A Conversation With Fred Sheehan

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 - commentary - Cramer's Take) and Freddie Mac (FRE - commentary - Cramer's Take) 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?

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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.

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