Pearlstein: The Economic Crisis

Steven Pearlstein
Washington Post Columnist
Friday, July 18, 2008; 11:00 AM

Washington Post columnist Steven Pearlstein was online Friday, July 18 at 11:00 a.m. ET to discuss oil prices, the Fannie and Freddie rescue and the unfolding financial crisis.

Read today's column.

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.

Pearlstein was honored with the Pulitzer Prize for commentary for his columns about mounting problems in the financial markets. His award was one of six Pulitzer Prizes won by The Washington Post this year.

Read Pearlstein's latest columns.


Anonymous: Steven:

What is your take on Wall Street's definition of the Middle Class income being between $6000.00 and 30,000.00 per year?


Clark Hudson Washington

Steven Pearlstein: Doesn't sound right, does it. Who says that is Wall Street's definition? I sort of doubt that.


Reston, Va.: Steve,

Tell us the UPSIDE of all this doom and gloom and unwinding. For instance, I'm not convinced 4 dollars for a gallon of gas is all bad, because it's finally forcing people to make real choices and may be a catalyst for genuine change.

Many thanks.

Steven Pearlstein: The upsides have to do with repricing things to better reflect their real costs and real value. So in the case of gasoline, as you suggest, the cost takes in the environmental harm caused by burning fuel. We'll use less as a result, which is good, and move to other fuels, which is good. But unfortunately, because we have a low fuels tax right now, most of the benefit of that expensive fuel goes to the people who have the oil. That's a mistake.

On the other hand, housing had got too expensive for many families, and had distorted decisions about where people lived because they had to keep going farther away from where they worked to get something they wanted at a price they could afford. As house prices come down relative to everything else, that will be a boon to those who don't now/yet own and will gradually end this geographic distortion which in general leads to sprawl.

Its hard to think of too many other upsides.


Springfield, Va.: Perhaps this a good time to look at the energy "crisis" and the "housing" crisis as intertwined "crises." The activities of Fannie Mae and Freddie Mac; and the non-business home mortgage interest deduction, are contributing factors to urban sprawl. The sprawl has resulted in over large homes on over large lots in outer suburban fringes. Public transportation is inadequate to move all of these people into the inner city so many of them drive alone in their big SUV's to work.

If Fannie Mae's and Freddie Mac's charters were changed then maybe a more rational home ownership subsidy program could be developed. Furthermore, it's also a good time to debate whether maximizing the rate of homeownership is the best policy.

Steven Pearlstein: Well, your question anticipated my last answer in some respects. But I don't think we can layer onto Fannie and Freddie, which already have a hard enough time juggling their dual mission (providing liquidity to the housing market when it most needs it and generating a decent return to its investors) by adding on more mandates. Fannie and Freddie are big and powerful in the context of housing finance, but they don't set the terms of who gets mortgages for what houses under what conditions, except to the extent they relate to good basic underwriting.


Washington, D.C.: Given the current turbulent state of the stock market, is it a good time to be aggressive with a portfolio and invest heavily in domestic stocks; or is this a time to be conservative and invest this money in Bonds?

Steven Pearlstein: Don't think you want to rush into either right now -- not stocks because the economy really hasn't bottomed out yet and that could take a while, and not bonds because of inflation, which is a worry. Insured bank deposits are nice. Short-term treasuries held till maturity.


University Park, Md.: Your columns are some of the best I've ever read, you do a good job explaining things that really don't make much sense, but which have a huge impact on our lives. I know you're not a financial advice guy, but I am wondering when you think money inflow will start pushing the U.S. stock market up. A year ago, spooked by the global credit mess you so artfully helped to explain, I took most of my govt. TSP out of stocks. Even though the market went up, I felt OK because I'm still alarmed. (for example, I never heard of auction rate securities a year ago) Well it seems like they're lending big chunks of dough for dubious business propositions like the InBev deal, so is that a good sign? I'm retiring at the end of the year, but I don't intend to touch this TSP for 10 years or so. My idea a year ago was to wait for a drop, now that's about 13%, and put it back in slowly over a year or so. I have never tried to time the market before, but formulas like, 'no-doc' loans = AAA bonds continue to freak me out.

Steven Pearlstein: Thanks for the kind words. As I said above, it is probably a bit early for individual investors without a lot of experience to be getting back in. It's not true that you can't use common sense to time markets, as long as you don't try to time them too closely. You got out at a good time and you'll probably know when it's a good time to start buying again. Be patient. That is the key. Don't get fooled by sucker rallies. Just keep an eye on the fundamentals.


Anonymous: Steven........I know you have said that Fannie Mae and Freddie Mac may need help in the near future, but what about the view expressed in the Post that many people see this as privatizing the profits and socializing the losses? Who is out there working for the taxpayers? Thank You.

H. Harrison Savannah, Georgia

Steven Pearlstein: Nobody is more attuned than I am to situations where profits and privatized and losses socialized. Critics have always used this phrase against Fannie, because they basically don't like the structure of a government sponored enterprise that has private shareholders and an implicit government guarantee of its debt. But in those cases, the gains are not all captured by the shareholders and the executives. The bulk of the gains are captured by homeowners, who because of the efficiency of the housing finance capital markets and because of Fannie and Freddie's lower borrowing cost, enjoy lower interest rates and a pretty sure supply of mortgage funds, even when a lot of private investors are not interested in mortgage backed securities (like now). Nor is it clear the losses are all socialized: the stock investors in Fannie and Freddie certainly don't feel that way, I can tell you that.

Yes, the bondholders of the two companies do have an implicit guarantee, for which they receive a lower interest rate, just like the Treasury. But we don't say that people who buy Treasury bonds are the beneficiary of a scheme that "privatizes the profits." So you have to be clear what you are saying.

The reason we have these institutions is because, from time to time, the secondary market in mortgages -- the engine of housing finance -- collapses. It happened before, and it led to the creation of Fannie and Freddie (they used to have different missions, but there is really not much of a distinction now). And we need them now -- they are providing the funding, indirectly, for 80 percent of all new mortgages at the moment. That is why the government set them up, with the idea that they are working for the public and the economy at large. And those are all taxpayers.


Springfield, Va.: Steven, I enjoy reading your columns. Many who are are opposed to bailouts for the financial companies are portrayed as class warriors or simpletons who don't understand the magnitude of the fallout from failing financials. However, I believe that people realize that the economic mess was caused by financial institutions making bad financial decisions, i.e. making bad loans (they made their bed, let them sleep in it). These companies reap the benefits from wise business choices, let them feel the pain of foolish business decisions.

I think people would be more understanding if the financial companies were in a bind because of outside forces such as a world-wide drought or other type of catastrophe.

Do you believe that people are more inclined to oppose bailouts for this reason?


Steven Pearlstein: Yes, we all oppose bailouts for that reason. But be clear about who is getting bailed out. The shareholders -- and the executives with stock and stock options -- aren't getting bailed out. They are taking it on the chin, as a result of the dramatic fall in share prices. Many are losing their jobs. Yes, they took money out during the good years and no, we don't have a mechanism for going and getting that back. But that would be true even if we let these insitutions go under. The "bailouts" as you call them don't change that.

The people getting bailed out here are lenders and bondholders of these institutions, not the people who ran them. They also made "bad decisions," in the sense of bad underwriting and investment decisions. But it is more indirect than your complaint suggets. Would it be better if they were punished some as well? Yes. But if the tradeoff is a meltdown in the global financial system, then maybe its an unfairness that we have to live with because otherwise a lot of innocent people are going to get hurt.


Salt Lake City, Utah: Mr. Pearlstein:We appear to have learned little from the Savings & Loan Crisis, the Russian Crisis, the Mexican Crisis, the Far East Crisis, crisis ad nauseam. Seems to me that a significant part of the problem with the FED/Treasury (both mean us...!) having to bail out Fannie, Freddie and Bear and goodness knows how many subsequent financial institutions, is that Washington has not only allowed but in fact encouraged these investment challenged institutions to grow 'too big to fail'. So when they inevitably do through their greed and callous disregard for risk, then we're all in a fix where we have to bail them out so as not to dump the economy. Why not just bust them all down to about 1/10 their present mass, introducing more competition and when they do fail, their investors and mangers take the full brunt? P. Ogden SLC

Steven Pearlstein: I agree that Fannie and Freddie were allowed to grow their balance sheets too large when the private sector was plenty interested in buying up mortgages. That was a mistake and we can only hope that the new regulator, with his new powers, won't let that happen again. But having said that, even restraining Fannie and Freddie would have still left them very, very, very big players -- so big that they would STILL present systemic risks. Remember, they insure lots of mortgages that they don't hold on their balance sheets. That's probably a good thing.

By the way, the Fed stepped in to prevent a failure at Bear Stearns, on the assumption that that relatively small investment bank and primary dealer was too big to fail. So it's not something government can really control. The system now is dominated by large players and it is very interconnected. That's the reality. We need to get used to it, we need better regulation to prevent bubbles and busts, but in the end, there will be crisis and government will have to step in from time to time. And the reason we accept that is because the alternative -- no regulation, no rescues -- generates an outcome that is less good for everyone. How do I know that? Because we tried that during the 19th and early 20th century, and decided that the booms and busts were simply too devastating to ordinary people, who supported politicians and institutions and programs that sacrificed a bit of economic efficiency to attain a pretty good level of economic security. It is a tradeoff, I admit. But those who get all huffy about government intervention and bailouts don't acknowledge that there is a tradeoff, and that their rigidly free market model does leave people more exposed to the harsh winds of the boom and bust cycle. Just once I'd like to see themn acknowledge it.


Bangor, Maine: Mr. Pearlstein:

After looking at U.S. oil production/export figures and worldwide trends, it appears that energy prices are less a problem of supply and demand, and more a problem of currency manipulation by a global banking elite. It is curious that our elected officials continue to be reluctant to point a finger at the Federal Reserve (a private bank) and the system of central banking as root causes of our current economic plight, as well as many other societal ills. The history of such usury is well documented.

Steven Pearlstein: I don't agree and I see no evidence of widespread and successful price manipulation. An excess of investment, yes. Speculation, yes. But not manipulation.


West Palm Beach, Fla.: If the government, through our tax dollars, bails out private firms like Fannie and Freddie, which are billion dollar for-profit corporations, does this not undermine private enterprise? Why not use the money to bail out private citizens instead who are in financial trouble? That might help the economy, too! Or is it because private citizens do not contribute as much to the election campaigns as the big corporations?

Steven Pearlstein: First, these companies are not being bailed out in the sense that I think you mean it. Right now, they are being provided with access to borrowed money that the market wouldn't otherwise provide. Borrowed means they pay interest rate, they post collateral and they pay it all back. At some point, the government might decide to invest some equity capital in them, on terms that the Secretary of the Treasury would consider a good business deal -- that is, if it is patient, the taxpayers will wind up making a profit. That's helpful, it's unusual, it's not a free market solution -- but I'm not sure I'd call it a bailout, either. I like rescue. Now at some point, if things get really bad, the government might have to make good on its implicit guarantee of Fan and Fred's debt to bondholders. THAT would be a bailout, because it would cost taxpayers money. But the people getting bailed out won't be Fan and Fred or its shareholders -- it will be the bondholders. And who holds Fan and Fred bonds. Banks, central banks, money market funds, pension funds, etc. Those are intermediaries for lots of ordinary people. High rollers don't generally make a lot of money buying Fan and Fred bonds. A few hedge funds do, I admit, using a huge amount of leverage. But a couple of those that tried this recently went belly up, with the supposedly smart guys losing all their money.

Again, I'm happy to talk about all of this, but please let's use language which is a bit more precise.


Toronto: I don't get it. It seems to me that Republican economic policies and their ideology of unfettered capitalism has harmed pretty much everyone except for those enrolled in the No Crony Left Behind program. So why are opinion polls showing McCain only slightly behind Obama? Is it because of an uninformed electorate or latent racism or what?

Steven Pearlstein: Thats's a fairly common Canadian view. But I think you are reaching in drawing your conclusions. And every indication I see is that Obama will enjoy a siginficant victory in November.


Sunrise, Fla.:1) Why is it that some articles and programs in the media are calling for Fannie and Freddie to be capitalized as banks? The two entities have a mono line business that resembles a fixed income fund manager and an insurer (guaranteed CMOs.) What are your thoughts about the adequate level of capitalization for those two entities?

2) Where is the oil price heading by 2010 - 2012?

Steven Pearlstein: You make a good point. The amount of capital Fan and Fred hold is roughly what a bank would have to hold if all it had on its balance sheet were mortgages and mortgage backed securities. That said, it doesn't hold enough capital to support its insurance function, given what we know now about the possibility of a 25 percent national decline in average house prices and the default rate that would accompany that. The private insurance firms probably don't have enough capital either -- that's why their losses on housing are eating into the capital they have to back up their insurance of municipal bonds. So it's a problem, but not one unique to GSE's. The "free market" didn't solve that problem either.


Silver Spring, Md.: Steve.. great column. You attribute the recent drop in oil prices to congress starting to talk about getting tough. However, I recall reading that the drop coincided with a notably better than expected report on US supplies from the energy department. Instead of using up 2 million barrels of supply we gained 2 million. Ever since gas hit $2 people have said - when will it affect demand? $3? $4? Is the recent drop not just that the answer to that question is about 4 bux? Transit ridership has soared in just about every city in the country. Toyota can't keep Prius on the lots. People are taking shorter vacations. Airlines are cutting back on flight schedules. How much of the recent drop do you think is actually just good ole supply and demand? We'd played catchup with increasing prices because 99 cent gas never really made any sense in the supply/demand equation and now we're getting back in line with demand decreasing a little bit?

Steven Pearlstein: I think it is both. These things aren't perfectly linear. In a bubble, there are lots of people who invest into it who know it is a bubble and know it can't last, but they want to stay around as long as possible. And that fact is self-fulfilling -- its extends the bubble. But these people are always on the lookout for the thing that might burst the bubble. And a change in regulation that would restrict speculation in commodities is just such a thing, since it will reduce the pressure on the long side of this market. That's why I think the threat of legislation/regulation has had an immediate effect, against a backdrop in which everyone can see that demand is responding to higher prices. That means that when the bubble does burst (we'll see whether it has over the next few weeks), the prices will decline sharply.

Think of these things in terms of tipping points.


D.C.: Do you think any of the local banks, besides Wachovia, are in trouble?

Steven Pearlstein: Don't really know. Sorry.


Reston, Va.: As the new administration sets up shop in January, you are given the option of Chairman of the Fed or Sec. of the Treasury. Which would you take? And what actions would you take to steady the economy?

p.s. Thank you for your wonderful columns.

Steven Pearlstein: I would say, given my snarky columns about the two ranking members of the Senate Finance Committee, that I am unconfirmable for any high economic position in government. But thanks for thinking of me.


Cherbourg, France: French reports indicate that there is neither an oil shortage nor a food shortage. They say that 40% of the price of oil is due to speculation, and that the oil companies have upped what their refineries charge for processing the oil by up to 400%. They say the Hedge Funds are the major speculators. Isn't it time to introduce SEVERE controls and penalties, including long prison terms, for those who run the hedge funds and a BIG windfall profits tax on all their ill gotten gains?

Steven Pearlstein: I think we can get a handle on this without criminalizing people for making smart investment decisions.


Falls Church, Va.: Let's say you had more than the FDIC insured limit in your bank account. Would you rush out and open another account in order to keep both below the 100k threshold?

Steven Pearlstein: The chance of any one particular bank failing is pretty low, but if you're worried about it, do it. You'll sleep easier.


Pompano Beach, Fla.: As foolish as this may sound - weren't we better off when OPEC was setting the price of oil as opposed to Wall Street?

Steven Pearlstein: Good question. OPEC doesn't like these prices because it can see that people and businesses are now making permanent changes in the way they live and operate that will depress demand significantly over the long term. They like prices to rise steadily and slowly, so we just accept the price increases and don't change our behavior much.


Pleasantville, N.Y.: The accounting scandals that Fannie and Freddie were involved in several years ago stemmed not from credit losses but from the interest-rate risk they took on when they ramped up their on-balance sheet holdings of mortgages and MBS and their attempts to hide huge financial impacts (Fannie: $9 billion loss, Freddie: $6 billion gain) from so doing through the infamous technique of "earnings smoothing".

The current problem the GSEs face does seem mainly to be credit loss-related, but it seems to me that any fix should incorporate prohibiting the further taking on of mortgage assets and the orderly sale over a number of years of the assets they now hold.

The administration and the Fed have made it as clear as possible without explicitly stating it that they will stand behind the GSE's guarantees and senior obligations. The capital markets, continuing to be comfortable with these implied assurances, can absorb $1.5 trillion of additional mortgage-related assets over time.

The only reason the GSEs put mortgage assets on their balance sheets was the desire to make money. The "G-fee", the fee they charge for their guarantees, is 20-25BP, while the nominal spread between their on-balance sheet mortgages and the liabilities supporting them can be far higher if those liabilities aren't co-terminous with the assets (which I don't think they ever are except in the case of participation certificates). In their arrogance, the GSEs felt they could greatly reduce the interest-rate and prepayment risk on these assets through callable debt and derivatives. They were wrong. We as a nation are lucky that the debacle of several years ago wasn't far worse.

From reading the papers and watching TV, I understand that the sub-prime crisis is spreading into prime mortgages, the traditional purview of the GSEs, and I infer, perhaps incorrectly, that their current credit losses are a combination of prime business and some sub-prime that leached onto their balance sheets in the past several years. I'm five years removed from making a living looking (indirectly) at the GSEs, but I suspect that loan losses alone aren't going to drive them into the arms of Uncle Sam. However, when you add interest-rate and prepayment risk to the mix, you have a potentially deadly combination.

The mission of Fannie and Freddie is to support the U.S. residential housing market. They can do this perfectly adequately through guarantees alone. What do you think of this statement, and what do you think of making the GSEs divest themselves of their on balance sheet mortgages?

Steven Pearlstein: A very intelligent and reasoned analysis. I would say, however, that Fan and Fred have hedged a lot of their interest rate and prepayment risk. The real risk, as I understand it, is in a rising default rate on the mortgages they have guarateed, and secondarily, on having to take mark to market losses on assets on their balance sheets that they don't really want to hold to maturity.


Falls Church, Va.: You briefly mentioned it in your column today, but I haven't seen it said much - every bubble is described as "different this time" while we're in it. The tech stock bubble was different because it was a new economy, the housing bubble was different because "there's a limited supply of housing", and now the commodity bubble is different because of China and India and the growing world middle class. Alternately, it's different because people really have to take delivery of commodities, they're not just paper. I guess my question is - is this one really different?

Steven Pearlstein: You got that right -- they always say it's different this time. When you hear that with great frequency, it's usually a big sell signal.


Baltimore, Md.: In all the housing crisis bailout commentary, I rarely see any mention of the impact on renters. I've been a renter most of my life, recognizing that I don't want to make the sacrifices necessary at my income level to own a property in the kind of neighborhood I like. I can afford rent there (barely!). What really peeves me is that homeowners got the tax deduction, speculators helped drive rents up because more rehabbed properties became available, so renters are penalized in many ways. Now, my taxes will be used to bail out these same people. I'm furious and feel powerless. If the mortgage deduction went away balance might be restored. Your thoughts?

Steven Pearlstein: Well, you are right to be upset that renters (who as a class are poorer than homeowners) subsidize homeowners through the tax code. It's regressive and leads to over-investment in housing (particularly, investment in too much house) and to higher-than-necessary housing prices, putting houses even farther out of the reach of renters. Bad public policy, no doubt about it.

As for your tax money being used to bail out homeowners, first, no tax money has been used yet and second, to the degree it is done to prevent a meltdown in the financial system, and the secondary effects on the overall economy, that might be a use of government powers and funding that you would benefit from along with everyone else.


New York, N.Y.: Steve, What bothers me significantly about the current crisis (aside from losing money) is that while Wall Street, Freddie, Fannie, are running to the taxpayers with a tin cup for donations during bad times, are they going to cough up some money to the taxpayers during good times? These companies took stupid, outlandish risks so let them, their shareholders and their employees pay for it. Didn't you once say the modus operandi of these firms is "Privatize the gain, socialize the losses." On a related note, I work in Lower Manhattan near firms such as Goldman, Merrill, etc. It bugs me that NYC is giving Goldman $500 million for a new building. Wouldn't that money be better used for schools or hospitals or the subway? Thanks!!!

Steven Pearlstein: I've answered the first part of that several times. As for New York subsidizing Goldman, I couldn't agree more.


Washington, D.C.: Steven, thank you for your columns, I believe you are performing a public service in addition to your spot on reporting and analysis.

Question - we are in a situation with negative real interest rates, which is putting so much pressure on the dollar. Do you believe the Fed has it in them to at least raise the interest rate 25 basis points in order to give some semblance of supporting the green back?

If not, what are the consequences for continuing negative real interest rates?

Have a great weekend!!!

Steven Pearlstein: Negative real federal funds rate, if it persists too much longer, is a small problem. Rates for the rest of us aren't negative. I suspect the Fed will have to start raising them soon, unless the economy really craters.


Richmond, Va."More recently, some of those same people have been saying that the big flow of investment capital into commodities futures had little, if anything, to do with the dramatic run-up in the price of oil and other commodities -- that it's really all about the growing gap between stagnant supply and surging demand from China, India and other developing countries."

What's your take on the premise that the Wall Street Journal Editoral page has been promoting that a significant chunk of the commodity price increases, especially oil are due to Federal Reserve interest rate policy since August of 2007?

Steven Pearlstein: It may be a factor, but not the dominant factor. The transmission mechanism there is the dollar, but the changes in the dollar over the last six months can't explain most of the oil price runup.


Richmond, Va.: Is the proposal to get Freddie and Fannie into mortgages that were previously considered "jumbo" (I think Pelosi wanted something like $750k) now dead, or still alive?

Does any of this affect what the FHA does?

Steven Pearlstein: The bill now raises it, but not as much as the temporary authority granted a few months ago. It's a compromise. So, to answer your question, its half-alive.


Seattle, Wash.: Great column, per usual, but I don't think that pessimists have been "overly" pessimistic. Their analysis has been accurate so far (which is depressing) and as non-optimists who have looked at the relevant history know, housing markets take a much longer time to react than optimists are claiming, so the bad news isn't quite over and it's still unclear how much worse things will get. Pessimistic, yes. Overly, that's a value-judgment that probably isn't warranted.

Steven Pearlstein: Look, as one of the pessimists, I'd love to agree with you. There is reason for pessimism. But there is no reason to assume the worst about everything, like that all the banks and Fannie and Freddie are insolvent.


Dallas, Tex: Any chance of bringing back the Glass-Spiegel Act? Would that type of regulation do any good?

Steven Pearlstein: I think its Glass-Steagel (not sure how to spell it, actually), not Spiegel, which conjured up visions of banks offering household goods through a catalogue. But anyway, that genie is probably out of the bottle at this point. We need to move on.


Steven Pearlstein: That's all the time we have for today, folks. Good discussion. "See" you next week.


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