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I recently did a Q-and-A with Fred Sheehan for Real Money. Mr. 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.

Here are a few excerpts from an edited transcript of our conversation.

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.

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.

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.

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.
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Hi Hewitt,

Thanks for posting. I confess, this is the bleakest outlook I've seen. Comparing the US's prospects to 1920 Germany? That's even more dismal than the stuff John Mauldin posts (I quite like his stuff by the way).

I'm curious... I have no real ability to handicap macro prognostications. I can read a lot of different prediction, and I know enough to be able to follow along and understand the logic, but I can't handicap the odds of any of them being close to hitting the mark because I'm not knowledgeable enough to know what mitigating factors help round out the full picture. I've been operating under the assumption that housing will get worse... consumer spending will ease as a result... the economy will stall and we'll enter a recession that's not particularly deep, but may last a bit longer than most expect... we'll come out of it with a nice little bull market, but like the last decade we'll bounce around without making any lasting gains in the market for the next 5-10 years until normalized earnings catch up with valuations. It could take longer if taxes are raised substantially with the new incoming president.

The Fed being tapped out, nationalizing the entire financial system and hyperinflation didn't factor in to my thinking. I suppse you can't really second guess too critically the thinking of your guests or it might be tough to land interviews... but what's your take on Mr. Sheehan's predictions. A little overly gloomy maybe? I hope? It's so far beyond my ability to predict... I dont understand the reach of credit-default swaps or the liklihood the Fed will go bust.

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I agree--I hadn't read anything else quite that dire.

I think it was a good interview, with lots to chew on, but while I was reading, I could hear Peter Lynch's disembodied voice in the back of my head, talking about how people in the 70s underestimated the resiliency of the U.S. economy, discussing the impending collapse of the U.S., etc. (wish I could cite the page, though it must be One Up on Wall Street, as I just re-read it).

I'm not dismissing the arguments out-of-hand, to be sure--frozen capital markets sure are a pickle. I just can't help but think this is within spitting distance of the kind of unlikely worst-case scenario that is debated during difficult times.

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Mike makes an important point above.

My two cents to Mr. Sheehan's interview? The biggest financial problem facing the U.S. is not the seized credit markets, the potential $1 trillion loss in the housing market, or even our $9 trillion debt. Rather, it is the (present value) $40 trillion health care deficit over the next 75 years. Given that our GNP is just $14 trillion and household financial wealth is $45 trillion, healthcare costs--which are growing faster than the economy as a whole--is a massive frictional cost that will drive long-term rates several hundred basis points higher, I fear. In fairness to Mr. Sheehan, our conversation was limited to the credit markets; no doubt he would have mentioned health care if I asked him.

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Rather, it is the (present value) $40 trillion health care deficit over the next 75 years.

Thanks Hewitt...

Can you clarify that comment? Not that I question it, but I'd just like to clarify what constitutes that $40 trillion number and what the source is.

I know the unfunded liabilities in the social security and medicare program are going to knee cap us (medicare being the fat end of that club). Total unfunded liability and general revenue requirement to make up for the shortfall work out to a present value of $100.8 trillion (see calculation and sources below). With the total Federal tax revenue in 2006 sitting at $2.4 trillion^ and GDP just over $13 trillion, the magnitude of $100 trillion liability is almost absurd. I think there are (ballpark) 110 million households in the US? Each one is on the hook for $916,000 to fund these? The numbers look to work out to an additional tax in the ballpark of 18.1% of income on top of existing taxes to cover the shortfall. No matter what scary statistic you use, this is ugly. I'll avoid the rant these numbers naturally lead to. Particularly the part where the new part D program was introduced with only a mention of its cost during its first 10 years, and yet it suffers from a larger shortfall than the much ballyhooed unfunded social security liability that still hasn't been addressed. (Wait... did I avoid my rant? Sort of. :) )

Anyway, glad you guys brought it up and forced me to update my numbers for the biggest cudgel in my quiver when discussing (lack of) fiscal restraint. It's a heck of headwind in any case.


- Social Security* - unfunded liability (net of current trust fund): $15.2 trillion (1.1% of GDP, 3.2% of taxable payroll)
- Medicare part A (hospital insurance)** - unfunded liability: $34.4 trillion (2.6% of GDP, 6.1% of HI taxable payroll)
- Medicare part B (doctors visits)*** - required general revenue contribution to cover premium shortfall: $34 trillion (2.6% of GDP, (est) 6.1% of HI taxable payroll)
- Medicare part D (drug benefits)**** - required general revenue contribution to cover premium shortfall: $17.2 trillion (1.3% of GDP, (est) 3.1% of HI taxable payroll)
TOTAL: $100.8 Trillion

* source - 2008 trustees report, table IV.B7

** source - 2008 trustees annual report, table III.B11

*** source - 2008 trustees annual report, table III.C15

**** source - 2008 trustees annual report, table III.C23

^ source - random CBO memo, because I didn't feel like looking around that long
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looking at this, I probably shouldn't have used HI taxable payroll for parts B and D if they're going to be funded with a general revenue contribution... but the point stands I think.
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Kevin -

The most recent estimate I've seen is from Tom Donlan's column "The Annual Entitlement Lecture Medicare Elephantiasis," which ran in Barron's Mar. 31 issue.

If you have a Barron's online subscription click here:

Thanks for providing links to all those reports.

Last, this letter by First Pacific's Robert Rodriguez is required reading. Rodriguez, who has been named best stock and bond manager at various times during his career, says the Fed's socialization of risk will drive interest rates higher. I agree; at some later date we will pine for the "good old days" when the 10-year Treasury yielded 3.5%. The benchmark bond's 55-year average is 6.5%, or 300 basis points higher than current rates. The 10-year tells us the cost of money, and the higher the bond yield the more pressure this puts on stocks. If bond yields rise I expect, this will dampen enthusiasm for stocks (if it exists).

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Hi Hewitt,

Thanks for the Baron's link. I always appreciate your contributions on this board as they're always worthwhile.

I have read that Robert Rodriguez article. I had never heard of him until I read his "Absence of Fear" article last summer. Since then I check the First Pacific website every few weeks for more. He doesn't put much in that forum, but it's all very, very good and worth reading and re-reading many times to me. I think this newest "Socialization of Risk" article is the best thing he's put out since "Absence."

For those that haven't read it, I don't think Hewitt included the link. Here it is, and it's worth checking out.

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