Washington Post business columnist Steven Pearlstein was online Wednesday, March 7 at Noon ET to discuss his column about the meltdown in the subprime mortgage market, and will field questions about the recent ups and downs on Wall Street.

Read today's column: Policymakers' Approach to Risk: 'What, Me Worry?'.

A transcript follows.

About Pearlstein: Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

His column archive is online here.

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Bowie, Md.: There's an article in the Wall Street Journal today about increased forclosures outside the sub-prime, market, too, among borrowers who actually have good credit but are in bad products:

Mortgage Defaults Start to Spread

A responsible lender won't make loans to people who can't pay them. How much of the problem is lenders, who should have known better, gave loans to people who can't be expected to?

Steven Pearlstein: Indeed, we haven't seen the end of this string, which is just beginning to play out. The article points ou that the default raTE HAS DOUBLE DIN THE CATEGORY OF MORTGAGES BETWEEN SUBPRIME AND PRIME. And we have yet to hear from prime borrowers who, as you point out, also went in for these exotic mortgages that let [people not pay some month if they find it inconvenient, or reset after two years, or have little money down. If the problem in subprime causes house prices to fall further, this will begin to wash back to prime mortgages that have little equity and/or that reset at much higher interest rates. Anyone who argues that we've seen the bottom in terms of the housing busrft, and its impact on the financial sector and the reeal economy -- these folks are blowing smoke. And for Fed officials to embrace this line, as they seem to be doing these days, is downright irresponsible.

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Germantown, Md.: I am concerned that changes in the mortgage market could cause a free-fall in home prices in the D.C. area. The majority of local mortgages made in the last few years were ARMs and option-ARMs. I understand that soon lenders must qualify purchasers based on the final, not teaser interest rate of an ARM. In theory, if borrowers must qualify at rates that are about 3 times higher than before, housing prices would have to drop by 67 percent to maintain the same affordability as today, which is already low.

Add to that (1) a general trend of rising interest rates, (2) more conservative underwriting practices generally, and (3)fewer subprime lenders and products, and it seems local values are bound to drop through the floor. And worse, actions by regulators and legislators are accelerating us toward a crisis, not averting it. Please tell me I'm completely wrong.

Steven Pearlstein: Now, I wouldn't go overboard on the collapse of house prices. That's probably taking it a step to far. But there is nothing to say they can't decline 25 percent from their highs in some submarkets, given the huge increases of the precvious five years. Washington still has some strong job growth, which will cushion things for us. But out in autoland, like Ohio and Michigan, where people are losing their jobs and the economy is probably already in recession, you could have more serious default problems.

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Kensington, Md.: Mt. Pealstein,

I think most people, especially the Federal Reserve, recognize the risks you mention in your article. However, I think you far overestimate the Fed's jurisdiction in these matters. Or at least your article seems to suggest that you do. With regards to derivatives markets, not only are many of these instruments lightly regulated, if they are regulated at all (excepting financial accounting standards that determine how institutions value them), the size of the market is largely unknown. And what would you have the Fed do about this? The Fed's primary functions are to ensure a sound infrastructure for the banking system; even risky business practices of banks are matters for other agencies, such as the FDIC and OCC. Second, the monetary policy mandate specifically points to the real side of the economy--jobs and income. Financial markets and the long list of things that can affect consumers income because of wealth effects, but nowhere is the Fed charged with babysitting Wall Street.

I don't know where this idea that the Fed existed to keep Wall Street on track comes from. I guess Greenspan certainly did not discourage it. In many of the matters you cite, Fed officials can at most offer opinions, not take any direct action. Why don't you call out the chief financial regulators in this country, like the heads of the SEC, FDIC, and OCC if if you are worried about underlying instability in financial markets, especially the obvious "wild west" culture in complicated derivatives instruments. Nobody even knows who these people are. It is naive to think that the Fed's tweaking of the Federal funds rate really matters that much. And I think it is a good idea for the media to wean the public--and maybe Congress will catch on--that the Fed is all-knowing and all-powerful.

Steven Pearlstein: This has nothing to do with the federal funds rate. It has to do with the Fed'as role as prudential regulator of bank holding companies, including most of the large Wall St. banks and investment houses that are the originators of much of this credit -- in the subprime market, in the takeover market, in commercial real estate, in commodity sdpeculation. In short, everywhere that we have seen bubbles (everyone, that, is, except the Fed, which believes you can only see bubbles ex post). And in this role as prudential regulator, the Fed is proving itself once again to be a day late and a dollar short. Here's my irrefutable piece of evidence: loans of tens of billions of dollars for highly leveraged buyouts like Equity Office with few, if any, conditions that would allow the loans to be pulled, or price increaseed, if certain rosy scenarioso n which the loan was made do not materialize. Any regulator, in this environment, who doesn't step in and say this is a problem isn't doing his job. And I don't care what the bank's risk mabnagement system says about it. Prudential regulation is not simply about making sure the bank has enough of its own capital to cover its losses. Its about reigning in a very competitive market so that this kin dof risky lending doesn't become the norm, causing systemic risk that would requres the Fed to step in and arrange a "private sector" workout or bailout. Thweir faith in the self-correcting powers of markets is misplaced -- its there, but it often takes a long time to show up. That's why we have regulation -- something Mr. Warsh et all seem to forget.

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Falls Church, Va.: Good column today, but it's worth noting that the biggest financial meltdown in recent history, and the one that cost the taxpayers most dearly, was the savings-and-loan crisis -- a failure of over-regulation, not under-.

It's easy to demonize securitization and derivatives, since they seem so arcane and dehumanized. But overall they do allow a more accurate pricing of risk and better hedging against market volatility. Individual investors who over-indulge (Orange County, LTCM) get burned, but those failures disappear without a ripple in the larger economy. It may not be a coincidence that these instruments haven't faced "a deep recession or global market meltdown;" they may be working to make such events less likely.

It's hard to care that Citigroup may be overextended, because it puts itself in this position every ten years or so. And home builders go bankrupt on a cyclical basis. The sky isn't falling.

Steven Pearlstein: That's right -- the sky isn't falling. But the sun ain't shining, either.

On the S&L crisis, it was indeed a failure of prudential regulation, as those risky loans were piling up on the books of the savings institutions, nothing was done. Then, the mistaske was conmpounded by forcing all those insitutions into receivership at one time, causing the assets to be dumped on the market and driving down pricves to the point that it brought down otheer institutions. Which, to my mind, speaks to the need to intervene early when the pattern of risky lending begins to assert itself -- because if the regulators get there after the fire is already roaring, there are really only bad options left.

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Laurel, Md.: When I took out my ARM three years ago, its fully indexed rate was only 3.75 percent because short term rates were only 1.25 percent. Today it would be 7.50 percent, and if I were near lock expiration I'd re-fi tomorrow at about 6% fixed.

Are the sub-prime forclosees people who thought 4 percent indexed rates could continue forever; people who weren't expecting such a severely inverted interest rate curve (7.5 percent fully-indexed short vs. 6 percent long-term fixed available); or, um, people with little knowledge of economics who were put into a complex mechanism they didn't understand.

If the latter, that's why government exists.

As a related question, has there ever been a time when ARMs were a good option for homeowners who expected to hold them long-term into their fully indexed period; or were they always for those who intended to flip, move, or re-fi before the end of the rate lock?

Steven Pearlstein: No, there have been times when interest rates were at hisorically high levels that made it a good time to do an ARM. But doing an ARM in a low interwest rate environment, for most homeowners without much income cushion, is silly. The savings of a quareter or a half of a point isn't worth the risk. If you can't afford the 15 year fixed in that environment, you probably can't afford the house.

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Noraville, Australia: How badly will top-of-the-food-chain entities like Goldmann Sachs, J.P.Morgan, etc. fare when the over-leveraged bloated arbitrages of the subprime market explode from the overindulgent and rampant feasting that's been going on since the tech-bubble burst?

Steven Pearlstein: I would only note that the implied rating from the swaps market in the bonds of some of these insitutions are somewhere around junk. These derivativers markets have a tendency to overshoot, soyou shouldn't eread too much into that. But it also means that somebody out there is worried about the quality of credit behind the credit.

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Danvers, Mass.: Job number one for the Fed: insure the balance sheets of the big boys against catastrophe (even if it's their own doing)the justification being to prevent a wider system problem.

Job number two: to justify and create a reserve army of the unemployed to preserve the income statements of the big boys by keeping labor costs sufficiently low. (Labor globalization is making this pretty easy.)

So, Steve, how bad does the subprime problem and follow-on consequences have to be before the Fed starts to pay out on its insurance, boosting liquidity, reducing rates?

Steven Pearlstein: Pretty bsad, actually. John, I wouldn't think this a good time for any major central bank to reduce rates absent evidence of a dramatic economic slowdown. Markets are still too frothy, with too many participants believing that the world has changed and many of these assets prices are justifiable.

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Chicago, Ill.: How important are financial models to the problems created by subprime mortgages?

I was struck by a paragraph in Warren Buffett's annual letter that didn't get any press coverage. In discussing his need for a younger person to take over the investing for Berkshire, Buffett wrote:

"We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions."

The February 20 New York Times had a very interesting article on the substantial limitations of models used for scientific issues. It seems equally applicable to financial models.

Steven Pearlstein: Boy, you can say that again. This faith in the models is tautological nonsense. The people who do the models to direct hedcge fund trading strategies are the same very smart people who devise the risk managemernt models at the banks. So it should be no surprise that when something happens that was never forseen by the one set of models, it will also challenge the assumptions underlying the other. There simply isn't enough experience with stress since many of these new instruments and trading strategies became prevalent foer thr models to be relied upon the way they are. We need more old-fashioned common sense added into the regulatory and risk management mix.

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Arlington, Va.: Do you think Alan Greenspan realized, a little too late, that he needs to be just as careful about what he says now that he's no longer Head of the Fed as when he was?

Steven Pearlstein: His comments were surprising, and I suspect they have the folks over at the Fed a bit annoyed. But look -- it had to come sometime that his views would differ from that of his predecessor. Now that it has, it probably won't be taken as such a big deal in the future. So its probably just as well we all got over this hump.

Having said that, the difference between the Fed forecast and Greenspans is that Greenspan was always more intuitive that the modelers. And this is precisely the time when intuition trumps models, because by their nature, models cannot predict market or economic turns.

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Manassas, Va.: I enjoyed your column "Time for Northern Virginia to Take Road Less Traveled" in that it brought up many "economics of transportation" issues that need to be addressed much more thoroughly than we can ever hope.

However, the weakest part of your column was brushing over the issue of using education funds for transportation. I wish you would expand on the whole economics of that clash.

It was a bit offensive to dismiss well-meaning people wanting to preserve funding for education as part of the "old interest-group hustle by parent and teacher groups . . ." That is just blaming the victims. If they don't see things exactly as you do, maybe it is due to a lack of education.

Yes, transportation raises money for education, but education also raises money for transportation. Educated people earn more salary and pay more payroll taxes. Could you address the cost/benefit analyses of state funded education more thoroughly in future columns?

washingtonpost.com: Time for Northern Virginia to Take Road Less Traveled (By Steven Pearlstein, March 2, 2006)

Steven Pearlstein: Your comment assumes as if this money is the private property of the education estalishment. Look, spending on education has recently gone up substantially. It will continue to do so, All that is being proposed is that, for one year, a portion of the anticipated growth isd used for another vital public service -- one that will allow the NoVa economy to continue growing and producing those annual increases in tax revenue. That is just smart, long-run fiscal policy -- and foer the education establishment not to see it only reveals a terrible short-sightedness on their part.

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Rockville, Md.: Mr. Pearlstein: isn't the Fed's utter indifference to the systemic risks posed by the exploding hedge fund industry --- an industry that is utterly opaque and almost entirely unregulated -- a stunning contrast to its obsession with Freddie and Fannie -- two local, monoline companies that live in a political and regulatory fishbowl?

Steven Pearlstein: Yes. The Fed would argue that, because of the implied guarantee of Fannie and Freddie's debt, they require closwer supervision. I agree. But to say that regulators should have zero visibility into highly leveraged intermediaries like hedge funds and private equity firms is also unwise.

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Salt Lake City, Utah: I am a wholesale A/E for conforming and Alt-A. My question relates to the Alt-A products. What I have seen is the high LTV Stated income seconds (100 percent) go away. Why is this being affected? Are these prodcuts considered Sub-prime?

Additionally I have a comment. With the sucess of Fannie Mae's, "My Community" and FHA's loan program, which are basically a sub-prime loan that is insured, why doesn't the market follow their sucess? This has never made sense to me.

Robert Carrington

A/E Bankerswest Funding.

Steven Pearlstein: Not sure I understand the lingo. Sorry.

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Rockville, Md.: Better underwriting standards can't cause a free-fall in home prices-- only the evaporation of liquidity can do that. That's why Congress created Freddie and Fannie to serve the middle class, conventional mortgage market back in 1970: when there was a liquidity crunch severely affecting middle class homeownership. Because of their GSE status, Fannie and Freddie have the ability to keep mortgage markets liquid when liquidity gets hard to come by in the general capital markets.

Steven Pearlstein: Precisely. And you can be sure that once the banks decide that mortgages aren't ther things to hold, they'll all sell them off quicker than you can say Resolution Trust Corp. The idea that these guys are careful, deliberate and wise in their investment decisions is laughable. They behave like a herd on the way up and the way down.

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College Park, Md.: Shouldn't any credit-worthy person be able re-finance today at about 6 percent fixed?

Are the forclosees people who can't handle even that? Did mortagers really lend to people who needed 4 percent as their permanent rate?

Steven Pearlstein: I'm afraid they did. Pretty neat, huh?

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Annapolis, Md.: Has America, culturally, over-rated homeownership? American Dream, and all that?

Other than lifelong singles who live in cities, just about everyone who can afford it WANTS to own; and we encourage it through government-subsidized fixed rate mortgages and interest deductions because home ownership builds stable communities.

Is renting a better option that it's given credit for; and not a sign of failure?

Steven Pearlstein: Yes, I think thwere is a cultural bias, as well as a tax bias toward home ownership that is overdone.

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Boston, Mass.: I don't understand all this worry about the subprime lending market. The subprime lending market is a good thing. Everyone that is able to get subprime loans now were simply shut out of the credit market altogether in years past. They have worse credit, perhaps debt, perhaps lower income, but there is an interest rate that reflects that risk and thats what they pay. When we talk about record defaults rates please please note the actual rate, and recognize for the 1 person defaulting there are a few struggling and dozens living happily in homes that they wouldn't have had access to.

Steven Pearlstein: You know, the problem in subprime isn't that people with basd credit hisotirs got loans. Its that they got loans structures in a way that pose big risks down the road -- not because the people have bad credit histories, but because they really didn't have the income and assets to justify a loan of that size. You don't do anyone a favor making them an owner of a home they can't afford.

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Alexandria, Va.: What causes an inverted yield curve?

Steven Pearlstein: In this case, too many investors and central banks wanting to buy Treasuries at a time when the Fed is trying to use overnight rates to control inflation.

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Fairfax, Va.: Steven,

Do you see any parallels developing between the present mortgage default rate trends and what happened in the late 1980's early 1990's when the economy slipped into recession, banks and S and L's became under capitalized, credit tightened, and home values fell hard resulting in a massive rise in foreclosures. I don't yet sense that those doomsday forces are in play today. The economy seems strong, employment is relatively low and banks liquidity positions seem strong. People who remain employed and don't have to sell can continue to make payments even if their home price is less than their outstanding mortgage amount. Maybe this is just a minor blip from people who took on a more risky loans than they should have?

Steven Pearlstein: Yes, there are some scary parallels. Let's hope regulatorde have learned the lessons from previous mistakes.

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Pasedena, Md.: How localized is this? Is it mainly a problem in the urbanized areas where the housing price bubble created pressure for illusionary low-rate mortgages; or is the low-cost heartland in trouble, too?

Steven Pearlstein: Biggest problems now are in Aeriz and Florida, bubble territory, but also the heartland where manufacturing problems have impacted the job market.

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Rockville, Md. The great part of today's column is that it lays bare the underlying politcal-economic forces driving Bernanke's shoddy analysis. The Fed loves the hedge funds and the big banks m aking money on these subprime ARMs but the products "work" only because the profits come out of subprime borrowers hard-won home equity. When macro conditions (falling home prices, end of borrowers' ability to use remaining home equity to refi into another bad loan) prevent that from happening, end of free ride. Your point: that's where Freddie and Fannie need to come in and use their government sponsorship to engineer a transfer of those borrowers who can be saved into a transparent, affordable fixed-rate product that entails no further equity-stripping. I think that's your point? Am I mistaken?

Steven Pearlstein: Not exactly, but its a provocative analysis.

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Atlanta, Ga.: There are plenty of people who can't afford higher payments - there are tons of people who have refi'd and owe 125 percent or more on their home. (answer to above question).

I'm happy we owe 25 percent or less of what we could sell our home for (that would be a bad market). It's still a large mortgage, but doable. And, I think I saw something about owning vs. renting re: NYC where so many just rent without thinking - one of the drawbacks is that after 20, 30 or more years, most renters have not built up equity, and while their peers have, and can do what they want (includes retirement) they just don't have the savings. This was cited as a negative for the rent control that NYC has (that is a horrible practice, for so many other reasons as well.). No matter what the cost of the house, at the end (if you're responsible) you own it. So even if rent is LESS, over time, you are forced to save.

Steven Pearlstein: Yes, the forced saving aspect of a house is a good thing. Of course it weorks only if house prices rise over time, which certainly has been the case. Not sure, hoever, that the next 40 years will have the same appreciation as the last 40.

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Steven Pearlstein: That's it for today, folks. Got to go out and shovel snow!

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