HCMF Investor Letter October 2009 FINAL

8/14/2019 HCMF Investor Letter October 2009 FINAL

1/24

October2,

2009

Youcannotspendyourwayoutofrecessionorborrowyourwayoutofdebt. DanielHannan,MemberoftheEuropeanParliament

DearInvestors:

TherehavebeenmanysignificantglobaldevelopmentssinceourMarchletter. Governmentsaroundtheworld

arerunning

fiscal

deficits

at

levels

never

before

seen,

while

central

banks

have

loosened

monetary

policy

and

areprintingmoneyatarecordpace. WhiletheUSappearstohaveavoidedasystemicimplosion,thequestion

becomesatwhatcostnowandinthefuture? Inthisletter,weaddress:

Thegoodnewsandbadnewsofthecurrenteconomicsituation; Areasofopportunity; TheimplicationsofglobalandUSmonetarypolicy; ThecurrentstateoftheUShousingmarketandexpectationsforthefuture; TheInternationalMonetaryFundspolicyprescriptionfordealingwithtroubledeconomies; TheboomandpotentialbustinChina; TheloomingdebtcrisisinJapan;and Howthefundispositionedtocapitalizeontheseissues.

Thepurposeofthisletterisnotsimplytocommunicatehowthefundispositioned,butalsoandpossiblymore

importantlytostimulatethoughtanddiscussionaboutthebigpictureimplicationsoftheseissues. We

believe

that

we

are

in

the

midst

of

a

once

in

a

lifetime

(literally)

economic

shift

that

has

affected

or

will

affect

everyone. Whiletherearecertainlyhardshipsandchallengesahead,wealsoseeopportunities.


2/24

22009HaymanAdvisorsL.P.

TheGoodNews?

Thegoodnewsistherecessionisofficiallyover. RealGDPdroppedonly4%peaktotrough,S&P500revenues

droppedonly18%,andhomepricesdroppedonly31.3%nationwide. Broadbasedunemployment (including

theunderemployed)reached17.0%,whichtranslates into17.4millionAmericansoutofworkandanother9.2

millionworkingparttimejobsthatare insufficient topaytheirbills.1 After losinganaverageof578,346jobs

everyweek

since

October

2008,2

the

headline

unemployment

figure

improved

in

July

from

9.5%

to

9.4%.

Never

mind that inAugust theBureauofLaborStatistics (BLS) revised theirpriorestimates,andaportionof the

improvement in July was achieved by adjusting the total size of the labor force (think increasing the

denominatortoreducethepercentage)andunemploymentcontinued itsupwardtrajectoryto9.7% inAugust

and9.8% inSeptember. Weare leftwonderinghowbroadbasedunemploymentwent from itsmost recent

troughof7.9% inDecember2006to17.0%currently,whiletotalretailsalesdeclinedonly3.6%overthesame

timeperiod.3

Source:MikeKeefe,TheDenverPost. Reprintedwithpermission.

Bernankeandcrewhavedoneamasterfuljobofpullingoutallofthestops(andthensome)tosavetheUSand

worldbankingsystemfromcollapse. Havinggonefrompotentialcollapsetovaluationswellabovethe10year

averages,theS&P500nowtradesat2xbookvalueand20xEPSandcreditspreadsrelativetoTreasuriesare

backtopreLehmanlevels.

WhereWeareBullish

There are greatbusinesseswhichhave toomuch leverage,which are beingorwillbe recapitalized through

consensualrestructurings

or

Chapter

11

bankruptcies.

These

capital

transformation

investments

usually

involvebuyingseniordebtandworkingwiththecompanysstakeholdersandmanagementtocraftaplausible

1AccordingtothelatestdataavailablefromtheBLS,15.142millionAmericansareincludedinthelaborforceandare

classifiedasunemployed. Another2.219millionwouldliketowork,buthavenotsearchedforajobinthelastfour

weeks. Anadditional9.179millionareclassifiedasparttimeforeconomicreasons,meaningcurrentlyemployedpart

timeasanalternativetonotworkingatall.2AverageInitialJoblessClaimssincethefirstweekofOctober,aspublishedbytheDepartmentofLabor.3Source:Bloomberg.


3/24


capitalstructure to return theentity tohealthandgrowth. As thecapitalmarketshave recovered,money is

flowingandmanyprivateequityplayersarepreparedtoinvest intheirexistingportfoliocompaniesafteror in

conjunctionwithadebt restructuring. It is in these typesof situations thatwe see greatopportunity. Our

investments are focused on assetheavy businesseswherewe can buy into the right portion of the capital

structureinadvanceoftherestructuring. Onthebackend,wewilllikelyendupowningsomeamountofsenior

debt with attractive current pay characteristics and in certain circumstances end up holding equity in the

companyforlittle,ifany,realcost. Thisisoneareawhereweareacutelyfocusedandwebelievepresentsthe

mostasymmetricreturnsforbeinginvestedonthelongside.

Ifthestorycouldjustfinishherewithsuchahappyendingunfortunately,here iswherethereallybadnews

begins.

NeverBeforeandHopefullyNeverAgain

Westerndemocracies, communistic capitalists, and Japanese deflationists are concurrently engaging inwhat

may be the largest, global financial experiment in history. Everywhere you turn, governments are running

enormous

fiscal

deficits

financed

by

printing

money.

The

greatest

risk

of

these

policies

is

that

the

quantitative

easingwillpersistuntilthevalueof thecurrencyequalstheactualcostofprintingthecurrency (which isjust

slightlyabovezero).

Therehavebeen28episodesofhyperinflationofnationaleconomies in the20th century,with20occurring

after1980. PeterBernholz(ProfessorEmeritusofEconomicsintheCenterforEconomicsandBusiness(WWZ)

at theUniversityofBasel,Switzerland)has spenthiscareerexamining the intertwinedworldsofpoliticsand

economicswith specialattentiongiven tomoney. Inhismost recentbook,MonetaryRegimesand Inflation:

History,EconomicandPoliticalRelationships,Bernholzanalyzesthe12 largestepisodesofhyperinflationsall

ofwhichwerecausedby financinghugepublicbudgetdeficits throughmoneycreation. Hisconclusion: the

tippingpointforhyperinflationoccurswhenthegovernmentsdeficitexceed40%ofitsexpenditures.

AccordingtothecurrentOfficeofManagementandBudget(OMB)projections,USfederalexpendituresare

projectedtobe$3.653trillioninFY2009and$3.766trillioninFY2010withunifieddeficitsof$1.580trillionand

$1.502trillion,respectively. Theseprojections implythattheUSwillrundeficitsequalto43.3%and39.9%of

expendituresin2009and2010,respectively. Toputitsimply,roughly40%ofwhatourgovernmentisspending

hastobeborrowed. OnehastoaskwhethertheUSreachedthecriticaltippingpoint? Beyondthequantitative

measurements associatedwith governmentdeficits andmoney creation, there exists aqualitative aspect to

suchascenariothatmaybefarmoreimportant. Thequalitativeperceptionsoffiscalandmonetarypoliciesare

impossibletocontrolonceconfidenceislost. Infact,recentpriceactioninmetals,thedollarandcommodities

suggeststhatthemarketisalreadyanticipatingthefuture.

M1moneysupplyisthemostliquidmeasureofmoneyoutsideoftangiblecurrency. Thechartbelowillustrates

M1growthoftheworldsmajorcurrenciessince2007.


4/24


M1GrowthofMajorWorldCurrencies(December2006=100%)

90%

100%

110%

120%

130%

140%

150%

160%

Dec

06

Jan

07

Feb

07

Mar07

Apr07

May

07

Jun

07

Jul07

Aug

07

Sep

07

Oct07

Nov

07

Dec

07

Jan

08

Feb

08

Mar08

Apr08

May

08

Jun

08

Jul08

Aug

08

Sep

08

Oct08

Nov

08

Dec

08

Jan

09

Feb

09

Mar09

Apr09

May

09

Jun

09

Jul09

Aug

09

UK

Japan

US

China

Eurozone

Source:Bloomberg.

Thegreatestconcernisthat,withtheexceptionofJapan,themajorglobalcurrencieshaveexperiencedmoney

supplygrowthbetween1555% in lessthanthreeyears,andHaymanbelievesthattheprimaryreasonJapans

moneysupplyhasnot increased is that for the lastdecadeYenhave fled the Japaneseeconomy insearchof

higheryieldingassets(widelyknownastheYencarrytrade).

Toputthisintoperspective, imagineagameofMonopolywheretheparticipantsareplayingwithonebankof

money.Then,

halfway

through

the

game,

the

central

banker

decides

that

money

is

too

tight

and

the

velocity

of

the game is slowing down, or a few players are about to go broke. In a Godlike fashion (with a little

ecclesiasticalwhiteout), the centralbankerdecides toadd twomorebanksofmoney to the game thatare

distributed to the participants as the central banker deems fit. Under this scenario, did the real value ofanythingchange? Doesthebarteringforpropertyincreaseordecreaseprices? Dideachunitofmoneybecome

worthmoreor less? Howdoes the centralbankerdecide toallocate theextramoney? Is ita fairprocess?

Dependingonhowyouwerepositionedpriortotheadditionalbanksofmoneybeinginjectedintothegame

andhowyouplayedtherestofthegame,youeitherfeelfortunate(ifyouwereabouttogobroke)orcheated(if

youhadplayedthegameprudently). AsaplayerintodaysreallifeMonopolygame,howareyoupositioned?

Belowis

amore

detailed

assessment

of

what

we

are

seeing

domestically

and

internationally,

and

how

we

have

positionedyourcapitalsothatyoumayemergefromthegameawinner.


5/24


WhyHasnttheMoneySupplyintheUSIncreasedMoreSignificantly?

The Federal Reserve has engaged in roughly $1.2 trillionworth of quantitative easing (a niceway of saying

printingmoney) this year, including Federal Reserve purchases of both Treasury and Agency securities;4

however, seasonallyadjustedM1andM2haveonly increased$73.2billionand$109.9billion, respectively.5

That being the case, perhaps printingmoney is not such a terrible thing it has driven rates down,made

mortgagesmore

affordable

and

has

not

blown

up

the

dollar

money

supply.

From

aquantitative

perspective,

we

areconcernedaboutthepotentialmoneysupplygrowththatcouldoccurquiterapidlyasaresultofthemoney

printingthathasalreadyoccurred.

Tounderstandthemonetaryimpactsofquantitativeeasing,onemustunderstandtherelationshipbetweenthe

monetarybaseandthemoneysupplyinafractionalreservebankingsystem. Themonetarybaseisnotmoney

supply;rather it isthefoundationonwhichthemoneysupply isbuilt. Inshort,themonetarybaseconsistsof

two key components: tangible currency andbanking reserves. Banking reserves represent themoney that

banks are required to hold againstdeposits. Dependingon the specific nature of the deposits, the reserve

requirement istypicallyonly10%. Thismeansthatforeverydollarabankreceives indeposit, itcan loanout

$0.90.This

$0.90

then

gets

deposited

elsewhere,

and

$0.81

can

be

re

lent.

The

$0.81

then

gets

re

deposited

into the system and another $0.73 is lentout,and soon. This ishow themoney supply accumulates to a

multipleofthemonetarybase.

Undernormalcircumstances,bankstypicallyholdonlytheminimumrequiredreservesbecauseanyexcesscan

belentoutataprofit. SincethecollapseofLehman,however,bankshavebeenaccumulatingexcessreserves.

AstheFederalReservehasengagedinquantitativeeasing,thisfreshlyprintedmoneydoesnotfinditswayinto

themoneysupplybutinsteadstacksupatthebanks. ExcessreservesintheUSbankingsystemcurrentlystand

at$855billion,up from$2billionjusttwelvemonthsago. EventhoughtheyarenotrequiredbytheFederal

Reserve tohold these excess reserves,banks arenot lendingbecause theyareeither capital constrainedor

concernedabout

additional

losses

deteriorating

their

existing

capital.

Additionally,

the

Federal

Reserve

has

agreedtopaybanksasmallrateontheirexcessreservesof0.25%.

SinceSeptember2008, thebanking systemhasbuiltupexcess reserves to levelsunprecedented in thepost

WorldWarIIhistoryoftheUS. Thechartbelowshowsthecompositionofthemonetarybasefrom1959tothe

present.

4AgencysecuritiesrefertothoseissuedbyGinnieMae,FannieMae,FreddieMacortheFederalHomeLoanBanks.5Source:UnitedStatesFederalReserve;Bloomberg.


6/24


USMonetaryBase(January1959August2009)

(DollarsinBillions)

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

01/1959

08/1960

03/1962

10/1963

05/1965

01/1967

08/1968

03/1970

10/1971

05/1973

01/1975

08/1976

03/1978

10/1979

05/1981

01/1983

08/1984

03/1986

10/1987

05/1989

01/1991

08/1992

03/1994

10/1995

05/1997

01/1999

08/2000

03/2002

10/2003

05/2005

01/2007

08/2008

Other/Adjustments

VaultCash(NotusedforReserves)

ExcessReserves

RequiredReserves

Currency

Source:United

States

Federal

Reserve;

Bloomberg.

The threat to themoney supply occurs if banks decide they are comfortablewith deploying those excess

reservesorlendingthemout. Ifthisweretohappen,itwouldnotincreasethemoneysupplyby$855billion;

ratheritwouldincreasethemoneysupplybysomemultipleofthat. Historicallythismultipleisconservatively

around7x,whichimpliesapotentialincreaseinthemoneysupplyofapproximately$6trillion. Thechartbelow

showsthebankingreservemultiplierdatingbackto1959. Thereservemultipliershownrepresentstheratioof

checkabledepositstobankingreserves. Noticethemultiplierhascollapsedfromits(recent)historicalnormof

around7xdowntounder1xduetothebanksholdingexcessreservesratherthan lendingandrelendingthem

intotheeconomyastheytypicallydo.

BankingReserve

Multiplier,

shown

as

Checkable

Deposits/Banking

Reserves

(January

1959

August

2009)

2.0

4.0

6.0

8.0

10.0

12.0

14.0

01/1959

11/1960

09/1962

07/1964

05/1966

03/1968

01/1970

11/1971

09/1973

07/1975

05/1977

03/1979

01/1981

11/1982

09/1984

07/1986

05/1988

03/1990

01/1992

11/1993

09/1995

07/1997

05/1999

03/2001

01/2003

11/2004

09/2006

07/2008

RequiredReserveMultiplier

10yrMA

TotalReserve

Multiplier

10yrMA

Source:UnitedStatesFederalReserve;Bloomberg.


7/24


The FederalReservehas said repeatedly that it canwithdraw thisexcessmoney from the systemwithouta

problem. ConsiderforamomentwhatthatwouldentailtheFederalReservesellingitsholdingsofTreasuries

andAgencysecuritiesintothemarket. Thesesaleswouldputsignificantupwardpressureonrates,whichcould

beverydamagingtowhatwilllikelybeafragilerecovery. SincetheonsetoftheAgencypurchaseprogram,the

FederalReservehaspurchasedmore than 100%of thenet issuanceofbothAgencydebt andAgencyMBS.

Imaginewhatwillhappenwhentheonlybuyer in themarketplacebecomesaseller,especially ifChina isno

longer interested inbuyinganyAgencysecurities. Interestingly,thechartbelow,whichshows foreignofficial

institutionspurchasesand salesofTreasuryandAgency securities, illustrates thatas foreign institutionsare

sellingAgencysecuritiestotheFederalReserve, theyareusingtheproceeds tocoverasubstantialportionof

theirTreasurypurchases. Inotherwords,theFederalReserveAgencypurchaseprogramis,indirectly,fundinga

Treasurypurchaseprogram.

ForeignOfficialInstitutions2009YeartoDatePurchase/(Sale)ofTreasuryandAgencySecurities

(DollarsinBillions)

$(40,000)

$(30,000)

$(20,000)

$(10,000)

$

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

January February March April May June July

Yearto

Date

Agency

Purchases

/(Sales)

YeartoDateTreasuryPurchases/(Sales)

Source:FederalReserve.

Whatifthevshapedrecoverythatappearstobepricedintothemarketstakeshold? Asbanksconfidencein

therecoverystrengthens,theyshouldbecomemorewillingtolend. Astheyallrushtodeploytheexcessmoney

theyaresittingon,themultipliercould increaseveryquickly. DoyoutrusttheFederalReserveetal.toselectthe precise timingofwhen towithdraw themoney from the system, such that a recovery is sustained and

inflationdoesnottakehold? Webelievethemarket, initsforwardlookingnature,doesnot. Webelievethat

neither theFederalReservenor theTreasuryhas thewillpower to force long rateshigher in themidstofa

fragile recovery. Therein lies the qualitative aspectsof theperceiveddangersof theactionsby the Federal

Reserveandothercentralbanksthatwillcausearush tohardassetsevenbeforethequantitativeaspectsof

moneyprintingtakeover. WearetodayinthemidstofwhateconomistsoftenrefertoastheGoldenperiod

whereeverything feelsgoodand the longtermeffectsofdeficitspendingandmoneyprintinghavenotbeen

realized. Thisperiodtypicallylasts1218months.


8/24


ALittleHairoftheDog,Anyone?

Duringthehousingcrunchthatbeganin2007,thegovernment(viaFHA,FannieandFreddie)essentiallybecame

theentiremortgagemarket. These combinedagencieswrote/guaranteedover90%of the total loansmade

duringthe firsthalfof2009withFHA loansbecomingan increasingly largershareofthepie (FHA loanswere

17.9%of total2009mortgage loansasof6/30/09).6 It isno secretwhyFHA loanshave increasedwildly in

popularitythis

year.

FHA

loans

only

require

a3.5%

down

payment

and

the

government

is

offering

atax

credit

of

$8,000 to first timehomebuyers. With the$8,000 taxcredit,a first timehomebuyer could fund theirentire

downpaymentonahousecosting$230,000or less. Sound familiar? Onceagain,homebuyersareable to

purchaseahousewithnoskininthegame,andweallknowhowthatmovieends. Lookingathousingdata,itis

proventimeandtimeagainthatalowdownpaymentisoneofthegreatestpredictorsofdefaults. Thistime,it

willnotbeWall Street holding the bag. Itwillbe theUS taxpayers thatwillultimatelypay theprice. The

followingadvertisementfromtheFHAswebsiteisparticularlyinteresting:

Purchase or Refinance

FHA HOME LOANS

DoasISay,notasIDoTheInternationalMonetaryFollies

TheInternationalMonetaryFund(IMF)wasfoundedalmost60yearsagoby45membercountriestoprovide

aframeworkofinternationalcooperationthatwouldattempttoavoidarepeatoftheeconomicpolicymistakes

during the 1930s. While the IMF advancesabroad rangeofpolicy initiatives, its key function is toprovide

stability to the international financial system through rainy day funds for fiscally irresponsible countries.

TodaytheIMFmembershipincludes186countrieswitheachcountryassignedaquotalinkedtoitsrelativesize

intheworldeconomy. Amember'squotaresemblesitsfinancialandorganizationalrelationshipwiththeIMF,

includingitscommitmentobligations,votingrightsandborrowinglimitsandrepresentsasubstantiveabilityto

pay.

ThelargestcontributorstotheIMFaretheUSandJapanwitheachcountrycommittinganadditionalUSD$100

billionin2009. TheUSandJapan,thetwo largestdebtornationsintheworld,currentlyrunlargedeficitsand

thereforeare

saddling

their

own

citizens

with

additional

debt

to

fund

these

commitments.

Wait

aminute

the

twomost indebted nations in theworld are the largest contributors to the IMF, even though they have to

borrowtocontribute? Noneedtoworry. Asone influentialpoliticiantoldusafewmonthsago,Itsnotreal

money. Itsjustajournalentry. Atleasttheyearnawhopping0.24%perannumontheirIMFcommitments!7

6Source:InsideMortgageFinance.7Source:IMF. RepresentsAdjustedRateofRemunerationfortheweekof9/21/099/27/09.


9/24


In September 2009,China createdmuch fanfare by committingUSD$50 billion to the IMF,but the Chinese

commitmentsare inthenovel formof5yearbondswithamarketrateof return (itmakesyouwonderwhat

Chinasdefinitionofmarketwillbe). PerhapsChinarecognizesthatitscitizensdeservecompensationfortheir

generosityand that the IMFsbusinessmodelneedsan injectionofmarketdiscipline. Asamatterof fact, in

preparation for the upcoming G20 summit, itwas reported by CaijingMagazine that Chinese Central Bank

GovernorGuoQingPingsaidonSeptember15thattheIMFshouldsetspecificgoalsandtimetablestotransfer

votingrightsfromdevelopedtodevelopingnations.

Aslargeeconomiesandcontributors,theUSandJapanpossessoutsizedinfluenceattheIMFthatenablesthem

to steer its lending practices. They attempted to impose a facade of commercial discipline on the IMF by

establishinglendinglimitsbasedonthesizeofmembersquotasandcovenantsoneachmemberloan.TheIMF,

however,withimplicitpermissionfromtheUSandJapan,routinelyignorestheseguidelines. Forexample,until

March2009, the IMFscumulative lending toany individualborrowerwas limited to200%of theborrowers

quotaattheIMF(Whysetquotaswhenyoucanborrowmultiplesofthem?). Whenitbecameobviousthatthe

financialcrisiswouldrequirenumerousbailoutloansinexcessofthe200%limit,theIMFsimplychosetomove

thegoalpostsbyincreasingtheborrowinglimitsto600%oftheborrowersquota.8 Still,theIMFcannotrestrain

itselffrom

ignoring

even

these

higher

limits

to

lend

whatever

is

necessary

to

bailout

creditors

(i.e.

the

internationalbanks)asdemonstratedinthefollowingtable.

IMFLoanCommitmentsandBorrowingsShownasPercentofBorrowersQuota(AsofSeptember10,2009)

0%

200%

400%

600%

800%

1000%

1200%

1400%

TotalCommitments UnderStandbyAgreements

OutstandingBorrowingsfromtheIMF

UndrawnFlexibleCreditLine

BorrowingLimitUntil March2009

BorrowingLimitSinceMarch2009

Quota

Source:IMF.

Whenwespokewithpolicymakers intheUSthatactastheconduitbetweenWashingtonandthe IMF,they

werebaffledto learnhowtheIMFhaschosentosystemicallyexceedthequotaratio lending limits.Ourpolicy

makersare committing funds tobailoutswithout recognizing that the sizeof loan relative to the sizeof the

economymakesrepaymenthighlyunlikely.

8Source:IMFPublicInformationNoticeno.09/40.


10/24


LatviaACaseStudyofanIMFBailout

While the IMF attempts to impose covenants on loans in the form of fiscal austerity measures and

macroeconomictargets,theyrarelyenforcetheseconditionsasevidencedbythecaseofLatvia. Latviahasa

populationofapproximately2.2millionpeopleandreportedaGDPofapproximately$34billionfor2008. Sofar

in2009, theLatvianGDPhasshrunk toanapproximate run rateof$28billion. Below isachronologyof the

sheerridiculousness

of

Latvias

IMF

led

bailout.9

November2008

Standard&Poor'scutsitsratingsonLatviatoBBB Latviaprojectsa2009budgetdeficitoflessthan2%

December2008

Latvia enters into a $10.5 billion bailout (almost one third of itsGDP, approximately 100% of initialbudgeted 2009 revenue and nearly 130% of the updated 2009 budgeted revenue10), $2.4 billion of

whichwas

in

the

form

of

astandby

credit

agreement

from

the

IMF,

and

receives

its

first

disbursement

withtheremaindertobemadeinnineinstallmentssubjecttoquarterlyreviews

TheIMFcreditagreementamountstoawhopping1,200%ofLatvia'sIMFquota IMF bailout is predicated on Latvia maintaining a budget deficit of no more than 5%, assumes

unemploymentratestoaverage9%for2009,andassumesthatrealGDPwillshrinkby5%

February2009

Latvia'sPrimeMinisterandcabinetresign Unemploymenthits9.5%

March2009

LatviasnewPrimeMinistertakesoffice IMFwithholds2ndinstallmentofbailoutplanasLatviafailstoimplementnecessaryconditionstomeet

loanterms

Unemploymentreaches10.7%May2009

Latviareportsan18%declineinGDPforthefirstquarterof2009 Unemploymentreaches11.3%

9AlldatapertainingtoLatviabailoutchronologywassourcedfromtheIMFandBloomberg.10

Source:LatvianSaemaPassed2009BudgetinFinalReading,TheBalticCourse,November17,2008. Latvian

ParliamentPassesAmendmentsto2009StateBudget,Eurofound,June16,2009.


11/24


July2009

LatviaandtheIMFrenegotiatethebailoutpackageandnowpreliminarilyagreetoarevised10%budgetdeficitfor2009(noapparentpenaltywaschargedforthisrenegotiation)

LatviaJulynewcarsalesdrop86.6%fromJuly2008 Unemploymentreaches11.8%

August2009

Latviareportsan18.7%declineinGDPforthesecondquarterof2009 LatviaandtheIMFrenegotiatebailoutpackage(again,forthethirdtime,withnoadditionalcovenants,

prepaymentsorincreasesininterestexpense)andagreetoa13%budgetdeficitfor2009

Unemploymentreaches12.3%September2009

LatvianFinancialandCapitalMarketsCommission reportsnearly25%ofall loansaredelinquentwithalmost

14%

overdue

by

more

than

90

days

AccordingtoLatviasStateEmploymentAgencyDirectorBaibaPasevica,fromSeptember2008toSeptember2009,theunemploymentlevelinLatviahasincreasedapproximately250%

AccordingtothechiefeconomistatSwedbank(oneofLatvialargestlenders),bythemiddleof2010,Latvia'sgrossdomesticproduct(GDP)willhavecontractedby25%,comparedwiththehighestpointit

reachedin2007,andwillbebackto2004levels

Toput this intoperspective, imagineLatvia isapersonwitha$10,000credit line fromabankand incomeof

$285,000. NowLatviafindsoutthatheisgettingapaycutandexpectstoonlymake$250,000thisyear. It is

importantto

note

here

that

$250,000

is

his

total

income,

not

disposable

income.

As

is

the

case

with

any

household,hehascertainexpensesthathesimplycannotcut. Additionally,hiscreditscoredeclines,andatthe

sametime,hisfamilysbillsarecominginhigherthanexpected. Recognizingtheimplicationsofhissituation,he

appliesforadditionalcredit. Fearingtheworst,Latviaiselatedtolearnthathehasbeengrantedcreditinthe

amountof$240,000! Inreturnforthebanksadditionalrisk,itsetscertainlegallybindingfinanciallimitationsto

makesureLatvia isasprudentascanbewith thenew funds. As themonthspass, thesituationworsens for

Latviaandhisfamily. Hetakesanotherpaycutand learnsthathis incomewillonlybe$200,000. Hisfamilys

expensesarespiralingoutofcontrol,andheletsthebankknowhecannotevencomeclosetocomplyingwith

the financial restrictions previously set by the bank. He is scared that the bank will call its loan back

immediately,but tohispleasant surprise, thebank lifts the restrictions, keeps the credit line the same and

chargesthe

same

rate

as

before.

Would

your

bank

be

as

accommodating

as

the

IMF?

Latvia failed to complywith virtually all of thematerial financial covenants and its prospects continue to

worsen, yet the IMF continues to fund a large loan to Latvia thatwill likelyneverbe repaid. As frequently

stated,youcannotborrowyourwayoutofdebt. ItisonlyamatteroftimebeforeLatviarecognizesthisfolly

and the internationalcoalitionof lenders ledby the IMFwillbe leftwitha$10.5billion IOU. IfLatvianever

repaysitsloanfromtheIMF,thentheUS,Japan,andotherdevelopedcountriesthatfundtheIMFsactivitieson

noncommercial termsare simplywriting charity checks to fundcreditorbailouts. The IMFpreachesagainst


12/24


exactlythistypeofbehaviorto its troubledborrowers inanexampleofdoas Isay,notas Idopolicy. We

believe the IMFshould force restructuringsand/ordevaluationsandthen loanmoney to troublednations,as

theyshouldhavelearnedinthecaseofArgentinaearlyinthisdecade.

ChinaExplodingLikeaFireCracker?

Despitethe

historic

size

of

the

fiscal

stimulus

injected

into

the

US,

UK

and

Japanese

economies,

it

is

the

cagey

communists inChinathattakethecakewithamassiveUSD$586billionoffiscalstimulus(foraneconomyone

thirdthesizeoftheUS)andanexplosioninmonetarypolicy.

Manyeconomicandpoliticalstrategistshavesuggestedthatagrowthrateofatleast8%isneededbyChinajust

tomaintain stability as it seeks tomodernize thewestern half of the nation still stuck in theMiddle Ages.

Maintainingstabilityandorderistheabsolutepriority,andstrongGDPgrowthisviewedastheessentialtoolto

achieve it. As such, the Chinese government surpassed even the Federal Reserve and Bank of England in

respondingtothecrisiswithfreemoney.

ThePeoplesBankofChina (PBoC)expandedChineseM1moneysupplybyastaggering28.7%yearoveryear

fromSeptember2008toSeptember2009.11

Ontopofthiscoremoneysupplyincrease,theChinesegovernment

wasalsoabletodirectitsbankstoexpandlendinginordertokeepthevelocityofthatmoneyfromfallinglikeit

has intheUS. Unlike intheUS,whereFDIC insured institutionshaveseenadecrease intotalassetsbetween

September2008and today,12 theChinesebanking systemhasgrownatanextraordinary rate. TotalChinese

banking assetswere approximately RMB 57.5 trillion at the endof June2008, andhad grown tooverRMB

73.7trillionbytheendofJune2009.13 Thisincreaserepresentsalmost54%ofChineseGDPequivalenttotheUSincreasingtotalbankassetsbyUSD$7.5trillioninasingleyear.Withthistsunamiofmoneyandcreditcreation,itisnotsurprisingthatChinahasbeenabletoincreasethelevel

of fixedasset investmentandboost industrialproductionandretailsales (whichrepresentwholesaletoretail

salesrather

than

final

sales

to

consumers)

from

the

levels

seen

during

the

trough

in

economic

growth

late

last

year.Therealeconomyhasbeenunabletoabsorballoftheinflow,andthePBoChassuggestedthatupto20%

ofthenewcredithasflowedintoassetspeculation14(i.e.20%oftheRMB18trillionwentdirectlyintothestock

market, speculative real estate investments, etc.). Evidence of this is clear from the 80% rebound in the

Shanghai Stock ExchangeComposite Index from its low inOctober2008 (despiteprofitsdecliningbyalmost

30%)aswellasarebound inpropertypricestoprevious inflated levelsthat leavetheratioofmedianpriceto

medianincomeinChinaat7xthatoftheUS(andwearewellawareofhowbadourUShousingproblemis). We

wonderwhattheencorein2010willhavetobetosustainsuchgrowth. Webelievethedatasettowatchis

nottheirstockmarket,bondmarketorGDP;rather, it istheircostoffood,whichcurrentlyrepresents40%of

householdexpenditures. FoodpriceinflationcouldbethetippingpointforChina.

Aggressiveloangrowthofthistypeusuallycreatesrealnonperformingloan(NPL)problems.Butinthiscase,

theexpanded lendinghasbroughtatemporaryreprieve fortroubledborrowerswithnonperforming loansat

11Source:Bloomberg.

12Source:FederalDepositInsuranceCorporation.

13Source:ChinaBankingRegulatoryCommission.

14http://www.telegraph.co.uk/finance/financetopics/financialcrisis/6011674/CredittighteningthreatensChinasgiant

Ponzischeme.html


13/24


Chinese banks falling to just 1.77% of assets from 16.6% in March of 200415 (again, think increasing the

denominator to reduce the percentage). Admittedly, in an environment where credit is unlimited and

underwritingstandardsareallbutnonexistent, it isprettyhardtodefaultorbedelinquentona loanwhen it

can be constantly refinanced or termed out to an even larger one.We have adapted an ancient proverb

originallypublishedbyErasmusaroundtheyear1500todescribethisphenomenon:Arolling loangathersnoloss. Thecurrentsituation isonlysustainableas longascreditcontinuestoexpandatadizzyingpace. Itfeels

eerilysimilartocreditmarketsintheUnitedStatesin20062007.

InChina,assetpricesarerising,butthepricesforconsumablegoodsandservicesareplunging. Thissituationis

beingexacerbatedbythecontinuedweaknessinexports(down23.4%yearoveryear,thesixthmonththisyear

witha20%+decline16),whichsuggeststhatthere issimplytoomuchmanufacturingand industrialcapacity in

China.Importshaverecoveredmodestlyfromtheir lowsatthebeginningoftheyearand, intermsofvolume,

have exceeded last years levels. The domestic demand for raw materials may have driven a rebound in

commodityprices,butrecentofficialcommentsaboutcurbingdomesticcementandsteelproductionmaybea

signalthatthestockpilingisslowingdown.

Thekey

question

with

regard

to

China

is

whether

this

story

is

too

good

to

be

true.

Are

the

trillions

of

Renminbi

of new lending being devoted to profitmaximization and the investment in assets that genuinely generate

incomesufficienttoservicethedebt?OrisChinacompoundingtheexistingproblemofovercapacitybybuilding

moreandmorerealestateassets,factoriesandinfrastructurewhenahugeinventoryoverhangalreadyexists?

Webelieveitisthelatter.

Tous,oneofthemostcompellingsetsofdatapointstocomeoutofChinaisthesubstantialdropinpricesfor

goods and services (Purchasing Price Index (11.4% yearoveryear),Wholesale Prices (7.1%), and Producer

Price Index (7.9%)) inanenvironmentwherenotonlymoneysupply,butalsocredit, investmentandretail

salesare increasingatdoubledigitpercentage rates.17Thisdownturn startedafter the financial collapse last

September

and

has

not

responded

to

any

of

the

fiscal

and

monetary

stimulus

so

far.

15Source:Bloomberg.

16Source:Bloomberg.

17Source:Bloomberg.


14/24


ChineseYoYChangeinConsumer,WholesaleandPurchaserPrices(June2008August2009)

15%

10%

5%

0%

5%

10%

15%

20%

ConsumerPriceIndex

PurchasingPriceIndexofRawMaterials, FuelsandPower

Wholesale PriceIndex

Producer

Price

Index

Source:Bloomberg.

If theworldsmost aggressive fiscal,monetary, credit and investment expansion can, atmost,deliver trend

growthwhileincreasingdeflationarypressures,weareskepticalofitssustainability.Atsomepointtheliquidity

spigotmustbeturnedoff,andtheresultingchangeinmomentumwillbeamassiveshocktothesystem.

However, inaneconomywhere thegovernmentexerts substantial controlover creditallocation, investment

and

particularly

domestic

savings,

the

potential

to

keep

the

balls

in

the

air

is

greater

than

that

of

a

more

open

system.Webelievethere isanNPLtimebombwaitingtogooff intheChinesebankingsystem,drivenbythe

overexpansionofcreditintononeconomicinvestmentsandhiddenbymassiveliquidityinjectionsandyetmore

creditexpansion. Allthewhiledomesticcapitalispreventedfromleavingthecountryandforcedintothehands

of thedomesticbankswhere thecreditmachinecan spinaroundandaround,ever larger for some timeyet.

Likewise the continued external demand for Chinese goods, services and assets (as represented by the net

inflow of foreign capitalwhich is clearly apparent in the buildup of foreign exchange reserves) allows the

governmenttomaintainthecurrencycontrolsthatpreventdomesticcapital fromescapingthecountry inany

meaningfulway.

As such, it is crucial to identify the catalyst thatwill set fire to all this combustible credit. In our view, a

continued decline in speculative inflows, foreign direct investment (which has rebounded slightly but is still

down17.52%yearoveryear)andtradesurplusincome(down19.3%)couldplacepressureonthisstructure.18If

thisstructureweretounravel,webelievethattheChinesemonetaryandbankingsystemscouldfacesubstantial

devaluationanddefaultpressure.

18Source:Bloomberg.


15/24


WebelievethattheChineseendgameistokeepthestimulusflowinguntilthereiseitheradangersignofreal

CPIinflationortherestoftheworldseconomiesreturntothepatternofgrowthandconsumptionthatwehave

seenforthepastsixyears.Alongtheway,lipservicehasbeenpaidtotherestructuringoftheChineseeconomy

inordertoincreasedomesticconsumption,butwithoutsubstantialsocialreformandredistributionofwealth,

therewillnotbethe levelofdomesticdemandandconsumptionrequiredtoallowthekindofgrowthseen in

moredevelopedeconomies.

ThebestcasescenarioforChinaisthatthecurrentstimulusbuysenoughtimeforthedevelopedworldtoreturn

to2006/2007 levelsofdemand forChinesegoods,servicesandassets.Along theway theChinesewillslowly

attempttorebalancetheireconomy infavorofdomesticdemand;however,dangertothisrecoverynarrative

doesexist. Therelativeresilienceofemergingmarkets(andChinainparticular)hasbeenasourceofoptimism

andbullishsentimentforequityandfixedincomeinvestorsinthedevelopedworld. Ifthebrightshininglightof

Chinesegrowthturnsouttobetheflamingdestructionofameteorcrashingtoearth,thiscouldbetheshock

thatinstigatesanotherroundoffrenziedriskaversioninglobalmarkets.

JapanLandoftheSettingSun

Japan isonepeculiarcasewheredecadesofchronicdeficitspendingandcentralgovernmentborrowinghave

notledtomaterialcurrencydevaluationandhigh(nominal)interestrates. Ananomalyofdevelopedeconomic

history, Japan experiencedmore than a decade of low (near zero official) interest rates and almost non

existentgrowthinbothrealandnominalterms,whilecontinuingtogrowitscentralgovernmentsdebtburden

atanacceleratingpace. CulturalforcesspawnedthegenerallyacceptedbeliefamongJapanesecitizensthatitis

theirpatrioticduty to lend theirgovernmentmoney. Combinedwithanabnormallyhigh savings rate (when

comparedtotherestofthedevelopedworld),thisidealallowedtheJapanesegovernmenttofund95%ofallof

itsbondsalesbysellingthemdirectlytoJapaneseinstitutionsandindividuals. Theabilitytofundalmostentirely

bysellingbondstotheirowncitizensallowedratesonJapaneseGovernmentBonds(JGBs)toremain lowas

theydid

not

have

to

compete

for

international

capital;

however,

ifnet

new

issuance

of

JGBs

outstrips

economic

growth,thismodeleventuallybecomesunsustainable. WebelievethatJapanhasreacheditsinflectionpointin

2009. AreviewofJapanesedemographic trendsshowswhythismodelmaybeclosertobreakingthanmany

mayrealize. Firstandforemost,Japanspopulation is inseculardecline. TheNational InstituteofPopulation

andSocialSecurityResearch (IPSSR)estimates that the Japanesepopulationactuallypeaked in2004and is

nowonalongtermnegativetrajectory. Pleaseseethechartbelow:


16/24


JapaneseTotalPopulation(19502050E)

(InThousands)

80,000

90,000

100,000

110,000

120,000

130,000

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2018

2022

2026

2030

2034

2038

2042

2046

2050

Actual(Census)

Projected (IPSSR)

Source:NationalInstituteofPopulationandSocialSecurityResearch.

Perhaps of even greater importance than the total population is the composition of the population. The

followingchartshowsthepercentofthepopulationaged65orolderprojectedoutto2050. Inanidealworld,a

population under a common economy will reproduce at a rate that keeps the senior proportion roughly

constant, especially in a societywhose public retirement program utilizes payasyougo funding. Currently

seniorsmakeup22.8%ofJapanspopulation(versus12.9%intheUSand7.6%globally).19 TheOECDestimates

thattheratiowillreach29%by2020andwillcontinuetogrowthereafter.

PercentofPopulationAged65orOlder(19502050E)

0%

5%

10%

15%

20%

25%

30%

35%

40%

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2018

2022

2026

2030

2034

2038

2042

2046

2050

Japan

UnitedStates

World

Source:

OECD.

Solid

lines

denote

historical

actuals.

Dotted

lines

denote

2009

2050

estimates.

The impactofthistrend istwofold: (i)thecentralgovernmentandultimatelyJapaneseworkerswillcarryan

acceleratingsocialsecurityburdenwhichwillrequiresomecombinationof increasedwithholdings (effectively

highertaxes)andfurtherdebtissuance;and(ii)thepositivesavingsratethatJapanhasenjoyedfordecadeswill

turnnegative. Infact,thechartbelowillustratesthatJapanshouseholdsavingsrateasapercentofdisposable

19Source:OECD. Percentagesrepresent2009estimates.


17/24


income and pension payments has been on a general downtrend since 1981 (admittedly interspersedwith

upwardmovementsinsomeyears)andhasnowfallento2%fromapeakofover18%.

AnnualHouseholdSavingsandSavingsRate(FY19802007)

(JPYinTrillions)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

AnnualNet

Savings

(Left

Axis)

SavingsRate(RightAxis)

Savingsas%ofGDP(RightAxis)

Source:ESRI;JapaneseMinistryofFinance.

Inthecourseofourdiscussionswithourinvestingpeersaswellasanalystsacrossthemajorbrokerdealers,we

oftenhearthelargepoolofJapanesesavingsreferencedasthereasonJapanwillbeabletocontinuetosustain

thismodel. Theproblemisthatallthecurrentsavingspoolallowsistherollingofexistinggovernmentdebt,as

allthesavingstodatearepresumablyalreadyinvested. Thebestthecentralgovernmentcouldhopeforfrom

thecurrentpoolofsavings issomereallocation towardahigherweightingof JGBs,whichwouldcomeatthe

detriment toothersecurities (corporatebondsandequities). Fordomestichouseholdsavings tocontinue to

supportnetnewJGB issuance,theremustbenetnewsavingsaswell. Asagreaterpercentofthepopulationreachesretirementage,savingswillactuallybecomenegative,creatingapoolofJGBsellersnotbuyers. The

demographicand

savings

trends

suggest

that

this

is

not

far

off.

Are

you

willing

to

lend

the

profligate

Japanese

governmentmoneyfor10yearsat1.3%? Asprudentfiduciaries,wecertainlyarenot.

Interestingly, theGovernmentPension InvestmentFund (GPIF), Japanspublicpension fundandhistorically

thebiggestindividualnetbuyerofJGBs,saidinJunethatitmaybecomeanetsellerofsecuritiesthisfiscalyear

(endingMarch2010)inordertopaybenefits.20 Granted,theamounttheGPIFistalkingaboutselling,onanet

basis, isonly JPY45 trillionnotenough tomaterially impact themarkets. The trend,however, isofmore

importance than thenominalamount. AnotherkeystatementmadebyGPIFPresidentTakahiroKawasewas

that the fund shouldonlyneed to sell JPY45 trillionbecause theadditional shortfallwillbemadeup from

maturing government bonds. In the case of a borrower being a consistent net issuer of debt, there is nodistinction

between

the

lender

becoming

aseller

of

debt

and

ceasing

to

roll

near

term

maturities.

Currently

GPIFholds19.6%of itsassets ina typeof JGB calleda FILPbond (Fiscal Investmentand LoanProgram).21

WhilenotconsideredGeneralJGBs,FILPbondsrepresent15%oftotalcentralgovernmentdebtand19%of

total JGBs.22 GPIF owns 19%of all FILPbondsoutstanding and for years had been anetpurchaser. What

20Source:GPIF:maybecomenetsellerin2009/10,Reuters,July8,2009. WorldsBiggestPensionFundMaySell

JapaneseBonds,Bloomberg,June15,2009.21

Source:GPIF.22

Source:JapaneseMinistryofFinance.


18/24


happenstodemandforthesebondswhenthemostsubstantiveholderbecomesanetseller? Whathappensas

privatefundsandsaversarefacedwiththesamefundingissuesasGPIF?

Justhowbig istheproblem? Asthechartbelowshows,JapanscentralgovernmentdebtasapercentofGDP

hasincreasedfrom99%,whichisadangerousnumberinandofitself,toastaggering170%inthelasttenyears

(as of the latest fiscal year ended March 2009). Through a combination of declining GDP and additional

issuance,we

expect

this

number

to

exceed

200%

by

the

end

of

the

current

fiscal

year.

JapaneseCentralGovernmentDebt/GDP(FY19962009E)

60%

80%

100%

120%

140%

160%

180%

200%

220%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

TotalCentralGovt.Debt/GDP

HaymanEstimate

Source:JapaneseMinistryofFinance;BankofJapan;Haymanestimates.

Any rational person (well leave it to you to decide whether we at Hayman qualify) would expect the

compoundingimpactsofissuingdebttoservicedebtandfundbudgetshortfallstoleadtoanexponentialrisein

interestexpensewhichwouldonlyexacerbate theproblemofneeding to convincemorebuyers to lend the

governmentmoneyatlessthan1.5%. Inreality,simplefinancialalchemyandarithmeticallowedtotaldebtto

increasewhile interestexpensepaidby the Japanesegovernmentactuallydeclinedmarkedly. Through zero

interestrate

policy

instituted

by

the

Bank

of

Japan

(BOJ),

the

government

was

able

to

issue

an

aggregate

of

JPY365trillionofGeneralJGBswhileannual interestexpensedeclined fromJPY11.0trilliontoJPY7.0trillion

between1991whengovernment interestexpensewasat itspeak through2006when it reached the trough.

Ratesdeclinedenough tomore thanoffset interestexpense incurredasa resultofnewdebt issuance. As it

becomes cheaper toborrow,howmuchof yourownpersonalbalance sheetare youwilling tobeton rates

remaininglowindefinitely? BelowisacomparisonofJGBissuancetogovernmentinterestexpense.


19/24


JapaneseNetGeneralJGBIssuanceandInterestExpense(FY19832009E)

(JPYinTrillions)

6.0

7.0

8.0

9.0

10.0

11.0

12.0

13.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

GeneralJGB Issuance(RightAxis)

InterestExpense(LeftAxis)

Source:JapaneseMinistryofFinance;Haymanestimates.

Asan

aside,

this

analysis

considers

only

General

JGBs

and

does

not

consider

FILP

bonds

or

other

borrowings

of

thecentralgovernment. Theinclusionofthosedebts,forwhichwehavedetaileddatabackto1996,paintsan

uglierpicture in terms of true debt issuance. The key thing tonote about the chart above is that interest

expensehasbegun toexplodeagain. Asolderdebtshave rolled tonewerdebtsat thenew lower rates, the

nominal impactofzerointerestratepolicyappearstohaverun itscourse. Sincedebthasbeensocheap,the

Japanese government has been able to borrow like anAmerican subprimehomebuyer in LasVegas. Japan

continuestoborrowatsignificantlybelowmarketratesandhassetitselfuptobedealtapotentiallyfatalblow

withanyslightuptickinrates.

Thenextchartshowsthat,intermsofgovernmentbondrates,Japanhasmilkedzerointerestratepolicyforall

its

worth.

Hayman

believes

the

piper

must

be

paid

in

the

near

future.

BOJDiscountRateandCentralGovernmentBondYields(March1983June2009)

0%1%

2%

3%

4%

5%

6%

7%

8%

9%

3/1983

3/1984

3/1985

3/1986

3/1987

3/1988

3/1989

3/1990

3/1991

3/1992

3/1993

3/1994

3/1995

3/1996

3/1997

3/1998

3/1999

3/2000

3/2001

3/2002

3/2003

3/2004

3/2005

3/2006

3/2007

3/2008

3/2009

BOJDiscountRate

ImpliedSovereignInterestRate

Generic5Yr

Generic10Yr

Source:JapaneseMinistryofFinance;BankofJapan;Bloomberg.

July1991markedthebeginningofaseriesofcutsintheBOJdiscountratetoward0.1%,whichwasreachedin

September2001. Astobeexpected,JGByieldsfollowedsuitandcontinueddecliningevenaftertheBOJrate


20/24


flattened. JGByieldseffectivelybottomedoutin2003andhavemovedmoreorlesssidewayssincethen. Even

if the BOJwere to cut the discount rate to zero tomorrow (from awhopping 0.10% today) the impact on

governmentborrowingcostswouldbedeminimis.

Considering thedemographic challenge facing the countryand the fact that theBOJmaxedouton rate cuts

years ago, there is a frightening scenario unfoldingwhereby JGB issuance will continue to be significantly

positivewhile

domestic

demand

for

the

bonds

turns

secularly

negative.

There

are

no

further

good

tools

availabletokeepthegovernmentsinterestcostsfromgrowing,furtherincreasingtheneedtoissuemoredebt.

18%oftaxrevenuesarealreadyusedjusttopayinterestexpense.23 WecansympathizewithformerMinisterofFinanceShiochiNakagawa,whoappeareddrunkataG7newsconferencelastFebruary. Youtoomighthavea

fewtoomanydrinksifyouwereresponsibleforJapansbudget.

It is alsoworthpointing out that approximately 26%of Japans total central governmentdebt (including all

government bonds, financing bills and other borrowings)matureswithin one year. Thismeans that a 1%

increase in interestrateswouldmassively increasetheborrowingcostsofJPY223trillionofgovernmentdebt

withinthenexttwelvemonths.24

Whatwillhappentorateswhenthecentralgovernmentaskstoborrowmoremoneyfromitscitizens,whoare

themselves becoming net sellers and net consumers? Ultimately Japan will have to compete for capital

internationally. Will a 1.3% 10year bond be attractive? We dont think so, and judging by the new

advertisementsinJapanesetaxicabsencouragingcitizenstocontinuepurchasinggovernmentbonds,itappears

thattheJapanesegovernmentsharesourconcerns.

JapaneseAdvertisementforJapaneseGovernmentBondsinTaxiCabs

AccordingtoBloomberg,theMinistryofFinancesaysintheadvertisement,Governmentbondsareworthanotherlook. Thead

featuresapictureofformerNHKanchorJunkoKubo,37.

23Source:JapaneseMinistryofFinance.

24Source:JapaneseMinistryofFinance;Haymanestimates.


21/24


WhileourdiscussionofJapanuptothispointhasfocusedontheirsovereigndebtburdenand implicationsfor

interestrates,itisalsoimportanttofocusonthestateoftheJapaneseeconomyandtheYen. Duringthecourse

oftherecession,quarterlyseasonallyadjustedGDPdeclined8.4%peaktotrough(calendarfirstquarter2008to

first quarter 2009) in real terms. Asof the latest quarter,GDP is stilloff 7.9% from its peak. Toput it in

perspective,thepeaktotroughdecline,whichspannedfourquarters,wipedout17quartersofGDPgrowth,or

everything since the fourth quarter 2003. Wehave arguablyjust lived through the greatestAsianboom in

history,andJapannevergotoff itsback. Howdoyouthinkthecountrywilldonowwithdoubledigitoutput

gapsandstructuraldemographicissuescomingtoahead?

ExaminingthemajorcomponentsofGDPrevealstheprimarydriversofthedecline. Privateconsumption,which

is the largest component at 58% currently, declined 2.8% peaktotrough. Government consumption (not

investment), the second largest component at 18.8%, grew by 0.6%. Private nonresidential investment,

representing13.1%ofGDP,declined20.4%overthepeaktotroughperiod(anddeclinedfurther lastquarter).

Nowwearegettingsomewhere,but itstilldoesnotexplainan8.4%decline inGDP. Grossexportscurrently

represent12.4%ofGDPanddeclineda staggering36.2%peaktotrough. For thoseofyoukeeping scoreat

home,thedeclineingrossexportscomprised72.4%ofthetotalGDPdecline.

ThechartbelowillustratesnotonlythatthebulkoftheGDPdeclinehasbeenaresultofexportdecline,butalso

thatanygrowthseenoverthelasttwentyyearshasbeendrivenalmostexclusivelybyexportsandgovernment

consumption. Infact,32.7%ofGDPgrowthfromDecember1989tothepeakwasduetogrowthinexports.

RealGDPanditsPrimaryComponents,Quarterly,SeasonallyAdjusted(December1989=100%)

50%

100%

150%

200%

250%

300%

Dec

89

Jun

90

Dec

90

Jun

91

Dec

91

Jun

92

Dec

92

Jun

93

Dec

93

Jun

94

Dec

94

Jun

95

Dec

95

Jun

96

Dec

96

Jun

97

Dec

97

Jun

98

Dec

98

Jun

99

Dec

99

Jun

00

Dec

00

Jun

01

Dec

01

Jun

02

Dec

02

Jun

03

Dec

03

Jun

04

Dec

04

Jun

05

Dec

05

Jun

06

Dec

06

Jun

07

Dec

07

Jun

08

Dec

08

Jun

09

GDP

Exports

Imports

PrivateConsumption

Government

ConsumptionPrivateInvestment

PublicInvestment

Source:JapaneseMinistryofFinance.

Likeitornot,Japanisanexporteconomy. ThepersistentstrengtheningoftheYenrecentlyanditsreputationas

asafehavencurrencyarepuzzling. AstheYenstrengthensagainstthecurrenciesofitsmajortradingpartners

(the US being one), who are experiencing their own financial challenges, Japanese exports become less

competitive (i.e. more expensive to foreign consumers), and the second greatest growth engine (after

governmentconsumption)ofthelasttwentyyearsshutsdown.


22/24


TheDemocratic Party of Japan (DPJ) tookpower from the LiberalDemocratic Party (LDP) in a landslide

victoryintheAugust2009generalelection. TheDPJleader,YukioHatoyama,hasoutlinedpoliciesfocusingon

fiscal stimulus and domestic consumptionwith a disregard for the importance of exports. Relative to the

policiesoftheLDP,hehasplacedemphasisondistributionandwelfare. Amonghis(admittedlynoble)initiatives

areincreasedchildbenefits,freepublichighschooleducation,andanabolitionofhighwaytolls. Mr.Hatoyama

believes they can fund theseprogramswithout taxhikesandwithout increasing the fiscaldeficitviabudget

reformsandefficiencyimprovements indeploymentofpublicfunds. Hehasyettoprovidesubstantivedetails

withrespecttotheseplans.25

Given the DPJs focus on the Japanese domestic consumer,Mr. Hatoyama hasmade public statements in

supportofastrongYenas ittheoreticallydrivespricesdownand increasespurchasingpower. This istruefor

tradebalancedeconomiesandnet importers. The flaw inMr.Hatoyamas logic is that inorder topromote

domesticconsumption(withoutfiringupthe leveragemachine),theywillneed incomegrowthwhichrequires

growthincorporategrossprofitanddividends. Allelseequal,astrongYenwillpunishJapaneseexporterswhich

willcreatesignificantheadwindsforincomegrowth.

Manyof

the

DPJs

initiatives

are

not

scheduled

to

be

implemented

until

the

next

fiscal

year

(beginning

April

1,

2010). In themean time, Japans fiscal2009budget (endingMarch31,2010) should concern investorswho

regardJapanasasafedestinationforcapital. RevenuesareexpectedtobeJPY51.0trillion,downnearly10%

fromtwoyearsago(thisdoesnot includeJGBorFILPdebt issuance,whichtheMinistryofFinance includes in

theirbudgetasrevenue). ExpensesincludinginterestareexpectedtobeJPY91.6trillion. Theimplieddeficitis

JPY40.6trillion,or44%ofgovernmentexpenditures.26 Interestingly,theBankofJapan(BOJ)hasauthorized

itself topurchase JPY21.6 trillionYenperyearof JGBs. Nevermind the JPY1 trillionof financial institution

stocksthattheBOJ isauthorizedtopurchasethroughApril2010,ortheJPY3trillionofcommercialpaperand

JPY450billionofcorporatebondsauthorizedforpurchasebetweenOctoberandDecemberofthisyear.27 Japan

isonfulltiltwiththegovernmentbuyingallclassesoffinancialassets inanattempttopropuptheirhouseof

cards.

Whenwe connectallof theproverbialdots,weexpecteitherhigher rates in Japan,aweakerYen,or (most

likely)somecombinationthereof. ApersistentlystrongYenwillkeeppressureonexportswhichwillresult in

lower GDP and lower government tax revenues,whichwill lead to greater debt issuance. Now that zero

interestratepolicyhasreachedtheextentof itspotentialbenefits,thecompounding impactsof issuingmore

debt will increase Japans interest expense burden (and consequently the deficit) even further. Soon the

issuanceof JGBswillbemetwitha lackofdomesticdemand,and rateswill feelsignificantupwardpressure.

TheJapanesegovernmentcaneitherallowratestorise,whichtheyprobablyknowtheycannotafford,orthey

canincreasequantitativeeasingtoattempttokeeprateslow. Webelievethenetresultofalloftheabovewill

behigher

rates

and

aweaker

Yen.

25Source:DPJPolicyImplementationCouldInflateJapan'sFiscalDeficits;CompensatingMeasuresWillBeKey,Standard

andPoors,August31,2009.26

Allfiscal2009budgetdatasourcedfromtheJapaneseMinistryofFinanceandadjustedtoreflectcommentsinFinance

MinisterYosanosspeechonApril27,2009regardingincrementalstimulusspending.27

Source:BankofJapan.


23/24


CapitalizingonOurViews

Tosummarizeourviews,webelievethatglobalcurrencyprintingwillinevitablyleadtohighlevelsofinflation

outrightcurrencydebasement. Historically, ithastaken18monthstotwoyearstotakehold,butwebelieve

that itcouldbesoonerduetothesizeofbothmonetaryandfiscalstimulusaswellasthecoordinatedglobal

natureoftheactions.

Wearenotparticularlybullishon theworldmacroenvironmentor theUSconsumer for thatmatter,butwe

continuetoinvestslowlyanddefensively.

Basedonourthesisofimpendinginflationandcompetitionforsovereigncapitalasworldgovernmentsrunhuge

fiscaldeficits(andselldebttofinancethem),weareinvestingcautiouslyincredit. InthecoreHaymanportfolio,

we are invested in short duration credit andmortgages. Hayman has built amortgage position equal to

approximately50%ofassetsundermanagement. Thecorestrategy isto invest inmortgagebackedsecurities

that are very high in the capital structure, have relatively short weighted average lives and that provide

attractiveriskadjustedyieldsbasedonourassumptions. Ourunderwritingstandardstakeintoconsiderationa

range

of

macro

variables

including

further

home

price

depreciation,

maintained

stress

on

consumer

balance

sheetsandaprolongeddownturn inthe labormarket. Additionally,we lookatabroadarrayofpoolspecific

traitsandservicingtechniqueswhendeterminingvalue. Webelievethatcertainsecuritiesremainattractivedue

tomanyofthetraditionalmortgagebackedbuyersshyingawayfromthemarketwhichwillprovideopportunity

goingforward. Additionally,Haymanhasaddedcorporatecreditpositions,primarilyhighyieldbondsandbank

loans,equal toapproximately25%ofassetsundermanagement. We target two typesof situations short

durationperformingcreditsthatprovidecurrentincomeanddistressedcreditswithsolidassetcoverage. While

weexpectcorporatedefaultstoremainelevated,wewillcontinuetoselectivelyinvestincorporatecreditsthat

meetourcriteria.

WebelieveglobalOECDrateswillbegintheirascentoverthenext1824monthsandthatthebestconvexityfor

rates is in Japan. Wehavealsoallocated aportionof theportfolio topreciousmetals andare seekingout

unique opportunities in natural resources. Many of our larger positions tend to have the same kind of

asymmetricalrisk/returncharacteristicsthatwestrivetobuildintotheportfolio.

Hayman continues tobelieve that the transferofprivatedebtonto thepublicbalance sheet in the formof

deficitspendingandgovernmentguaranteesisunsustainable. Thecreditworthinessofmanymajoreconomies

inWesternEurope,AsiaandNorthAmericahasbeensubstantiallyaffectedbytherapidaccumulationofnew

debtinthenameofstimulusspendingandbailouts;however,intheshortterm,thecentralbanksoftheworld

havecommittedtofundingtheissuanceofnewsovereigndebtdirectlythroughquantitativeeasing(intheUS,

UKandJapan)and indirectlythroughrepurchaseagreementswithfavorableterms(Eurozoneandelsewhere).

Thishas

allowed

artificial

demand

for

sovereign

debt

and

low

interest

rates

despite

the

massive

amount

of

new

supply. For example, banks from Ireland have absorbed approximately 15% of the European Central Banks

outstandingliquidityinjections,despiterepresentingonly1.9%ofEurozoneGDP.Thedebtfinancingpositionof

sovereigngovernmentshasbecomeverydependentonhistorically loosemonetarypolicy.Webelieve that in

the event thismonetary policy is actively tightened or indeed not actively loosened further, the ability for

sovereignstofundthemselvesatthecurrentrateofdeficitspendingisquestionable.Unlessanewdoseoffiscal

sobrietyemergesaround theworld,centralbankswillhavetochooseatsomepointbetweenthe integrityof

themoneysupply,andtheborrowingneedsofsovereigngovernments.Wearepositionedforbothoutcomes.


24/24

24

Respectfully,

J. Kyle Bass

Managing Partner

Theinformationsetforthhereinisbeingfurnishedonaconfidentialbasistotherecipientanddoesnotconstituteanoffer,solicitationorrecommendationtoselloranoffertobuyanysecurities,investmentproductsorinvestmentadvisoryservices.Suchanoffermayonlybemadetoeligibleinvestorsbymeansofdeliveryofaconfidentialprivateplacementmemorandumorothersimilarmaterialsthatcontainadescriptionofmaterialtermsrelatingtosuchinvestment. Theinformationandopinionsexpressedhereinareprovidedforinformationalpurposesonly.AninvestmentintheHaymanFundsisspeculativeduetoavarietyofrisksandconsiderationsasdetailedintheconfidentialprivateplacementmemorandumoftheparticularfundandthissummaryisqualifiedinitsentiretybythemorecompleteinformationcontainedthereinandintherelatedsubscriptionmaterials. Thismaynotbereproduced,distributedorusedforanyotherpurpose. Reproductionanddistributionofthissummarymayconstituteaviolationoffederalorstatesecuritieslaws.

HCMF Investor Letter October 2009 FINAL

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