!
!
November!30,!2011!
!
“Men!prefer!a!false!promise!to!a!flat!refusal.”!
!Quintus"Cicero"
Imminent!Defaults!
We!write!to!you!today!to!provide!our!thoughts!on!the!most!likely!path!of!global!debt!and!the!potential!
consequences!of!a!cluster!of!sovereign!defaults.! !We!see!an! interesting!relationship!between!the!dual!
aspects! of! the! situation! –! the! quantitative! and! the! qualitative.! ! First,! the! quantitative! data! sets! are!
simple! facts!which!are!easily!analyzable.! !Second,!and!much!more!open!to!debate,!are!the!qualitative!
thoughts!and!reactions!of!market!participants!to!that!data.!
Often!when!there!is!a!large!and!rapid!change!in!a!market!dynamic!to!a!new!paradigm!there!is!a!chorus!
of! analysts! proclaiming! that! “nothing! has! changed”,! yet! undeniably! the!market! indicates! it! has.!We!
believe!that!in!many!cases!the!quantitative!data!leads!the!qualitative!change!in!opinion!to!such!a!degree!
that!it!may!look!like!nothing!has!changed!in!the!data!to!drive!the!change!in!opinion.!In!most!cases!this!is!
merely!the!market!catching!up!with!the!fundamentals.!!!
Once!the!quantitative!data!points!get!as!bad!as!they!are!today! in!many!nations,!the!qualitative!beliefs!
and!actions!of!the!participants!can!rapidly!change!a!situation!from!benign!or!stable!to!full!crisis!(think!
Italy).!!It!is!the!beliefs!of!the!participants!that!are!most!important!in!times!like!today.!!The!data!sets!are!
large!and!slow!moving,!but! the!qualitative! interpretation!of! them! is! far!more!mercurial.! !We!operate!
under! the! assumption! that! most! participants! are! educated! and! informed,! and,! therefore! the!
quantitative!analysis!should!already!be!done.! !However,! it! is!clear! that!some!previously!unquestioned!
qualitative!beliefs!are!hard!to!shake.!!One!of!the!axioms!that!we!have!been!developing!at!Hayman!is!a!
more!precise!definition!of!debt! sustainability.! !Debt! sustainability! is!often!defined! as! the! ability!of! a!
country!to!meet!and!service! its!debt!obligations!without!requiring!debt!relief!or!accumulating!arrears.!!
The!non"linearity!of! the! relationship!between! expenses! (primarily! the!delta! in! interest! expense)! and!
revenues! is!a!concept!we! spend!a! lot!of! time!on.! !When!a!nation’s!debts!become!many!multiples!of!
central!government!revenues,!a!non"linear!relationship!develops!that!becomes!insurmountable!because!
expenses!grow!faster!than!revenues!even!in!inflationary!or!growth!environments.!We!believe!the!debts!
of! the! following! nations,! among! others,! are! not! sustainable! in! the! current! economic! environment:!!
Greece,! Italy,! Japan,! Ireland,! Iceland,! Japan,! Spain,! Belgium,! Japan,! Portugal,! France,! and,! have! we!
mentioned!Japan?!!The!United!States!is!quickly!approaching!the!zone!of!insolvency!but!can!avoid!it!with!
2!©!Hayman!Capital!Management,!L.P.!2011!
!
massive! spending! cuts! and! severe! reductions! in! entitlements! into! the! future! (but! don't! hold! your!
breath).!!!
While!there!are!many! inputs!that!are!functionally!relevant,!we! look!for!a!couple!of!warning!signs.! !We!
move! a! nation! out! of! the! risk! free! category! as! soon! as! they! spend!more! than! 10%! of! their! central!
government!revenues!on! interest!alone.!!We!also!worry!about!debt!loads!that!represent!more!than!5x!
the!revenue!of!the!responsible!government.!When!these!and!other!characteristics!are!met!or!exceeded,!
it!can!quickly!move!the!country!into!checkmate.!
!
Global!Debt!Saturation!
Since!2002,!total!global!credit!market!debt!has!grown!at!more!than!an!11%!compound!annual!growth!
rate!(“CAGR”)!from!$80!trillion!to!approximately!$200!trillion.!!Over!the!same!time,!global!real!GDP!has!
only!grown!at!approximately!a!4%!CAGR.!!!
!
Total!Global!Debt!(Left!Axis)!and!Global!Debt/GDP!(Right!Axis)!
($"in"Trillions)!
!
As! it! stands! today,! total! credit! market! debt! is! 310%! of! GDP.! ! We! are! saddled! with! the! largest!
accumulation!of!peacetime!debts!without!any!playbook! for!what!happens!next.! !Throughout!history,!
whenever! total! credit!market!debt!breached!200%!of!GDP,! it!was! commonly!due! to!deficit! spending!
fueled!by!borrowing!as!nations!prepared!for!and!then!fought!wars.! !To!the!victor!went!the!spoils!(and!
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 2010
Global!D
ebt!/!GDP
Total!Global!Debt!(Trillions!of!Dollars)
Public!Debt!Securities Private!Debt!Securities Bank!Assets Debt/GDP!(Right!Axis)
3!©!Hayman!Capital!Management,!L.P.!2011!
!
debt!pay"downs)!and!to!the!loser!went!defeat!and!default.!!Given!the!enormity!of!the!debt!burdens!of!
the!PIIIGSBF!(Portugal,!Italy,!Ireland,!Iceland,!Greece,!Spain,!Belgium!and!France)!coupled!with!those!of!
Japan! (and! at! some! point! the!US),! lending! schemes! designed! to! lend!more! into! an! intractable! debt!
problem!are!destined!to!fail!miserably.!!There!is!no!savior!large!enough!with!a!magical!pool!of!capital!to!
stave! off! this! unfortunate! conclusion! to! the! global! debt! super! cycle.! !We! think! hard! defaults! are!
imminent.!
For! those! of! you! that! aren’t! following! European! rates! closely,! please! see! the! charts! below.! ! After!
reviewing!the!history!of!rates!in!EMU!member!countries,!one!key!takeaway!is!that!the!markets!have!told!
participants!that!the!EMU!has!ALREADY!BROKEN!UP.!!
!
Greek!2"Year!Government!Bond!Yield!
!
!
!
!
!
!
!
!
4!©!Hayman!Capital!Management,!L.P.!2011!
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Portuguese!2"Year!Government!Bond!Yield!
!
!
!
Italy"Germany!10"Year!Government!Bond!Spread!
!
!
5!©!Hayman!Capital!Management,!L.P.!2011!
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Many!absolute!levels!as!well!as!spread!levels!are!higher!and!wider!than!pre"Maastricht!extremes.!!This!
indicates!something!that!the!politicians,!bankers,!and!regulators!don’t!want!to!acknowledge:!!They!have!
already!lost!control,!and!they!will!not!be!able!to!put!this!genie!back!into!the!bottle.!!It!is!already!over!for!
the!EMU,!they!just!do!not!want!to!admit!it.!!Below!we!compare!Moody’s!official!sovereign!ratings!to!the!
implied! default! ratings! derived! from! market! trading! levels! of! sovereign! debts! –! the! “marketplace!
ratings”.!!
!
!
Needless!to!say,!a!seven"notch!differential!prompted!a!three"notch!downgrade!for!Italy.!!When!there!is!
a! 10"notch! differential! (Belgium)! or! even! a! 9"notch! differential! (France),! expect! a! multi"notch!
downgrade!in!the!very!near!future.!
!
The!Mirage!of!the!IMF!and!EFSF!(and!whatever!the!next!vehicle!is!called)!
Recently,!!rumors!circulated!in!the!press!of!a!EUR!600!billion!loan!($794!billion)!being!readied!by!the!IMF!
for!Italy,!which!would!(theoretically)!provide!the!country!with!another!12"18!months!of!runway!to!sort!
out! its! intractable!debt!problems.! !I!suppose! it!was!only!a!matter!of!time!–!another!“bazooka”!with!an!
eye"popping! headline! number! put! forth! to! calm! the!market! participants.! ! It! is! unconscionable! that!
Country Moody's!Rating CDS!Implied!Rating Notch!Difference
Austria Aaa/Stable Baa3 Nine
Belgium Aa1/Rvw!Dng Ba2 Ten
Cyprus Baa3/Rvw!Dng B3 Six
Estonia A1!/Stable Baa2 Four
Finland Aaa/Stable Aa3 Three
France Aaa/Stable Baa3 Nine
Germany Aaa/Stable A2 Five
Greece Ca/Developing C One
Ireland Ba1/Negative B2 Four
Italy A2/Negative Ba2 Seven
Malta A2/Negative Ba1 Five
Netherlands Aaa/Stable A3 Six
Portugal Ba2/Negative B3 Four
Slovakia A1!/Stable Ba1 Six
Slovenia Aa3/Rvw!Dng Ba2 Eight
Spain A1!/Negative Ba2 Seven
6!©!Hayman!Capital!Management,!L.P.!2011!
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anyone! thinks! that! lending!more! into! this! debt! problem! “solves”! anything,! but! in! the! true! spirit! of!
Keynes!and!White,!Lagarde!and!Draghi!are!attempting!to!placate!the!market!with!optics.!!The!problem!is!
that!the!optics!have!now!broken!down.!!!
The!optics!of!an!EFSF! levered!CDO! idea!are! collapsing!as!one!of! the! largest!guarantors!of!early!EFSF!
bonds!–!Italy!–!!is!now!looking!to!be!a!recipient!of!aid.!!Recently,!the!EFSF!had!to!purchase!its!own!bonds!
as!there!were!no!takers!for!20%!of!a!EUR!3!billion!issue.!!Imagine!how!they!will!do!when!they!attempt!to!
issue!EUR!200!billion!more!(answer:!poorly,! if! it!happens!at!all).! !One!other!point!to!ponder! is!the!fact!
that!sovereign!bond!managers!take!career!risk!by!simply!owning!these!toxic!securities!(therefore!they!
won’t!do!it).!!Again,!there!is!a!need!to!fully!comprehend!the!enormity!of!the!circular!reference!involved!
with!the!IMF!and!EFSF!schemes!being!contemplated.!!The!EFSF!is!a!combination!of!a!handful!of!debtor!
nations!that!are!out!of!money.! !The!mechanism! is!only!as!strong!as! its!weakest! link,!and!the! links!are!
crumbling.!!How!will!EFSF!bonds!trade!in!the!marketplace!when,!in!the!first!issue,!there!are!a!group!of!
guarantors! and! a! single! recipient! while! in! the! second! issue! there! will! be! differing! guarantors! and!
recipients! (where! a! prior! guarantor! is! now! a! recipient)?! ! For! all! intents! and! purposes,! the! EFSF!
mechanism!is!dead!on!arrival.!!It!is!amazing!to!us!that!this!idea!continues!to!be!pursued!by!the!Eurocrats!
in!their!17th!emergency!summit!on!December!9th.!!
Now,! let's! discuss! the! IMF.! ! Perhaps! this!would! be! a!workable! temporary!mirage! in! the! near"term!
assuming!the!IMF!had!the!funds!at!its!disposal!to!make!such!a!promise.!!As!it!turns!out,!that!assumption!
is!way!off!the!mark.!!Currently,!IMF!resources!fall!significantly!short!of!the!rumored!Italian!loan!amount,!
and! further! increases! to! IMF! funds! exacerbate! the! circular"reference! problem! of! heavily! indebted!
nations! providing!money! –! that! they! do! not! have! –! to! bail! each! other! out.! ! Even! former! IMF! chief!
economists!agree!that! the! IMF!was!never!designed!to!make!even!a!medium"sized! loan.! !The! IMF!was!
designed! to!assist! small! third"world! countries!with!balance"of"payments!problems.! !The! IMF!was!not!
designed!to!act!as!a!lender!of!last!resort!for!profligate!debtor!nations!in!Europe!or!Japan.!!It!may!seem!
bizarre! given! some! suggested! IMF! action,! but! the! socialization! of! global! losses! run! up! by! profligate!
developed!nations!cannot!be!found!in!the!IMF!mission!statement.!!
According! to!data!provided!on! the! IMF’s!official!website,! there! is!only! approximately!$385!billion!of!
remaining!firepower!currently!available!to!provide!aid!to!member!nations!(referred!to!by!the!IMF!as!its!
“forward!commitment!capacity”)1.! ! In!other!words,!a! loan! the!magnitude!of! the! rumored! Italian! loan!
would! exhaust! currently! available! IMF! resources!more! than! twice! over.! ! Including! total! committed!
capital! under! the! IMF’s! New! Arrangements! to! Borrow! (“NAB”)! (assuming! activation! could! be!
expeditiously!approved!and!funded),!total!forward!commitment!capacity!would!increase!by!$153!billion,!
to!approximately!$538!billion! (excludes! commitments! from!Greece,! Ireland!and! Italy).! !Even! still,! the!
Italian! loan!would! fully!exhaust! the! committed! (funded!and!unfunded)! resources!of! the! IMF!and! still!
leave!a!hole!of!$256!billion.!!
We!are!reaching!the!point!at!which!the!amount!of!funds!required!to!continue!delaying!the!inevitable!is!
simply!becoming!too!large.!!As!more!countries!require!aid!and!thus!are!unable!to!provide!aid,!the!burden!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!1!http://www.imf.org/external/np/tre/liquid/2011/0911.htm!
7!©!Hayman!Capital!Management,!L.P.!2011!
!
on! the!remaining!contributing!nations!grows.! ! If! Italy,!currently! the!seventh! largest!contributor! to! the!
IMF!as!measured!by!both!its!quota!and!its!lending!commitments!under!NAB,!is!too!big!to!save,!what!is!
to!become!of!France!(fourth! in!terms!of!quota!and!fifth! in!terms!of!NAB!commitment)?!Or!worse!yet,!
Japan!(second!in!terms!of!both!quota!and!NAB!commitment)?!
Imagine!a!team!of!mountain!climbers!all!strapped!together!for!safety!as!they!ascend!a!treacherous!peak.!
While!they!are!all!holding!on!to!the!mountain!there! is!no!additional!strain!placed!on!each!other.!Now!
consider!what!happens! if!one!climber,! let’s!call!him!Stavros,!slips!and! loses!his!grip.!He!places!added!
strain!on!the!remaining!climbers.!One!climber!might!not!make!a!difference,!but!as!Seamus,!Pablo!and!
Jose!each! lose! their!grip! they!not!only!add!extra! total!dead!weight! to! the! team!but!also! increase! the!
amount!each!other!climber!has!to!carry,!until!finally!Francois,!Luigi!and!Takehiro!let!go!and!poor!Jurgen,!
and!Uncle!Sam!are!left!trying!to!keep!the!whole!team!on!the!mountain.!
The! IMF!has!already!made!a!mockery!of! its!own!policies!by!making!a!commitment!to!Greece!that!was!
3,200%!of!the!Greek's!SDR!quota.2!!With!the!Troika!owning!40%!of!Greek!sovereign!debt,!a!100%!write"
down! (complete! loss)! of! the! remaining! public! sector! debts! will! not! bring! Greece! into! "debt!
sustainability".!It!appears!to!us!that!the!IMF!and!the!ECB!might!have!to!take!a!loss!on!their!Greek!debt!
as!well.! ! Just! think,! the! ECB!has!been!purchasing!Greek!bonds! in! the!open!market! since!May! 2010.!!
Greek!10yr!rates!were!as!low!as!6.34%!while!the!ECB!was!initially!purchasing!bonds.!!The!ECB!and!IMF!
now!own!40%!of!the!outstanding!debt!of!Greece!and!Greek!10yr!rates!are!now!at!ALL!TIME!HIGHS!of!
31.98%.! ! If!the!ECB!can't!hold!back!Greek!rates,!what!makes!anyone!believe!they!can!do!anything! for!
Italian!rates!(where!Italy's!debts!are!$3!trillion!while!Greece!was!a!paltry!$500!billion)?!
The!bill!is!due!and!payment!time!is!now.!!The!world!sits!with!nearly!$200!trillion!of!total!credit!market!
debt!(on!balance!sheet!excluding!contingent!liabilities!arising!from!social!welfare!programs!and!the!like).!!
One!more! dollar!worth! of! global! credit!market! debt! produces! almost! no! additional! utility! via! GDP!
growth.!
Below!we!present!the!largest!contributors!to!both!the!IMF!New!Arrangements!to!Borrow!and!the!EFSF!
in!order!of!total!commitments,!largest!to!smallest.!!!
!
How!do!the!optics!of!these!schemes!look!to!you?!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!2!The!commitment!as!a!percentage!of!the!quota!fell!to!2,400%!this!year!after!IMF!raised!its!quota!for!Greece.!
IMF!New!Arrangements!to!Borrow EFSF
United!States !Germany
Japan !France
China !Italy
Germany !Spain
France !Netherlands
United!Kingdom !Belgium
Italy !Greece
8!©!Hayman!Capital!Management,!L.P.!2011!
!
IMF!Facilities!Committed!and!Outstanding!as!%!of!Countries’!Quotas!
!!
Pre"!or!Post"?!
After!perusing!about!as!many!opinions!on!the!current!debt!crisis!as!is!humanly!possible,!it!becomes!clear!
that!the!consensus!solution!involves!the!idea!that!the!ECB!takes!the!gloves!off!and!freely!prints!euros!to!
“solve”!the!debt!problems!of!Europe.! !The!consensus!argues!that!when!the!pain!becomes!most!acute!
and!unbearable!(i.e.!threatens!the!breakup!of!the!EMU),!the!ECB!will!jump!in!and!print!money!until!all!
problems! go! away.! ! The! qualitative! inputs! here! have! become! predictable! as! we! have! all! been!
programmed!to!think!that!we!will!always!be!saved!from!default!in!a!post"Lehman!world.!!The!Eurocrats!
know! full"well! that! they!don’t!have!any! spare! capital! to! recapitalize! their!entire!banking! system! in! a!
post"default!world,!nor!to!adequately!recapitalize!them!pre"default.!!Instead,!EU!member!nations!know!
that!they!will!be!required!to!print!money!in!order!to!re"capitalize!their!systems.!The!$18!trillion!dollar3!
question!for!the!EMU!periphery!is:!Should!they!(National!Central!Banks!or!the!ECB)!print!before!or!after!
a!default?! !We! think! they!print!post"default!as! they! come! to! the! realization! that!printing!pre"default!
without!addressing!the!toxic!debt!problem!would!rewind!the!clocks!back!to!the!days!of!Von!Havenstein!
and!then!you"know"who.!!
!
!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!3!The!total!credit!market!in!the!European!periphery!is!$18!trillion!(source:!IMF).!
"500%
0%
500%
1000%
1500%
2000%
2500%
3000%Greece
Portugal
Ireland
Mexico
Iceland
Poland
Latvia
Maldives
Ukraine
Pakistan
Bosnia!
Antigua
Macedonia
St.!Kitts
Dom.!Rep.
Colombia
Georgia
Sri!Lanka
Moldova
Jamaica
El!Salvad
or
Roman
ia
Angola
Arm
enia
Iraq
Liberia
Seychelles
Kosovo
Guinea"Bissau
Comoros
Togo
Kenya
Benin
Solomon!Is.
Tajikistan
Mauritania
Cote!d'Ivo
ire
Ghan
a
Honduras
Yemen
Djib
outi
Burkina!Faso
Grenad
a
Malawi
Burundi
Congo,!D
R
Nicaragu
a
Mali
Haiti
Zambia
Sao!Tome
Sierra!Leone
Congo,!Rep.
Afghanistan
Total!Committed
Total!Outstanding
Total!Credit!
Outstanding
7%
Total!Undrawn!
Commitments
22%
Draft!
Contribution!to!
Eurozone
35%
Total!Outstanding!and!Committed!Credit!Lines!as!%!of!
Aggregate!IMF!Funding!Capacity
Member!
Currencies,!!
$414,900!
Arrangements!
to!Borrow!
from!
Members,!!
$573,494!
IMF!Funding!Sources!($!in!millions)
9!©!Hayman!Capital!Management,!L.P.!2011!
!
The!Importance!of!Psychology!"!Self!Deception!
Whether!it!is!Kahneman’s!“availability!heuristic”!(wherein!participants!asses!the!probability!of!an!event!
based! on! whether! relevant! examples! are! cognitively! “available”),! the! Pavlovian! pro"cyclicality! of!
thought,!or!the!extraordinary!delusions!of!groupthink,!investors!in!today’s!sovereign!debt!markets!can't!
seem! to! envision! the! consequences! of! a! default.! ! The! psychology! of! the! situation! is! crucial! to!
understanding!why! and! how! the! gap! between! perception! and! reality! can! be! so! large.! ! Participants!
haven’t!contemplated!hard!defaults!(until!most!recently)!because!they!have!been!conditioned!to!believe!
they!cannot!occur!because! it! is!against!the! interests!of!too!many!powerful!parties.! ! !They!believe!that!
there!is!no!upside!to!thinking!this!scenario!all!the!way!down!through!the!logical!steps!due!to!the!fact!the!
last! few! steps! are! so! painful! for! everyone! (both! financial! and! non"financial).! ! Developed!Western!
sovereigns! haven't! defaulted! since!WWII! and! current! generations! have! not! experienced! a! cluster! of!
defaults!or!any!developed!default!in!their!lifetime.!!However!financial!history!has!shown!repeatedly!that!
waves!of!default!are!commonplace!across!a!longer!time!horizon.!!As!events!transpire,!investors!will!be!
forced!to!accept!developed!defaults!with!enormous!loss!severities.!!The!risk"free!rate!won't!be!risk"free!
any! longer.!The!very!foundation!of!the!collective!financial!education!will!be!proven!to!be!flawed.! !The!
Value"at"Risk! (VAR)!models! that!Wall! Street! continues! to!use! today!will!blow! apart!once! again.! !The!
models!that!currently!provide!us!with!some!of!the!most!mispriced!anomalies! in!the!history!of!finance!
because! of! their! reliance! on! historical! implied! volatility! as! substitute! for! true! risk!will! be! rendered!
useless.!!It!is!analogous!to!driving!a!racecar!using!the!rear"view!mirrors.!!
!
Japan!Will!Soon!Be!on!the!Front!Page!
Madoff's! scheme! collapsed! for!one!primary! reason!–!he!had!more! investors!exiting!his! scheme! than!
entering.! !As!soon!as! this!happened,! it!was!over.! !According! to! the!most! recent!census,! the! Japanese!
population!peaked!within!the! last!few!years!at!127.9!million!and!has!since! lost!almost!3!million.!Japan!
has! one! of! the! most! homogeneous! –! and! some! might! even! call! it! xenophobic! –! societies! of! any!
developed!nation!in!the!world.!!!It!is!no!secret!that!there!is!no!love!lost!between!the!Japanese!and!their!
neighbors,! and! therefore,! immigration! is! an! unlikely! answer! to! a! dwindling! populace.! Even! if!
immigration!was!encouraged,!such!an!influx!would!depress!carefully!balanced!wages!and!would!further!
disrupt!the!three!jewels!of!Japanese!corporate!culture!(seniority!based!wages,!employment!for!life,!and!
company!unionism).! ! It! is! indisputable! that! Japan!has! the!worst!on!balance! sheet!debt!burden! in! the!
world!(roughly!229%!of!GDP).!!Japan!has!the!worst!debt!dynamic!(total!debt!outstanding!as!a!multiple!of!
central!government!revenues)!of!any!country! in!the!world!(at!a!staggering!20X).! !They!now!have!more!
people! leaving! the!workforce! than!entering.! !Soon! they!will!have!more!people!dis"saving! than!saving.!
Without! re"hashing!our!entire! thesis!here,! the! funding!mechanism! (including! Japan's! current!account!
surplus)!is!dwindling!and!in!fact,!we!forecast!the!trade!component!of!the!current!account!to!be!negative!
for!FY2011.! !Personal!savings!of!the!Japanese!population! is!forecast!to!be!below!zero!by!the!middle!of!
2012.!!Their!ability!to!fund!themselves!internally!is!coming!to!an!end.!!We!believe!that!Japan!would!have!
a! bond! crisis! of! its! own!within! the! next! two! years!without! the! current! European! debt! crisis.! ! The!
10!©!Hayman!Capital!Management,!L.P.!2011!
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European! debt! crisis!will! simply! act! as! an! accelerant! to! the! Japanese! situation! as! it!will!most! likely!
change!the!qualitative!thoughts!of!JGB!investors.!!We!believe!that!this!sequence!of!events!is!set!to!begin!
in!the!next!few!months!(beginning!with!defaults!in!Europe).!!Attached,!please!find!several!recent!articles!
showing!the!initial!stresses!beginning!to!show!in!the!JGB!and!swaps!marketplace.!
!
The!Problems!Between!Kaiserville!and!Medland!
Recently,!Larry!Lindsey,!former!Director!of!the!US!National!Economic!Council!at!the!White!House!and!a!
trusted!friend,!penned!a!satirical!piece!that!warrants!inclusion!into!this!letter.!!With!Larry's!permission,!
we!are!pleased!to!share!it!with!you.!
Kaiser!on!the!Hill!
The"European"Finance"Ministers’"meeting"hardly"qualified"as"King"of"the"Hill,"maybe"Earl"of"the"
Hill,"and"had" it"not"been" for"the"actions"of"the"world’s"central"banks,"equity"markets"would"be"
headed"south"today.""The"central"bank"action"certainly"qualifies"as"doing"the"urgent.""Odds"were"
we"were"days"from"a"major"European"bank"collapse"and"heading"that"off"was"both"urgent"and"
important.""But"the"underlying"sovereign"debt"crisis"remains.""Hopes"now"focus"on"a"deal"in"which"
centralized"fiscal"control" is"a"quid"pro"quo"for" increased"ECB"purchases"of"peripheral"debt." "We"
consider" the" underlying" dynamics" of" this" by" examining" what" happened" in" Medland" and"
Kaiserville,"who"were"locked"in"a"currency"union"known"as"the"Uberalles."""
Medland’s" economy" was" 60" percent" private" sector," 40" percent" public" sector." " It" financed" its"
public"sector"with"a"25"percent" income" tax"on"all"workers"and"a"20"percent"VAT" levied"on" the"
private"sector.""The"VAT"left"the"private"sector"with"only"48"percent"of"GDP"to"pay"its"workers"and"
investors,"so"total"income"tax"collections"were"22"percent"of"GDP.""Coupled"with"VAT"collections"
of"12"percent"of"GDP," revenues"were"6"percent"of"GDP" short"of" the"40"percent"of"GDP"being"
spent.""In"addition,"the"accumulated"debt"of"Medland"was"up"to"100"percent"of"GDP,"on"which"it"
had"been"paying"a"4"percent" interest"rate," just"equal"to" its"nominal"growth"rate." "That" interest"
was" being" paid" to" the" banks" in" Kaiserville" who" owned" Medland’s" bonds." " Recently" they" got"
nervous" and" demanded" a" higher" interest" rate"which"would" put"Medland’s" debt" position" in" a"
clearly" unsustainable" position" and" provoke" both" a" sovereign" crisis" and" a" banking" crisis." " The"
Prime"Ministers"of"Medland"and"Kaiserville"and" the"head"of" the"Uberalles"Central"Bank" (UCB)"
agreed"on"a"Grand"Plan"to"fix"the"problem." "The"Medland"VAT"would"be"raised"by"10"points"to"
generate"the"6"percent"of"GDP"needed"to"fix"the"primary"budget"deficit.""In"return"the"UCB"would"
buy"enough"Medland"debt"to"stabilize"the"Medland"interest"rate"at"4"percent."""
The"sovereign"bond"crisis"was"averted"and"markets"rallied"as"the"banks" in"Kaiserville"would"no"
longer" take" losses" on" their" bond" holdings" and" it" looked" like" Medville’s" fiscal" problems" were"
solved." "But"the"higher"VAT"posed"a"problem." " In"many"countries"higher"VATs"are"passed"on"to"
consumers" in" the" form" of" higher" prices." " But" the" UCB" favored" price" stability" and" there" was"
sufficient"slack" in" the"Medland"economy" that" firms" lacked"pricing"power." "Medland"companies"
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could"only"respond"by"cutting"costs"(in"this"case"wages)"from"the"old"rate"of"48"to"the"new"rate"of"
42,"which" is"what" they"had" left"after" the"higher"VAT." " Income" tax"collections"on"private"sector"
workers"immediately"dropped"from"12"to"10.5,"so"state"revenues"declined"and"the"primary"deficit"
reappeared." "With" after!tax"wages" now" down," demand" for" private" sector" goods" and" services"
dropped"by"7"½"percent.""Layoffs"rose.""Both"VAT"and"income"tax"receipts"began"to"drop.""Worse"
for" the" long" run,"Medland’s"most"productive"private" sector"workers"and" entrepreneurs"began"
leaving"as" their"current" compensation"was"now"unattractive" relative" to"both" the"public" sector"
and"to"Kaiserville’s"private"sector"and"their"prospects"were"bleak."
The"banks" in"Kaiserville"quickly" sensed"something"was"wrong"and"began" to" sell" their"Medland"
bonds"to"the"UCB.""Their"rationale"was"simple.""If"Medland"should"default"or"be"restructured,"the"
UCB"would"not"take"a"haircut.""This"meant"that"the"more"bonds"the"UCB"bought,"the"greater"the"
haircut" would" be" on" private" sector" bond" holders." " The" rush" for" the" exit" quickly" became" a"
stampede"as"more"banks"caught"on"and"sensed"that"the"UCB’s" interest"rate"stabilization"policy"
was"their"best"chance"to"head"for"the"exits.""The"Grand"Plan"was"coming"apart"and"UCB"money"
creation" through" the" purchase" of" Medland" debt" did" not" solve" the" problem." " Medland’s"
fundamental"problem"was"that"its"unproductive"public"sector"was"too"large"and"its"tax"wedge"on"
its"private"sector"to"onerous." "Restructuring"a"country’s"or"a"company’s"finances"buys"time,"but"
unless"its"fundamentals"are"also"restructured,"it"returns"to"the"same"problem.!
!
If!we!are! correct! regarding!our!hypothesis!on! the!outcome!of! the!debt! crisis,! the!world!will!have! its!
social!fabric!ruffled!or!even!torn!for!a!period!of!time.!!Be!mindful!that!we!are!not!talking!about!the!end!
of! the!world!as!we!know! it;!we!are!simply!saying! that! it!will!be!a!different!and!slightly!more!difficult!
place!to! live! in! for!those!of!us! in!the!developed!and! indebted!West.! !We!will!all!wake!up! in!the!days,!
weeks,! and!months! afterward! and! go! to!work,! continue! to! invest,! and! live! our! lives.! ! I! am! eagerly!
awaiting!the!day!to!finally!arrive!when!our!fiduciary!duty!compels!us!to!worry!less!and!invest!more.!!It!is!
our! job! as! a! fiduciary! to! avoid! nursing! 50%+! losses! because! we! failed! to! believe! that! a! cluster! of!
sovereign!defaults!was!even!possible!(let!alone!probable).!!We!urge!you!to!consider!the!ramifications!of!
our!thesis!being!correct,!preparing!yourself!for!the!worst!while!hoping!for!the!best.!!As!one!of!my!closest!
friends!advises!me;!"Trade!as!you!like,!divest!accordingly."!
!
Sincerely,!
!
!
J.!Kyle!Bass!
Managing!Partner!
12!©!Hayman!Capital!Management,!L.P.!2011!
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an
offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment
advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential
private placement memorandum or other similar materials that contain a description of material terms relating to
such investment. The information and opinions expressed herein are provided for informational purposes only. An
investment in the Hayman Funds is speculative due to a variety of risks and considerations as detailed in the
confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by
the more complete information contained therein and in the related subscription materials. This may not be
reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may
constitute a violation of federal or state securities laws.!
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