The Fed Response

Washington Post business columnist Steven Pearlstein was online Friday, Aug. 17 at noon ET to help separate fact from myth in understanding how the Fed responded to recent financial market turmoil.

Fed Intervenes to Calm Markets (Post, Aug. 17)

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.

A transcript follows.

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Rochester, Minn.: It seems that for us small, Roth IRA, 403b investors about the only thing to be done is grit our teeth and hold on for the ride. Is that an accurate portrayal of these tumultuous times?

Steven Pearlstein: I think it is fair to say you could have seen this coming in the last couple of weeks and taken some profits by selling some or all of your stocks. I'd say if you have some good longterm gains, it would not be a bad idea to take some money off the table, put it in a moneymarket or bank CD for six months, and let things calm down a bit. There is still a lot of downside risk here.

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Washington, D.C.: Am I off base to feel a little disappointed that the Fed is doing this? On some level, I feel that a lot of the turmoil in the market is due to the bad decisions of business over the last few years coming back to finally bite them, therefore don't feel they should get any help in weathering this. I understand that "Real People" are getting affected by this with tightening credit, but it still seems to be that this is a natural extension of bad decisions by the companies. Thanks for any insight you can provide.

Steven Pearlstein: Look, the kind of trading volatility and freezeups on credit markets have gone well beyond the point where you get when you have a need to have the bad decisions "punished" and the warning sent about future risk taking. The Japanese stock market today closed down 5 percent in one day. This is a free fall--and there isn't much subprime debt in Japan. The Fed got it exactly right this morning, and by he way still did not cut the key federal funds rate. Trust me: the wise guys are going to suffer plenty before all this is over. And it ain't over.

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Boston: With the Fed dropping the discount rate (and holding off for now any change to the Fed Funds rate), how many cards does the Fed have left to play? What does it mean if none of them have the desired effect of stabilizing the markets?

Steven Pearlstein: The Fed has lots of cards to play. There is the Fed Funds rate, there is widening the kinds of things they will buy or take as collateral, there is allowing other entities besides banks and thrifts from accessing the discount window. There is currency intervention, which it does with the Treasury. As a bank regulator, it has some interesting powers as well, being able to relax some rules while tightening others, in response to particular freeze-ups. We're a long way from having to worry about their having no powder.

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Charlotte, N.C.: If the $40,000 income earner can't make the negative amortizing payment on his $650,000 loan when it adjusts, he won't be able to make it whether Fannie Mae or Freddie Mac buys the loan, or not. The loan is a loss.

When a person's home has become worth less than their loan, it's time to walk and that's it.

The only problem with this approach is that the mortgage is not written such that in such an event by repossessing the house the liability of the homeowner would be eliminated. Hopefully soon we will have a change in laws to ensure that

Steven Pearlstein: Nobody is suggesting FAn and Fred buy loans that are badly underwritten, unless, of course, they are at a big discount so that they can refinance it on sustainable terms at a lower principal amount. As I've written several times in the last few months, there needs to be some creative new mechanisms to make it easy for the mortgage holders to do these workouts and refinance the loans according to Fan and Fred standards so they can buy them up. The problem is that the regulators aren't encouraging/requesting Fan and Fred to really take the lead here in designing these new products, at least as far as I can tell, because their basic attitude is that Fan and Fred are illegitimate financial entities, political thugs and accounting fraudsters who are a mortal threat to the safety and soundness of the financial system.

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Washington, D.C.: I have CD's with Countrywide Financial that are FDIC insured. Should I be worried about them? Should I be worried about buying additional CD's with them? I don't know what the process would be if they happened to go into bankruptcy. How hard is it to get my money from the FDIC?

Steven Pearlstein: Don't worry. Your CDs are insured and the FDIC is very good at making sure you can have access to your money if, God forbid, something should happen to Countrywide. At this point, things seem to have stabilized, and my sense is that the regulators have been helpful in getting Countrywide the financing it needs temporarily while it reduces its operations and sells off some of its portfolio.

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College Park: Hello Mr. Pearl,

Would it be accurate to characterize today's Fed move as a bail-out? If so, would if be fair to characterize it as something good in the short term that will probably eventually come back to bite us?

Steven Pearlstein: No and no. It is an appropriate government response to a well-known market failure, known as collective action problem. That is, if everyone keeps lending to good customers, and rolling over good loans at a somewhat higher rate, then in the end, this thing will get worked out, people will take their haircuts, and markets will reprice all this stuff in an orderly way. But if everyone acts on fear and decides to pull back at the same time, then everyone will wind up worse off. So this is getting everyone to act collectively in their collective best interest, rather than doing what may look to be in their short-term interest but in fact creates a self-fulfilling downward spiral. The interventions help to convince people to act rationally, calmly, and not throw out good assets and good loans with the bad. It prevents everyone from running for the exits at the same time, which can get a lot of innocent people burned.

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Harrisburg, Pa.: Do you think there are going to be more sudden surprises at closing in the next few weeks in the DC area? We're in the process of buying a condo and already had to switch to another lender after a sudden demand by BOA for 20% down a week before closing. And that's on a relatively modest $300,000 condo . . . not a jumbo.

Steven Pearlstein: You betcha. The mortgage market is in a big state of flux, not only in terms of availability and cost of money but just the terms of loans that will be accepted, and who will deal with whom, and what the fees are, etc. Stuff will get done, but it will just take more time and patience.

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Vienna, Va.: You still see ads for very low interest, no documentation, loans; even in the WashPost today. Isn't it obvious that the rate cut by the Fed is premature, meant only to satisfy the proverbial 'big' boys?

Steven Pearlstein: You may see ads, but the people putting them in the paper may have to hold those loans themselves, because there isn't much of a secondary market for them. Or they may be advertising something as a come on that they can't deliver on. I just don't know.

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Fairfax, Va.: So does any one really know the extent of the mortgage potential loss? How high would it be? A few hundred billions or maybe even trillions?

Steven Pearlstein: Many hundreds of billions. But you have to understand that its not that simple, because the losses in the mortgages may be less than the losses in the values of the securities backed by packages of mortgages, at least in the short and medium term. So that hit to the financial system could be very large.

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Richmond, Va.: Excuse me, please, but I thought that new fed chairman was going to be different than the old fed chairman and let the sellers of these bad loans finally pay for their nefarious behavior. I'm pretty sure, aren't you, that this is another sign that any financiers that want to make and take any risks know, by years and years of bail outs, that they will be saved by the government? Jeesh.

Steven Pearlstein: They are not being saved. If they were, I'd agree with you. The fed is not buying these bad loans. It is not accepting them as collateral. It is merely injecting cash into a system that is temporarily short of cash. If there are bad loans, the piper will be paid in full.

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Laurel: The exchange value of dollar vs the Euro is up about 2% in the last month and the price of crude and gasoline have dropped.

Is illiquidity of credit making our greenbacks more valuable?

Steven Pearlstein: Since I screwed up in this morning's column and mixed up buying and selling yen, I'm reluctant to answer your question. The dollar is up recently because of the flight of investors to US Treasuries, which they need dollars to buy. Longterm, it has to continue to decline.

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Prescott, Ariz.: How come we get fed a bunch of tripe about the "free market" and "personal responsibility", but when the overlords start getting some "personal responsibility" handed to them for constructing these elaborate Ponzi schemes all the talk turns to bailouts and emergency interest rate cuts?

Steven Pearlstein: As I said, its not a bailout, and people will suffer. One group that won't suffer as much as it should are hedge fund managers who have already got big payments because the value of their funds grew very briskly over the past couple of years, earning them big fees. Unfortunately for the investors, now that the funds are decliningin value, the managers don't have to give back those fees -- no clawback, as they say on Wall Street. And that is something to get enraged about, since many of those investors of pension funds that manage the retirement money of lots of ordinary people.

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Alexandria, VA: Contrarians often do better than everyone else.

What are contrarians saying and doing?

Steven Pearlstein: They're buying, selectively.

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Laurel: Anyone can time the stock market in retrospect.

The S&P 500 is down about 10% from its June/July highs, but still up since March.

Was there anything that should have indicated to hold in March and sell in June?

Steven Pearlstein: There were lots of sell signals in June. I said so at the time.

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Oviedo, Fla.: Take money off the table? I just lost $41k, about 7% of my portfolio. Why would I sell low?? I like the Vanguard and T Rowe Price mutual funds I have and plan to stand pat. I don't plan to touch the $ for at least 12 years... single mom - I wasn't worried until I read your sell idea

Steven Pearlstein: You should never look at these decisions in terms of what you just lost. The question is where you think things are going from this point. If they go down another 7 percent, you would have preferred that you were sitting on cash paying 4 percent. That's an 11 percent difference. Now can I tell you stocks will fall another 7 percent. Of course not. And in the long run, they will be back above their recent highs. In general, I don't recommend trying to time the market. But there are times when you know a correction is coming. And in this case, there is no indication that it has played itself out. Sure, if you are sophisticate money manager, you can play these markets and make a lot of money. But in general, this is not a market for amateurs. Either stand pat, as you usually do, or stand to the side.

By the way, you should continue to buy stocks each month through this period as money goes into an IRA. The only thing I'm talking about what to do about the stuff that was already there. Why the difference. Because if things are going down, you are buying on the way down, which is taking advantage of the lower prices.

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Washington, D.C.: Recently discovered your columns and chats. Wish I had found you two months ago! Here's my question. With the changes in the mortgage market, it seems that home prices will have to fall. Do you think that's correct? We're thinking of buying a starter home, meaning we would want to sell in 2, 3, maybe 4 years. With interest rates going up, we feel pressure to buy now before they go higher. But I worry that prices will fall, and when we want to sell, the value of the home may have fallen from our buying price. Are these legitimate concerns? Any advice? Thank you.

Steven Pearlstein: All legitimate concerns. I suspect the bigger danger now is the falling in the value of the equity you will have in the house, as opposed to the extra money you might spend on interest rates. In the long run, house values are affected by interest rates -- when rates go up, values go down, and vice versa. But since you are dealing with a relatively short period of time, you have to focus on not losing money on buying and selling the house, ,particularly after paying all those fees. That means you shouldn't rule out the rental options.

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Washington, D.C.: Do you think that the Feds Fund Rate will decrease on September 18?We're searching for property now (we currently rent an apartment), but, with the latest jitters, should we hold off?

Thanks

Steven Pearlstein: As I said, that sounds like a good option.

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Arlington: From today's Post--

"The Dow Jones industrial average closed down 15.69 points, or 0.1 percent, at 12,845.78. It is up 3 percent for the year,"

Wow, things sure have gone to hell-in-a-hand-basket. The Dow is only up 3 percent for the year.

Seriously, I know there are some problems but your move to cash advice smacks of panic and market timing. Two things good investor should avoid.

Steven Pearlstein: Yes, its market timing. But market timing in the first few weeks after a credit bubble has burst, a huge one, is not a bad idea. That's different than a normal stock market correction. This is a credit market correction, with serious implications for the economoy and stocks. A different animal. And I don't think it is beyond the ability of the ordinary person to tell the difference. Apparently it is beyond the ability of market professionals,however.

As to what happened yesterday on the stock market, there are lots of complex dynamics going on there, including lots of short covering and coming up on the end of futures contracts. I would say that the 5 percent decline in Tokyo, along with the incredible volatility yesterday, was definitely not a good sign for the market. As I said, this is not a typical stock market correction story.

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Re: Paying: You said: "Trust me: the wise guys are going to suffer plenty before all this is over. And it ain't over."

For us little guys, how are they going to pay?

Steven Pearlstein: Their portfolios will be a lot lower. Their stock prices will be lower. They won't get those bonuses this year. Their reputations may be tarnished, or they may lose their jobs, particularly if they originated bad loans.

Now, having said that, it is true that the people at the top of Wall Street always find ways to make sure that they are playing with other people's money, so when things go down, it is the other people who suffer, collectively, the bulk of the losses.

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Baltimore: Steve: It is amazing how quickly things changed in the mortgage industry. In 2000, I bought a row house in Baltimore for just under $90K. As I was self-employed and putting 5% down on a 80-15 loan (to avoid PMI), I had to furnish two years worth of tax returns, statements from my savings account, my IRAs, etc. When did the industry (or a large segment of it) decide not to ask nosey questions (like, how much money do you have) when people were buying half million dollar homes with exotic below market short term rates? And how could the industry not see this would have to blow up eventually? I know these are rhetorical questions, but was this the 21st century version of Dutch tulip bulb mania, as cataloged in that wonderful book Extraordinary Popular Delusions and the Madness of Crowds.

Steven Pearlstein: It was a good book, and it is amazing, isn't it. What were these people thinking about?

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Manassas:"By the way, you should continue to buy stocks each month through this period as money goes into an IRA. The only thing I'm talking about what to do about the stuff that was already there. Why the difference. Because if things are going down, you are buying on the way down, which is taking advantage of the lower prices."

This makes no sense. What you are saying is I should buy stocks today, but then tomorrow once I have them, I should sell.

I think you need a better plan.

Steven Pearlstein: Picking bottoms is really, really hard. You might want to suspend purchases for a few months, and see how things go. But picking bottoms is really, really tough. By the same token, I would have suggested gradually lightening up on purchases as the bubble got bigger and bigger.

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Raleigh, N.C.: I have my retirement in mutual funds. I'm in my mid-40s, and I have my money in fairly agressive funds. In previous times like these I've just rode out the market, but I'm seriously thinking now about moving to more conservative funds. Would that be a good move?

Steven Pearlstein: Move some money to cash (not bonds). Euro cash, even better.

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Sterling, Va.: With regards to the housing market, and the prices and the likelihood of more bad things to come, I'm always struck by the NAR's optimistic viewpoint. I know they represent realtor's, but what possible benefit is there to being that optimistic, and destroying any credibility that you might have? They can't really be that optimistic, can they?

Steven Pearlstein: They have actually got much more sober and realistic in the last few months, although they were in denial for a long time.

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Washington, D.C.: I need to buy an annuity fairly soon. So, as far as I know, for me, higher interest rates are better. Am I right to think that buying today is probably better than waiting perhaps 6 months?

Steven Pearlstein: You can't be sure. On the one hand, the spread between what borrowers pay over risk-free Treasuries is widening. But if the economy is about to slow, overall rates could fall by the end of the year. So it is a tough call. If you need to buy an annuity, buy an annuity. Trying to time rates in this environment over the next few months is very, very hard.

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Unreal Trading: You raised a good point in your New Order column last Friday that merits more attention as a fundamental problem:

'It is now common for the aggregate value of "derivative" instruments to be many times the volume of the stocks, bonds or commodities on which they are supposedly based.'

This is why the hedging models (quantitative and otherwise) break-down. The underlying problem of too much risk-taking is underrecognized because the models are based on past trends - they are 'free-riding' on old information and not analyzing the new fundamentals.

Seen any good articles on this?

Steven Pearlstein: That's not exactly free riding. That's being stupid. But thanks for the compliment. Maybe there is more to say about the quants.

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Boulder, Colo.: Since I'm a relatively new investor (in my mid-30's), a lot of this is new to me. However, it seems that a lot of these messes that we've had over the past 7 or 8 years is the direct result of Wall St. greed. In the late 90's, it was all about pushing out small, immature companies to the public markets and recently has seen a glut of LBO's (excuse me, private equity) and CDO's hitting the market. It seems to me the only common thead among all of these items are the fees that Wall St. can charge for each of the actions.

How can Wall St be held more accountable for their actions even though they are in the business of making money?

Steven Pearlstein: This is a very good and very fundamental question, because the markets don't seem to punish them for their mistakes. I think the reason is that there isn't good information out there for investors and issuers of securities to be able to tell which underwriters have good track records (the stuff they bring to market or the deals they organize turn out well) and which one have bad records. Unfortunately, people just go by reputation, which are not always deserved. But another problem is that there is insufficient competition in that market of investment banking because entry of new players is so hard. Without good information and robust competition, firms are not held accountable for their bad advise and judgment..

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Prescott, Ariz.: You say the "piper will be paid in full" by the people who made bad loans. Isn't an underlying issue here that these bad loans were repackaged over and over up the proverbial food chain to where they were eventually sold under safe bond ratings and whatnot, thus these bad loans were are propping up even the risk adverse investments people with little financial acumen were making, like mutual funds and pensions? Doesn't this mean that the piper will be paid not only by the risk takers but by people who were trying to stay out of riskier investments?

Steven Pearlstein: In that case, you'd hope the people who lost money because they were mislead or misadvised could have some resource with the people who mislead or misadvised them. But in these matters, it is hard to tease out the responsibility investors have to take care in what they buy, and the responsibility of those who advised them. Both are responsible, and in the idea world, both would be "punished" for the bad investments and loans. Whether that pain is apportioned appropriately is a big, unanswered question, but it is why an upcoming Supreme Court case is so important. The industry and the White House want to make sure that rating agencies or accountants or investment banks can't be sued if they aid and abet others who mislead investors. And if the industry and the White House succeed, it will really weaken the system, in my opinion, because these advisers and gatekeepers will always err on collecting the big upfront fees and shortchange the ultimate investor, knowing there is no recourse.

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Arlington, Va.: What about the under-30s?

Most of the people I've talked to seem to be inclined to ride it out.

Steven Pearlstein: That's fine. In the long run, you'll do fine.

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Washington: As I recall, you've been saying "sell" and being pessimistic for well over the past couple months. You were bound to be right at some point, just like the people who have been calling for a housing downturn for the past five years.

Steven Pearlstein: I was warning about this credit bubble for a long time. But I also know these bubbles last longer than you think they will. I didn't actually suggest people take money off the table until May and June.

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Princeton, N.J.: Steve, I don't see why people are jumping on you for making a clear stock market prediction. Most people don't have the guts to go out on a limb. They can do what they please and in a few months we will see if you were correct.

Personally, I managed to lose 60% of my equities holdings in 2000 through a combination of stupidity and greed. I am now trying to duplicate this feat.

Steven Pearlstein: I hope you fail....And thanks for the encouragement.

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Washington, D.C.: I have not yet made my $4000 yearly contribution to my Roth IRA. Is now a good time to buy since prices are low?

Steven Pearlstein: Again, if you've held back this far, I'd hold back a bit longer and see how things go. But you should be looking to start buying again when we've had a couple of weeks of relative calm in the markets.

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Indianapolis, Ind.: As a renter, I was wondering how long do you think it will take the events of the last month to impact the price of houses? Or do you think that building will slow down enough to maintain prices?

Steven Pearlstein: Even the homebuilders and realtors acknowledge there will be further price declines. Again, you don't want to try to find the absolute bottom before buying. But I don't see any need at the moment to go rush out and buy, unless you suddenly find the perfect place that is so unique you shouldn't pass it up. Later this year, as the normal season winds down, there should be some pretty motivated sellers out there.

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Washington, D.C.: Steven: To the poster from Raleigh, you said: "Move some money to cash (not bonds). Euro cash, even better."

How would an American move money to Euro cash? Are there funds traded here that hold Euros?

Steven Pearlstein: Don't know. You have to ask your banker or broker. Buy eurobonds, I suppose.

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Washington, D.C.: Please explain for this naive reader: "the spread between what borrowers pay over risk-free Treasuries is widening" -

thanks!

Steven Pearlstein: The difference between what households and companies pay for loans, and what the government pays to borrow for the same duration. That's the spread, since the government borrowing is considered risk free. That

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Arlington, Va.: Within the last half hour, I dumped $2100 into my mutual funds under the theory of buying low. Unfortunately I then checked WashingtonPost.com and saw the markers had shot up and you are recommending that people sell. Did I make a silly mistake?

Steven Pearlstein: Nobody can say now for sure. Obviously, it was better you bought today than a month ago, so think of it that way, and you'll feel better.

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Gaithersburg, Md.: If I follow your advice and take my money off the stock market table, will you tell me when it's hit bottom and I should get back in?

Steven Pearlstein: No, I just said, calling market bottoms is very very hard. Tops are hard too, but in the case of credit bubbles, it is a bit easier.

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Charlotte NC: An excellent commentary today on CNN.com/Money by Allan Sloan under the title

"The escape of the enablers. When Wall Street fails, it inevitably asks for a handout. Fortune's Allan Sloan says there must be a better way".

Wall Street loves to talk about letting financial markets weed out the weak. But when the Street itself gets in trouble, it sticks out its little tin cup, asking for help. And gets it.

The subprime-mortgage-market meltdown is a classic example of the way small fry get devoured, but the whales of Wall Street get rescued. Here's the deal: People with crummy credit who took out mortgages are being allowed to fail in record numbers. The mortgage companies that made those loans are being allowed to fail.

The Street itself? It's bailout city.

It's the "too big to fail" syndrome. In a world in which big players make incredibly large and complex deals with one another - that's what derivatives are - regulators don't dare let a big or important institution fail for fear that the collapse of one would lead to "cascading failures," and other institutions wouldn't be able to collect what the collapsed institution owed them.

Sure, we know that Ben and the boys will always bail out the biggies. And none of us - I think, anyway - wants the world's financial system to implode. But I'd feel a lot better if the Street had to pay a serious price to its rescuers--say, having to fork over a big equity stake and pay a loan-shark interest rate. That way taxpayers, who are picking up the tab for the rescue, would get paid bigtime for taking on bigtime risk.

After all, that's the Wall Street way

Steven Pearlstein: We'll let Alan have the last word. That's all for today folks. Hope to see some of you next week.

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