Market Commentary
A Conversation With Fred Sheehan
By Hewitt Heiserman Contributor

4/3/2008 2:29 PM EDT URL:

Fred Sheehan is co-author of Greenspan's Bubbles, with Bill Fleckenstein. A contributor to Marc Faber's Gloom, Boom & Doom Report and a former market strategist with John Hancock, Sheehan told clients eight years ago that U.S. credit markets were at risk. I recently caught up with Sheehan from his Boston office to learn how we got into this mess and what we can do to protect our net worth. An edited transcript of our conversation follows.

Fred, how did you go from studying history at Annapolis to studying the world financial markets?

By way of the Navy, then business school and finally to Hancock. I wrote my eighth-grade term paper on the 1929 stock market crash, so this progression seems to have been foredoomed. What is the state of the U.S. financial markets now?

The bond market is not functioning. It is priced for a depression. The stock market is volatile -- but at least it trades.

Equities don't seem concerned about a recession, even though the lifeblood of corporate America --commercial paper, junk bonds, bank lending, etc. -- is frozen. Some think the government's recent activities will solve these problems. But money-center banks will stay out of the lending business for at least a year. At this point in the credit cycle, when losses and erosion of reserves are still mysteries, banks are reluctant to lend. A year from now will be too late to prop up the economy that has relied on credit cards and loans. Profit growth is harder to achieve when banks don't lend money.

The Fed has been busy. Are they helping things or hurting?

Four things concern me.

First, the fed funds rate is 2.25%, down from 5.5%. The Fed's goal here is to increase liquidity to the credit markets and to support stocks. But at these low rates, Chairman Bernanke can't cut much further. He doesn't have many more bullets in his gun; soon he'll be shooting blanks.

Second, the Fed's balance sheet is in ruins. It is lending banks and other financial institutions its Treasury portfolio in exchange for all kinds of stuff. Before the credit markets seized, the Fed had about $870 billion in assets, including around $700 billion of Treasury securities. We don't know exactly what securities the Fed is accepting as collateral, but my bet is they're taking the worst paper. It would be rated CCC by an outside auditor.

Our financial system has regressed from a currency that was redeemable into gold, to fiat currency that was backed by the Federal Reserve System's U.S. Treasury securities. Now, the dollar is backed by mortgage securities that banks and brokers can't sell. The investment firms are in the early stages of writing off bad paper; they'll need plenty more good paper just to meet their reserve requirements. What can the Fed do? Nothing, except ask for the Treasury to print money.

Third, the Fed started loaning Treasury paper to primary dealers on March 7. This unsettling behavior heralds a new era for the Fed, since they are now funding the banking system and the brokerage industry. This compromises the Fed's authority; they wouldn't have gotten involved unless the brokers demanded it -- in effect, telling the Fed they couldn't function. The Fed no longer has the balance sheet to help the credit markets. Broker-dealers hold about $3 trillion in assets, or four times the Fed's assets. What the Fed offered the brokers is just a drop in the bucket, and yet the Fed is practically tapped out.

Fourth, Fannie Mae (FNM) and Freddie Mac (FRE) have the green light to make $200 billion in loans, but their delinquencies and defaults are rising. They can't escape higher write-off rates in the future, since they are so large -- they are the market, and the housing market is getting worse.

These GSEs are also highly leveraged. Fannie is at 20-to-1 without off-balance-sheet guarantees, 75-to-1 with. They are raising more capital, but if default rates continue to rise, there is a good chance their capital bases will be wiped out. Normally, the Fed would not bail them out. But as recent headlines show, the Fed's appetite for bailing out financial institutions has gone well beyond its original mandate. Again, the Fed is practically tapped out. Fannie and Freddie have no room for error, and neither does the Fed.

And if Fannie or Freddie fail?

The government may have no choice but to nationalize them. A nationalized housing market puts us on the road towards a nationalized financial system, which will destroy the economy.

Let me give you an example. In 1913, one German paper mark was redeemable into one gold mark, meaning the country had an honest currency. By 1918, 1.6 paper marks were needed to buy one gold mark. In 1920, the ratio passed 10-to-1, and in 1922, it passed 1,000-to-1. By November 1923, it took one trillion paper marks to buy one gold mark. You've seen those famous news clips of housewives running down the street pushing wheelbarrows of money. Germans had lost faith in the Reichsmark.

The lesson here is that the Reichsbank took advantage of the people's trust for a long time before the general population wised up and rejected their currency. I fear the same loss in credibility may happen to the Fed and the dollar.

But our financial system today is a lot more sophisticated than Germany's circa 1920s. We'll never make the same mistake that Germany did.

People confuse information for wisdom. Also, Bernanke thinks the way to fix bad economies is by printing more money. In a much-discussed speech in November 2002, the [future] Fed chair promised to drop greenbacks from helicopters if the country needed a stimulus. Combining Bernanke's thesis with the Treasury's recent proposals, I fear Washington wants to hand out enough money to homeowners to stop house prices from going down. They can do this, but only by printing so much money that a loaf of bread will cost $100.

We are much better off with deflation in the form of falling housing prices, with admittedly some people getting hurt, than inflation, which destroys all of society. Just look at the way inflation destroyed Germany in the 1920s, as I mentioned earlier.

How's the dollar reacting?

By lowering rates, the Fed is further debasing the greenback. A lower dollar begets additional consumer inflation -- which was already spiraling out of control.

Foreigners have warned us for years they won't buy U.S. Treasury securities and mortgage-backed securities at a rate to accommodate our home-renovation plans. With our national balance sheet destroyed and increased government spending, we're getting closer to bankruptcy. A trillion-dollar housing bailout by Congress might be the "sell" signal for foreign governments.

So you don't think the credit market problem will be fixed by this summer?

No. These problems have a long way to run, especially since the Fed is not letting nature take its course.

Some analysts compare the U.S. government's efforts now to Japan's efforts in the 1990s and predict these initiatives will prevent an asset price collapse. Japan didn't let its institutions fail; banks, insurance companies and industrial companies were supported through behind-the-scenes maneuvers. We're doing the same thing now.

But if we don't get the people out of houses who can't pay the mortgage, and if we don't let the bad banks fail, then the solvent banks can't make a profit. The good banks still have to compete with the bad banks, the latter which suck oxygen out of an economy that's gasping for air. By following the current course, we're not dealing with the destruction of credit directly. Our failing financial institutions need to be allowed to fail, or at best we'll follow Japan's path: 18 years of stagnation and the stock market is still down 60% from its peak.

In reality, we don't have the luxury to follow Japan's path. Our situation is more dire. Japan could borrow from itself because the national savings rate was 10% before the crash. Our savings rate is zero. Also, Japan had accumulated huge savings; we haven't. We are tapped out.

What else?

Our debt bubble isn't confined to just mortgages. It also includes credit cards, autos, commercial property and student loans. I am also concerned about derivatives. These come in many forms. The type, I think, that will be front-page news next are credit-default swaps.

A credit default swap, or CDS, is a form of insurance. CDS's have grown to a $45 trillion market from nothing in less than a decade. JPMorgan Chase (JPM) has the greatest CDS exposure -- it sold $7 trillion of protection against default through June 2007. This is one reason the Fed paired Bear Stearns (BSC) with JPMorgan. If Bear defaulted, the financial system might follow, including Morgan. Other commercial banks with large CDS exposures include Citigroup (C), Bank of America (BAC) and Wachovia (WB) .

These securities aren't regulated, the issuers haven't reserved for these losses, and the models don't assume a full credit cycle. What will Bernanke and Paulson do if every CDS chit is cashed in at the same time? The Bear Stearns mess will pale in comparison.

The Financial Select Sector ETF (XLF) rose more than 7% on Tuesday. Aren't the credit markets old news now, and is Wall Street looking ahead?

This ramp was a "first day of the quarter" phenomenon, where a lot of retirement money got invested. It was not due to fundamentals. This credit market problem has a long way to run, at least two to three years.

How can RealMoney subscribers protect their financial assets?

Every asset class is leveraged, including my favorites like gold, silver and platinum. There are no "safe havens" now, because investors around the world are deleveraging. If we see a $100 decline in the price of gold, the reason may be because hedge funds leveraged at 30-to-1 have to sell. Nothing is more liquid than gold, so this is what panicking hedge funds will liquidate. So you'll need a cast-iron stomach. Still, the purchasing power of gold will be much higher than the dollar bill three to five years from now. Everyone should hold real money -- all precious metals beat paper claims.

There are different ways to own gold. First, you can buy coins, such as Krugerrands. Second, there are ETFs, like [StreetTracks Gold Trust] (GLD) . Third, there are mutual funds, like Tocqueville's TGLDX.

Also, world grain inventories are the lowest level since 1972. Yes, the ethanol distortions contribute, but new supply is limited. The water tables have fallen significantly in China, India and in the United States over the past 30 years. Crop yields are falling. New cities are reducing crop land. So buy companies that make the products that farmers need, such as fertilizer and farm equipment.

Also, buy the energy commodities and the companies that help reduce the supply problems. There are plenty of these companies that trade for less than 15 times earnings -- Encana (ECA), BHP Billiton (BHP) , Freeport McMoran (FCX) , Bunge (BG) , Valero (VLO) .

Isn't their five-year run over?

The deleveraging of speculators may hit commodities hard, as I said. So these are investments for someone with a three-to-five-year time horizon.

Are U.S. Treasuries overpriced?

Yes, and they'll stay overpriced as long as credit concerns chase investors from ordinary money market funds into U.S. Treasury bills. The 28-day Treasury bill yield fell to 0.12% in mid-March. The popularity of Treasuries means fixed-income investors do not trust non-government paper. Government bonds are also being bid up by hedge funds getting margin calls, and who are trying to buy collateral that their primary dealers will accept.

How do we know when the credit markets are thawing?

When yields on the 10-year Treasury go up 1.5%, to around 5%, this is a bullish sign. It means petrified investors are loosening up and are willing to venture into other bonds.

Also, watch the media. They are a contra-indicator. When CNBC gives up hope for a recovery, then this is the time to buy undervalued bonds.

Any other advice?

A friend told me of a jeweler on New York's 47th Street who just bought a $130,000 necklace for $30,000 from a woman who needed the money. We are going to hear a lot more of these stories. So stay liquid. Opportunities will arise.

>You just wrote a book called Greenspan's Bubbles. Why your interest with the former Fed chair?

Greenspan's decision to cut the funds rate in late 1995 led to a stock market bubble, followed by a housing bubble. Sir Alan left the United States on the edge of ruin when he retired.

Thanks, Fred


Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit Earnings Power. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email. has a revenue-sharing relationship with under which it receives a portion of the revenue from Amazon purchases by customers directed there from