48965946 the Cognitive Dissonance of It All

8/2/2019 48965946 the Cognitive Dissonance of It All

1/17

February14,

2011

TheCognitiveDissonanceofitAll

"Men,ithasbeenwellsaid,thinkinherds;itwillbeseenthattheygomadinherds,whiletheyonlyrecovertheirsensesslowly,andonebyone."

CharlesMackay,ExtraordinaryPopularDelusionsandtheMadnessofCrowds.DearInvestors:

Wecontinuetobeveryconcernedaboutsystemicrisk intheglobaleconomy. Thusfar,thesystemicriskthat

was prevalent in the global credit markets in 2007 and 2008 has not subsided; rather, it has simply been

transferred from theprivate sector to thepublic sector. Wearecurrently in themidst of a cyclicalupswing

driven by the most aggressively procyclical fiscal and monetary policies the world has ever seen. Investors

aroundtheworldareengaging inanacuteandseverecognitivedissonance. Theyacknowledgethatexcessive

leverage created an asset bubble of generational proportions, but they do everything possible to prevent

rational deleveraging. Interestingly, equities continue to march higher in the face of European sovereign

spreads

remaining

near

their

widest

levels

since

the

crisis

began.

It

is

eerily

similar

to

July

2007,

when

equities

continuedhigherascreditmarketsbegantocollapse. This letteroutlinesthemajorsystemicfault lineswhich

webelieveallinvestorsshouldconsider.Specifically,weaddressthefollowing:

WhoisMixingtheKoolAid?(KnowyourCentralBankers) TheZeroInterestRatePolicyTrap TheKeynesianEndpointWhereDeficitSpendingandFiscalStimulusBreakDown JapanWhatOtherMacroPlayershaveMissedandtheComingofXDay WillGermanyGoAllIn,oristhePriceTooHigh? AnUpdateonIcelandandGreece DoesDebtMatter?

While good investment opportunities still exist, investors need to exercise caution and particular care with

respecttoinvestmentdecisions.Weexpectthat2011willbeyetanotherveryinterestingyear.


2/17

2HaymanCapitalManagement,L.P.2011

In 2010, our core portfolio of investments in US mortgages, bank debt, highyield debt, corporate debt, and

equitiesgeneratedourpositivereturnswhileourtailpositionsinEuropecontributednominallyinthepositive

direction and our Japanese investments were nominally negative. We believe this rebound in equities and

commodities is mostly a product of goosing by the Feds printing press and are not enthusiastic about

investingtoofaroutontheriskspectrum.Wecontinuetohaveaportfolioofshortdurationcreditalongwith

moderateequityexposureandlargenotionaltailpositionsintheeventofsovereigndefaults.

WhoisMixingtheKoolAid?

Unfortunately, academic has become a synonym for central banker. These days it takes a particular

personality type to emerge as the highest financial controller in a modern economy, and too few have real

financialmarketorcommercialexperience. RogetsThesaurushasnotyetadoptedthisuse,butthepractical

reality is sad and true. We have attached a brief personal work history of the US Fed governors to further

illustratethis

point.

So

few

central

bankers

around

the

world

have

ever

run

abusiness

yet

so

much

financial

trust is vested with them. In discussing the sovereign debt problems many countries currently face, the

academic elite tend to arrive quickly at the proverbial fork in the road (inflation versus default) and choose

inflationbecausetheyperceiveittobelesspainfulandlessnoticeablewhilepushingtheharderdecisionfurther

downtheroad.Greenspandroppedratesto1%andtradedthedotcombustforthehousingboom.Heknew

thattheroadoverthenext10yearswasgoingtobefraughtwithsomuchdangerthathehandedthereinsover

to Bernanke and quit. Central bankers tend to believe that inflation and default are mutually exclusive

outcomesandthattheyhavebeenanointedwiththepowertochooseonepaththatisseparateandexclusiveof

theother.Unfortunately,whencountriesareasindebtedastheyaretoday,thesechoicesbecomesynonymous

withoneanotheroneactuallycausestheother.

ZIRP(ZeroInterestRatePolicy)isaTRAP

As developed Western economies bounce along the zero lower bound (ZLB), few participants realize or

acknowledgethatZIRPisaninescapabletrap.WhenaheavilyindebtednationpursuestheZLBtoavoidpainful

restructuring within its debt markets (household, corporate, and/or government debt), the ZLB facilitates a

pursuitof

aggressive

Keynesianism

that

only

perpetuates

the

reliance

on

ZIRP.

The

only

meaningful

reduction

of

debt throughout this crisis has been the forced deleveraging of the household sector in the US through

foreclosure.Totalcreditmarketdebthasincreasedthroughoutthecrisisbythetransferofprivatedebttothe

publicbalancesheetwhilerunningdoubledigitfiscaldeficits.Infact,thisisanexplicitpartofacentralbankers

playbook that presupposes that net credit expansion is a necessary precondition for growth. However, the


3/17


problemofoverindebtednessthatisamelioratedbyZIRPisonlymadeworsethelongerasovereignstaysatthe

ZLBwithevergreaterconsequenceswhenshortrateseventually(andinevitably)returntoanormalizedlevel.

TotalGlobalDebt(LeftAxis)andGlobalDebt/GDP(RightAxis)

Source: IMF Global Financial Stability Report; IMF World Economic Outlook; Moodys Country Credit Statistical Handbook; BIS;

CIAWorldFactbook;Haymanestimates.

Consider the United States balance sheet. The United States is rapidly approaching the Congressionally

mandateddebtceiling,whichwasmostrecentlyraisedinFebruary2010to$14.2trilliondollars(including$4.6

trillion held by Social Security and other government trust funds). Every one percentage point move in the

weightedaveragecostofcapitalwillendupcosting$142billionannuallyininterestalone.Assuminganything

butan invertedcurve,amovebackto5%shortrateswill increaseannualUS interestexpensebyalmost$700

billionannuallyagainstcurrentUSgovernmentrevenuesof$2.228trillion(CBOFY2011forecast). Even ifUS

governmentrevenuesweretoreachtheirpriorpeakof$2.568trillion(FY2007),theimpactofariseininterest

rates is still staggering. It is plain and simple; the US cannot afford to leave the ZLBcertainly not once it

accumulatesafurther$9trillionindebtoverthenext10years(whichwillincreasetheannualinterestbillbyan

additional$90billionper1%). IfUSratesdostartmoving, itwillmost likelybeforthewrong(andmostdire)

reasons.

Academicresearch

on

this

subject

is

best

defined

as

alchemy

masquerading

as

hard

science.

The

onlyhistoricalobservationofadebtdrivenZIRPhasbeenJapan,andthetrueconsequenceshaveyettobefelt.

Never before have so many developed western economies been in the same ZLB boat at the same time.

Bernanke,ourcurrentWizardofOz,offeredthis littletidbitofconjecture inapiecehecoauthored in2004

whichwasappropriatelytitledMonetaryPolicyAlternativesattheZeroBound:AnEmpiricalAssessment.He

clearlydidnotwanttocallthispaperaHypotheticalAssessment(asitreallywas).

240%

250%

260%

270%

280%

290%

300%

310%

320%

330%

340%

350%

$

$20

$40

$60

$80

$100

$120

$140

$160

$180

$200

$220

2002 2003 2004 2005 2006 2007 2008 2009 2010E

GlobalDebt/GDP

TotalGlobalDebt(Trillions

ofDollars)

PublicDebtSe curities PrivateDebtSecurities BankAssets Debt/GDP(RightAxis)


4/17


Despite our relatively encouragingfindings concerning thepotential efficacy of nonstandard

policiesatthezerobound,cautionremainsappropriateinmakingpolicyprescriptions.Although

it appears that nonstandard policy measures may affect asset prices and yields and,

consequently,aggregatedemand,considerableuncertaintyremainsaboutthesizeandreliability

of these effects under the circumstances prevailing near the zero bound. The conservative

approachmaintaining a sufficient inflation buffer and applying preemptive easing asnecessary to minimize the risk of hitting thezero bound still seems to us to be sensible.However,suchpoliciescannotensurethatthezeroboundwillneverbemet,sothatadditional

refiningofourunderstandingof thepotentialusefulnessofnonstandardpoliciesforescaping

thezeroboundshouldremainahighpriorityformacroeconomists.

Bernanke,Reinhart,andSack,2004.(EmphasisAdded)ItistellingthatheusestheverbescapinginthatfinalsentenceinstinctivelyheknowstheZLBisdangerous.

TheKeynesianEndpointThingsBecomeNonLinear

As Professor Ken Rogoff (Harvard School of Public Policy Research) describes in his new book, This Time is

Different:EightCenturiesofFinancialFolly,sovereigndefaultstendtofollowbankingcrisesbyafewshortyears.

His work shows that historically, the average breaking point for countries that finance themselves externally

occurs at approximately 4.2x debt/revenue. Of course, this is not a hard and fast rule and each country is

different, but it does provide a useful frame of reference. We believe that the two critical ratios for

understandingandexplainingsovereignsituationsare: (1)sovereigndebttocentralgovernmentrevenueand

(2) interestexpenseasapercentageofcentralgovernment revenue. Webelieve that these ratiosarebetter

incrementalbarometersoffinancialhealththantheoftenreferenceddebt/GDPGDPcalculationscanbevery

misleading. We believe that central government revenue is a more precise measure of a governments

substantive ability to pay creditors. Economists use GDP as a homogenizing denominator to illustrate broad

pointswithoutparticularattentiontotheidiosyncrasiesofeachnation.Usingourpreferreddebtyardsticks,we

findthatwhendebtgrowstosuch levelsthat iteclipsesrevenuemultipletimesover,(everycountry isunique

andthemaximumsustainablelevelofdebtforanygivencountryisgovernedbyamultitudeoffactors),thereis

anon

linear

relationship

between

revenues

and

expenses

in

that

total

expenditures

increase

faster

than

revenuesduetotherise in interestexpense fromahigherdebt loadcoupledwithahigherweightedaverage

costofcapitalandthenaturalinflationofdiscretionaryexpenditureincreases.Themeansbywhichsovereigns

fall intothis inescapabledebt trap is thecriticalpointwhichmustbeunderstood. Insomecases,onbalance

sheetgovernmentdebts(excludingpensionshortfallsandunfundedholes insocialwelfareprograms)exceed

3xrevenue,andcurrentfiscalpoliciespointtoacontinuingupwardtrend.


5/17


TheBankofInternationalSettlementsreleasedapaperinMarch2010thatisparticularlysobering.Thepaper,

entitled The Future of Public Debt: Prospects and Implications (Cecchetti, Mohanty and Zampolli) paints a

shockingpictureofthetrajectoryofsovereign indebtedness. WhiletheauthorsfocusonGDPbasedratiosas

opposed to ourpreferredmetrics, the forecast isneverthelessalarming. The study focuseson twelvemajor

developedeconomiesandfindsthatdebt/GDPratiosriserapidlyinthenextdecade,exceeding300%ofGDPin

Japan;200%intheUnitedKingdom;and150%inBelgium,France,Ireland,Greece,ItalyandtheUnitedStates.

Additionally,theauthorsfindthatgovernmentinterestexpenseasapercentofGDPwillrisefromaround5%

[onaverage]todaytoover10%inallcases,andashighas27%intheUnitedKingdom.Theauthorspointout

thatwithoutaclearchangeinpolicy,thepathisunstable.1

Whencentralbankersengageinnonstandardpoliciesinanattempttogrowrevenues,theresultingincrease

in interestexpensemaybemanymultiplesofthechange incentralgovernmentrevenue. For instance,Japan

currently maintains central government debt approaching one quadrillion (one thousand trillion) Yen and

centralgovernment revenuesareroughly48trillion. Their ratioofcentralgovernmentdebt torevenue isa

fatal20x.Aswediscusslater,Japansailedthroughtheirsolvencyzonemanyyearsago.Minuteincreasesinthe

weightedaverage cost of capital for these governments will force them into what we have termed the

Keynesianendpointwheredebtservicealoneexceedsrevenue.

In Japan, some thoughtful members of the Diet (Japans parliament) decided that they must target a more

aggressive hard inflation target of 23%. For the past 10+ years, the institutional investor base in Japan has

agreedtobuy10yearbondsandreceivelessthan1.5%innominalyield,aspersistentdeflationbetween13%

peryearprovidesthebuyerwitharealyieldsomewherebetween2.5%4.5%(nominalyieldplusdeflation).

(We believe that Japanese institutional investors may base someof their investment decisionson realyields

whereasexternal JGB investorsdonot.) IftheBankof Japan (BOJ)were to target inflationofjust1% to2%,

whatratewouldinvestorshavetochargeinordertohaveapositiverealyield?Inordertoachieveevena2.5%

realyield,thenominal(orstated)yieldsonthebondswouldhavetobeinexcessof3.5%. Herein liesthereal

problem. IftheBOJchoosesaninflationtarget,theJapanesecentralgovernmentscostofcapitalwillincrease

bymorethan200basispoints(overtime)and increasetheir interestexpensebymorethan20trillion(every

100

basis

point

change

in

the

weighted

average

cost

of

capital

is

roughly

equal

to

25%

of

the

central

governmentstaxrevenue). Forcontext,ifJapanhadtoborrowatFrancesrates(aAAAratedmemberofthe

U.N. Security Council), the interest burden alone would bankrupt the government. Their debt service alone

couldeasilyexceedtheirentirecentralgovernmentrevenuecheckmate.TheZIRPtrapsnapsshut.Thebond

1http://www.bis.org/publ/work300.pdf(p.9)


6/17


marketstendtoanticipateeventslongbeforetheyhappen,andwebelieveaJapanesebondcrisisislurkingright

aroundthecornerinthenextfewyears.

Below,pleasefindapieceofourworkdetailingsomeimportantcountriesandthesekeyrelationships:

GovernmentDebt/Revenue(2010E)

Note:IcelanddataincludesgrossIcesaveliabilities.

Source:MoodysCountryCreditStatisticalHandbook.JapandatasourcedfromJapaneseMinistryofFinance.GovernmentInterestExpense/Revenue(2010E)

Note:IcelanddataincludesgrossIcesaveliabilities.

Source:MoodysCountryCreditStatisticalHandbook;Haymanestimates;JapandatasourcedfromJapaneseMinistryofFinanceFY2011

budget.

0%

100%

200%

300%

400%

500%

600%

1900%

2000%

0%

5%

10%

15%

20%

25%

30%

35%


7/17


WhatotherMacroParticipantsHaveMissedandtheComingofXDay

Japanhasbeenakeyfocusofourfirmforthe lastfewyears. While itrepresentsasmallamountofcapitalat

risk in theHaymanCapitalMasterFundL.P., it remains theplacewherewebelieve themostasymmetryand

outsizedreturnswillbegenerated inthecomingyears. Wecouldspendanother10pagesdoingadeepdive

intoour

entire

thesis,

but

we

will

save

that

for

our

investor

dinner

scheduled

for

April

26th.

For

now,

We

are

goingtostickwiththecatalystsfortheupcomingJapanesebondcrisis.

Investingwith theexpectationsof rising rates in Japanhasbeendubbedthewidowmakerby someof the

worldsmosttalentedmacro investorsoverthepast1520years. It isourbeliefthatthese investorsmisseda

crucial piece to the puzzle that might have saved them untold millions (and maybe billions). They operated

undertheassumptionthatJapaneseinvestorswouldsimplygrowtiredoffinancingthegovernmentdirectlyor

indirectly with sucha low return on capital. However, we believe that the absence ofattractive domestic

investmentalternatives

and

the

preponderance

of

new

domestic

savings

generated

each

year

enabled

the

Japanesegovernmenttoselffinancebysellinggovernmentbonds(JGBs)toitshouseholdsandcorporations.

This is done despite their preference for cash and time deposits via financial institutions (such as the

Government Pension Investment Fund, other pension funds, life insurance companies, and banks like Japan

Post)thathavelittleappetiteformorevolatilealternativesandlittleopportunitytoinvestinnewprivatesector

fixedincomeassets. Essentially,theytake inthesavingsasdepositsandrecyclethem intogovernmentdebt.

Thus,itisnecessarytounderstandhowlargethepoolofcapitalforthesaleofnewgovernmentbonds.

Wefocusonincrementalsalesorflowversusthestockofaggregateddebt.Tosimplify,theavailablepools

of capital are comprised of two accounts household and corporate sector. The former is the incremental

personal savings of the Japanese population, and the latter is the aftertax corporate profits of Japanese

corporations.Thesetwopiecesofthepuzzlearetheincrementalpoolsofcapitaltowhichthegovernmentcan

sell bonds. As reflected in the chart below, as long as the sum of these two numbers exceeds the running

government fiscaldeficit, theJapanesegovernment(intheory)hastheabilitytoselffinanceorselladditional

government bonds into the domestic pool of capital. As long as the blue line stays above the red line, the

Japanesegovernment

can

continue

to

self

finance.

This

is

the

key

relationship

the

macro

investors

have

missed

for the last decade it is not a question of willingness, but one of capacity. As the Japanese governments

structuraldeficitgrowswider (drivenbythe increasingcostofanageingpopulation,higherdebtservice,and

secularlydecliningrevenues)thedivergencebetweensavingsandthedeficitwillincrease.Interestinglyenough,

Alan Stanford and Bernie Madoff have recently shown us what tends to happen when this selffinancing

relationship inverts. When the available incremental pool of capital becomes smaller than the incremental


8/17


financingneedsofthegovernmentoraPonzischeme,therubberfinallymeetstheroad.Theseveredeclinein

thepopulationinadditiontoJapaneseresistancetolargescaleimmigrationcombinetoformavolatilecatalyst

foratoxicbondcrisisthatcouldverylikelybethelargesttheworldhaseverwitnessed.Belowischartdepicting

thisrelationship:

JapaneseNetDomesticSavingsvs.GeneralGovernmentDeficit(%

of

GDP)

Source:IMFWorldEconomicOutlook;JapanNationalAccounts;Haymanestimates.

PersonalsavingsinJapan,whilehistoricallyhigherthanalmostanyothernation,isnowapproachingzeroand

willfallbelowzerointhecomingyears(asrecentlypointedoutbytheBankofTokyoMitsubishi)asmorepeople

leavetheworkforcethanenter.Foratleastthenext20years,webelievethatJapanwillhaveoneofthelargest

naturalpopulationdeclinesinadevelopedcountry.

JapaneseHouseholdSavingsRateand60+PopulationRatio(%)

Source:BankofTokyoMitsubishi.

4%

2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

NetSavings/GDP Deficit/GDP

Thedeficit/savingsgap

needstobefilled

fromexternalcapital

Excessdomesticsavingsprovided

significantroomforprivateandpublic

creditexpansionatlowinterestrates

BTMUbelieves

Japanesehousehold

savingswillcrossinto

negative territoryin

2015 thedownward

trendisirreversible

withoutasignificant

changein

demographicprofile.


9/17


One last pointabout Japan that ismore psychological thanquantitative: there isan interesting psychological

parallelbetweenJGBsandUShousing. Inthe last20years,Japanesestockshavedropped75%,Japanesereal

estatehas declined70% (with highend realestate dropping 50% in the last two years), and nominal GDP is

exactlywhereitwas20yearsago.Whatoneassethasneverhurtthebuyer?Whatoneassethasearneda20

yearprocyclical,Pavlovianresponseassociatedwithsafetyandevenmoresafety?Thebuyersandownersof

JGBshaveneverlostmoneyinthepurchaseoftheseinstrumentsastheirinterestrateshavedonenothingbut

fallforthebetterpartofthelast2decades.Itisfascinatingtoseeaninstrument/assetbeviewedasoneofthe

safest in the world (10yr JGB cash rates are currently 1.21%) at a period of time in which the credit

fundamentals have never been riskier. Without revealing the Master Funds positioning here, we certainly

intendtoexploittheinefficienciesofoptionpricingmodelsoverthenextfewyears.Theprimaryflawinpricing

theriskofrisingJGByieldsistherelianceonhistoricalvolatilitywhich,tothispointintime,hasremainedvery

low.Webelievethatvolatilitywillrisesignificantlyandthatcurrentmodelsundervaluethepotentialmagnitude

offuture

moves

in

JGB

yields.

WithalloftheevidenceliterallystackingupagainstJapan,afewmembersofsomeofthemajorpoliticalparties

arebeginningtodiscussandplanfortheominouslynamedXDay. AccordingtoTheWallStreetJournaland

BusinessWeek,XDay isthedaythemarketwillno longerwillinglypurchaseJGBs. Planning is intheveryearly

stages,butcentersaroundhavingasetofseriousfiscalchangesthatcouldbeannouncedimmediatelywiththe

intentionofgivingtheBankofJapanthecovertheywillneedtopurchasemassiveamountsofJGBswithmoney

printedoutofthinair. IftheBOJweretoengage inthistypeofbehavior,webelievetheYenwouldplummet

against

the

basket

of

key

world

currencies

which

would

in

turn

drive

Japanese

interest

rates

higher

and

further

aggravatetheirbondcrisis.NeithertheFed,theBankofEnglandnortheEuropeanCentralBankhavebeenable

to consistently suppress bond yields through purchases with printed money the bigger the purchase, the

greater the riskofacollapse inconfidence in thecurrencyandcapital flight.Nomatterhowtheyattemptto

quellthecrisis,nomatterwheretheyturn,theywillrealizethattheyareincheckmate.

WillGermanyGoAllInoristhePriceTooHigh?

We believe that an appreciation of the extent and limits of German commitment to full fiscal and debt

integrationwiththerestoftheEurozone iscrucialtounderstandingthepath forward forEuropeansovereign

creditissues.

Despite consistent attempts by the European Commission and other members of the Eurozone bureaucratic

vanguard to publicly promote as done deals various proposals to extend debt maturities, engage in debt

buybacksanddramaticallyextendboththescopeandsizeoftheEFSFtheoutcomehasremainedindoubt.In


10/17


the end, the national governments of the member states will determine these policies regardless of what

unnamedEuropeanofficialsleaktothenewswires.

We believe that Angela Merkel has heeded the discord in the German domestic political sphere

(whereconsistentpollingshowsadeclineinsupportfortheEuroandanincreaseinbeliefthatGermanywould

havebeen

better

off

not

joining)

and,

as

aresult,

set

aseries

of

substantial

criteria

for

any

German

approval

of

further reform and extension of the EFSF structure. The areas canvassed balanced budget amendments,

corporate tax rate equalization, elimination of wage indexation and pension age harmonization read like a

wish list for remaking the entire Eurozone into a responsible and conservative fiscal actor in the mold of

moderndayBerlin.However,webelieve(absentadramaticchangeinthepoliticalmood)thatseveralmember

stateswillneverallowtheserequeststobecomebindingprerequisites for further fiscal integration the Irish

and Slovaks on tax, the French on pension age, the Belgians and Portuguese on indexation and almost

everybodyonthebalancedbudgetamendment.

SotheEurozoneseemstobeatan impassetheGermansarereluctanttostep further intothequagmireof

peripheralsovereigndebtwithoutassurancesthatallnationswillbecompelledtobringtheirhouses inorder,

andtherestoftheEurozonerejectstheburdenofaGermanfiscalstraightjacket.Wecontinuetobelievethat,

intheend,theGermanpeoplewillnotgoallintobackstoptheprofligacyandexpediencyoftherestofthe

Eurozone without a credible plan to restructure existing debts and ensure that they can never reach such

dangerouslevelsagain.

A

variety

of

solutions

have

been

proposed

to

allow

the

de

facto

restructuring

of

Greek

debt

without

engaging

in

formal default. The ECB and EC continue to be obsessed with preventing what they have deemed to be

speculators frombenefitingvia the triggeringofCDSonGreek sovereigndebt. Notonly is thispointlessly

statist in its opposition to market participants, but it is also counterproductive to their other stated aims of

maintaining financial stability and bank solvency, as much of the notional CDS outstanding against Greek

sovereigndebtisheldasabonafidehedge.DatafromtheDepositoryTrustandClearingCorporation(DTCC)

clearly invalidatestheassertionthataroguearmyofspeculators is instigatingaGreekbondcrisisforaprofit.

Accordingto theDTCC,there isonly$5.7billionnetnotionalCDSoutstandingonsovereignobligationsofthe

HellenicRepublic,

versus

approximately

$489

billion

of

total

sovereign

debt

outstanding

(as

of

September

30,

2010).NetCDSonGreeksovereigndebtisequalto1.2%ofdebtoutstanding.2

Any revaluationofdebt thatreducestherealornominalvalueofGreecesdebtoutstandingeitherthrough

maturity extensions or through discounted debt buybacks necessarily creates a loss for existing holders. The

2http://www.dtcc.com/products/derivserv/data_table_i.php?tbid=5.


11/17


Europeanstresstestsshowedthatupto90%ofsovereigndebtisheldtomaturitybyinstitutionalplayers,and

thusisstillatriskoffuturewritedowns.Thereisnoincentivetovoluntarilysubmittoanextensionorabuyback

thatreducesthenominalorrealvalueofthesebonds,andcoercionwillsimplyforcethelosses.

In the end themathematics of the debt situation in Greece are inescapable there is more than350bn of

Greeksovereign

debt

and

at

least

200

billion

of

it

needs

to

be

forgiven

to

allow

the

debt

to

be

serviceable

given

current yields and the growth prospects of the Greek governments revenues. This loss has to be borne by

someone either bondholders or nonGreek taxpayers. The current policy prescription that has Greece

borrowingitswayoutofdebtispurefolly.Thatistherealityofasolvencycrisisasopposedtotheliquiditycrisis

thattheEurozonehasassumedtobetheproblemsincelate2008.

Untilaworkableplan iscreated thatshares theburdenof these lossesandthen formalizesa recapitalization

plan, itwillcontinuetofesterandspreaddiscordintherestoftheEurozone. Infact,it isclearfromtheprice

andvolume

action

in

peripheral

bonds

that

there

is

an

effective

institutional

buyer

strike,

and

it

is

only

the

moneyprintingbytheECBthat iskeepingtheseyields fromenteringstratospheric levelsyetstilltheygrind

higher. Some of this move in peripheral European bond yields has been driven by broader moves higher in

rates,butputting thesespreadsaside, it istheabsoluteyield levelsthatgovernserviceability for thesestates

andbothSpainandPortugalarecurrentfinancingatunsustainablyhighlevels.

Absentaseriousrestructuringplan,theEurozonewillcontinuetoreelfromoneminicrisistothenexthopingto

putoutspotfiresuntilthebankingedificefinallycomescrashingdownunderitsownweight.Inourview,itwill

severely

affect

a

few

states

considered

to

be

in

the

core

of

Europe

as

well.

OfIcelandandGreece

We recently traveled to Greece and Iceland in order to better understand the situations in each of these

financialwastelands. Wemetwithcurrentand formergovernmentofficialsaswellas largebanksandother

systemically important companies and wealthy families. This trip confirmed our quantitative analysis and

ultimatelywasalessoninpsychology.Wemetmanyinterestingpeopleinbothplacesbutvirtuallyallofthem

livedinsomestateofdenialwithregardtoeachcountrysfinances.AsMarkTwainoncesaid,Denialaintjust

ariverinEgypt.

InGreece,theycurrentlyspend14%ofgovernmentrevenuesoninterestaloneandarefranticallyattemptingto

gettoaprimarysurplus.ThisisanalogoustoaheavilyindebtedcompanytryingtogettopositiveEBITDAwhile

stillbeingcashflownegativeduetointerestexpense.TheGreekgovernmentsrevenueisamonstrous40%of

GDP(only15%intheUS)andGreecehasraisedtheirVATtaxto23%fromjust17%thispastsummer.Wedont


12/17


think theycanpossiblyburden their taxpayingpopulationmuchmoreeven though theprevalent thought in

Greeceisthattheyneedtotaxthepopulacemoretomakeupforthosewhopaynotax.Greeceskeyproblems

today are all of the small and medium enterprise (SME) loans that are beginning to default. As the

governmentbeginstoincreasetaxesontheGreeks,businessesaremovingoutofGreecetoplaceslikeCyprus,

Romania,andBulgaria(analogoustoCalifornians,Illinoisans,andNewYorkersmovingtoTexas)wheretaxrates

aremuchlower.GiventhefiscalsituationinGreece,arestructuringoftheirdebts(i.e.default)seemsthemost

probableoutcome. Atnearly140%sovereigndebttoGDPand3.4xdebttogovernmentrevenues,Greeceput

itselfintocheckmatelongago.

Inoneofthemorecomicalmeetingswehaveeverattended,onechiefeconomistatoneofthelargestbanksin

Greecesurmisedthat ifthesovereigncouldtransfer100billionofgovernmentdebttothepersonalbalance

sheetsof thepopulation that itwouldbeapotentialmagical fix for the states finances (and subsequently

pointedoutthatGreecewouldnotbesuchanoutlierasa result). WhenaskedhowtheGreekstatecould

accomplishsucha feat,hesaidhedidnotknowand thatmaybeHarryPottercould findaway. It ishard to

believe,buthewascompletelyserious.Forhim,itwasntimportanthoworifitcouldhappenaslongasthe

potentialoutcomemadethesituationlookbetterforprospectivebondinvestors.Greekbankshavebetween3

3.5xtheirentireequity invested inGreekgovernmentbonds. Considerthat ifthesebondstooka70%haircut

(Haymansestimateofthenecessarywritedown),Greekbankswouldlosemorethantwicetheirequity.

Shortlyafter thismeeting,myhost informedmeofanaudit recentlydoneononeof the largesthospitals in

Athens. ThishospitalwashemorrhagingEuros,andtheGreekgovernment isrequiredtomakeup thedeficit

withcapital

injections.

Officials

began

an

inquiry

into

these

losses

and

found

45

gardeners

on

staff

at

the

hospital. The most interesting fact about the hospital was that it did not have a garden. The corruption is

endemic in the society, and it is no wonder that Greece has been a serial defaulter throughout history (91

aggregateyears inthe last182orapproximatelyhalfthetime). It isunfortunatethat it isabouttohappen

onceagain. Althoughaswehavepreviouslystated,restructuring isactuallythegatewaytorenewedgrowth

andprosperityovertimewehaveidentifiedatleasttwoassetsthatwewouldliketoowninGreeceinapost

restructuringenvironment.

Iceland,on

the

other

hand,

has

asimilar

balance

sheet

and

different

culture.

Icelands

abrupt

decline

into

financialobscuritywasthedrivingforceatHaymanthatpromptedusto lookattheworldthroughadifferent

lens.IfirstencounteredIcelandshistoryandcultureinabookIhadreadseveralyearsagotitledCollapse:How

SocietiesChoosetoFailorSucceedwrittenbyPulitzerPrizewinnerJaredDiamond. Diamondisaprofessorof

geographyatUCLAandadeterminedenvironmentalist. Hisanalysis isbasedonenvironmentaldamage that


13/17


societiesinflictonthemselvesandthatthereareothercontributingfactorstoacollapse.Onecommentmade

earlyinthisbookcaughtmyeyemanyyearsago:

SomesocietiesthatIshalldiscuss,suchastheIcelandersandtheTikopians,succeededinsolving

extremelydifficultenvironmentalproblems,have therebybeenable topersistfora long time,

andare

still

going

strong

today.

JaredDiamond,Collapse:HowSocietiesChoosetoFailorSucceed.Whatcaughtmyattentionwas the fact thatDiamonduses Icelandasacountry thathasbeenable toget it

rightasasocietyforaverylongtime.Whatbroughtthemtotheirkneesinthelastfewyearswasacomplete

disregardfortherisksinherentinallowingtheirbankingsystemtogrowunchecked(duetotheoverwhelmingly

positivecontributiontoGDPandjobgrowth). Inanationof318,000peopleandapproximately$20billionUSD

ofGDP(2008), Icelandhadover$200billionUSD inassets injustthreebanks. More importantly, Icelandhad

over 34x its central government revenue in banking assets. To put this into context, a 3% loss ratio in the

bankingsystemwouldcompletelywipeout thebanksand thecountrysability todealwith theproblem. Of

course,this ispreciselywhathappenedand Iceland finds itselftoday inastateofsuspendedanimation. The

governmentimmediatelyimposedcapitalcontrols(moneywasallowedin,butnomoneywasallowedout)and

beganaprocessofdeterminingwhichdebtstheycouldpayandfromwhichmultilaterallendinginstitutionsthey

wouldhavetobeg.ConventionalwisdomsuggeststhatIcelandhasturnedthecorneranddealtwithitsdemons

andwillemergestrongerandsmartergoingforward.Unfortunately,wedontbelievethattobethecaseyet.

Icelandcurrently

spends

an

estimated

118

billion

Icelandic

kroner

on

interest

expense

(including

gross

interest

onIcesave liabilities)aloneagainstapproximately600billionkronerofrevenuesataweightedaveragecostof

capitalof roughly4.7% (evenwith heavily subsidized loans from the IMFandother Nordiccountries). With

grossdebtsasapercentofGDP(includingIcesave)thatexceedGreece(whose10yrbondsyieldover11%),we

couldntfindarealpublicmarketforIcelandsdebt. Today,theirstatedexchangerateofkronertotheUSD

hoversaround117andtheblackmarketoroffshorerate forthekroner is176 (a33.5%devaluationfrom

theonshorerate).Precrisis,theofficialexchangeratewas60kronertothedollareventheonshoreofficial

rateshavedevaluedbynearly50%totoday. Governmentrevenuedeclined innominaltermsthroughoutthe

crisisevenwhilethecurrencydepreciatedby50%! Imaginesufferinga50%devaluation inpurchasingpower

andaconcomitant increase inexportcompetitiveness,yetthegovernmentcannotmaintainnominalrevenue,

whichisakeypartoftherecoveryplantoavoideventualrestructuring.WhileIcelandishardlyanoasisoffiscal

reform,weexpectover time that itwill recognize that restructuringwillafford thebestopportunity toshare

financialpainevenlyandrestartalongthepathofgrowth.LikeGreece,wehaveidentifiedattractiveassetsand


14/17


investmentopportunities in Icelandonce the restructuringoccursandcapitalcontrolsare lifted,allowing the

currencytodepreciatefurthertowardsarealmarketrate.

Iceland isamicrocosmofwhatwentwrongwiththeworld,butaftertheIMFandNordic loans,attentionwas

divertedawayfromtheproblem.IcelandandIrelandsharesimilarrootswhenitcomestotheiracuteproblems.

Withthe

development

of

the

European

Union

and

the

creation

of

aEuropean

free

trade

zone,

inefficiencies

wereexploitedbetweencountrieswhohaddifferingtaxanddepositstructures.SmallcountrieslikeIrelandand

Iceland could actually compete with much larger counterparts by offering slightly higher deposit rates with

programslikeIcesaveaccounts.Thekeyproblemwasthatnoprovincialregulatorpaidanyattentiontothesize

and leverage in each countrys banking systems or even cross border capital flows. In meetings with key

politicians,academics,andregulatorsinearly2009,itbecameclearthatabsolutelynobodywaspayingattention

tothegrosssizeofeachcountrysbankingsystemsortheabilitytodealwiththeproblemsemanatingfromthe

crisis.

BothIcelandandGreecewillhavetorestructuretheirdebtsbeforetheyaretoattractsustainedforeigndirect

investmentagain. Webelieve lossesontheirgovernmentandgovernmentguaranteedbondswillexceed50%

andnewchaptersinfinancialhistorywillbewritten.Untilthen,weaskallofourreaderstorememberaquote

fromC.NorthcoteParkinson:Delayisthedeadliestformofdenial.

InflationAnImmediateConcern

We will keep our thoughts on this subject brief and straightforward. While the inflation/deflation debate is

vigorouslydefendedonbothsides,andwecertainlyrecognizetheongoingneedfordeleveragingwhichshould

applydeflationarypressures, it isdifficultto ignoresimpledatawhichpointstothecontrary. Infact,we find

very few assets around the world outside of US housing that are actually deflating in value. Hard and soft

commoditiesacrossvirtuallyallclassificationscontinuetoclimbinvalue(innominalterms)andmanyareator

nearalltimehighs.


15/17


CommodityPriceIndiciesfromJanuary2009

White=FrontmonthWTICrudeFuture

Red=BloombergSpotPreciousMetalsIndex

Yellow=BloombergSpotBaseMetalsIndex

Green=UBSBloombergCMCIAgricultureIndex

Source:Bloomberg.

Avery interestingchart fromarecentGoldmanSachsresearchpublicationcaughtourattention. Theauthors

highlightedthesevereriskstoheadlineinflationstemmingprimarilyfromglobalfoodprices.Morespecifically,

they assess the risk to headline inflation on a countrybycountry basis in a scenario where local food prices

catchuptointernationalfoodpricesinlocalcurrency(aswasthepatterninthe20072008foodinflationspike).

Theresultsarealarming:

Source:GoldmanSachsGlobalEconomics,CommoditiesandStrategyResearch,GlobalViewpoints,February9,2011.

HeadlineifInternational

FoodPricesRemainat

CurrentLevels

HeadlineifInternational

FoodPricesRemainat

CurrentLevels

Dec10 Q22011 Change Dec10 Q22011 Change

Philippines 2.99 10.06 7.07 Switzerland 0.52 1.58 1.06

Russia 8.73 15.00 6.27 Japan 0.00 0.92 0.92

China 4.76 9.06 4.30 Mexico 4.43 5.09 0.66

Chile 2.99 6.59 3.60 Poland 2.90 3.55 0.65

Korea 3.50 6.25 2.75 Euroland 2.19 2.71 0.52

Israel 2.57 5.24 2.67 Indonesia 7.00 7.34 0.34

Turkey 6.40 9.06 2.66 Hungary 4.61 4.83 0.22

Singapore 4.58 6.63 2.05 Sweden 2.11 2.20 0.09

HongKong 3.08 4.77 1.69 UK 4.77 4.55 (0.22)

Brazil 5.78 7.44 1.66 Taiwan 0.64 0.30 (0.34)

SouthAfrica 3.48 4.87 1.39 India 8.29 7.53 (0.76)

USA 1.39 2.54 1.15 Norway 2.72 1.75 (0.97)

CzechRepublic 2.33 3.40 1.07


16/17


We believe that that commodity price inflation has primarily been driven by demand coupled with (in some

cases)supplysideshocksin2010.Interestingly,UnitedStatescoreinflationwillnotmovemateriallyuntilthe

UShousingmarketturns,whichwebelievecouldbeupto3yearsaway. The reason forthisphenomenon is

thathousing(excludingtheenergycomponent)comprisesroughly37%oftheheadlineCPIcalculationand49%

of the core CPI calculation3. The rest is just details, especially when food and energy are removed.

Unfortunately,ifyoueatordriveeveryday,youarealreadyfeelingtheimpactofinflation.

UnweightedCPIComponents(December2008=100)

Note:HousingandTransportationcomponentsshownaboveeachincludetheirrespectiveenergycomponents(approximately10%and

29%ofHousingandTransportation,respectively).Forillustrativepurposes,Energyisalsoshownasaseparateitem.

Source:FederalReserveBankofSt.Louis.

Justremember:

Hyperinflationsarealwayscausedbypublicbudgetdeficitswhicharelargelyfinancedbymoney

creation.Ifinflationacceleratesthesebudgetdeficitstendtoincrease(TanzisLaw).

PeterBernholz,MonetaryRegimesandInflation.(EmphasisAdded)With Helicopter Ben printing $3.3 billion per day ($2.3 million every minute), the consequences of this

financialexperimentcouldbestaggering.

3http://www.bls.gov/cpi/cpiri2010.pdf.

95

100

105

110

115

120

125

130

Dec08

Jan09

Feb

09

Mar09

Apr09

May09

Jun09

Jul09

Aug09

Sep09

Oct09

Nov09

Dec09

Jan10

Feb

10

Mar10

Apr10

May10

Jun10

Jul10

Aug10

Sep10

Oct10

Nov10

Dec10

HeadlineCPI CoreCPI Food

Energy Housing MedicalCare

OtherGoods&Services Recreation Transportation

Apparel Education&Communication


17/17

17 Hayman Capital Management L P 2011

DoesDebtMatter?

We spend a lot of time thinking about and discussing systemic risk. This is not because we are natural

pessimists;rather,webelievethatmany investorscannotseetheforestforthetreesastheygetcaughtup in

theshortlivedeuphoriaofthemarkets.

Weask

ourselves,

and

urge

you

to

ask

yourself

one

simple

question:

Does

debt

matter?

It

was

excess

leverage

and credit growth that brought the global economy to its knees. Since 2002, global credit has grown at an

annualizedrateofapproximately11%,whilerealGDPhasgrownapproximately4%overthesametimeframe

creditgrowthhasoutstrippedrealGDPgrowthbyanastounding275%.Webelievethatdebtwillmatterlikeit

haseverytimesincethedawnoffinancialhistory.Withoutaresolutionofthisglobaldebtburden,systemicrisk

willfesterandgrow.

Whilewepositionourselvesdefensivelyagainsttheriskswehaveidentified,weareopportunisticinotherareas

ofthe

portfolio

and

are

constantly

seeking

unique

situations

across

multiple

asset

classes,

long

and

short.

We

areenthusiasticabout sharingmore detailon some of our keypositionsatourupcoming investordinneron

April26th inDallas. At thedinner, the investment teamwilldiscuss indetail someof theways inwhichwe

intendtoopportunisticallycapitalizeonourmacroviewsdiscussedherein.

BestRegards,

J.KyleBass

ManagingPartner

Theinformationsetforthhereinisbeingfurnishedonaconfidentialbasistotherecipientanddoesnotconstituteanoffer,

solicitationorrecommendationtoselloranoffertobuyanysecurities,investmentproductsorinvestmentadvisoryservices.

Suchanoffermayonlybemadetoeligibleinvestorsbymeansofdeliveryofaconfidentialprivateplacementmemorandum

orothersimilarmaterialsthatcontainadescriptionofmaterialtermsrelatingtosuchinvestment.Theinformationand

opinionsexpressed

herein

are

provided

for

informational

purposes

only.

An

investment

in

the

Hayman

Fundsisspeculative

duetoavarietyofrisksandconsiderationsasdetailedintheconfidentialprivateplacementmemorandumoftheparticularfundandthissummaryisqualifiedinitsentiretybythemorecompleteinformationcontainedthereinandintherelatedsubscriptionmaterials.Thismaynotbereproduced,distributedorusedforanyotherpurpose.Reproductionand

distributionofthissummarymayconstituteaviolationoffederalorstatesecuritieslaws.

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