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Pearlstein: Housing, Credit and the Fed

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Steven Pearlstein
Washington Post Columnist
Wednesday, December 19, 2007; 11:00 AM

Washington Post business columnist Steven Pearlstein was online Wednesday, Dec. 19, at 11 a.m. ET to discuss the housing crisis, credit crisis and the Fed's new rules on mortgage lending.

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Read today's column: A $500 Billion Correction

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.

The transcript follows.

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Who Is To Blame?: There are two groups that caused the entire sub-prime mess.

The first group are singles and couples making a decent (but not amazing) income of between 90-200K a year that bought more home than they could afford. They think that because they are bringing home 8K a month that they should spend 3k of it on a home. Or they are single and bring home 5k a month and think that they can swing 2500 a month for a house payment. They are doing this because they want to "live fancy".

The second group are people that are simply uneducated about all things financial and don't have real purchasing power and don't make a lot of money. The day they started looking for a home was the beginning of their end. People that are savvy and have purchasing power don't allow themselves to be played by an agent, a mortgage company or a bank. These people are not "better" than the people that are not savvy. They are just "smarter" about this stuff.

Blame the agents, loan officers and "greedy" home sellers but they are not the problem. Everybody wants a granite countertop and that 56-year-old woman finally wants to stop renting even though she only makes 33K and has lousy credit...

Steven Pearlstein: You are right, up to a point, but I think the group of "people who should have known better" is a lot larger than that. Wall Street's structured finance machine kept demanding more and more mortgages to package and sell, and that demand had a lot to do with deteriorating lending standards.

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Dunn Loring, Va.: Maybe I'm thinking too hard but instead of raising the ARMs and letting the borrower go into foreclosure why can't the lender simply redo the mortgage, keeping the payments the same and tack on the difference to be paid at the end of 30 years or when the property is sold, whichever comes first?

Steven Pearlstein: Well, that's the Pearlstein Plan, proposed months ago. But you're the first one to pick up on it, as far as I can tell. The problem is that the owners of the mortgage now don't want to accept that, because it means they won't get the cash flow in the short term that they were expecting. My idea was actually to give them a lien against the property for the difference in the cash value of the old mortgage and the new mortgage, and then let them sell those liens in a secndary market that was initially set up by Freddie and Fannie. That way, they could get some cash up front rather than having to wait.

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Oakland, Calif.: Why is this housing depreciation crisis always referred to as a "sub prime" crisis?

I see many friends and associates that are "prime" borrowers having to make the decision to either try and sell their home now and attempt to save what remains of their equity or there coming to realize that to "get out from under" their homes will take 100K or more.

How can this be called a "sub prime" problem?

Wake up! This is a depreciation problem or a hyper deflation problem in real estate value at the same time we are suffering through a hyper inflationary period as it relates to food and energy.

The housing issue might well have been grounded in the banks never ending quest for interest bearing loans to securitize hence the creation of the sub prime, no prime, no doc, ninja and other loan issues, but the issue now is the realized 1 trillion loss in equity and the future loss of 3 or 4 trillion more in equity at a time when most homeowners equity is unbelievably over leveraged, just like our businesses. This is the underlying reason banks will not loan to each other. They KNOW that if their balance sheets look like they do they KNOW their competitors must be as bad or worse. This is not a liquidity crisis, but a crisis of realization.

Steven Pearlstein: You're right: this is fundamentally a credit/solvency crisis. But at the moment the threat of that solvency crisis is also creating a liquidity crisis because the extent and location of the bad loans is not known.

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Richmond, Va.: Okay, so the Fed has put in a whole gaggle of new regulations to ensure the "housing crisis" won't happen again ... things like (according to today's Post) "an active regulatory role ... that would affect borrowers, lenders, banks and brokers. Home buyers would have to provide proof of income to ensure that they are not taking on more debt than they can handle. Mortgage ads could not promote only low "teaser" rates. Victims of predatory lending would be empowered to sue their mortgage providers." So, what was the Fed's job before if it wasn't what they are proposing now? It is extraordinary that these new steps were not part of their prior job description. It just smells fishy.

Steven Pearlstein: They were very good at rationalizing why they shouldn't do it. For any particular regulation, the industry was very good at giving them all sorts of reasons not to do it, all of which were overblown but some of which had merit. And so they took a pass. What they didn't do is compare the "costs" of putting in the new regulation (and there would be costs) against the eventual costs of doing nothing and letting a bubble develop. And they never did that with any intellectual rigor or honesty. The thing about regulation is that its not perfect and there are tradeoffs when you impose them. But the question is: Are they good tradeoffs. But the way the system now works, if industry can show that there is any downside, it "wins" the argument, particularly in a climate where there is a pro-industry, anti-regulation environment.

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Boston: With regard to the subprime mess, shouldn't the ratings agencies take the most blame in that they were a key checkpoint in the system that didn't judge the risks of the securitized mortgages efficiently? One could argue everyone else, while not blameless, was just following their economic interests but the ratings agencies had the greatest responsibility to adequately assess the risks to create and maintain an efficient market where prices reflected those risks?

Steven Pearlstein: They are right up there, certainly. But this is like the murder on the Orient Express: They all did it!

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Charleston, S.C.: Your article today makes some good points about the fact that even erstwhile sophisticated firms who could look out for themselves got burned.

But it does make me wonder what's different about Goldman Sachs. They uniquely seem to have escaped damage from the credit crunch and subprime meltdown; indeed they profited handsomely by shorting those markets.

What do you think it is about Goldman that made them so much better able to anticipate the problems and avoid them? While everyone else has shown herd mentality, they seem to have been able to rise above that, and in the absence of any market regulation designed to "protect" them.

Are there lessons that can be learned from the way they operated that would provide good guidance for other firms in the future?

Steven Pearlstein: Hey, they were smart and clever and foresightful. So was Bank of America, which never got into the subprime game. But I don't thin there is any way to regulate such outcomes, or regulate against herd mentality. What regulators should do, however, is understand about this herd mentality and factor that into their thinking when they are stress-testing a bank's balance sheet to see if it is operating prudently. and if you do that, then you anticipate a sudden drying up of mortgage finance like we've seen, rather than saying, "Whoops, this is so far outside the recent experience that we never even considered it." That is the lame excuse they are now offering.

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Palm Beach, Fla.: So, land prices react to demand and decline, same for material and labor. Less jobs in banking, furniture etc. Jobs lost, a negative attitude for the consumer that is underwater with debt. 'stagflation'! What is going to stimulate a new round of buying? Thanks.

Steven Pearlstein: Pricing stabilizing at levels that make economic sense. Economic slowdown ending. Luck.

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jim, baltimore: Steve: For those of us who didn't speculate on condos in Naples, Fla., how will this trickle down and affect us? Tax dollars. Do the prudent now subsidize the imprudent? Unique concept the fed has by the way..........the lender must now confirm that the borrower can afford the loan before funding it?

Steven Pearlstein: In good times and bad, the prudent subsidize the imprudent. Lenders set rates based on an assumption of a default rate, without knowing exactly which borrower will default. And whoever defaults is essentially subsidized by those who don't and have paid a slightly higher rate to cover those anticipated losses. Now banks and other lenders have tried to minimize that cross-subsidy in recent years by charging different interest rates to different borrowers based on credit scores or the riskiness of business venture -- in other words, doing a better job of pricing risk. But that gets you only so far in reducing the cross subsidy. It doesn't eliminate it--just as in insurance, where the people who make no claims subsidize those who do. On the other hand, would you want to be the person whose house burns down, or the one whose house doesn't burn and pays a premium nonetheless?

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atlanta, ga.: Actually, for this instance, I would prefer that the feds stay out of it. Let all these houses go to foreclosure, etc.

I have read that people think that those who are getting helped are those who are complaining - i.e., you and me (so to speak) who played by the rules and are not getting our houses handed to us - as in, prices won't go down as much as they could if the 'fix' wasn't in.

But I think the credit/banking people need to really FEEL the hurt. If it hurts ME, well, then so be it. It won't be so bad, cause I put 20 percent down, have paid off half my mortgage in 7 years (WITH an interest only - no one FORCES you to pay ONLY the interest), and therefore - I have TONS of equity in my home (even if I have a fire sale tomorrow).

Those who -did- play by the rules KNOW that they should only buy a house if they're going to be there long term (no speculators), so there you go - if that's the plan, then why do you care what the market does short term?

So if the speculators get hurt (and they are, believe me), then well, you shouldn't be speculating if you can't handle the risk.

Cause none of those bankers are giving back their million dollar bonuses, not that I've read, anyway.

Steven Pearlstein: We can talk about whether the government should do anything to help those who are losing their homes -- there is a vigorous debate about that. But I don't think there is much of a debate that the government should have regulations that prevent predatory lending or abusive practices or help to prevent banks and investment firms from taking on too much risk or misleading investors.

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"In good times and bad, the prudent subsidize the imprudent.": Great line!

And no better line of demarcation between us right-wing free-market nuts and those left-wing socialist pinkos: Your statement is true, but some of us think it's a bad thing, while some of them think it's a good thing.

Steven Pearlstein: Now, now, let's not get into name calling. Not all collective action is a bad idea. Again, think of the insurance example. Are you saying home fire insurance is a bad thing because it punishes the careful and subsidizes the uncautious?

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Altoona, Pa.: Could my bank, my credit union, my insurance companies (and I don't know what else may be linked) be weakened by this crisis? How can I find out?

Steven Pearlstein: You betcha. You can find out some things, but unless you are an accountant, it won't mean anything to you. Most of these institutions are insured, however, in part because the vast majroity of consumers cannot make intelligent choices on these matters.

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Alexandria, Va.: Steve, big fan of your work, my question is this: Do we have any idea as to the potential impact of the subprime mess on the credit default swap market? It would seem to me that many people who invested in mortgage backed securities, industry bonds, etc could own CDS that they could call, which in turn could bankrupt the parties responsible for paying on CDS...which may be even more severe than the mortgage mess...is Treasury doing anything on the CDS front?

Steven Pearlstein: Credit default swap market is another shoe that is likely to drop, with all sorts of ripple effects int he world of finance. That's one reason that this whole crisis is a long way from playing itself out.

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Washington, D.C.: Have not economies and bankers always relied on new consumers? At times I fear we are scapegoating "subprime" homebuyers who really wanted nothing more than to participate in the comfortable life they see others living around them. Perhaps too many Americans were tricked and deluded into believing they could afford the life they dreamed of, but how do the political and financial stewards of a healthy, growing economy extend the promise of inclusion to new groups without creating paroxysms like today's credit crisis? My parents and millions like them bought their first house with zero down on the GI Bill and they were about as subprime as you can get. Thank you.

Steven Pearlstein: Fair point. But your parents generation were better at not taking on more debt than they really could afford, and much bettter about making whatever sacrifices were necessary to keep their homes. I would also say the 1950s were a special period in US economic history where everything was up in a pretty straight line.

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because the extent and location of the bad loans is not known: Why not. These bankers don't know where there money is? Baloney

Steven Pearlstein: Trust me, if they knew where the ultimate risks were, they wouldn't be so nervous. Its a complicated system we have now for spreading risk, and a lot of it is undisclosed in public documents. So if a hedge fund is insuring a CDO, nobody knows about taht other than the holder of the CDO and the hedge fund and maybe the bank that lent the CDO holder the money to buy the CDO. But maybe the hedge fund isn't a trustworthy counterparty, in which case the risk is back with the bank and the CDO holder. And that's just a simple example.

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Anonymous: Where's the accountability? If you lied to get a loan, if the loaner helped the loanee to lie to get a loan, if an appraiser inflated the home value, aren't these crimes?

Steven Pearlstein: Yes, in many cases they are. FBI is on the case.

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government should have regulations that prevent predatory lending or abusive practices or help to prevent banks and investment firms from taking on too much risk or misleading investors: Wasn't it your article this morning that stated these were already in place but Greenspan chose not to act?

Steven Pearlstein: No, the point of the column was that they weren't in place, but should have been.

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Longmont, Colo.: I seem to remember Bush stating in the 2004 Republican national convention that his goal was to make America an "ownership society", where everyone owns a home and is "invested" in America. This along with Greenspan singing praise to the new mortgage financing tools provided Joe home-buyer with the confidence to get in a little (or a lot) over his head. Heck, why not buy a house when the government seemed to be encouraging it?

Steven Pearlstein: There is too much cheerleading for homeownership -- and too much government subsidy as well. It winds up inflating home prices and having lower income people subsidizing higher income homeowners, which is loopy.

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Boston, Mass.: Fannie Mae and Freddie Mac appear to be woefully undercapitalized. I read one of these companies commenting that they're okay if home prices nationwide drop 5 percent. My question is, "if home prices decline by 10 percent nationwide, do Fannie and Freddie survive without government recapitalization?"

Steven Pearlstein: Hard to say, but I think they have a lot of capital to blow through and strong franchises that will allow them to raise additional capital. It may not be pleasant for Fan and Fred shareholders, but that is what they signed up for.

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Washington, D.C.: Steve: What is your take on the Fed's Term Auction Facility? I don't understand why they think it will remove the stigma of only troubled banks borrow from the discount window. After all, who (except a troubled bank) would pay more for funds at the discount window when they can get the funds for 1/2 percentage point less on the Fed funds market. What am I missing?

Steven Pearlstein: Apparently it does remove some of the stigma. Not sure they have to publicize who bid at the auctions.

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DC: Hey Pearlstein,

A few months ago I chided you for suggesting that people sell their stocks because you predicted the market would go down. Then the market went up (briefly).

Though my primary point is that individual investors should not make buy/sell decisions on predictions about where the market might go (ie, market timing), I need to acknowledge at least that... you were right.

Signed,

Eating Crow in DC.

Steven Pearlstein: Hey, even a broken watch is right twice a day! But thanks.

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Rockville, Md.: How much responsibility for this unregulated, free-for-all fiasco does Mr. Greenspan bear? Has he ever met a regulation he liked?

Steven Pearlstein: Plenty. He was not only determined to deregulate financial services as the top regulator in the field, but went out of his way to grab power from other regulatory agencies that wanted to be more active.

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Rockville, Md.: You know how much a person spends on housing is their choice. I resent this "smug" satisfaction I see in your writers. I have overspent on housing for many years and never had a late payment. Right now, I live next to the Grosvenor metro station and pay a premium. But my gasoline bill was under $15 a month this year. I think more people who are in trouble were told they could refinance before the higher payments kicked in. Most of us can count and work a budget. Just a complaint for the "smug folks."

Steven Pearlstein: Okay.

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Right-wing free-market nut here re: Collective Action: No, clearly pooling risks for insurance has worked well enough to cover fire risk.

But a better example of why we're frustrated is flood insurance. I pay a couple thousand bucks a year for flood insurance on two homes here in the Sunshine State, but you and I both know that if we had a major flood, the feds would bail out (so to speak) the people who didn't bother.

That's a more accurate parallel to the mortgage bailouts, because those of us who pay our bills and pay our taxes will, once again, pay to rescue those who don't. We'll pay in terms of taxes, fees, increased costs to borrow, decreased home values, and more.

Steven Pearlstein: Maybe we should leave it at that, then.

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Washington, D.C.: Is there a 'healthy' Homeownership Rate? I'm for the 'American Dream' but maybe 70 percent is not healthy after all? Like most everything, overdoing it is usually as bad as under-doing it.

Steven Pearlstein: The healthy home ownership rate is the one that would result if we stopped subsidizing home ownership. I don't know what that is, but it is probably less than 70 percent, although not necessarily a lot less. In Britain, they did away with the tax subsidies and the home ownership rate didn't go down much.

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Waldorf, Md.: Steven, Thanks for blowing the ending to the 'Orient Express'. I was going to read that!

Steven Pearlstein: Try another Agatha Christie novel.

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. That's one reason that this whole crisis is a long way from playing itself out: So what do we do? Cash under the mattress?

Steven Pearlstein: Cash in an insured bank CD is a good thing.

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Chump in Florida: Three years ago, when I built more house than I could afford on my dream property, I took a 30-year fixed at 6 percent Alt-A.

Why?

'Cuz I figured that my excellent credit couldn't withstand a big rate adjustment a few years later.

Now my deadbeat neighbors are getting extensions on their teaser rates, and my good credit is being maintained by continuing to make payments on a house that I couldn't sell for 25 percent less than the 2005 appraisal.

This reminds me of the loan officer at FEMA after Charley: "If your good credit tells us that you'll pay us back, we'll lend your business the money. But if your bad credit tells us that you won't pay us back, we'll give you the money."

How about considering the good people in these solutions too?

Steven Pearlstein: So why are you not better off for your decisions? What does the other guy have to do with you, except perhaps for letting you feel righteous?

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Herndon, Va.: Steve,

In answer to WDC's comment about new consumers you spoke about how the new borrowers in the '50s were much better at handling their debt.

In hindsight they were, but a review of the contemporary literature will reveal that many of the comments made here about greedy bankers and risky lending to unproven consumers were also made at the time about VA and FHA loans. We have the luxury of knowing their positive effects in hindsight.

Remember too, just after WWII ended academics predicted the GI Bill would turn the nation's colleges into "hobo towns" of unemployable ex-GI students. We all know how that turned out, don't we?

This liquidity crisis will pass, as all the previous have passed before us, everyone just needs to settle back, take a deep breath, and let the markets work themselves out. As is often heard in the halls of the George Mason University Economics Department, "Markets fail but trust the Market."

Steven Pearlstein: I trust markets a lot, particularly when they exist within well crafted legal and political structures.

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I'm torn:: Part of me says, "let 'em lose their houses," but on the other hand, a bunch of homes in foreclosure will bring other home values down. On yet the other hand, I'm tired of paying for people's mistakes.

(sigh)

Steven Pearlstein: You're not paying for their mistakes for the most part.

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Washington, D.C.: The real problem is that the cost of housing is too high. People don't want to buy housing now because it simply costs too much. In many metropolitan areas, inflation in the price of housing far exceeded growth in average or median income. The solution is simple: prices need to go down. There would be adequate liquidity if individuals and banks didn't want to sell property for more than what the market dictated it was worth. And ultimately, the market price for housing is related to income.

Steven Pearlstein: You're right about one thing: It is best for everyone if inflated real estate prices fall to where they can be justified in terms of people's incomes. That's a necessary part of this economic healing process. It's also a lot fairer to people trying to get into the housing market for the first time.

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Laurel, Md.: I am curious as to why Wells Fargo has been silent during all of this? I know they are very involved in both the retail mortgage origination and in securitizing both residential and commercial mortgages. This included sub-prime loans from other lenders, and their own originated mortgages. Do you know if they have issued anything related to their mortgage business?

Steven Pearlstein: No, I don't know about that. Maybe we're about to find out.

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Anonymous: Who you like, the Pats or the Packers?

Steven Pearlstein: Pats.

Thanks for joining in today. Hope to "see" you next week.

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Editor's Note: washingtonpost.com moderators retain editorial control over Discussions and choose the most relevant questions for guests and hosts; guests and hosts can decline to answer questions. washingtonpost.com is not responsible for any content posted by third parties.


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