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Pearlstein: Credit Crisis

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Steven Pearlstein
Washington Post Columnist
Wednesday, December 5, 2007; 11:00 AM

Washington Post business columnist Steven Pearlstein was online Wednesday, Dec. 5 at 11 a.m. ET to discuss the meltdown in the credit markets, which he says has not happened yet. He says it is more than just subprime and mortgages that are affected.

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Read more in: It's Not 1929, but It's the Biggest Mess Since (Post, Dec. 5).

The 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.


Forest, Va.: Could you comment on the Inflation Outlook for 2008, (compared with 2007)? How much of a threat to our economy is inflation? And what can the Federal Reserve do about it?

IMHO, Inflation is on the rise -- certainly in China and among the Oil Exporting Countries in the Middle East, and in Europe (which saw a 3 percent jump this month, including a 46 percent increase in oil prices this year and rising food costs, which is driving inflation above the ECB's 2 percent ceiling).

According to the latest Producer Price Index (PPI), the price of Finished Goods on a non-adjusted basis was up 6.1 percent year-over-year. Food increased 7.1 percent, and energy was up 16.1 percent.

I noticed that the number of items on McDonald's dollar menu is shrinking -- as is the size of their "Big Mac", (an "indicator" of the devalue of the dollar).

Steven Pearlstein: There are obviously inflation pressures, many of them global (higher food and energy prices because of increasd global demand, falling dollar). They won't abate as much as many people expect when the economy slows because, as I just said, they are global, not national. This is something I think people are missing. And it means we will have some stagflation for a while.


Amsterdam, Netherlands: Will there be any spillover effects to consumer spending on a macro level in the US?

Steven Pearlstein: Not sure how you can avoid spiloover effects on consumer spending. It is part of the self-reinforcing downward cycle that is part of any bust, just like it is part of the virtuous cycle on the way up.


Palm Springs, Calif.: What's your opinion of the consumer "credit rating" agencies (Trans Union, etc)? The reason I ask is, I know of people, my mother included, who when they filed for BK last year their credit score was above 700! I knew these people were in trouble but why didn't the credit models these companies use show it?

Steven Pearlstein: Have to admit I know nothing about all that. Sorry.


Wheaton, Md.: Any end in sight or is this just the first inning? Also, I've been reading about the subprime mess and no one seems to have a good solid answer as to why 7 percent of all loans are subprime (from what I've read), yet they have this huge reverberating effect on the whole economy. What is the key negative driver that is causing our economy to cascade into a recession?

Steven Pearlstein: It is one of these truisms in economics that the action happens at the margin. Over the period 2005 to 2007, about 20 percent of the mortgages were subprime, and that concentration has a big impact on the mortgage backed securities of that vintage. And that is having a big impact on the whole market, including on paper based on mortgages of an earlier era.


Laurel: Background: I am the farthest thing from a subprime borrower, and can easily handle any fluctuation in my current mortgage.

When I took out my current 5/1 ARM, the spread between my lender's teaser rate and the 5-yr Treasury was 1.25 percent. They have a program that you can reset your ARM to the current teaser for a reasonable fee. But currently the 5-yr Treasury is about 3.3 and their teaser rate is 5.75, a spread of about 2.5 percent.

Should we expect these spreads to get smaller by having the mortgage rates drop; get smaller because Treasuries rise; or to keep having big spreads? Or does this tie into the fact that other rates, like LIBOR, have become divorced from Treasuries?

Steven Pearlstein: You ask very good questions. We'll see two things. The cost of federal borrowing, including the federal funds rate set by the Fed, will fall, even as spreads increase to reflect the greater perceived risk of mortgage lending and the liquidity crunch in private lending. Which will be the stronger force? Hard to say. Right now, the spread widening is stronger. But at some point in the future, I think the spreads may flatten out, which means that a 25 basis point reduction in Federal rates should translate into a 25 basis point reduction in Libor and mortgage rates. But its complicated, as you suggest.


Reston: Steve---always enjoy your columns. Can you gaze into your crystal ball and tell us where you think mortgage interest rates will be 6 months into the future?

Steven Pearlstein: As you can see from the last answer, I don't really know. But I wouldn't delay doing what you need to do because you think they are going to go down a whole lot. If they do, you can always refinance (assuming you get a loan that gives you that option).


Reston, Va.: Thank you for your articles - very informative. For those of us very close to retirement, the fear of what could happen is huge and we won't have enough time to recover from any bad recession. While holding cash is looking better and better, the inflation potential could make that a loser too.

What is best, short term Treasuries to pick up the eventual higher interest? What about global income funds or stocks- are they these less likely to crash? thanks.

Steven Pearlstein: Those are good ideas. Nothing wrong in a period like this about a strategy of preserving principal. And that might mean buying not only Treasuries, but bonds of Europe or Japan, where you get a currency play.


Philadelphia, Pa.: Good morning. In your column today, you wrote: "Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression."

We have had other housing recessions -- even bad ones -- since the Depression, right? Then how can it really be true that house prices have never declined nationally since the Depression? This just seems hard to believe. Could you please explain?

Steven Pearlstein: I think it is true that, in fact, there has been no national decline in home prices in the post-war period, until now. Maybe a month here or there, but nothing sustained over a year.


Silver Spring, Md.: If I own several real estate properties, what is the best way to protect my assets?

Steven Pearlstein: I generally prefer guard dogs....Just kidding. Basically, you can't do much other than ride things out.


New Haven, Conn.: Do you think the financial press has done a good job of covering the credit crunch? Why has so much attention given only when the Wall Street banks reported losses, when subprime lending has been of concern for the past few years?

Steven Pearlstein: We've been pretty good for the last year in raising the alarm, I'd say. Before that, not so good. We got caught up in how clever and profitable the new financial technology was, and forgot to ask if the easy availability of credit was leading to a reduction in standards. The evidence, of course, was right there in the advertising in our own publications. But we weren't focused on it, perhaps because we thought that it was just overhyped marketing. It turns out that they really were offering loans with no documentation, no money down, etc.


Cambridge, Mass.: Could you please explain what the role of the private mortgage insurers is with regard to all of the mortgage defaults? If lenders generally require mortgagees to carry private mortgage insurance (barring a down payment of at least 20 percent), why isn't it the case that, even if all borrowers default, the lenders will be made completely whole by the private mortgage insurers?

Steven Pearlstein: I'm not knowledgeable enough to answer that question. There is insurance for all sorts of things (like faulty titles), but most of the insurance against credit loss comes from Fannie and Freddie and FHA for conforming loans. The private market deals with non-conforming loans, including subprime and jumbo. I just don't know how much of the subprime was insured, to what extent, and how that loss might trigger any financial dominoes in terms of the health of the insurers. It is a good question.


Rockville, Md.: How much more depreciation must we go thru for the real estate market to hit bottom and start stabilizing again?

Steven Pearlstein: Obviously, it depends a lot on the geographic market. On a national basis, the latest estimates among realistic analysts is that the decline, over three years, will be 10 percent, maybe as much as 15. That's a reversal of a couple of years of recent house price inflation, which seems reasonable.


Boston: Can you compare the deals that Citigroup and Etrade struck recently? Which company was in the worse position in reality and the market perception? Which company got the better deal relative to their position? $0.27 on the dollar seems on the face of it to be a pretty big haircut for Etrade when the majority of the mortgage position was held by higher credit quality individuals.

Steven Pearlstein: I can't do that analysis on the fly. Sorry. But I agree 27 cents was a very distressed price by a company in very desperate situation. But think of it this way. If, right now, it looked like a bond would lose 40 cents on a dollar because of credit defaults, would you, as a investor, pay 60 cents? No, because the risk of it being more is pretty high. Considering that risk level, you'd have to look at the security as something of a junk bond requiring double digit return. Which means that you are talking about paying not 60 cents on the dollar, but 40 cents, say. And no matter how you slice it, that's a pretty big decline.


Edgewater, Md.: Mr. Pearlstein, It seems to me that the problems cited in today's column as well as many of the other "business decision" related economic problems are caused by three problems. First, business leaders suffer no significant consequences for bad management and bad decisions (i.e. You're fired but here is your 10 million dollar severance package). Second, many of our politicians regard the machinations of the private sector as almost sacred and thwart the regulatory monitoring necessary to avoid disastrous economic (or other types) of consequences. Finally, the ability to lobby quickly, quietly and very forcefully (for example the kill-off of the off set for the AMT) makes needed legislative change difficult if not impossible. How do we get past these obstacles?

Steven Pearlstein: You've identified three very big factors in all this. And I have no easy answers to your question. Obviously we can structure pay packages a bit better if only directors woldn't give away the store when they are negotiating the original contracts. As long as investors have no real say in who is chosen as a director, and as long as pay packages don't require shareholder approval, that's not going to happen. The reverance for market solutions and distrust of regulation is shifting, finally. We should get better balance on that. And as to reducing the ability of special interests to twist public policy to their liking -- well, let's just say that after decades of attempted reform, we haven't accomplished very much on that front, either. I'm afraid unless and until we're willing to amend the constitution and go to public financing of campaigns, we're not likely to get much progress on that one.


Danvers, Mass.: If Robert Shiller is right, that housing prices reached 70 percent above trend, then if they are to return to trend as this unwinds, there's about a $90,000 loss of market value for the median US homeowner. A direct reduction in what people think of as their net worth.

What do you think the follow on effects of people, funds, and others realizing what their reduced position is will be?

Steven Pearlstein: It won't be as disastrous as you might expect. It was mostly paper wealth on the way up, and it will be paper wealth on the way down. Obviously, people won't be using their homes like an ATM machine. And it will affect their psyche and willingness to spend or take on other debt. But, to repeat myself, it will mostly be the decline in paper wealth.


Washington, D.C.: Assuming the situation will get as bad as you indicate, what does that mean to those of us who are not directly involved in subprime or credit markets? In particular, for those of us near or in retirement, with a balanced portfolio, but needing the markets to work somewhat normally for our financial plan, does this situation call for action?

Steven Pearlstein: It calls on you to look at your portfolio and make sure that any money you need to take out over the next five years is in the form of cash or some security that won't be subject to big swings in market price.


Philadelphia, Pa.: Do you believe a major stock market correction (DJ index below 8,000)could happen within the next few months because of the US credit problems, the devaluation of the dollar, the high prices of commodities (oil, gold, copper,etc.)and the problems with the sub primary mortgage market?

What would happen if the holders of US Bonds/Notes decided to sell most of these US debt because of the dollar's continuing devaluation?

Steven Pearlstein: I wouldn't bet too much money on the fact that the Dow would go down to 8,000 -- that's a pretty dire prediction. And the recent evidence is that, in times of market murmoil, people still flock to Treasuries. I don't see massive foreign dumping, although there may be a slow diversification that will put upward pressure on US rates and therefore downward pressure on the value of US bonds.


Freising, Germany: If the U.S. does enter a recessionary period, how would you rate the rest of the world's ability to not do likewise now, compared to 5 or 10 years ago. Are the Chinese and Indian economies really more independent of American consumer buying power?

Steven Pearlstein: I think there is a decoupling. But please remember that there ar bubbles -- huge bubbles-- still to burst in china, Russia and India, in particular, around their property markets and their stock markets. We can't tell the spillover consequences from those, since there is really no precedent there. But I seriously doubt it will be positive.


Washington, D.C.: Enlightening article this morning. Thank you. So what should the average investor do with his retirement portfolio? Do you recommended making adjustments now?

Steven Pearlstein: If not now, when?


Denver, Colo.: What do you think about the negative synergy of the credit crunch, the falling dollar, and the high price of oil on the U.S. economy? On the world economy?

Steven Pearlstein: That's a question that seems to answer itself, doesn't it?


Washington, D.C.: We're just about to buy a home inside the beltway. If we wait six months to a year, do you think prices will drop a lot?

Steven Pearlstein: A lot? Not sure how to define that. But its a pretty good bet they will be lower and that you'll still have lots ot chose from.


Baltimore Md.: Steven: Thanks for opening your piece with a quote from the author of "Extraordinary Popular Delusions and the Madness of Crowds." What we are facing is truly the 2007 version of Dutch Tulip Bulb Mania, which Mackay writes about so vividly.

Two questions: If you were a person who had a lot of his 401k in the intermediate bond fund of a large, respected mutual fund company, would you be looking at money markets as an alternative right now, giving up the interest for safety? (And that's presuming the MM fund chosen doesn't "break the buck.")

Secondly, do you think the wizards who conceived of this slicing and dicing and spreading risk, which in turn fuelled the insanity of no doc loans for people buying $600,000 houses, really thought it would work long term? Or was this just an ultra-sophisticated and deliberate pyramid scheme in which a relatively small number individuals saw the possiblity for accumulating huge wealth before the pyramid tumbled? I'm not a conspiracy buff by nature, but what the markets did seems so inherently bogus that I begin to wonder.

One last note: I personally knew the tech boom was coming to an end when I saw the first TV ad for pets dot com--which wanted to sell you dog and cat food over the Web. As I said to my girlfriend, "The dog's gonna be hungry long before the food gets here. Why not go to the grocery store?"

Steven Pearlstein: At the broker and originator level, there may have been a realization that this would all come crashing down. But at the higher levels, I think we're talking about self-deception.

I'm not sure I'd prefer money markets over bank CD's right now.


Baltimore, Md.: Question and comment in two parts:

1. In terms of bailouts for individual homeowners (not that it looks like current plans will help very many of these), I have mixed feelings. The part of me that pays rent since I don't want to make the sacrifices in life style I would need to own is really ticked off at bailing out people who already get a huge tax break (mortgage deduction) that I don't. Anyone looking at tax implications of a individual owner bailout? For example, if homeowners already pay a penalty for bank forgiveness, etc. what is the difference if the bank forgives an increase over the mortgage term?

2. BTW, I have zero sympathy for the banks, wall street firms, and others caught up in this mess. If the economy tanks, so be it. I'm bitter that my wages for great job performance net me a lousy 3-5% raise each year rather than thousands, millions, etc. in bonuses employees of these firms get, payments now recognized as being based on stupidity or outright dishonesty. I'm hunkering down for a recession, and already saving more $ in case my job disappears.

Steven Pearlstein: Thanks for that. Other than the tax holiday, there really isn't much of a bailout by the public being contemplated for homeowners who took on debt they shouldn't have. The bailout, such as it is, would come from the investors, which seems right to me.


Amasa, Mich.: Why were SIV's allowed to go unregulated?

Steven Pearlstein: They actually weren't unregulated. But they were not properly disclosed in the filings of the banks that sponsored them and, for reasons of reputational risk, will now be bailed out by the banks or taken back on their books. I think the SEC was remiss on that and should come down hard on them for it now. Certainly the plaintiff's lawyers will.


Savannah, Ga.: Steve: Where are the buyers that will be needed for the Housing Market to make a come back coming from. Here in Savannah,downtown we have 300 Condos on the Market,with 600 more being built.

Steven Pearlstein: Markets do finally clear at lower prices. But it takes a long time to get there when it comes to real estate.


Washington, D.C.: OK, so it's not 1929... what does that mean for individuals? We don't need to be stockpiling food and ammo, but should we brace for a recession, even if that means doing things that help bring on on elongate one, like reducing discretionary spending?

Steven Pearlstein: Taking a more conservative stance, whether it relates to your investments or your spending, is the right thing to do in the fact of this kind of uncertainty. You don't have to overdo it. But if you didn't respond at all, that would be irrational. Will that help accelerate the downturn if everyone does that? Obviously -- that's how downturns occur. But this is the way market economies correct for their excesses.


Madison, Wis.: Thanks for your article and for taking questions. Given the enormity of the pending credit disaster, have you reconsidered your prior opposition to the Fed's recent reductions in interest rates? Granted, by lowering interest rates, the Fed is likely contributing to the same moral hazard that gave rise to the credit crisis. But by doing nothing, could the eventual repercussions actually be worse - including to simple passbook savings account holders like me?

Steven Pearlstein: At the time, financial market conditions were improving and it didn't seem to me that it was required, particularly given the inflation threat and the fact that it might delay the necessary adjustments in credit markets. Since then, financial conditions in credit markets have returned to about where they were in August. That's why the Fed itself has changed its stance in the last couple of weeks. And they may be right.

Having said that, everyone should understand that the Fed is not, and should not, be in the business of preventing a downturn that is necessary to cleanse the economy of the mispricing and excessive risk taking and excessive consumption that had built up. But it may be necessary to slow that process so that it is more orderly and doesn't become an overly vicioius cycle that overshoots on the way down the way it did on the way up. That's a legitimate goal for the Fed.


James, Arlington, Va.: Steven, It seems clear that what we were all calling a "housing boom" was really a "lending boom." With so much credit available to so many buyers, the competition for properties sent home prices soaring.

The Washington D.C, NOVA, MD area was no exception to this. With prices in condos soaring from an average of $150,000 (new) in 2001 to over $400,000 in 2006 for a 1BR. Obviously unrealistic appreciation. It's not like Arlington is short on land say as you have in NY or San Francisco so new condos will always be going up (in fact many are being converted over to apartments). How much do you see D.C. Real Estate readjusting to?

Secondly, I worry about our overall economy/stock market. Every week its another note of bad news that keeps coming in, but what is more disturbing is when a Fed Rate is coming, stocks go up, everyone acts like everything is rosy now, only to come down again by more bad news the next day. Seems be to an unrealistic cycle here and we need to let this mess clear out and stop the credit cycle. Unless we tighten our rules to who can get loans and money, we're just digging the hole deeper.

Steven Pearlstein: That was precisely what I meant to say in my last answer, only you said it better. Thanks.


Washington, D.C.:"While holding cash is looking better and better, the inflation potential could make that a loser too." That's why I own Treasury Inflation Protected Securities, both through a TIPS (Vanguard) fund and directly through Treasury Direct, as well as in my Roth IRA. The VIPSX fund has done very well the past six months.

Steven Pearlstein: That's good too.


Rockville, Md.: When a bank does a "write down" of debt, what does it mean. Can a home owner do it as well without tax consequences?

Steven Pearlstein: No, because you don't have to issue a quarterly balance sheet and you never "wrote up" the value of your asset in the first place.


Arnold, Md.: In your humble opinion, how much additional correction do you see for stocks?

Steven Pearlstein: Not sure. Stocks are not the key driver here, they are collateral damage, like the larger economy.


Floris, Va.: Steve: It looks to me, that in order to avoid a recession that would doom a 2008 Republican presidential candidate, the administration will do everything it can to avoid a recession. Other than lowering interest rates, bailing out the mortgage brokers, and flooding the money supply, is there any surprise the White House can engineer to temporarily bolster the economy?

Steven Pearlstein: Not sure that a recession necessarily hurts the Republican presidential candidate just because it is the party that now holds the White House. If that were true, then it is also true Al Gore should have been president in 2000 based on the good performance, up to that point, in the economy. What may make it hard on Republicans, however, is that their focus on tax cuts, deregulation and anti-government rhetoric may seem less attractive to voters worried about the economy and angry about the recent financial excesses.


Atlanta, Ga.: Yesterday, Sen. Obama issued a credit card bill of rights, and Sen. Levin held a hearing on credit card co. practices. It seems the subprime mortgage mess could lead to gov't restrictions on subprime credit generally, esp. for credit cards. Isn't there a risk that we'll end up widening the credit divide in this country if we get to the point where people with blemished credit ratings cannot get access to credit. it seems that consigns them to permanent subprime status, since pawnshops and payday advances don't help improve your credit score. Thoughts?

Steven Pearlstein: If lending was too loose, then it is inevitable that when you tighten it, some people won't get credit. That's a good thing for the system, but even more important, it is a good thing for those people who are denied the right to get themselves into a big whole. The devil is in the details on these things. You can have responsible subprime lending if you take care to do it right, like limiting the amount of exposure, taking extra effort to figure out the better risks from the bad ones and pricing it all correctly.


Princess Anne, Md.: My neighbor told me about a possible meltdown in the US in the very near future. Is that it?

Steven Pearlstein: Not sure what a meltdown is. But I wasn't exactly painting a rosy scenario this morning.


Arlington, Va.:'decline in paper wealth'

Is there any data that indicates how much of the increase in paper wealth was used up as cash-out for furniture, tv's, jaccuzzi's, etc.?

Steven Pearlstein: Yes, Alan Greenspan and some colleagues did that paper either just before or after he left the Fed. You can find it on the Fed's website, I believe.


Steven Pearlstein: That's all for today folks. Good discussion, and many more people on line. Come back next week.


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