hcmf investor letter october 2009 final
TRANSCRIPT
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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
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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.
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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.
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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:
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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.
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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.
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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.
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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
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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.
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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.
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8/14/2019 HCMF Investor Letter October 2009 FINAL
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222009HaymanAdvisorsL.P.
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.
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232009HaymanAdvisorsL.P.
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.
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24
Respectfully,
J. Kyle Bass
Managing Partner
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