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Pearlstein: Global Markets Plummet

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Steven Pearlstein
Washington Post Columnist
Tuesday, January 22, 2008; 11:00 AM

Washington Post business columnist Steven Pearlstein was online Tuesday, Jan. 22, at 11 a.m. ET to discuss what's happening on Wall Street and the global markets.

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Read today's updated column: More Room to Fall

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.

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Maryland: Good Morning Steven - scary times, huh? I'm wondering what good rate cuts and tax rebates are going to do, given that our country continues to increase its debt and our dollar value continues to drop. Wouldn't it be better to let the market reflect the US's problems and just stop spending money? We keep trying to avoid a recession, but why, if that's what we need?

Steven Pearlstein: Well, we're not going to avoid a recession -- that's already baked into the cake. And you are right -- we need to adjust to the reality of living within our means, which means a decline in the overall standard of living from what it was. Recessions are a way that that happens, and that lots of things that got overpriced are repriced. The Fed won't say this publicly, of course, but it has no intention to prevent that process from going forward.

What it does want to prevent is a bad dynamic that you can get where bad news feeds more bad news and you get a self-reinforcing downward spiral, powered as much by fear as by rational repricing of assets and risk. And that dynamic can be pretty dangerous and get out of hand. So you want the unwinding of the credit bubble to be orderly. That's why the Fed intervened today as it did.

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Prescott, Ariz.: I would like to submit for the record that just a few short years ago, a Republican President flew around the country and tried to convince us to put our Social Security money into the hands of the financial "wizards" at Citibank and Merrill Lynch. There seems to be a lesson here, though I can't tease it out.

Steven Pearlstein: This makes for great sport, of course. But remember, over the long term, stocks do perform better than US treasuries, and putting money in Social Security all your life is definitely long term. I don't think the President's program was the right one -- Americans seem to value the safety net that Treasury-based Social Security offers. They can play the market with other retirement funds.

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London: Have we just eliminated the remnants of the Western Hemisphere's liquidity? Is the bailout coming from the East and Arabian Peninsula?

Steven Pearlstein: Not sure what you mean.

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Detroit, Mich.: In regards to the causes of a potential recession, how much has the Iraq war played a part in this? I know from the news that the war has almost cost a trillion dollars. Would we be facing a recession if the U.S. had never gone into Iraq, or are more important factors leading to a poor economy?

Steven Pearlstein: I don't think the war has been a big factor. The cost has contributed to the federal deficit, but that's not been the big driver here. We're dealing witht he unwinding of a massive, global credit bubble whose roots, to be sure, are in the huge U.S. current account deficits of recent years. so while it hasn't helped, I doubt its been a big factor.

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Rochester, Minn.: Do you believe the 75 basis point drop was appropriate in light of inflation worries or was this a Wall Street bailout? A follow up is whether this all is just delaying the true day of reckoning?

Steven Pearlstein: It won't seriously delay the day of reckoning. I probably would have done 50 basis points but, in the larger scheme of things, this was not about what is the precisely correct level of the federal funds rate, but what was needed to calm markets. So far, it looks like the Fed got it about right in terms of the US market -- a down day, but not a disaster. More interesting is that, right now we've got a 2 to 3 percent rally in Europe without the ECB having done anything, and that may be excessive optimism on their part. But when you see the big banks there reporting big losses ovr the next few weeks, the decline there will continue.

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Shelton, Wash.: I keep hearing that any actions the Government takes to rescue the economy must be short-term. Isn't it time to begin to think about long term changes?

Steven Pearlstein: Not now. Later. After we hit bottom.

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Baltimore, Md.: Steven: Your Cassandra-like warnings, issued early last summer as I recall, are coming to fruition, so congratulations (I think).

I do have one question. I heard on one of the chat shows that Barney Frank had been warning for a number of years about the threat posed by the subprime market, securitizing of mortgages, etc.

I know that the Democrats have only had a majority for a year, but I am wondering why no one in government seems to have heeded Frank's warnings, given his acknowledged expertise in finance, or those of others who warned that this trend was a time bomb. Are both Dems and Republicans too beholden to Wall Street to have acted responsibly, or was this a case of people thinking that there had been a fundamental, permanent shift in the way financial markets operate? (Much as, until 2001, many were declaring that the dotcoms had changed the operating paradigm for business forever.) Thanks.

Steven Pearlstein: Barney wasn't the only one -- there were a number of groups, and regulators knew it had gone too far. But they were just too bureaucratic in moving against in, in part because of oppostiion from the White House and Congress that were doing the bidding of powerful financial interests such as the mortgage bankers, brokers, large banks and the real estate industry. And this is where I put a lot of the blame, with those organizations, which were really piggy and didn't see that they had pushed things too far and that, in the end, they will wind up in much, much, much worse shape than if they had accomodated the criticisms in a positive way rather than dismissing it all as carping from lefty, pinko community activists.

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Washington, D.C.: I have good credit and lots of equity in my home, does this new rate cut mean that I should even try to refinance if I'm paying 5.75 percent interest right now?

Steven Pearlstein: You probably have to get down to 5.25 to make the refinancing worthwhile. But you may get there in the next few weeks and months. I certainly would consider it, particularly if you don't have a fixed rate mortgage.

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When we sneeze,: everyone else thinks they have norovirus. For all the talk about the booming Chinese and Indian markets, and for all the money going into other emerging markets, and for all of Europe's claims to a strong independent market, apparently the United States still matters.

Steven Pearlstein: Apparently so. This is a function as much of the integration of financial markets as the integration of economies, which is something that economists and economic policy-makers tend to overlook (but investment types don't). The fact is that Goldman Sachs probably has as many professionals in London, Hong Kong, Frankfurt, Rio, Shanghai, Moscow and Mumbai as it does in New York. These are global firms with global clients and they don't particularly pay attention to political boundaries established by monarchies in the 14th century.

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Prescott, Ariz.: I just read an article comparing the market drop today to the one right after 9/11. What percentage of the great Americans in corporate management do you think are going to get awarded magically low priced stock options today?

Steven Pearlstein: Honestly, I doubt they're thinking about that right now. In any case, its going to go lower.

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Arlington, Va.: How will the interest rate drop effect mortgage rates? They are so low right now, and it doesn't seem like they are forecast to get much lower, nor are the two exactly linked?

As someone considering purchasing a home, I wonder if this means I should wait a few weeks to see what happens or go forth with the current rates. Also, would this likely cause home prices to drop again?

Steven Pearlstein: The change in the price of the home is more important than the change in the price of the money. Wait a few months and you'll probably have cheaper money and a cheaper house.

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Winnipeg, Canada: When I heard George Bush announce the incentive plan after months of him saying that the economy was strong, I took that as another 'Brownie, you're doing a heck of a job' moment. In other words, that was a clear message that the ecomony was in worse shape than anyone couild imagine. Do you think that major financial analysts and investors took the same message, causing the current plunge, or would it have happened anyway?

Steven Pearlstein: No, they're not that cynical. Although when I heard Hank Paulson, who for the last year has been saying the U.S. economy is "fundamentally sound," saying the global economy was "fundamentally sound," I took it as a sell signal.

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Washington D.C.: Hello, I'm a college student just trying to grasp this fully. Can you explain what's going on today with the markets in a pretty broad scope? Thanks so much.

Steven Pearlstein:...along with the meaning of life...

There was a huge global credit bubble -- too much credit at too low price to too many risky borrowers doing too much speculation. The bubble is bursting, and the unwinding process has all sorts of unpleasant effects on the real economy and the price of financial assets and real estate. That's what's happening. And we're only in the fourth inning of that process.

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Newark, Del.: I understand the rush to reduce interest rates to increase liquidity. But it doesn't seem that there's been any action on the underlying cause of why liquidity has dried up. Lack of confidence.

The reason we're in this mess is that very shaky mortages and other securities were bilked as gold plated AAA assurances. Now that the bubble has burst, the reason liquidity has dried up is because no one wants to touch certain investments with a ten foot pole! I haven't noticed a push at improved regulations or a clearer method for grading certain securities. Therefore, won't confidence continue to be a problem in the near future because buyers will be hesitant about what sellers are pushing.

To put it another way, until the Fed or goverment takes action to reinforce confidence, won't these problems continue even with a lower interest rate? To use a medical anology, is the Fed treating the symptoms but not excising the infection?

Steven Pearlstein: Well, as I tried to explain this morning, this isn't a liquidity problem at this point, and the Fed understands that. It is a credit problem -- there are a lot of borrowers out there (and this goes beyond homeowners to financial institutions) that won't be able to pay off their debts or make good on derivatives contracts. And many of these losses still need to be realized, and the workouts done, and everything repriced.

What the rate cuts are designed to do is stimulate other economic activity and reflate the balance sheets of banks that borrow short and lend long. And the more rates are cut, the bigger that spread gets, which means the banks can make more money to make up for the losses from their past mistakes. This is a bank and insurance company bailout operation at this point, although the Fed will never admit that. Its not a direct bailout, but it is a proven way to improve their profitability so they can rebuild capital and avoid ugly outcomes that could feed on each other and snowball out of control.

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Richmond, Va.: What's next for the market? What is the Fed likely to do at its next meeting?

Steven Pearlstein: The market expects more cutting. i kind of doubt that.

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Baltimore, Md.: Re: bad news driving more bad news...doesn't it feel like we're there already? What gets me is the simultaneous downward turn of so many overseas markets.

Steven Pearlstein: Believe me, if you get a number of these bond insurers going under, or hedge funds that sold credit default swaps and bet wrong, you'll see an unwinding that will make this look tame.

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Alexandria, Va.: So how best to ride out a recession that seems to be one of our own doing? I've pulled back my IRA contributions to pay off credit cards/mortgage/student loans and now only have student loan and mortgage debt. I do have some big purchases I have to make (busted appliances etc...) so I'll be contributing to the greater consumer good there. But I can't help but think that this may be a good thing for people as they realize that taking out more debt on their house to buy TVs, fancier cars, kitchen upgrades etc. was probably not the wisest choice in the world.

Steven Pearlstein: That's called a recession, when everyone pulls back for that reason at the same time. That's why I said before its both a good thing and a necessary thing but has bad short-term consequences.

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Rochester, N.Y.: Thanks again for doing these chats.

A friend of mine who used to work as mortgage bond analyst tells me that he thinks the government should have started regulating the subprime market once it was clear it was out of hand a couple years ago. Do you think this is true? Or is it natural that the banks, which lost a fortune on mortage-backed bond defaults, would look for someone else to blame?

My impression is that things certainly did change once lenders could package their loans into something that could be sold to investors -- and that it more or less removed the incentive for them to do due diligence on potential borrowers. Your thoughts?

Steven Pearlstein: Yes and yes. Both correct observations. It will be interesting in the coming months, as the Treasury completes its review of the whole affair, to see what it considers the "lessons learned." Their instincts will be to say that the markets fundamentally work and its best to leave them be, that the good outweighs the bad. But they'll have to embrace at least some additional form of regulation and require that mortgage originators have much more skin int he game to reduce their incentive to make questionable loans, collect a juicy fee, sell the mortgage and run.

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Re: London: I believe London's point is that the relative value of western hedge funds has deteriorated precipitously with the markets while there are trillions parked in relatively safe, low yielding securities in sovereign funds in the middle east and China with more petro-dollar and trade imbalance infusions of liquidity on the way. How is the west creating investment capital liquidity today relative to our friends (and maybe enemies) elsewhere?

Steven Pearlstein: Well, there's some truth to that.

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Anonymous: So when a corporation buys back its own shares they hold on to them just like any other person buying shares of that stock? Does the market value the stock as if the company owned shares don't exist?

Steven Pearlstein: When a company buys back its own stock --- which companies were doing like crazy over the past few years -- it reduced the number of outstanding shares, thereby increasing the profit per share (same profit, fewer shares). And since stock prices are often keyed off a multiple of ap rofit per share, that increases the stock price. So the theory is that it is a way of giving back money to shareholders, who get it at the tax-advantaged capital gains rate rather than as ordinary income (dividends). But now that dividends and capital gains are taxed at the same 15 percent rate, its not clear that is such a great idea, particularly when companies buy back stock when the market is at record levels, which effectively wastes the shareholders hard-earned profits.

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Baltimore, Md.: Hi there- If the cause of the current crisis was partly too easy access to credit, why is part of the solution lowering interest rates? I don't get it!

Steven Pearlstein: Well, it is paradoxical, isn't it. That's why there is a reluctance on the part of central banks to do it. But somethings it is the lesser of two bad alternatives. You do it to calm markets, and as soon as you can, you stop doing it and maybe even raise rates.

You have to understand one thing here: no matter what the Fed does with the federal funds rate, money for speculators, investors and businesses is still more expensive than it was and not so easily available. So to some extent it is a technical thing. In the real world, if you were to go to a bank today and say I need a 90 percent loan to do a corporate takeover, the answer would be no at any price. And before the answer was, Shall we deliver the money now or an hour from now. And that reality is not changed much by the lowering of the federal funds rate. As I said, that has more to do with goosing up bank profits.

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Albany, N.Y.: Hi, I am still not understanding how all this (credit bubble, recession) would severly affect a developing country like India. Indian economy is expected to grow at 9 percent this year and 8 percent next year. Indian companies are posting solid results quarter after quarter. A U.S. recession would affect economies that depend heavily on exports to U.S. like China. But India, it is believed, is largely isolated from sub-prime mortgage issues and is not as dependent as China on exports to US(exception being IT exports).

Steven Pearlstein: India has its own stock market and property bubble, it is bursting or is going to burst, and what may prick it is a slowdown in the growth of service exports to the U.S. and western Europe. That's the sector that has been driving Indian growth and if it merely slows down, then the speculative prices being paid for companies and real estate will turn and you'll get a very mean correction. Trust me on this: it will happen. They said it wouldn't in Ireland and it kept going for a couple of years. But now it is unwinding.

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Washington, D.C.: Last night Hillary mentioned her program to restructure adjustable rate mortgages so that people could stay in their homes. How will this solve the problem when home values continue to decline? It seems that the problem isn't just interest rates, but that these loans were only favorable when the market was on the up.

Steven Pearlstein: That's the case for many of these loans, but not all of them are underwater, as they say. In other instances, it is merely that the borrower wont' be able to pay the new, higher interest rates.

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San Antonio, Texas: Good Morning Steven,

I am concerned about the economic policies followed. We, as a nation, save less and consume more. That is the cause of declining wealth and increasing debt in this country. What is the point at this stage to put $800 in every taxpayer's hand so that he can spend it at the cost of raising deficit. Why can't we follow the good old values of save and conserve? Of the $800, most will end up in Chinese or Middle East economies. That is not a smart thing to do. Why not endure pain and modify our behavior?

Steven Matta

Steven Pearlstein: Not necessarily true that most of it will end up in the Middle East and China, although some surely will. At the margin, we tend to spend on imported stuff. But in the process, it will stimulate economic activity here (jobs, profits, investment), which is the point. When the storm passes, and if the economy rebounds faster than it otherwise would have, then the idea is that we'll more than make up for the cost.

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Washington, D.C.: The last time the Fed cut rates three-quarter of a percentage point was in October 1984. My memory of that time is that Walter Mondale had beaten Ronald Reagan in the first of two debates on domestic policy. What was happening in October 1984 that caused the Fed to take such a drastic move?

Steven Pearlstein: We were fighting our way out of the worst post-World War II recession, which had been engineered by the Federal Reserve with interest rates in the mid-teens, to fight a virulent inflation.

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Woodbridge, Va.: Are we looking at a U.S.recession or a fundamental restructuring of the global economy or both? It seems to me we still have the problem of hitherto unachievable productivity producing unheard of revenues that result in a glut of capital savings in search of GOOD investments. As the global savings mount, the funds are put into ever riskier investments resulting in a series of short term bubbles follewed by the inevitable crash. How do we solve for this? Income redistribution would still leave a savings glut, albeit spread across a larger pool of potential investors.

Steven Pearlstein: You were going fine until you got to the redistribution part. Where does that come from. There is no redistribution involved in what is going on. There are losses for people who made bad investments, but that's not a redistribution. Its a loss. Wealth (paper wealth) simply disappears.

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Wake Forest, N.C.: I love how rich people and corporations want a free market economy with no regulations but cry for the Fed to step in when they are about to lose their shirts. Of course the Fed, bowing to its corporate masters did exactly what they wanted.

Steven Pearlstein: To some extent, that is true. But believe me, the people who get hurt most from a recession are the little guy -- not in absolute terms, perhaps, but in relative terms.

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Pittsburgh, Pa.: Your columns are a refreshing change from the economic illiteracy of the mainstream press. While I have been satisfied with the performance of my growth and income mutual funds I have been concerned about the real underlying health of our economy. The recently released employment figures show that that since Mr. Bush was inaugurated the economy has produced just 4.47 million private sector jobs. During the equivalent time-frame in the last administration, the economy produced 18.722 million jobs. I really do not understand how the Republican pary can continue to run on supply-side/tax cut/no regulation economics. What do you think the GOP's economic platform will look like in the general election?

Steven Pearlstein: Supply side/tax cuts/no regulation. Mice learn lessons faster than today's Republicans.

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Mt. Pleasant, D.C.: How does this "crisis" hit Main Street? It seems like this is really impacting Wall Street and large institutions. Isn't this exactly the kind of thing that regular investors who buy and hold longterm can benefit from or not worry about? Seems to me that the greatest concern for Main Street investors is inflation, inflation, inflation. A .75 basis point cut without concerted action by the ECB will only exacerbate this problem, don't you think?

Steven Pearlstein: It might be a bit inflationary (which, not coincidentally, helps out borrowers). But it avoids a further contraction of credit, some home forclosures and a reduction in economic activity that leads ot layoffs and business closures. The Fed action won't change the direction of the economy. But it may make the recession a bit shorter and less severe.

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Washington, D.C.: Explain this to me: The Fed cuts the rate that it gives to banks. Yet banks, who issue the credit cards, are allowed to raise their credit-card interest to a usurious, knee-capping 30 percent if the customer is late only once with any bill, anywhere, and keep the rate at 30 percent ad infinitum. So the bank ends up making more money than before the Fed rate cut. This benefits the consumer HOW?????

Steven Pearlstein: First, it may mean that rates will go up less than they otherwise would have. It doesn't necessarily mean they will go down, in the case of credit cards.

But to the degree it avoids a recession, it helps card holders. A bad recession causes more credit card defaults, which forces the card companies to raise rates on good customers to pay for the behavior of the defaulting customers.

That said, however, you are right to a significant degree: one aim of a rate cut is to improve lending spreads of the banks and increase their profits so they can withstand the losses they are suffering on other things.

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Kansas City, Mo.: Another 10% drop and the stock market is basically where it was when Bush took over. Would that be unusual for their to be no net growth during a president's term?

Steven Pearlstein: Wouldn't be unheard of, but that's probably the outer limit of what to expect. Stocks are down about, what, 18 percent from their highs. Another 10 percentage points would be a lot.

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Anonymous: Phoenix; Please enumerate how our standard of living will be lower and whom will be most effected.

Steven Pearlstein: Many many people. Inflation will eat away at purchasing power. And wages, salaries, profits, capital gains will be lower than they would have been otherwise. It happens over a couple of years, and for many, it is not an absolute decline, just not as much of a gain as they might have had. But for some, it means living within their means rather than using equity from a house or savings or credit card debt to live beyond their means. That is a reduction in the absolute standard of living. Painful but necessary.

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Washington, D.C.: A week or so ago, Citibank wrote off $2.6 of $2.7 billion in mortgage-backed securities. I don't understand why the value of those mortgages is nearly zero? They are not having a 99% default rate on those mortgages, so why is the mortgage fund worth nothing?

Steven Pearlstein: They may have not been mortgages but risky tranches of mortgage-backed securities that get wiped out because they absorb the first 20 percent loss of a package of mortgages.

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Washington, D.C.: In light of the European equity market drops, isn't it about time for the European central banks to start cutting rates, perhaps leading to an eventual weaker euro/pound?

Steven Pearlstein: Yes, its time.

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Newport News, Va.: Stagflation on the horizon?

I know a recession is supposed to bring prices down, but my family, like many others, is caught in lurch by rising grocery, gas, and utility bills. Again, I know these are the variables that are left out of inflation calculations but honestly a lot of us are in a pinch. Isn't this practically stagflation? I don't see how the coming recession will lower the outrageous cost of groceries, gas, and heat.

Steven Pearlstein: Yes. I've been warning about this privately for years, and publicly since the spring. Stagflation is the end game of the credit bubble unwinding.

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New York: Realistically, is there anything the government can do to stimulate the economy, or must it all just run its course? Is the stimulus just a populist measure in an election year?

Steven Pearlstein: It can have an effect, but there is a political aspect to it, certainly.

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Arlington, Va.: Anyone with common sense and wisdom knew this was coming. The scam is over.

The question is now, how far is bottom. 1 percent rates? Housing adjusting to 2002 levels? I've seen some ridiculous adjustments in Arlington alone in the last year. $800K 2 BR condo that is listed now for $499K.

Steven Pearlstein: Now that's a repricing!

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Baltimore, Md.: So, it's all down to, "when you owe the bank ten thousand dollars, you have a problem. When you owe the bank ten million dollars, the bank has a problem."

Steven Pearlstein: That's right -- not in terms of individuals so much as big borrowers like hedge funds.

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Bottom-feeder in Washington, D.C.: Not now, wait until we've hit bottom, you said. If you knew when the bottom was at the time, you wouldn't be writing columns; if I knew, I wouldn't be reading them.

So what should be done in real life?

Steven Pearlstein: It's true -- if I was that smart, I'd be rich enough not to have to be chatting with you. But let me turn the question on you: at this point, do you think the odds are that stock prices will go up or down over the next six months. I think the direction is pretty clear. When it becomes less clear (not certain, just less clear), then it is the time to go bottom-fishing.

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Baltimore, Md.: Dropping the funds rate 75 basis points - that sounds big. They can't do this too many times, can they? How much more room is there for them to cut anything?

Steven Pearlstein: You got that right.

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Steven Pearlstein: Out of time for today, folks. Let's pick up again tomorrow, same time.

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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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