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Transcript of 48965946 the Cognitive Dissonance of It All
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8/2/2019 48965946 the Cognitive Dissonance of It All
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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.
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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
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3HaymanCapitalManagement,L.P.2011
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)
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4HaymanCapitalManagement,L.P.2011
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.
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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)
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6HaymanCapitalManagement,L.P.2011
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%
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7HaymanCapitalManagement,L.P.2011
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
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8HaymanCapitalManagement,L.P.2011
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.
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9HaymanCapitalManagement,L.P.2011
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
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10HaymanCapitalManagement,L.P.2011
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.
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11HaymanCapitalManagement,L.P.2011
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
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12HaymanCapitalManagement,L.P.2011
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
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13HaymanCapitalManagement,L.P.2011
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
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14HaymanCapitalManagement,L.P.2011
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.
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15HaymanCapitalManagement,L.P.2011
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
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16HaymanCapitalManagement,L.P.2011
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
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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
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