Washington Post business columnist Steven Pearlstein was online Wednesday, Aug. 15 at 11 a.m. ET to help separate fact from myth in understanding how the Fed responded to the financial market turmoil.

Read today's column: Seeking a Wrench To Stop the Drip (Post, June 13).

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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Washington, D.C.: What happens exactly when the Federal Reserve puts liquidity into the market? Where does the money go?

Steven Pearlstein: The money, freshly printed, goes into the banking system, which needed the cash for some reason because it offered to swap some of their no-risk securities for cash at the overnight "repo" window at the NY Fed. The target interest rate for that kind of overnight loan is set by the Fed. The next day, those loans can be rolled over, or not, at the Fed's discretion, depending on whether the Fed wants to inject more liquidity into the system or needs to intervene in the market in order to get the prevailing overnight bank interest rate at its target.

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Gainesville, Va.: Given the recent stock market troubles, is the housing market still headed downward? I ask because it seemed as if it was starting to level its self out. Now I'm hearing that the uncertainty on Wall Street and those ARMs adjusting this year and next will lead to more foreclosure's and more unsold homes. Are we going to continue to see the price of homes fall? If so, how much longer do you estimate this slide to continue?

Steven Pearlstein: The better bet is that they will continue to decline for quite a while.

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Baltimore, Md.: Steven: I heard some financial analyst opine the other day that the damage is going to be limited to hedge funds and private equity--that "Joe 401(k) won't be the one hurt by this."

How can anyone make such a statement? When the market drops nearly 1000 points in a month because liquidity has dried up, how can "Joe 401(k)" not get hurt?

And I know you are not a financial advisor, nor do you play one online, but if you were "Joe 401k" with some years to retirement, would you let the turmoil play out, or would you do the modern equivalent of stuffing cash in a mattress--flee to CDs and money markets?

Thanks as always for helping us make sense of stuff that makes no sense.

Steven Pearlstein: I would have told you a few months ago to take a good deal of your profits and load up on cash. That would still be a good idea, although obviously a bit less good. The chance that you are going to miss a big up in the market is a lot lower than the chance you'll miss another significant leg down.

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Orlando, Fla: Dear Steven: Nobody has talked about the costs of FED's actions by injecting such amounts of liquidity in the financial system. Is it possible to treat the monetary policy as manna coming from heaven without any cost to society?

Steven Pearlstein: It looks like printing money because that is precisely what it is. If you do too much of it, you run down the value of the currency. But in temporary dollops like the Fed is doing now, just to maintain its target federal funds rate, it is a free lunch.

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Boston, Mass.: What is worse: inflation or a credit crunch?

Steven Pearlstein: That's the Fed's dilemma. And the problem is that it is facing a double-front war with a limited number of crude weapons.

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Washington, D.C.: Not a question, just a thank you to you and your colleagues for your ongoing coverage and analysis of the market gyrations of the past fortnight. I opened up the paper Saturday morning (actually, logged on to WaPo.com), and was pleasantly surprised by the number and depth of stories outlining the week on the Street and in the markets, particularly for a Saturday paper in the dead of August.

Even in this day and age of the incredible shrinking newspaper, I'm glad to see there's still some there there when it comes to quality business coverage.

Steven Pearlstein: Thank you. I'll pass on the sentiment to my colleagues.

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Columbia, Md.: Well, is now a good time to start buying beaten down stocks or do you think that should wait a while longer, say after October? Thanks.

Steven Pearlstein: Probably not a good time for an individual investor unless you have a high appetite for risk.

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Arlington, Va.: What are the chances we'll see a worldwide recession as a result of the current financial crisis?

Steven Pearlstein: Higher than they were last week, certainly, and rising fast.

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Rockville, Md.: Steven, I wish I understood this better. Could you suffer some basic questions:

1. Other than raising our awareness level, do you see any good things coming out of this?

2. "Liquidity" is sometimes used by market traders as a kind of euphemism for being on the wrong side of a supply/demand equilibrium (i.e. "stock XYZ isn't liquid right now, so I can't dump my shares without falling the price") Is the problem here truly liquidity, or is it something more fundamental.

3. I had sometimes wondered if all the home price increases, which in turn allowed homeowners to borrow against increased nominal property values, was increasing the money supply and hence driving inflation and the weak dollar. Is this crisis in some sense making our money real again?

Steven Pearlstein: The good coming out of this is that it will reduce a money supply that had got out of hand, will wring the system of the excess credit that has built up, and bring real estate and other asset prices down to an economically justifiable level. Its a necessary, painful adjustment that is, at most, a quarter finished.

Liquidity is simply cash. There are all sorts of situations when there is a temporary shortage of cash to borrow when sentiment turns bearish very quickly, as it has in recent days--when the normal lenders are actually trying to borrow themselves. It is not that these institutions are insolvent, it is just that their assets aren't easily turned into cash. And at that point, having the Fed act as a temporary lender of last resort helps provide some lubrication for the financial system to prevent it from freezing up.

Your last point is very insightful. Banks aren't the only institutions that create credit any longer. Bond and derivatives market do as well. So there was a virtuous cycle on the way up: higher real estate prices led to more lending and borrowing, which in turn helped to push up asset prices again, and so forth. Now that virtuous cycle has turned vicious.

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Tampa, Fla.: Re: Credibility: Bloomberg News reported ("Banks Sell 'Toxic Waste' CDOs to Calpers, Texas Teachers Fund", June 1) that Bear Stearns was pitching CDO equity tranches (aka first loss tranches) to public pension funds as having "strict oversight" by the ratings agencies. This is utterly fraudulent, of course. The ratings agencies only state their views on the likelihood of default. Further, the report says half of all CDOs sold in 2006 had sub-prime mortgages in them.

To me, this epitomizes Wall Street's hypocrisy. Can you think of a better example?

Further, I think this shows that the sub-prime crisis goes far deeper than is commonly believed. Public pension funds will have to make up their losses on CDO equity tranches. I wonder what Wall Street will try to sell them to fix that problem.

washingtonpost.com: Banks Sell 'Toxic Waste' CDOs to Calpers, Texas Teachers Fund, Bloomberg, June 1

Steven Pearlstein: It is true that these securities were widely held. But if a pension fund had just a bit of exposure, it shouldn't really affect the pensioners over the long run. You wins some and you lose some in this business.

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Freising, Germany: How long do you think the stock market will be depressed by the credit situation? If funds are being forced to sell off good assets, then aren't those assets still good assets?

Or is the panic instinct of the herd expected to draw out this predicament over a longer time?

Steven Pearlstein: The good assets are still good, but if too many people are desperate to sell them to raise cash, then it will tend to drive the price of those assets down on trading markets. Remember, prices are set by whatever the last trade was. And the decline in the market price of good assets will show up as declines in the stock indices, and then to a lower confidence on the part of investors everywhere.

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Alexandria, Va.: You write: Actions of big banks and investment houses have resulted in "effectively shutting down the $3 trillion global market in short-term commercial paper ".

I have never understood what causes would make a money market fund's value to fall. Are we in the middle of such a causative event? Is the result of extravagant investment strategies going awry going to be a devaluation of conservative investments such as money market funds?

Steven Pearlstein: The value of a money market fund might temporarily fall. But remember, these are short term IOUs, and as long as nobody defaults on those loans (which is not happening yet, and may never), then all the money market fund has to do is hold the IOUs until they mature and then get 100 cents back for every dollar lent, plus interest. So investors in money markets shouldn't have to worry much about the decline in the value of the commercial paper on secondary trading markets, as long as the fund has a manager smart enough to hold on to the paper until maturity.

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Great Falls, Va.: To one of your main points of late: There are news reports today of an Australian hedge fund that estimates it's lost 80 percent of its value, but that's a loose estimate because it is incapable of providing an accurate value of the assets it holds. No market for the assets, I suspect.

Steven Pearlstein: Precisely. And if it holds on, there is a good chance it will get a better price for those assets when the market for them finally opens again, which it inevitably will.

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McLean, Va.: If I hold an individual bond and there is stock market turmoil, that bond becomes worth less because there is more demand more newly issued bonds with higher yields. But how does the stock market turmoil typically affect a bond fund (for purposes of this question, let's assume a bond fund that stays out of the riskier stuff), which I presume is constantly either (a) trading in and out of bonds or (b) having old bonds mature and buying new bonds?

Steven Pearlstein: I'm not sure you have identified the key factors there.

The price/value of any bond, no matter the yield on its face, goes down when the general level of interest rates goes up. It goes up when rates go down.

Another factor in the price of bonds is whether the issuer, the borrower, becomes a greater or lesser credit risk, that is, a risk of not paying back on time. So you can have a situation when interest rates are going down, and the price of the bond goes down, if the bond was issued by a company that may be in trouble or backed by an asset that may not be worth what was originally expected.

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Gainesville, Va. (again): Mr. Pearlstein, thank you for your assistance.

What are the chances that we enter a Depression or Depression-like stage in the economy? I am only 25, but it seems like forecasters are acting as if the end is near? A little scary for a recent grad and first time home buyer.

Steven Pearlstein: We're not going to have another Great Depression because the world has gotten smarter and we have institutions to prevent it going down like that again.

But we are in for a tough period in financial markets with negative consequences for the real economy. That's about all anyone can say at this point.

Some people disagree with me on that, arguing the markets will soon rebound because all this selling is irrational. If you turn to CNBC, you can hear the cheerleaders almost non-stop. To my mind, they have their head in the sand.

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Dumfries, Va.: Is this action by the Fed a temporary "finger in the dike" or will it have a lasting effect?

Steven Pearlstein: It is clearing up a temporary breakdown in certain kinds of credit markets. It won't prevent, nor is it intended to prevent, the deleveraging of the financial sector and the economy and the repricing of risk, which are the fancy names for what happens when a bubble bursts.

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Great Falls: You've done a tremendous job of identifying this problem months before it came to a head. I agree with your recent comment that the WSJ is the place to get the best insight (at least for a layman), but your commentary has been some of the most clear-sighted that I've read.

What's your thinking behind the suggestion that Bernanke might soon open the door to a rate cut? I agree more with the sentiment that the Fed can't be viewed as bailing out irresponsible behavior -- and it seems to me that we need a few more months of neutral Fed positioning to send that message.

Steven Pearlstein: Bernanke needs to demonstrate that he is aware of the dynamics going on in markets and how those dynamics could spill over into the economy. If he is candid and honest about that, he has to admit that the chances of an economic downturn are now at least as high as the chances that inflation will accelerate--and, indeed, that there could be a period of slow or now growth AND inflation. That's a conundrum for a central banker, whose primary tool, raising or lowering interest rates, can't be used simultaneously against both problems. So he has to indicate what he might do to try to fight this two-front war.

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Washington, D.C.: Addendum to the recent question from Baltimore about individuals' savings -- note that money market accounts may not be all that safe either. It's recently been disclosed that some of them held riskier CDOs as well.

Steven Pearlstein: There is that risk, but as long as the CDO pays all or most of the monthly payments that are expected of it, it shouldn't be a problem. If not, then the value of the money market fund will fall and investors might suffer a loss of principal.

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Washington, D.C.: To follow up on the housing market question, I don't want it to drastically effect the rest of the economy too much, but hope that it keeps sliding quite a bit? Is that a crazy thought?

A lot of people who have made hundreds of thousands in the last decade almost deserve to get their comeuppance for their naked greed.

Steven Pearlstein: Housing prices have to come back in line with household incomes, assuming a reasonable interest rates and mortgage terms. Recently, the assumptions had been based on rock bottom rates and too easy terms. And even then, house price growth had exceeded income growth.

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Dayton, Ohio: Steven - how much of the house price decline is due to a surplus of housing? Of course, this varies by regions and market sub-sectors: southern california, big-city condos, mcmansions, etc. - but is there a significant component of simple supply-and-demand at work?

Steven Pearlstein: I think you have to ask the question of why there is a surplus over demand. And that has to do with the credit bubble -- cheap financing for builders and developers, lots of speculation in residential real estate by the "flippers," etc.

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Reston, Va.: I thought that when segment of the economy tanks, others segments hold steady or grow, and that is why we all want to diversify. But it seems like everything - equities, international equities, precious metals, commodities, real estate, corporate bonds are going down. Is it because of the invisible linkage of bonds and derivatives world wide? Will this mess in the hedge funds move into derivatives? Also, it seems like this cash crunch would have to be ultimately inflationary and yet if everything but short term treasuries are going down - isn't that deflationary? Thanks

Steven Pearlstein: A credit bubble makes cheap, easy credit available to everyone -- all industries and all households. And so if that is a factor in driving up economic activity, and driving up the value of assets, then when the bubble bursts, they all go down together.

So to answer your question specifically, the folk wisdom you cite is true during lots of periods, but not always.

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Bethesda, Md.: Does "providing liquidity" mean that banks were unwilling to lend to borrower's, that there were not enough buyers in the market to ensure that transactions were closing at fair value, or both?

Steven Pearlstein: The liquidity crunch was, first of all, caused when the banks all decided to bulk up on cash themselves for various reasons, all at the same time. So they weren't lending to each other in the overnight market. That is the market that the Fed and other central banks intervened in.

It is also true that certain markets have ceased operation because there are few if any buyers for certain types of securities. You could call that a liquidity problem as well. It is really more a situation when nobody knows what the right price should be. Nobody wants to be the first into the market hanging back to see how things develop. But if everyone hangs back, there is nothing to see.

Then there is the situation when nobody wants to lend into a certain market. That's more a credit crunch than a liquidity shortage.

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When you say "cash"...: Do you mean plain cash? Intermediate-term bond funds? CDs?

Steven Pearlstein: I mean just that, cash.

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Tysons Corner, Va.: I overheard half of an interesting conversation yesterday. A man (apparently a broker, or investment advisor) was explaining to his client, "no, that's commercial paper, you don't have any of that." He then proceeded to explain what commercial paper is to the client. I wonder how many brokers are getting calls like that these days? I also wonder if the callers are missing the fact that they're exposed to the greater effects on the market even if they don't own any commercial paper themselves?

Steven Pearlstein: I don't think most individuals hold commercial paper. The commercial paper is held by the bond mutual funds and money market mutual funds they have invested in.

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Washington, D.C.: I have some money in a mutual fund which invests in financial companies. I looked at the particular companies (eg Goldman Sachs) when I bought the fund and didn't see any sign that they were involved in the subprime business. I didn't realize how interconnected everything was. In the last 3 weeks, my shares have lost 15% of their value and fallen below my cost basis. I intended to hold these for several years but now I'm thinking of jumping ship- Any advice?

Steven Pearlstein: I would not want to be holding a mutual fund now that is focused on the financial sector. Just a personal observation.

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Floris, Va.: Steve: In your view, with one being no chance and ten meaning an absolute certainty, what are the chances of a U.S. recession in 2008?

Steven Pearlstein: In my opinion, two chances in three, or 66.66 percent. How's that for being specific?

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BDTLR, Va: Steven Pearlstein: I would have told you a few months ago to take a good deal of your profits and load up on cash. That would still be a good idea, although obviously a bit less good. The chance that you are going to miss a big up in the market is a lot lower than the chance you'll miss another significant leg down.

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Please mark down that you said. Not I believe one way or the other, but market timing is essentially gambling.

Steven Pearlstein: In general, I don't believe in market timing. But this to me was not that hard -- you just saw that the subprime problem would work its way up the financial system. Let's just say there are a few people around the newsroom here who are grateful when I told them at the beginning of June that it was time to take profits and hold cash.

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Ogden, Utah: As much a comment as a question -- why the hand wringing over the prospect of house prices going down? Sure, we lose equity, but if you never planned to borrow against it, so what?

bigger point: in many communities, such as St. George, Utah, the house price inflation has driven the normal folk, the police and firemen and teachers and nurses, out of town because they can't afford to live there any more. Making housing affordable for them again strikes me as a good thing.

Steven Pearlstein: I couldn't agree more. Having inflated house prices come down to more reasonable levels is a good, necessary, healthy thing. But if you have a mortgage based on the full, inflated value of that home, then your lender is not going to be a happy camper.

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Rockville, Md.: Hi Steve,

Thanks so much for your thoughtful commentaries. I hope this isn't a dumb question, but I have read a number of references to "wait til October". Can you please comment of why October will be a significant month for the markets? Thanks.

Steven Pearlstein: Because in October, lots of publicly held companies and pension funds and some hedge funds will have to make their quarterly filing reports, and have to fess up as to how bad things are.

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Falls Church, Va.: SP: "I would have told you a few months ago to take a good deal of your profits and load up on cash."

Actually, the last time you said this, the Dow was right at where it is today, around 13000. I remember because it subsequently went up 1000 points, and has then come back down. It's worth noting that in all of the recent "turmoil" and scare talk, the market has only lost lost a couple of months' gain.

By the way, now is a great time to buy financial stocks on the cheap.

Steven Pearlstein: It may be a good time to buy financial stocks, but not if you are risk averse. Just because its a smart bet for Carl Icahn doesn't mean its a good bet for Joe Q. Public with a 401k valued at $100,000 that he'll need to live on in five years when he retires.

As to my missing the last 1,000 points in the Dow, you may turn out to be right if the Dow remains above 13,000. I'm not sure that's a very sound assumption.

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College Park, Md.: Cash, as in a savings account, yes?

Steven Pearlstein: Certificates of deposit, short term Treasury bonds and notes, money market mutual funds.

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Pittsburgh, Pa.: What factor(s), if any, would indicate to you that markets have stabilized/bottomed out?

Steven Pearlstein: One good sign: spreads between Treasuries and other bonds getting narrower.

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Steven Pearlstein: That's about all the time we have for today folks. "See" you next week.

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