Credit Bubble

Washington Post business columnist Steven Pearlstein was online Wednesday, Sept. 5 at 11 a.m. ET to discuss Carlyle Group's rescue of one of its publicly traded hedge funds, and what it says about the credit bubble.

Read today's column: In a Too-Close Tango, Carlyle Trips Over Age-Old Missteps (Post, Sept. 5).

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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Dunn Loring, Va.: Merrill Lynch said this morning that there is a 65 percent chance of a recession next year. Three weeks ago you said there was a 66.66 percent chance of a recession. Why are you two so far apart?

Steven Pearlstein: Oh, those Merrill analysts are so optimistic!

Obviously, this is a guessing game. You can either guess by making some assumptions about some variables, and putting them into a sophisticated computer model (Merrill) or you can guess by just putting your finger up in the air (Pearlstein). But it is a guess all the same. Educated, perhaps. But still a guess.

Think about it for a minute. We've got the follow sectors likely to be either flat or declining: financial services, homebuidling, commercial real estate, autos, government(declining local tax revenue), high ticket household goods like furniture and appliances and domestic business travel. On the plus side you've got manufactured exports, health care (of course), some business services, telecom and restaurants. I don't see how you get much growth out of that combination, particularly after a quarter of a lot of inventory buildup (which was probably auto driven). Combine that with a more generalized credit crunch and the negative wealth effect from the recent market turmoil, and its pretty hard to see how we avoid falling into the ditch for a time.

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McLean, Va.: I saw some suggestion yesterday that the big banks are creating new funds to which they are quickly moving their most damaged CDO assets, rather than actually opening the proverbial kimono in the coming days. Can that work? I suppose that the asset values will rebound some eventually. But it still sounds rather Enron-esque.

Steven Pearlstein: I can only imagine the converstaions now going on with the lawyers and the auditors to see what their options are. The trick, I suppose, will be moving assets into offshore vehicles and subsidiaries that don't have to mark to market, or moving them from the tradable column to the hold-to-maturity column. If the regulators aren't all over this right now, then there is going to be much mischief.

But I suspect at least a few banks will take the different approach. They'll write off as much as they can, take a big hit now, wipe out their tax bill for the year and declare that the worst is behind them, hoping that their stock price is already reflecting the damage and they can build a bottom from which to rebound. You'll want to watch for this strategy as well, because it gives the false impression that the problems have been fully dealt with. And, of course, they haven't.

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Arlington, Va.: Isn't there a good argument to me made that the government should do nothing to assist homeowners with sub-prime mortgages? How else will home buyers learn that buying a house without carefully considering the mortgage is a bad idea? Also, I find it hard to believe that the federal government should react at all to help investors in this market. Even if the economy tailspins into a recession, they need to take a bath, otherwise, they'll just lean on Uncle Sam the next time one of their risky investment goes sour. Will the politics of Washington allow this to happen?

Steven Pearlstein: We all seem to be going round and round on this issue.

First, there are very few serious people (that doesn't include members of Congress, BTW) who want to do anything to bail out the big financial institutions, the brokers, the lenders, the homebuilders, the hedge funds, etc. Nobody. We all want them to experience as full a measure as possible of the consequences of their bad judgment. Also, nobody wants to help those who speculated in real estate or mortgage-based securities.

But there are homeowners who were mislead or who are simply not sophisticated enough to have known what they were getting into, and this is particularly true in the subprime area. These people will suffer enough to remember it, believe me. But to make them suffer the absolute full consequence of their actions may not, at the margin, provide much of a benefit in terms of their future behavior. Experience shows they will be pretty risk averse in the future.

So then there are the people in the middle, who probably knew better, took what they thought were reasonable risks, and could suffer more or less depending on how quickly markets stabilize and how much of an irrational selloff there will be. Because that's the issue here: how much of an irrational selloff will there be after all the irrational buying and investing. The markets will overdo it on the way down just as they overdo it on the way up. And is it a fair question whether the government doesn't have some role in trying to stabilize things on the down side to prevent a vicious downward spiral that causes economic harm well beyond the people involved in the bad decisions.

That's always a tradeoff, and it is an art, not a science. I don't think the job of the government, or the Fed, is necessarily to prevent a recession, because that is probably not possible anyway. But it is to prevent a healthy market correction from turning into a vicious cycle that becomes so self-reinforcing that it is very difficult to pull out of (Great Depression, Japan 1990s). And because the tools available to the government work with a lag, they sometimes have to make the key decisions even before it is clear how far the correction has gone.

So please, let's lower the volume on this bailout issue. Nobody serious is wanting to prevent Wall Street and the real estate industry from having to take its medicine. Nobody serious is falling for all the Wall Street single-minded focus on what the Fed will do. Nobody is talking about an S&L type bailout, because at the moment, deposit insurance is not coming into play.

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Great Falls: I do some work with hedge funds, so they're not the mysterious bogeyman to me that they are to a lot of people. Even so, I can't quite grasp why they draw so many investors. Are you aware that SAC Capital reportedly charges a 50 percent incentive fee, or that Renaissance Technologies charged a 5 percent management fee to go along with a 44 percent incentive fee? One might say that's fine, because the investors are still (usually) netting more than they would through other investment vehicles. But that ignores the attendant risk, which is not insignificant.

I'm sure that there are plenty of wealthy people that don't mind gambling a bit with their money. But I fear that the explosion in hedge funds is really fueled by pension funds investing in them. If a big blowup is coming -- and I won't be surprised to see it in the next 90 days -- there might be a lot of unfortunate victims.

Steven Pearlstein: You got that right.

The fee thing is fascinating. You could imagine a competitive model in which the fund managers take all the surplus, leaving investors basically with no choice but to earn average returns no matter how good their particular fund performs. But that shouldn't happen in a competitive market, because at least one fund manager will realize that he can make more money by running a larger fund that chargers a lower fee, and thus generates a higher return. And once one guy does it, the others would have to follow along. And eventually the fees would probably equilibrate at some point where most, but not all, of the surplus (the profit from above-average investing) goes to the investor.

But that hasn't happened, has it. So it must be there is imperfect competition, probably because of imperfect information or difficulty of entry of new players or--my candidate--oligopolistic behavior in which the funds tacitly agree to compete on the basis of everything EXCEPT price, because they know it will be a slippery slope that will result in them all coming out losers.

As to your other point, there is simply no question that the fee structure incentivizes the fund managers to take undue risks. In the short run, that creates a frenzy to buy things that creates an asset bubble that makes them all looks like geniuses. But when it crashes, they still collect their fixed fees, and don't have to give back any of the incentive fees they made during the bubble. So it is a heads-I-win, tails-you-lose kind of bargain. And really smart investors will avoid these kinds of fee structures in the future, so that the managers have more downside risk over the long run. The tradeoff for that, of course, is that investors have to agree to have their money locked up for an extended period of time.

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Eden Prairie, Minn.: the current debt bubble will lead to deflation. why doesn't the media report the reality of this unprecedented economic situation? to think that the fed will come to the rescue is absurd......the fed is responsible for creating the bubble by keeping rates too low for too long and to attempt to reflate yet again will only prolong the inevitable. do you agree?

Steven Pearlstein: No I don't fully agree, as I explained before. To blame this bubble on the Fed is really overdoing it. The Fed didn't create all this credit and money. The unregulated credit markets did. If you want to blame the Fed, blame the Fed as the leading bank regulator, that allowed bank holding companies and big financial institutions to create all this credit. But don't blame the Fed for this because it kept interest rates too low for too long. That's probably true. But it was not the main driver. If any central bank is to blame for this, it is the central banks of China and Japan and Russia, which printed money in order to hold down the value of their currencies against the dollar.

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Atlanta: re: last week's column and poverty:

Did you read your colleague Robert Samuelson's column from today (he indicates that most of the 'increase' in poverty in this country is due to poor hispanics coming here, illegally, I might add)?

Or look over statistics regarding the fact that many people who live in poverty have TVs, cell phones, several bathrooms in their house, etc?

Or the fact that the government only uses income as a factor in poverty stats? So if you have no income, but have $500 million in the bank, you are considered 'poor'?

Steven Pearlstein: Well, if you remember my column, the first thing I did was chastise liberals for using the poverty statistics without acknowledging their imperfect nature. So I agree that things are not always as bad as it may appear from the headline numbers.

On the other hand, I know of many families here in DC that have color television sets and refrigerators and even air conditioners that are trapped in a cycle of poverty and dependency. By US standards, they have a very hard, depressing, dangerous life that is passed on from generation to generation. So let's not go overboard with the home appliance measures.

As to the impact of poor immigrants, illegal and legal, on the poverty and income numbers, there is no question it has an impact, and no question that longevity studies show that lots of people who start poor, or become poor at some point, can and do rise out of poverty. We've known that for a long time. Its an American tradition, for which we are rightfully proud. At the same time, we know there is this permanent underclass that isn't getting any smaller, and many of us find that unacceptable in the richest country the world has ever known. Don't you?

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DC: I don't know about Guernsey, but in the United States, there are good reasons for our rules about corporate governance and investor protection. And there are good reasons why prudent bankers don't allow investors to buy securities on 98 percent margin. Why is it that every generation of financial wizards feels the need to learn these lessons all over again?

A: Maybe because the returns on being a financial wizard have gotten so good that people retire in decade-wide cohorts, and institutional knowledge is lost faster and faster, even as the skillset required and financial environment change faster as well.

So, you end up with twenty- and thirty-somethings whose only knowledge of a recession was a six month period in 2000 running everything. No one who makes 10mil needs to stay in the trenches long enough to go through a whole business cycle anymore, so the wizards literally have no knowledge of it. It's like the field mouse who never heard of winter.

Steven Pearlstein: I love that theory. That people make so much during the boom times they retire and either enjoy the high life in Jackson Hole or go on to do other, more socially usefully things--and in the process, drain out of the system all the institutional knowledge. That makes perfect sense to me. but then again, I'm an old guy who traffics in experience and a sense of history, so I suppose I would say that.

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Bethesda, Md.: What credit bubble? Who cares? I thought I read that Bush was going to bail out anyone that can't afford the home the bought. I should have bought a bigger house.

Steven Pearlstein: Hey, you know, that's just not true. The Bush administration said and did nothing of the sort.

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College Park, Md.: This is off topic, but what did you think of Robert Samuelson's piece on poverty? He says that we have been very successful fighting poverty but that this has been masked because our immigration policy is effectively to import poor people. He also says that further efforts to reduce poverty may be limited in their effectiveness because there are some people who are poor because of bad habits and personal qualities.

Steven Pearlstein: Yes, the reason people fall into the permanent underclass is because they have bad habits and personal qualities, as you put it. Nobody disputes that. The question is why do they have bad habits and personal qualities. And the answer has to do with their environment, and learned behavior, and diminished hope and expectations. Now you can simply sit back and say, well, its all their fault and wash your hands of it. But you'll pardon my bleeding heart when I say that I can't look at a 5 year old kid in an urban ghetto and say she "deserves" a life like her mother or her father because she was unlucky enough to be born into that family and that neighborhood.

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Prescott, Ariz.: I read something yesterday about how after the passage of the 2005 bill making it harder to declare bankruptcy, lenders very aggressively increased their marketing of credit toward the people who were the biggest credit risks.

Just to get this straight, these are by and large the same financial conglomerates that are now looking for a government handout in the way of lower interest rates and being allowed to dump their bad loans into the quasi-governmental lenders like Fannie Mae, aren't they?

Steven Pearlstein: Look, nobody is dumping bad loans on Fan and Fred, trust me. They are pretty smart folks at those institutions, and they aren't into losing money, last time I checked.

As to your other point, it is probably true that the banks and credit card companies that pushed for bankruptcy "reform" turned around and continued to market aggressively to high-risk credit customers, knowing that they would be in a better position to collect on that credit in the future. Which is why I've always thought that real bankruptcy reform would give the bankruptcy court some leeway in determining how much of a loan needed to be paid back based, in part, on the sales and marketing tactics of the lender. But of course the industry opposes that, just as it opposes most efforts to bring reasonable regulatory oversight of its activities, or allow class action suits by victims of abusive marketing practices.

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Paris; France: It makes almost no doubts for me that we are close to recession:

- House market is crashing,

- Housebuilding market goes down,

- Car market is dramatically slowing down,

- Unemployment is growing up,

- The global private and federal debt is monstrous,

- Money is becoming rare and expensive...

So do you think we can still avoid recession?

If the answer is "yes", what are the economical factors that plead for optimism?

If "not", how far are we from recession?

Steven Pearlstein: About five months. By the way, unemployment, as yet, is not rising.

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Virginia Beach, Va.: What do you think of Peter Schiff's theory that the credit/housing bubble will likely cause our economy to crumble? He recommends that we buy foreign stocks and gold as a hedge against this.

Steven Pearlstein: Peter is a delightful bear, but he probably overstates the problem. Putting money into euro-denominated assets, however, is probably a smart strategy.

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Arlington, Va.: How does the statements made by Chinese ministers suggesting the use of US bond holdings as political leverage affect the possible actions that the Fed could use to stabilize the credit situation?

Steven Pearlstein: I don't think much, frankly. The reason China has all those dollars is that they don't want to allow their currency to float. If they sell them, the dollar peg will weaken and they will have to deal with the consequences of lower exports, lower employment growth, bank problems, etc.

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Laurel: Steven, what the next step in this logical cycle of history? In the mid 80's we had a stock market run and collapse (which straightened out reasonably later), a real estate bubble, a financial system collapse, then... Desert Storm. In the 60s-70s we had about the same sequence. What's the next step?

Steven Pearlstein: The next step is a painful correction in asset prices -- bonds, stocks, real estate, art works -- with a slowdown in US and global economic activity. And then once the excesses and irrationalities are wrung out of the system, we start the process all over again, making the same basic mistakes in new and creative ways.

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Rockville, Md.: Loved the last line of your column today - you may bring good writing back in fashion. But why did anyone think this was a way to "hedge?" Anyone.

Steven Pearlstein: I know, it's a scream, isn't it. The term hedge fund has become such a misnomer.

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"bad habits and personal qualities": Pretty much how you get to be a subprime borrower, too. Pay your bills and read the loan documents, and you can avoid a lot of trouble.

Steven Pearlstein: That's true. And there are also still a lot of uneducated, unsophisticated people out there who are good people who either can't or won't do that. I don't know about you, but I've been through a couple of closings in my life, and there are lots of documents I sign that I haven't fully read and digested. That's because I extend some degree of trust in the professionals I engage to help me in these transactions. So far, those professionals have not let me down. But there are other professionals who have not been so scrupulous and put their own interests ahead of their clients.

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Laurel: This looks like the same-old, same-old about mis-pricing risk by underestimating the chance of something bad happening.

Or perhaps, Big Money doesn't need to insure itself Armageddon because someone will bail them.

Just like bankruptcy court, is there too wide a safety net for those too big to fail?

Steven Pearlstein: Big Money doesn't have to rely on someone bailing them out because it is not their money they are playing with. It is other people's money. Big Money makes fees and bonuses and puts it into nice houses and boats and secure bank accounts, so it can live well even after other people have suffered the losses. It's not the bailout that is the big problem. It is that the risks they are taking are with someone else's life savings.

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Minneapolis, Minn.: What similarities do you see in the current mortgage crises to the S&L collapse of the 80's?

Steven Pearlstein: It's a variation on the same thing, except that, so far, no federally insured institution has to be rescued by the taxpayers.

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Washington, D.C.: Every "expert" who comments on the housing market seems to have some skin in the game -- usually in favor of short recovery period and quick rebound to higher housing prices. For instance, Freddie Mac and the Mortgage Bankers Association are often cited, but hardly impartial. Who do -you- think is a credible, unbiased source of information at this difficult time?

Steven Pearlstein: The Washington Post.

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RE: Foreclosures: A couple of points, and I'd appreciate your comments:

Here in southwest Florida, one of the hardest-hit real estate markets, the foreclosure notices are showing that less than a third of the homes being foreclosed are owner-occupied. That means low-down-payment investors are walking away...hardly a catastrophe unless you're also trying to sell a home in that low-price category.

The ARM's that are being blamed for the current mess aren't required by law to be increased. The bank holding the note can choose not to raise the rate if raising the rate will cause a delinquency or foreclosure. Wouldn't, in many cases, the bank do better overall by offering the homeowner a loan he can repay, at least in the short run?

Thanks for your comments!

Steven Pearlstein: Florida is something of a special case. Because so much of the housing market there involves vacation homes, it was the subject of a lot of speculation. I've heard similar numbers to the ones you cite. But that is not the situation in most other places, where, if you have half that level of speculation. Certainly, however, I share your sentiment that we don't need to worry about the foreclosures on speculative properties.

As for the ARMs, the problem arises when the mortgage has been packaged and sold to investors who hire a trustee to manage the portfolio in a way that maximizes the return to the investor. And the trustee has to decide if it is better to hold firm on the loan contract and force a foreclosure, or do a workout that may involve waiving or delaying or reducing the increase in interest rate. Yesterday, the bank regulators urged the trustees, and the service companies they hire, to show that kind of flexibility. But they probably would have anyway in those cases where they would wind up with less money by going to foreclosure.

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Why don't those large fees get bid down?: That the investment banks, fund owners and advisers make occasional mistakes doesn't bother me as much as the large fees they continue to extract, success or failure.

Why do the large smart pension funds continue to pay these fees? It makes me think that maybe my lefty friends are actually right about the old-boy/Ivy-league network scamming the rest of us. But isn't there enough money at stake that the advising market would get more efficient?

Steven Pearlstein: Yes, as I said before, it is a mystery. Another explanation: it turns out that there are a lot of dumb, mediocre money managers out there. Why should we be surprised?

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Baltimore, Md.: In a news report yesterday on NPR, it was stated that some of the sub-prime mortgages that are now undergoing rates increases are being rated at 10 to 11 percent interest. Why would a lender do that? Would it not virtually guarantee that the borrower will default?

Steven Pearlstein: They do it because that's what the loan contract calls for. In other words, they do it because they think they can. And if and when they discover that the borrower really can't handle it, and starts to miss a payment, then they will confront the question of whether it is better to hold fast and go to foreclosure, or work something out by making concessions as to rate or principal or whatever. I suggested last week a new mechanisms for making that workout more attractive for BOTH parties. So far, however, nobody has called from the Treasury or the Fed to get more details. Wonder if that says more about them, or my idea?

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Washington, D.C.: Do you think that Bernanke is up to the challenge of calling the shots on this crisis so early in his tenure? Or is this where we begin to long for the Good Old Greenspan days?

Steven Pearlstein: I think he missed a beat a few weeks ago during the August meeting of the Open Market Committee. But since then he's handled things just about perfectly, thanks in part to good advice from vice chair Don Kohn, Tim Geithner and his team at the New York Fed, and (I'm told) Governor Kevin Warsh, one of the Fed's newest members who has some Wall Street experience himself.

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Washington, D.C.: An interest rate cut by the Federal Reserve would have a positive effect on the stock market. But what about the broader economy? To what extent would such a cut's effects be only psychological?

Steven Pearlstein: A lot of it is psychological, frankly, since a quarter or even half a point change in the federal funds rate at this point will have very little direct affect on the cost and supply of credit.

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Falls Church, Va.:"twenty- and thirty-somethings whose only knowledge of a recession was a six month period in 2000"

I'm no expert, but the fact that recessions have dwindled to a short phenomenon that occurs once a decade strikes me as good thing, rather than a problem.

Steven Pearlstein: Fair point.

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Arlington Va.: Mr. Pearlstein, I'd like to negotiate with my landlord to extend the lease which is up end of Nov. because I don't want to buy in the next 12 months and really don't want to move. I'm thinking of offering a 5 percent rent increase as I see the rental market picking up pace rather faster going into the Fall. What do you think? Thanks!

Steven Pearlstein: Well, depending on how tight or loose the rental market is in Arlington, he'll either take you up on your offer, propose something higher, or tell you to take a hike. But its certainly worth trying.

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Savage:"At the same time, we know there is this permanent underclass that isn't getting any smaller..."

Didn't Samuelson point out that the underclass IS getting smaller, except for the immigrants who come to join it?

Steven Pearlstein: Can't say I studied Sam's column this morning between my tennis game and coming to work. But I doubt it is getting much smaller, just as I doubt it is getting much bigger. It has become something of a permanent feature of the U.S economy.

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College Park, Md.: I agree with you on the moral question regarding poverty but wanted your take on how likely new programs are to be effective. The other point that Samuelson was making was that past programs have been tremendously successful and this fact gets lost. So because people (falsely) think that poverty programs have not been successful they are less inclined to support future programs and that if we understood the impact of immigration we would see that these programs have been successful and there might be more support for future efforts.

Steven Pearlstein: On that, I agree -- in fact, I said the same thing last week. Food stamps, the EITC, SSI and Medicaid, subsidies for low income housing construction -- all these have been tremendously successful programs, despite the well-known problems with them.

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Washington, D.C.: You mentioned early in the chat that restaurant is one of the few business that could see growth. I wonder why. Shouldn't eating-out reflect the overall economic outlook? I remember from my Economic 101 class that in a down economic only fast-food chains (cheap eats) could see growth. Care to elaborate? Thanks!

Steven Pearlstein: Eventually. But at the moment, business is very strong.

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Falls Church, Va.: Actually, the S&L crisis was the opposite problem. They were over-regulated in the products they could offer, so that market changes forced them into a mismatch between low long-term home loan rates and high short-term deposit rates. The current problems are caused by under-regulation that has led to uncertain risk pricing of exotic assets like mortgage securities.

Steven Pearlstein: Fair point. As to why the regulatory situation was so bad, you have to point some of the blame at the industry itself, which pushed hard for certain changes that exacerbated the problem.

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Falls Church, Va.:"it kept interest rates too low for too long"

Keep in mind, though, that the Fed's interest rate policy has not led to increased inflation, which is typically what one would expect if rates were "too low." Raising rates, on the other hand, would have brought condemnation if it had choked off economic growth. (And whichever direction it leans, the Fed gets accused of stiffing the little guy). Fed chairman is a tough job.

Steven Pearlstein: I'm with you on that. Wish they did a better job at the bank regulation, however.

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DC: In passing, you mentioned that serious people are not pushing for a bailout. I'm curious about those who do advocate large-scale assistance to the financial institutions -- or even those that are over-the-top in their advocacy for sizable rate cuts. (I'm thinking more of the CNBC types than the politicos.) Are these people just shills, or are they just too close to the micro-level issues to see the bigger picture?

Steven Pearlstein: They are self-interested shills who are too close to the micro-level issues to see the big picture. In other words, they are not only kidding us -- they are kidding themselves.

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write off as much as they can...: Could you say a bit more about your second reply on how banks will deal with bad loans? Seems like if the banks write off as much as they can this year that they -have- fully dealt with the issue. Are you saying they need to write off more than their taxable income this year?

Steven Pearlstein: They will be aggressive in writing off what they know is already bad, in the hopes of convincing everyone that the chapter is closed. In fact, things will get worse before they get better, and more writeoffs will be necessary.

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Steven Pearlstein: Hey, time has flown by. This was a marvelous discussion. Hope to "see" you all next week.

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