the years, particularly among small developing nations. But in those cases the creditors were not able to seize assets - that would have meant an invasion and takeover of the country. In most cases, world bodies such as the International Monetary Fund work to reschedule or restructure debt so that creditors get some of their money back eventually. At the depths of Latin American debt crisis in 1990, more than four dozen countries were close to bankruptcy because they were unable to pay what they owed. Some were brought back from the brink by the creation of "Brady bonds" - a repackaging of defaulted loans that were backed by U.S. collateral.

FINANCIAL SYSTEM

What does "mark-to-market" mean?

Accounting rules require companies to calculate the value of their assets at the end of each quarter. That means they must "mark" (set the value) to "market" (the price they could get right now).

In the current volatile market, the values of some holdings - especially complex derivative instruments - can fluctuate wildly. And it is very difficult to put a value on some assets that trade very thinly or where the market has seized up completely.

What problems has mark-to-market accounting caused?

Some companies have had to take writedowns on assets that might easily recover in value by the time the firm is ready to sell them.

This may have contributed to the collapse of some U.S. financial institutions, which had to take huge writedowns that decimated their balance sheets.

Market watchers also say the mark-to-market rules contribute to short-term thinking among corporate executives.

Recently, U.S. and Canadian regulators have tinkered with some rules to give banks and other companies more flexibility, especially where frozen markets have made valuing assets difficult.

What are the differences in the regulation of investment banks in Canada compared with the United States? Were U.S. brokers really unregulated?

Independent U.S. investment banks were not completely unregulated, because they were governed by the rules of the Securities and Exchange Commission. But they had far less regulation than commercial banks, which came under the supervision of the Federal Reserve Board.

In September, however, the last two major investment dealers - Goldman Sachs and Morgan Stanley - became bank holding companies and thus moved under the purview of the Fed. As a result, they will have the same kind of capital requirements as banks, and will not be able to use borrowed money to leverage profits as they have in the past. The SEC will continue to supervise their brokerage activities.

This move puts the U.S. investment banks in a similar position to Canadian dealers. Here, the Office of the Superintendent of Financial Institutions sets the rules for banks' capital ratios and risk management activities on a consolidated basis, so the bank-owned brokerages fall under that umbrella. Canadian brokerage activities are also subject to supervision by provincial securities commissions, or foreign securities regulators if they have activities outside the country.

We keep hearing that Canadian banks are the most sound in the world. Who says so?

That verdict came from the World Economic Forum - the Swiss-based organization that runs the annual conference of big thinkers in Davos - in its 2008-2009 Global Competitiveness Report released early in October. It ranked 134 countries around the world on a wide range of issues related to their ability to attract business investment. Canada was 10th over all (the United States was first, followed by Switzerland and Denmark), but we came first in some of the dozens of individual measures.

Canada was not only ranked first for the soundness of its banks, it was also top dog when it comes to the ease of starting a business, the number of personal computers per capita, and the low incidence of malaria.

We also ranked in the top 10 on investor protection, number of Internet users, quality of scientific research organizations, quality of management schools, and telephone infrastructure.

The biggest problems in doing business in Canada, according to the study, are our tax rates and regulations.

We keep hearing that the financial regulatory system is "tighter" in Canada than in the U.S., and that's why our banks are healthier. What are some of the differences in regulation?

For one thing, the Canadian Bankers Association says, there are fewer bank regulators in Canada, so rules are a bit more streamlined. Here, the Office of the Superintendent of Financial Institutions sets the rules on capital levels, etc., while the Financial Consumer Agency of Canada tells them how they have to conduct themselves in the marketplace.

In the U.S., banks are governed by many regulators, including the Federal Reserve Board, the Office of the Controller of the Currency, and the Office of Thrift Supervision.

Another key difference is that the Canadian Bank Act says that anyone who borrows money to buy a home must get mortgage insurance if their mortgage is more than 80 per cent of the value of the home. That, along with a tendency to give out fewer subprime loans to borrowers with dubious credit history, has kept the banks here in better shape.

Canada's banks also benefit from the fact that regulations encourage them to operate nationally. That means they can move capital from one region to another, and when risk in the eastern manufacturing sector is higher, it can be offset by lower risk among western oil and gas customers, for instance.

Are bank deposits safe?

Bank deposits in this country - GICs or other deposits that mature in five years or less - are insured by the Canada Deposit Insurance Corp., a government agency. But the limit is $100,000 per person per institution. and not all financial institutions are members. Depending on the type of account in question, more than one account may be covered to $100,000 at a given bank. In Europe, some countries have recently removed any limits, to make sure that there is no rush of worried customers taking their money out and stuffing it under their mattresses. In Canada there has been no move to change the limit. The CDIC points out on its web site that banks in Canada don't fail often, but "it has happened and it could happen again." In fact, 43 CDIC members - mostly small ones - have collapsed since it was formed in 1967.

What is interbank lending?

Banks normally lend each other cash and short-term securities to help balance out their everyday activities. But lately, banks around the world have been extraordinarily cautious about this lending - partly because they are worried about getting repaid - and this is driving up the interest they have to pay when they want to borrow. This also makes the banks much more cautious about lending out the money they receive in deposits, thus making it harder - and more expensive - for homeowners, small businesses or corporations to borrow. The standard interest rate for interbank loans is Libor, an acronym for the London Interbank Offered Rate. Libor is an average of interbank rates offered by more than a dozen banks, and is calculated every day. The difference between Libor and government bond yields has been growing recently, and that's important because corporate loans, mortgages and student loans are all based on Libor.

Don't banks usually get the money they loan from deposits?

That is usually the case, but the balance is never perfect, and that's why banks lend money to each other. Currently, there is a lot of demand for loans from corporations, which until recently haven't needed much money because they've been so profitable. With little cash available, rates have increased.

Has the Canadian government ever owned shares in our commercial banks?

The Canadian government has avoided any direct investments in Canadian banks, and has tried not to get directly involved in rescuing troubled financial institutions, says Duncan McDowall, a historian at Ottawa's Carleton University.

"The pattern in Canada has consistently been that when commercial banks got in trouble, the federal government allowed them to collapse, or more likely, to fall into the arms of another bank that took its assets and its employees," Prof. McDowall said.

An example: In 1906, the Ontario Bank collapsed, but the federal and provincial governments and other commercial banks arranged to have Bank of Montreal take over its assets and operations.

The only active federal government involvement in banking, Prof. McDowall said, was Canada Post's ownership of the mainly rural Post Office Savings Bank, which had almost 1,500 branches but was shut down in the late 1960s after 100 years in existence.

Aside from that, "there's always been a complete arm's length relationship" between the federal government and the banks, he said. It also helps that the Bank Act is updated every decade or so, "which allows it to be attuned to changes in the market."

Interestingly, the federal government didn't even own the Bank of Canada when it was first established in 1935. For the first few years it was held by private investors, including the commercial banks. But in 1938 the central bank was nationalized and has been in Ottawa's hands since then.

What is Tier 1 capital and what does it tell you about a bank's health?

Tier 1 capital includes a bank's common equity - the value of the shares it has sold to the public - plus the value of its non-cumulative preferred shares, and its retained earnings. These are instruments that can't easily be redeemed by holders, so they are considered permanent.

Tier 1 capital, as a proportion of a bank's overall assets, is a key measure of its financial strength. There are international standards, set by the Swiss-based Bank for International Settlements, for this Tier 1 capital ratio. In Canada, the Office of the Superintendent for Financial Institutions sets the minimums.

Most Canadian banks have Tier 1 capital ratios of around 10 per cent (meaning that Tier 1 capital represents about one-10th of overall assets), well above the OSFI minimum of 7 per cent. The banks also measure second level, or Tier 2, capital which includes not-quite-so-permanent items such as reserves, loan loss provisions, and subordinated debt.

What is the TED spread?

The TED spread is a measure of how much premium banks have to pay when they borrow from each other, and it is a reflection of worries over possible defaults.

Originally, the TED spread was the difference in interest rates between three-month U.S. treasury bill contracts (the "T") and three-month Eurodollar contracts (the "ED").

Now, it usually represents the spread between risk-free three month T-bills and not-so-risk-free three-month LIBOR (the London inter-bank offered rate that banks use for interbank borrowing).

When the TED spread goes up, that suggests bank lenders are worried their counterparties on interbank loans might default. Late in 2008 the TED spread increased to more than 400 basis points (a basis point is one-hundredth of a percentage point) from "normal" levels of around 30 basis points.

INVESTING, MARKETS AND PERSONAL FINANCE

Canada Pension Plan and Old Age Security payments rise with increases in the consumer price index. What happens, though, if the CPI actually declines?

The two plans are indeed indexed to changes in the consumer price index, specifically the "all-items index" of the CPI.

But the rules for CPP and OAS make it clear that payments will never decline, even if the cost of living decreases.

The CPP is adjusted just once a year, in January, based on changes to prices in the 12 months ending on Oct. 31.

OAS is adjusted four times a year, at the beginning of January, April, July, and October. The January 2008 changes, for example, reflect a three-month moving average of consumer prices in August, September and October 2007, compared to the previous three months.

What does that mean for CPP and OAS payments in 2009?

Canada Pension Plan payments in 2009 will be up 2.5 per cent compared to 2008 payments. That moves the maximum monthly payment to $908.75.

Old Age Security payments in January, February and March, however, will not be increasing from the last three months of 2008. That's because the three-month moving average calculation of the consumer price index for August through September equals zero per cent.

The maximum OAS payment for each of the next three months is $516.96. The calculation will be re-done for April payments.

I often hear the term "secular bull market" or "secular bear market." What does the term "secular" mean in this context?

Secular is usually used to mean a very long-term trend in the market - covering a period from five to 20 years. These larger trends can include several shorter bull and bear markets, so they are by no means continuous upswings or downswings.

To be a secular bear market, each major trough over the duration is supposed to be lower than the one before it. A secular bull market has increasing peaks. Those numbers, however, have to be adjusted for real returns to give a true picture.

Are we in a secular bear market now?

The current secular bear market, if in fact we are in one, is thought to have begun at the bursting of the high-tech bubble in 2000.

Some analysts, however, think we were in a secular bull market right through from 1983 until the end of 2007, and that the long-term trend has only recently reversed.

Why do companies sometimes buy back their stock when the price falls?

When a company feels that its share price is too low, it can use some of its cash to buy shares on the open market and then cancel them.

In theory, this should help push up value of the stock - and therefore its price - as it reduces the float of shares and increases the key earnings-per-share number.

Buying back stock can also reduce the dilution that would otherwise occur when executives are granted stock options.

With the market in turmoil, I may buy some gold bars to keep under the mattress. How might I do this and would there be PST and GST? Do they come in convenient denominations?

It is actually pretty easy to buy gold in its physical form. In Canada, one of the biggest precious metal traders is Bank of Nova Scotia, through its ScotiaMocatta division. It has gold in various forms readily available for retail sale.

You can go into the main Scotiabank branch in downtown Toronto and buy gold coins, wafers or bars, ranging in size from one-twentieth of an ounce to 400 ounces (which will set you back more than $320,000). You can also buy gold in other bank branches around the country, but you have to make arrangements for delivery in advance.

There is no GST on most gold products, if they are very pure (above 99.5 per cent) and bought for investment purposes. There may be provincial sales taxes, depending on which province you live in. And you'll usually pay manufacturing, shipping and storage fees on top of the spot price.

Do I have to provide identification in order to buy gold?

You will have to show two pieces of identification, and a social insurance number, when you pick up your gold, and when you bring it back to sell later on. Because the profits on gold sales are taxable, Canada Revenue wants to keep track of these transactions. And the bank has to monitor any large transactions to watch for money laundering.

If I don't want to keep my chunk of gold at home, how can I buy it?

There are lots of alternatives to buying gold in its physical state. You can buy gold certificates, which mean you still own the metal but don't have to keep it yourself. You can also get exposure to gold by buying stocks in gold mining companies, gold exchange-traded funds, or precious metals mutual funds.

No Canadian bank has shrunk its dividend since National Bank cut its payout in half in 1992, but when was the last time a big bank's dividend was completely suspended?

The last time that happened was when National Bank eliminated its dividend in mid-1982. It reinstated the payments about a year later. That's the only time a bank has completely killed a dividend in recent decades - or centuries, actually.

The big banks have an astonishingly long record of consistently paying dividends. Bank of Montreal has been distributing them non-stop since 1829 - almost 180 years, the longest unbroken record of any Canadian company. Bank of Nova Scotia's streak goes back to 1833, TD's to 1857, CIBC's to 1868 and Royal's to 1870.

What about non-banks?

Until recently, BCE Inc. held the top spot among non-banks, with an unbroken series of dividends starting in 1881. But it stopped its payouts in July of this year to conserve cash ahead of the privatization scheduled to be completed in December.

That puts Imperial Oil Ltd. at the top of the non-bank list. It has been paying dividends non-stop since 1891.

When stock markets are plunging, who is buying all the shares that investors are selling?

In order to maintain an orderly market, the Toronto Stock Exchange has a system of "market makers." These are 22 brokerage firms that are assigned to make sure there is stable trading in each stock on the exchange. Essentially, they must step in to buy up shares that are offered by sellers, when there are no other buyers in the market.

That ensures anyone who wants to sell stock will always find a buyer.

The market makers are compensated for their work by getting a reduction in their exchange fees, and there is a certain prestige in holding that role.

But it also means brokerages can end up with a lot of shares in specific stocks at the end of a day, and they must manage this inventory carefully - eventually selling down their positions.

Does this also apply when stock markets are rising?

Yes, market makers also have to do the same job when markets are rising, ensuring that there is someone to sell stock to those who want to buy. To do this, they must have an inventory of shares of the stocks they are responsible for.

Market makers are also required to buy or sell odd lots - small numbers of shares (fewer than a board lot, which is usually 100 shares) traded by small retail investors.

Does the TSX have "circuit breakers" to stop precipitous falls in the market, similar to those at the New York Stock Exchange?

The TSX has linked its circuit breakers with those of the NYSE. So if the New York market is suspended, trading in Toronto will also stop.

There's a good reason for this, says Michael Prior, vice-president of market surveillance at the Investment Industry Regulatory Organization of Canada (the body that sets these rules). About two-thirds of the volume of trades on the TSX is in stocks interlisted with U.S. exchanges, he said. So it would cause big problems, and not be very effective, if trading on one of the exchanges were to be halted while the other remained open.

The U.S. circuit breakers are a bit complex. The three levels are set at the beginning of each quarter at 10 per cent, 20 per cent and 30 per cent of the average closing price of the Dow Jones industrial index for the preceding month, rounded to the nearest 50.

That means the current levels are 1,100 points, 2,200 points and 3,350 points. These thresholds will likely move downward sharply when they are reset at the beginning of the next quarter in January.

If the Dow drops by one of those values, the markets will shut temporarily, or for the rest of the day, depending on the level and the time of day that it occurs.

The only exception to the link between the NYSE and the TSX is on days when Canadian markets are open and U.S. markets closed. (If July 4 falls on a weekday, for example).

Then, the TSX has its own thresholds (currently 1,250 points, 2,500 points and 3,750 points). These kick in the same way as the U.S. circuit breakers.

IIROC executives can also halt TSX trading on an ad hoc basis if there is a made-in-Canada emergency. This was considered a possibility during the Quebec referendum in 1995, but it has never happened.

The whole circuit-breaker system was set up after the market crash of October, 1987. Initially it was designed to kick in after specific point drops, but the thresholds were changed to the percentage system late in 1997.

The only time the equity circuit breakers have tripped, so far, was on Oct. 27, 1997, when the Dow fell 554 points, or 7.2 per cent. That was enough to stop trading at the levels set at the time.

What are principal-protected notes, and why are they now an issue in the global financial crisis?

Principal-protected notes, or PPNs, are complex instruments that guarantee an investor will get his or her principal back at maturity, but also offer the potential for a far greater return if certain indexes, commodities, mutual funds or baskets of stocks appreciate in value. They are usually sold through financial planners.

Some are causing problems for the issuers because the stocks, funds or indexes have taken such a fall in recent weeks. A simpler form of PPN is the "market-linked" or "market-growth" guaranteed investment certificate (GIC). These GICs are sold to retail investors by many of the big banks and are less complex, but the idea is the same. You are guaranteed to get your money back, usually after a three- or five-year term, and you'll get more - usually up to a capped amount - if a specific stock index increases in value. GICs are also guaranteed by Canada Deposit Insurance Corp., while PPNs are not.

Am I going to lose money on the PPNs or market-linked GICs that I hold?

If you hold these instruments to maturity, you will get all your principal back. But if the instruments to which they are linked happen to fall over the term of the holding, you may not get a penny more. In effect your money hasn't appreciated at all - but at least you haven't lost anything.

Is there any way to build my own principal-protected note (PPN) so I don't have to pay the built-in fees on the ones sold by insurance companies and investment dealers? I also don't want to be subjected to a "protection event" that will kill off any potential for future gains.

It is possible to create a kind of do-it-yourself PPN, which will guarantee principal and still allow some exposure to market gains (if we ever get any). Here's one suggestion from reader Graeme Tweedie in Halifax. If you have $100,000 to invest, for example, you could buy a stripped bond with a face value of $100,000. It will cost you less than $100,000 - the bond's "present value" - but you will receive the full amount at maturity. The balance from your $100,000 nest egg could then be used to buy an exchange traded fund linked to the performance of the S&P/TSX composite index. If the value of the ETF rises by the time the stripped bond matures, you'll have earned an extra gain related to the market performance.

What is a margin call?

A margin call occurs when a brokerage tells an investor that he or she has to pony up more money, because the stocks purchased with borrowed cash have fallen in value.

In order to come up with the money to meet the call, the investor may have to sell some of the stocks - often at a loss.

MORTGAGES AND MORTGAGE INSTITUTIONS

What is the difference between a residential mortgage that is recourse, and one that is non-recourse. Is it true that most mortgages in the United States are non-recourse but in Canada mortgages are of the recourse variety?

If someone who borrowed money to buy a house fails to make the payments, the lender can seize the property. If the mortgage was non-recourse, that's all that can be taken.

In a recourse loan, however, the lender can go after the homeowner's other assets, if the value of the house isn't high enough to pay back the loan.

In the United States most mortgage loans are non-recourse. That's why so many people have just walked away from houses that have dropped substantially in value. The lender can take possession of the undervalued home, but they can't try to get any more money back to make up the difference between that value and the mortgage loan.

In most Canadian provinces mortgages are recourse, which allows lenders to go after other assets. The exceptions are Saskatchewan and Alberta (although in Alberta high-ratio mortgages are recourse).

This has not been a widespread issue in Canada because our housing market has been much stronger than in the United States, and we haven't seen people trying to walk away from homes that have dropped sharply below the value of their mortgages. That did happen back in the 1980s in Alberta, when the housing market there collapsed.

This whole downward spiral seemed to start with U.S. subprime mortgages. What exactly are they?

Subprime mortgages are home loans made to people who would not, under normal circumstances, be ideal candidates to get a mortgage - thus they are "subprime." These are individuals who have a higher risk of defaulting on their loan, such as those who have been delinquent in making payments in the past, or people with a bankruptcy on their credit record, or those who simply don't have a credit history.

Starting around 2005, U.S. lenders loosened their rules and began granting mortgages to borrowers who provided very little evidence of their income and ability to repay. Many of these mortgages had very low initial interest rates, for the first six months to three years, but when that period ended the payments jumped sharply. Borrowers were led to believe that they would be able to refinance their homes at this point because the value of the property would have increased. But the slump in the housing market meant that didn't happen. As a result many people - especially those who had not been completely frank about their income levels - defaulted on their mortgages and lost their homes.

What are Fannie Mae and Freddie Mac? Why the cute names?

Fannie Mae is the nickname of the Federal National Mortgage Association, while Freddie Mac is the Federal Home Loan Mortgage Corp. Fannie Mae is the older of the two. It was created as a government agency in 1938 under U.S. president Franklin Roosevelt's New Deal. The idea was to give local banks federal money to finance home mortgages, since private lenders were leery of lending money. The government wanted to help more people buy homes, and encourage the building of affordable housing. In 1968 it became a private company. Freddie Mac was set up in 1970 to expand the secondary mortgage market, and ensure there was competition with Fannie Mae's monopoly. Both companies buy loans from banks or mortgage firms, and re-sell these as mortgage-backed securities. Together they own or guarantee about half of U.S. mortgages. The two were put under "conservatorship" by the U.S. Federal Housing Finance Agency on Sept. 7 - essentially a takeover by the government.

Who owns Canada Mortgage and Housing Corp.?

CMHC was set up by the federal government just after the Second World War to help deal with a housing shortage exacerbated by the huge number of soldiers returning home. It helped finance home construction and provided funds for low-income housing. In the 1950s, when banks got into mortgage lending, CMHC started insuring "high-ratio" mortgages where home buyers initially made only a small down payment. This summer CMHC stopped insuring mortgages with zero down payment or 40 year amortizations.

CMHC also subsidizes aboriginal housing, provides loans and grants for certain kinds of renovations, and gathers statistics on the housing market. It also buys mortgages from financial institutions, and repackages them as mortgage-backed securities, which it sells to investors.

Copyright 2009 The Globe and Mail, a division of CTVglobemedia Publishing Inc. All Rights Reserved