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November15,2012

TheCentralBankersPotemkinVillage
Itseemstousthatwehavealreadywitnessedthepeak ofpoliticalsupportforausterityandfiscalconsolidation. Instead,battlecriesforstimulus(read:moneyprintingto finance deficit spending) emanate from the Krugman esquedisciplesdemandingmoreandmorecowbell1. Converting all balances to USD, central bankers around the world have expanded their balance sheets beyond $13 trillion, from only $3 trillion ten years ago. Global centralbanksassetsnowcompriseatleastaquarterof allglobalGDPupfromonly10%in2002.

TotalAssetsofGlobalCentralBanks($inBillions)
$14,000

$12,000 BOJ $10,000 FederalReserve

$8,000

$6,000

ECB

$4,000

$2,000

PBOC

$
Jan02 Sep02 Jan03 Sep03 Jan04 Sep04 Jan05 Sep05 Jan06 Sep06 Jan07 Sep07 Jan08 Sep08 Jan09 Sep09 Jan10 Sep10 Jan11 Sep11 May02 May03 May04 May05 May06 May07 May08 May09 May10 May11 Jan12 May12

Source:Bloomberg.

http://en.wikipedia.org/wiki/More_cowbell

Asinvestors,whatdowethinkaboutthequadruplingofcentralbankbalancesheetstoover$13trillion inthelasttenyears?Itcertainlydoesn'tmakemefeelanybettertosayitfastorforgetthatwemoved eversoquicklyfrommilliontobilliontotrilliondollarproblems. It has become increasingly clear over the last four years that the common denominator in policy response to financial crises is, and will continue to be, more central bank easing (printing money) to finance fiscal deficits. Let us recap the actions of three of the four most prominent, powerful and influentialcentralbanksintheworldoverthecourseofthelastseveralweeks:

EndlessMoneyPrinting:CentralBankAssetPurchasesAnnouncedSeptemberOctober2012
AnnouncementDate Action Introducednewunlimitedbondbuyingprogram, OutrightMonetaryTransactions("OMT"),through whichtheECBwillpurchase13yearbondsof distressedEurozonenations Announcedplantopurchase$40billionofmortgage backedsecuritieseverymonthindefinitely,which, whencombinedwiththeongoingOperationTwist, willadd$85billionpermonthinlongtermbondsto theFedsbalancesheet IncreasedthetotalsizeofitsAssetPurchaseProgram by11trillion,from80trillionto91trillion. Thisfollowsthepriormonth'sreleasewhichincreased theprogramfrom70trillionto80trillion. Cap

EuropeanCentral Bank

September6,2012

Unlimited

FederalReserve

September13,2012

Unlimited

BankofJapan

October30,2012

91trillion (fornow)

Source:ECB;USFedera l Res erve;BOJ.

Central bankersarefeverishlyattempting to create theirownnewworld:a utopiainwhichdebtsare neverrestructured,andtherearenoconsequencesforfiscalprofligacy,i.e.noatonementforpriorsins. They have created Potemkin villages on a Jurassic scale. The sum total of the volatility they are attempting to suppress will be less than the eventual volatility encountered when their schemes stop working. Most refer to comments like this as heresy against the orthodoxy of economic thought. We havea hard timeunderstandinghowthe currentsituationends anywayotherthanamassivelossof wealthandpurchasingpowerthroughdefault,inflationorboth. In the Keynesian bible (The General Theory of Employment, Interest and Money), there is a very interestingtidbitofKeynesconscienceinthelastchaptertitledConcludingNotesfrompage376: 2
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[I]t would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity value of capital. Interest today rewards no genuine sacrifice, any more than does the rent of land.Theownerofcapitalcanobtaininterestbecausecapitalisscarce,justastheowner oflandcanobtainrentbecauselandisscarce.Butwhilsttheremaybeintrinsicreasons forthescarcityofland,therearenointrinsicreasonsforthescarcityofcapital. ... Thuswemightaiminpractice(therebeingnothinginthiswhichisunattainable)atan increaseincapitaluntilitceasestobescarce,sothatthefunctionlessinvestorwillno longerreceiveabonus[.](emphasisadded)

This is nothing more than a chilling prescription for the destruction of wealth through the dilution of capitalbymonetaryauthorities. Centralbankshavebecomethegreatenablersoffiscalprofligacy.Theyhaveremovedtheproverbial policemenfromthebondmarkethighway.Ifcentralbankspurchasetheentiretyofincrementalbond issuance usedtofinance fiscaldeficits,the checksand balances ofnormalmarketinterestratesare obscuredoreveneliminatedaltogether.Thismarketphenomenondoesnothingtoencouragethebody politictotaketheirfootoffthespendingaccelerator.Itisbothourprimaryfearandunfortunatelyour predictionthatthisquixoticpathofspendingandprintingwillcontinueadinfinitumuntilrealcostpush inflationmanifestsitself.WewontgetintotheMV=PQargumenthereastherealityofthesituationis thefactthattheVisthesolveforvariable,whichisatbestaconcurrentorlaggingindicator.Given theenormityoftheexistinggovernmentdebtstock,itwillnotbepossibletocontroltheveryinflation thatthemarketiscurrentlyhopingfor.Aseach100basispointsincostofcapitalcoststheUSfederal governmentover$150billion,theUSsimplycannotaffordforanotherPaulVolckertoraiseratesand containinflationonceitbegins.


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RoadtoSerfdom
The current modus operandi by central banks and sovereign governments threatens to take us down FriedrichvonHayek'sRoadtoSerfdom.Publishedin1944,itsmessage,thatallformsofsocialismand economicplanningleadinescapablytotyranny,mightprovetohavebeenprescient.Inthe1970s,when Keynesianismwasbroughttocrisis,politicianswerevociferouslydeclaringthatattemptingtomaintain employment through inflationary means would inevitably destroy the market economy and replace it withacommunistorsomeothertotalitariansystemwhichistheperilousroadtobeavoidedatany price".Thegeniusinthebookwastheargumentthatserfdomwouldnotbebroughtaboutbyevilmen like Stalin or Hitler, but by the cumulative effect of the wishes and actions of good men and women, eachofwhoseinterventionscouldbeeasilyjustifiedbyimmediateneeds.Weadvocatesocialliberalism, butwealsoneedtogettherethroughfiscalresponsibility.Pushingforinflationatthismomentintime will wreak havoc on those countries whose cumulative debt stocks represent multiples of central governmenttaxrevenue. Thenonlinearityofexpensesversusrevenuesiswhatwillbringthemdown.

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The Largest Peacetime Accumulation of Total Credit Market Debt in World History
It took the United States 193 years (17891981) to aggregate $1 trillion of government debt. It then took 20 years (19812001) to add an additional $4.8 trillion and, in the last 10 years (20012011), a whopping$9.8trillionhasbeenadded tothefederaldebt.Since 1981,theUSincreaseditssovereign debtby1,560%whileitspopulationincreasedbyonly35%. Remembertheoldeconomictheoryofdiminishingmarginalutility?

UnitedStatesIncreaseinRealGDPperDollarofIncrementalDebt
5.0 4.61 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 19471952 19531984 19852000 2001Q22012

0.63 0.24 0.08

Source:NedDavisResearch;US FederalReserve;Bloomberg.

Similaramountshavebeenaccumulatedalloverthedevelopedworld.Totalglobalcreditmarketdebt hasgrownatovera10%annualizedpaceforthelast10yearswhileglobalpopulationhasgrownatonly 1.2%andglobalrealGDPhasgrownat3.9%.

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CompoundAnnualGrowthRateofVariousEconomicIndicators(2002 2011)
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% GlobalPopulation RealGDP GlobalCreditMarketDebt MajorCentralBankBalanceSheet Expansion* 1.2% 3.9% 10.7% 16.4%

Source:RealGDPfrom IMFWorldEconomicOutlook; GlobalCreditMarket datafrom IMFGlobalFinancialStabilityReports;Population data fromWorld Bank;Centralbank assetdatafromBloomberg.

TotalGlobalCreditMarketDebt($inBillions)
$225,000 $200,000 $175,000 $150,000 $125,000 $100,000 $75,000 $50,000 $25,000 $ 2002
Source:IMF;BIS.

BankAssets PrivateDebtSecurities PublicDebtSecurities

2003

2004

2005

2006

2007

2008

2009

2010

2011

Japanhasreachedanewmilestoneinitsfiscalprofligacy.Theyhavereachedoveronequadrillionyenin government debt. That's a 1 with 15 zeros after it for those keeping score at home (1,000,000,000,000,000). Assuming that it takes 1 second to count each number, it would take you 31,688,087years,297days,7hours,46minutes,and40secondstocounttoonequadrillion2.Itissimply foolhardyforanyonetothinkthisdebtcaneverberepaid(moretofollowonJapanlater).Whilewe generally agree with Alexander Hamilton that a sovereign nation does not have a finite life span and therefore can support a certain amount of debt into perpetuity, he should have defined excessive whenhewrotein1781:Anationaldebt,ifitisnotexcessive,willbetousanationalblessing.
2

Timingconsidersleapyearssothateachyearis365.25dayslong.

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AsinvestorsmullthefateoftheperipheralEuropeaneconomies,thebroadermonetaryunionandits foundational currency, the proverbial forest is finally coming into view through the trees. As our thoughtsevolve,weintendtoshareourviewsonhowand,moreimportantly,whywebelievetheworld sitsatacrossroads(withoneroadnowcompletelywashedout).Thebehaviorofmarketparticipantsis whatwewillbefocusedonoverthenextfewyears.

PavlovsPartyComingtoanEnd
Throughtravelandmeetingsaroundtheworld,ithasbecomecleartousthatmostinvestorspossessa heavily anchored bias that has been engrained in their belief systems mostly through inductive reasoning. Using one of the Nobel Laureate Daniel Khaneman's theories, participants fall under an availabilityheuristicwherebytheyareabletoprocessinformationusingonlyvariablesthatareproducts ofrecentdatasetsorevents.Letsfaceitthebrevityoffinancialmemoryisshorterthanthehalflife ofaJapanesefinanceminister. Humansare optimisticbynature.Peopleslivesaredrivenbyhopesand dreamswhichareallsecond derivatives of their innate optimism. Humans also suffer from optimistic biases driven by the first inalienablerightofhumannaturewhichisselfpreservation.Itisthisreflexmechanisminourcognitive pathways that makes difficult situations hard to reflect and opine on. These biases are extended to economicchoicesandevents.Thefactthatdevelopednationsovereigndefaultsdontadvanceanyones selfinterest makesthelogicaloutcomesodifficult toaccept. Theinherent negativityassociatedwith sovereigndefaultsbringsustosuchdifficult(butlogical)conclusionsthatitiswidelythoughtthatthe powersthatbecannotandwillnotallowittohappen.Theprimarydifficultywiththistrainofthoughtis thebiasthatmostinvestorshaveforthebaselinefacts:theytendtobelievethatthecentralbankers, politicians,andothergovernmentalagenciesareomnipotentduetotheirsuccessinavertingafinancial meltdownin2009. Theoverarchingbeliefisthattherewillalwaysbesomeoneorsomethingtheretoactasthesafetynet. The safety nets worked so well recently that investors now trust they will be underneath them ad infinitum.Marketsandeconomistsalikenowbelievethatquantitativeeasing(QE)willalwayswork byfloodingthemarketwithrelativelycostlesscapital.Whentheonlytoolacentralbankpossessesisa hammer,everythinglookslikeanail. Inouropinion,QEjustdoesntstimulateprivate creditdemand andconsumptioninaneconomywheretotalcreditmarketdebttoGDPalreadyexceeds300%.TheUK 7
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istheposterchildfortheabjectfailureofQE.TheBankofEnglandhaspurchasedover27%ofgross governmentdebt(vs.12%intheUS).UKbondyieldshaveallbutgonenegativeandarenownegativein real terms by at least 1%. Unlimited QE and the zero lower bound (ZLB) are likely to bankrupt pensionfundswhoseexpectedreturnshappentobeagood600basispoints(ormore)higherthanthe 10year riskfree rate. The ZLB has many unintended consequences that are impossible to ignore. DespitereadingthroughKeynesworks,wedidntfindasingleindexreferencingtheZLBoranysimilar concept.InhisGeneralTheory,thereare64entriesintheindexunderInterestbutnoentryforthe ZLB,zerorates,orevenreallylowrates. Our belief is that markets will eventually take these matters out of the hands of the central bankers. Theseeventswillhappenwithsuchrapiditythatpolicymakerswontbeabletoreactfastenough. Thefallacyofthebeliefthatcountriesthatprinttheirowncurrencyareimmunetosovereigncrisiswill bedisproveninthecomingmonthsandyears.Thosethattreatthisbeliefasaxiomaticwillmostlikelybe the biggest losers. A handful of investors and asset managers have recently discussed an emerging schoolofthought,whichpostulatesthatcountries,asthesolemanufactureroftheircurrency,cannever becomeinsolvent,andinthissense,governmentsarenotdependentoncreditmarketstoremainfiscally operational.Itispreciselythislineofthinkingwhichwillultimatelyleadthesheeptoslaughter.

PatternRecognitionandHysteresis
Asinvestors,wetendtorecognizeandextrapolatepatterns.Asthesepatternsrepeatthemselves,they becomeaxiomaticthroughinduction.Asrepetitiveeventsbecometruths,hysteresissetsin.Thepro cyclicality of thought takes over and this process moves markets far from normalcy. The path dependency of some of the largest global sovereign debt markets is a concept that will be studied, posthumously,muchmorein thefuture.When centralbankersinvokethe wordconfidenceintheir communiqus, they are centering on the holy grail of sovereign debt markets. Once the belief in the debtor is lost, it is next to impossible to regain. As there are followon restructurings to Greece, this confidence will be incrementally chipped away in the psyche of sovereign investors. The qualitative perceptionsofparticipantswillthereforechangeovertime.Itisthistimingofchangeinthebeliefsof theparticipantsthatismostdifficulttogauge.GiventherecentdefaultandrestructuringofGreekdebt plustheintractableproblemswithSpain,Cyprus,Portugal,Ireland,Italy,Japan,anddarewesay,France, thequalitativeassessmentsofsovereigninvestorsarebecomingthesinglemostimportantvariablein 8
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the equation. We believe that the only reason the European Monetary Union (EMU) has not let Greece go and devalue into the Drachma is the simple fact that Luigi is focused on what happens to Stavros bank deposits. For as soon as Stavros deposits are Drachmatized, Luigi will send all of his eurostoJurgensbank. Intheend,theEMUwon'tlookthesame,ifitexistsatall.Thisisevenbeforethetideturnsonsomeof theworldslargestsovereigndebtorsliketheUnitedKingdom,andofcoursethebiggestdebtzombieof them all: Japan. Trillions of dollars of debts will be restructured and millions of financially prudent saverswillloselargepercentagesoftheirrealpurchasingpoweratexactlythewrongtimeintheirlives. Again,theworldwillnotend,butthesocialfabricoftheprofligatenationswillbestretchedandinsome casestorn.Sadly,lookingbackthrougheconomichistory,alltoooftenwaristhemanifestationofsimple economicentropyplayedtoitslogicalconclusion.Webelievethatwarisaninevitableconsequenceof thecurrentglobaleconomicsituation.
Whenitbecomesserious,youhavetolie.

JeanClaudeJuncker(April20,2011) PrimeMinisterofLuxembourg ChairmanoftheEurogroupCouncilofEurozoneFinanceMinisters

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HowManyMarketParticipantsActuallyStudytheNumbers?
Throughoutthecourseofourresearchanddiscussionswithmarketparticipantsoverthepastseveral years, one thing that that is fascinating is that very few (even those expertly opining on the issues) haveactuallystudiedthenumberscarefully.Thinkaboutit,howmanypeoplethatfollowtheUSfiscal situation have read (cover to cover) through the CBO report on the US national budget? How many Europeans understand how large hostcountry banking systems are in relation to government tax revenues?

GovernmentDebt+MFIAssets/GovernmentRevenue
50.0x MFIAssets 45.0x 40.0x 35.0x 30.0x 25.0x 20.0x 15.0x 10.0x 5.0x GovernmentDebt

Source:ECB; Moody's; USTreasury;USFederalReserve;RBA;SNB;BOJ;JapaneseMinistryofFinance;IrelandDepartmentofFinance. Figuresinclude2012revenue estimates,latestavailableor2012yearendestimatedgovernment debt,andlatestavailableMFIassets. MFIassetsgenerallyincludeassetsofbanks,creditinstitutions,moneymarketfundsandotherfinancialinstiutionswhosebusinsessistotakedepositsand/orclose substitutesfordeposits.Fixedassetsareexcludedwhereavailabledatapermits.

HowmanyJapanesehavequestionedhow(ifever)aquadrillionyenofdebtwilleverberepaidwhenit representsover20Xcentralgovernmentrevenues?(Answer:itcan'tbe) Very few participants are aware of the enormity and severity of the problems the developed world faces. Those that are aware are frantically trying to come up with the next solution to the debt problems.Inouropinion(whichhasn'tchangedsince2008),theonlylongtermsolutionistocontinue toexpandprogramafterprogramuntiltheonlypathleftisafullrestructuring(read:default)ofmost sovereigndebtsofthedevelopednationsoftheworld(alalate1930sandearly1940swhen48%ofthe worldscountriesrestructuredtheirdebts). 10
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JointandSeveralLiabilitywithExtendedFamily?NoWay.
Howmanyofyourextendedfamilymemberswouldyouassumeallpastandfuturedebtswithjointly and severally? As complex as the EMU, European Stability Mechanism (ESM), European Financial Stability Facility (EFSF), LongTerm Refinancing Operation (LTRO), Outright Monetary Transactions (OMT) and the rest are, it all really boils down to one question in the nearterm. Will Germany assumethepastandfuturedebtsoftheprofligatemembersoftheEMUwithoutallofthemcedingtheir fiscalsovereigntyandeffectivelytheirnationalsovereignty?AsmuchasIlovemyextendedfamily,I wouldneveragreetobejointlyandseverallyliablewithanyofthem. Germanycurrentlyhas82%onbalancesheetsovereigndebttoGDPandtheythemselveshavenoteven restructuredtheirbanks,whichareleveredthreetimesmorethanUSbanks.Doesanyonereallythink Germanyisthefortressoffiscalrectitudethattheyaremadeouttobe?TheTarget2(TransEuropean Automated Realtime Gross Settlement Express Transfer System an expression of intraEMU credits anddebts)claimsagainstGermanycoupledwithEFSFandESMcommitmentsexceed900billiontoday. ThenewlyproposedEUBankingUnioncouldseetrillionsmoreinbankdepositguaranteesaddedtothis total.Thesetypesofsystemsaredeliberatelyopaqueasthegeneralpublicfindsitdifficulttodecipher betweencommitmentsandhardmoneycontributions(whichisexactlyhowtheEurocratsdesignedit).

Merkelavellianism
InourdiscussionswithEuropeanparticipantsaboutthedeliberatecomplexityandopacityofthevarious systemsproposedordevisedtosavetheEMU,wehavecomeacrossaterm,Merkelavellianism(which we cannot take credit for), the core ideologies of which are succinctly captured in the following key points: 1. Keepalloptionsopen,butdoitdecisively. 2. Showcalculatedhesitation. 3. Donteversayit,butleteveryoneknowBetteraGermaneurothannoeuroatall. 4. HidebehindthecomplexityItismucheasierthanapprovingthethird,fourthandfifthbailouts ofGreecethroughtheGermanParliamentandGermanpeople.

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MerkelhasexecutedtheGermanplaybookflawlesslytodate.Onequestionwehaveis:Atwhatpointis theGermanpublicaskedtheiropiniononthematter?Thereisaviewamongtheleadershipthatthe German people have begun to resign themselves to a state of relaxed fatalism, although weve also beentoldthatEurobondsareaboutaspopularastheItaliansoccerteaminGermany.Aspublicsupport for further transfers continues to decline, we believe in the end, Germany will balk at unlimited commitmentstotheprofligatenationsoftheSouth. Onechart,producedbyourfriendsattheLindseyGroupandincludedbelow,sovividlyconveyswhythe EMUwasunsustainablefromitsinception.WhethertheGermansrealizeditatthetimeornot,theyare certainlyawarenowoftheextremeimbalanceswithintheEMUwhichonlyseemtobeworseningbythe day.Basedonthesymmetryofthechartbelow,itappearstousthatEuropedoesmostofitstrading withitself,andwithoutdifferentcurrenciesthatconventionallyadjusttokeepthestateoftrademore orlessinbalanceoverlongperiodsoftime,theseimbalanceswillonlypersist.
CumulativeCurrentAccountBalanceFrom2002(EURinBillions)
2,000

1,500

Austria Netherlands

1,000

500

Germany

Spain
500

Greece Portugal
1,000

Italy Ireland France


2002Q1 2002Q3 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1

1,500

2,000

Source:TheLindseyGroup.

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TheEFSF,IMF,andaLessononCircularReferences
EachsubsequentsaveoftheEuropeandebtcrisishasbeendevisedbytheEurocratscomingupwith some new amalgamation of an entity that is more complex than its predecessor that is designed to projectsize,strength,andconfidencetoinvestorsthattheproblemhasbeensolved.Raoul,afriendof minewhoresidesinSpain,putitbest: Letsjustclearthisupagain.TheECBisgoingto buy bonds of bankrupt banks just so the banks canbuymorebondsfrombankruptgovernments. Meanwhile, just to prop this up the ESM will borrow money from bankrupt governments to buy the very bonds of those bankrupt governments. The EFSF, the IMF, the ESM, and the OMT (and whoknowswhatothervehiclestheywilldreamup next) have all been developed to serve as an optical backstop for investors globally. The
EFSFGuarantorsofSpanishBankBailout
Guarantee Commitment (EURinMM) 27,210 20,434 17,956 11,932 5,731 3,485 2,823 2,790 2,515 1,802 1,596 996 472 257 100,000

Country Germany France Italy Spain* Netherlands Belgium Austria Finland Slovakia Slovenia Estonia Luxembourg Cyprus Malta Total

%ofTotal 27.2% 20.4% 18.0% 11.9% 5.7% 3.5% 2.8% 2.8% 2.5% 1.8% 1.6% 1.0% 0.5% 0.3% 100.0%

*Accordi ngtotheEFSFfra meworka greement,i ti s expectedtha tSpa i n wi l l rema i na gua ra ntoroftheEFSF. Source:EFSF.

EurocratsarestickingwiththeMerkelavellianplaybookofhidingbehindthecomplexityofthesevarious schemes.Allonehastodoisreviewtherequiredcontributionstosaidvehiclesfrombankruptnations torealizethatthecircularreferencesarealreadybeginningtoshowinbroaddaylight.Doesanyonestop toconsiderthatthetwolargestcontributorstotheIMFarethetwolargestdebtornationsintheworld? Arethingsbeginningtomakesensenow? You may recall a reference we made in November 2011 to a team of mountain climbers tethered together for safety (Stavros, Seamus, Pablo, Jose, Francois, Luigi and Jurgen), ascending a dangerous peak.Incheckingbackinontheirprogress,Stavrosisnowdeadweight,hangingbytheropeastherest attempttocarryhimup.PabloandJoseappeartohavecontractedfrostbiteandarehangingonbyone hand,andLuigiisdeliriousfromoxygendeprivation.Francoisisbarelysupportinghisownweight,so Jurgen is left attempting to drag himself along with the dead, the sick and the exhausted up the mountain.HeissomewhatcomfortedbythefactthathecouldgrabthesatphoneandcallUncleSam

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andTakehiroforhelp;unfortunately,theyarefacingtheirownchallengesonanotherfaceofthesame mountain.
TopTenContributorstotheIMF,EFSF,andESM
IMF NewArrangementstoBorrow Commitment Country (SDRinMM) UnitedStates 69,074 Japan 65,953 China 31,217 DeutscheBundesbank 25,371 France 18,657 UnitedKingdom 18,657 Italy 13,578 SaudiArabia 11,126 SwissNationalBank 10,905 Netherlands 9,044
Source:IMF;EFSF.

EFSF AsAmended* Commitment Country (EURinMM) Germany 211,046 France 158,488 Italy 139,268 Spain 92,544 Netherlands 44,446 Belgium 27,032 Austria 21,898 Finland 21,639 Slovakia 19,507 Slovenia 13,974

ESM Commitment (EURinMM) 190,022 142,702 125,398 83,328 40,019 24,339 19,719 19,481 17,563 12,579

Country Germany France Italy Spain Netherlands Belgium Greece Austria Portugal Finland

*Amendedgua ranteecontri butions takei ntoa ccountthes teppingoutofGreece,Irel a ndandPortugal .

TheUSandJapan,theworld'stwolargestdebtornations,arethelargestcontributorstotheIMFbyafactoroftwo. Europe'smosttroublednationsaretheverycountriesthatareexpectedtocontributetoandsupporteachother.

TheIMFandtheFederalReserveserveasveryimportantmentalcrutchesfortheinvestingpublic.The FederalReservewascreatedintheyearsleadingupto1913andwasformedasadirectresultofthe Panicof1907intheUnitedStates.Itservesasanenigmaticinstitutionbehindawallthatwasdesigned toplacatedepositorfearsoflosingtheirmoney.Earlyon,forgetdualmandates,itserved(andstilldoes serve)asthementalcrutchofdepositorsalongwiththeFDIC. Born of the United Nations Monetary and Financial Conference in July of 1944 (better known as the Bretton Woods Conference), the IMF at its inception was formed as a global organization to promote fair international trade by putting in place and enforcing mutually agreeable rules preventing unfair monetary exchange practices, and if need be, to provide shortterm capital to alleviate the pressures createdbyseveretradeimbalances.NowhereisitstatedthattheIMFshouldactasafinancialbackstop foroverleveredfiscallyprofligatenations(usingcapitalprovidedbyother,slightlylessfiscallyprofligate membernations).Muchlikeotherfinancialandmonetaryauthoritiesaroundtheworld,thefunctionof theIMFhasbeenbastardizedandmanipulatedawayfromitsoriginalintentintoagloballenderoflast resort.

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Harry Dexter White (left) with John Maynard Keynes (right) at the first meeting of the IMF and World Bank governors in 1946. Two years prior, bothattendedtheUnitedNationsMonetaryandFinancialConference(more commonly known as the Bretton Woods Conference) in July 1944 at the MountWashingtonHotelinBrettonWoods,NH.Attheconference,Keynes representedtheUKandWhiterepresentedtheUS. Fouryearsaftertheconference,inAugust1948,amongaccusationsthathe passedsensitiveUSTreasurydocumentstotheSovietsduringWorldWarII, White testified to defend himself to the House UnAmerican Activities Committee.Hediedofaheartattackthreedayslater.

The idea that overlevered nations can and will support other even more overlevered nations into perpetuity,bywhatevermechanismstheymayattempt,willprovetobeunworkableinshortorder.Ina recentconversationwithawellrespectedcentralbanker,hesaidthemonetaryauthoritiesaretheonly
gameintown.Thissituationisnotsustainable.Anothercentralbanker,RichardFisher,expressediteven betterwhenhestated3:

Thetruth,however,isthatnobodyonthecommittee,noronourstaffsattheBoardof Governors and the 12 Banks, really knows what is holding back the economy. Nobody reallyknowswhatwillworktogettheeconomybackoncourse.Andnobodyinfact,no central bank anywhere on the planethas the experience of successfully navigating a return home from the place in which we now find ourselves. No central banknot, at least,theFederalReservehaseverbeenonthiscruisebefore.

No central bank has done more in recent months to flood the system with liquidity than the ECB one trillion Euros injected through two longterm refinancing operations. Those two operations demonstrated that liquidity is not theissuebecauseafterafewmonthswearebacktowherewewere.Theproblem isoneofsolvency. Wheretherearedebtorswhocannotaffordtorepay,therearecreditorswho willnotberepaid.Untillossesarerecognised,andreflectedinbalancesheets,the currentproblemswilldragon.Anhonestrecognitionofthoselosseswouldrequire amajorrecapitalisationoftheEuropeanbankingsystem.(emphasisadded) SirMervynKing(June14,2012) GovernoroftheBankofEngland AttheLordMayorsBanquetforBankersandMerchantsoftheCityofLondon

http://www.dallasfed.org/news/speeches/fisher/2012/fs120919.cfm

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JapanCrossingtheRubicon
Japan now sits on the doorstep to its own demise. We believe they have reached zerohour, where thingswillbegintounwindaltogether.Forthepasttwentyyears,Japansexportsandindustrialsector havemovedintandemwiththepanAsianindustrialcycle(evenastherestoftheirdomesticeconomy hasbeeninadeflationaryspiral).Infact,JapaneseoutputrecoveredwiththerestofAsiaduringthe global economic bounce in 2009. On the other hand, even before the Fukushima tragedy, Japans outputhaddecoupledfromthatoftherestofAsia.Today,Japanfacessecularproblemsthatarebad andonlyworsening.Wehadpreviouslyforecastedfullcurrentaccountnegativity(onarolling12month basis)takingplacebetweenQ3andQ4of2013(seethechartbelow).

JapaneseCurrentAccount(Rolling12monthAverage)(Billions)
2,500 2,000 1,500 100 1,000 500 80 140

120

Sep04

Sep05

Sep06

Sep07

Sep08

Sep09

Sep10

Sep11

Sep12

Sep13

Sep14

May13

May12

May11

May10

May06

May05

May04

May07

May08

May09

May14

(500) (1,000) (1,500) (2,000)

May15

Sep15

Jan04

Jan05

Jan06

Jan07

Jan08

Jan09

Jan10

Jan11

Jan12

Jan13

Jan14

Jan15

60

40

20

0 BearCase Existing BaseCase BullCase Yen

Source:Bloomberg; HaymanCapitalestimates.

We now expect the monthly October current account balance to be negative and believe it could be negativefortheentiretyofQ42012. Severe stresses are beginning to show in this once sleeping giant of a bond market. Their balance of trade is the worst it has been in the postWorld War II era, and the data released todate only encompassesabriefperiodinSeptemberwhentheunofficialeconomicboycottofJapaneseexportsby theChinesecompaniesandstateownedenterpriseswasjustbeginning. 16
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JapaneseTrailing12MonthTradeBalanceSince1960(Billions)
15,000

10,000

5,000

5,000

10,000
Sep64 Sep92 Sep71 Sep78 Sep85 Sep06 Sep99 Jul98 Jul05 Jul63 Jul70 Jul77 Jul84 Jul91 Mar03 Mar61 Mar68 Mar75 Mar82 Mar89 Mar96 May04 Mar10 Nov00 Jan02 Nov07 Jan09 May62 May69 May76 May83 May90 May97 May11 Jan60 Nov65 Jan67 Nov72 Jan74 Nov79 Jan81 Nov86 Jan88 Nov93 Jan95 Jul12

Source:Bloomberg.

During the past twenty years, the balance of trade has been a significant contributor to the positive currentaccountsurplustothetuneofatleast12%ofGDP.Thetradebalanceisnowontracktobea dragonthecurrentaccountofapproximately2%ofGDPbeforetheimpactoftheSenkakucrisis.Ifthe Japaneseautomanufacturersarearelevantbarometer,thedeclineinexportstoChinacoulddragthe tradebalancedownbyanother12%ofGDP.

Source:TheWallStreetJournal,10/09/2012.

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China has been the only bright spot in Japans economic future for the last decade. Since 2002, JapaneseexportvolumestoChinaareup+76%whiletheyaredown30%intheEUand27%intheUS. Ifrelationsareasstrainedastheyappear,thiswillbeanunmitigateddisasterforJapan.Forthosewho believeAbewillbeabletonegotiateapathbacktoChinaJapannormalcy,wethinkthegravityofthe situationisbeingunderestimated.Abeisknownasahardliner,whileXiJinpingsfatherwasanactive communistrevolutionaryandpoliticalleaderduringtheSecondSinoJapaneseWar.Thereisabsolutely nolovelostbetweenthesetwo. The current freefall in the balance of trade, while primarily secular, is occurring at a time when the globaleconomyisconcurrentlyslowingdown.WhetheritisJapansrelianceonimportedLNG,coaland crudeoilorwhethertheChineseareunofficiallyboycottingJapanesegoods,Japannowfacesasecular probleminexportssimultaneouswithasecularpopulationdecline.

WelltakeitfromhereShirakawasan
SincehewasappointedasMinisterforNationalStrategyandtheEconomyatthebeginningofOctober Seiji Maehara has become the first Japanese Government minister to attend Bank of Japan (BOJ) policymeetingssinceAprilof2003.MaeharaisonrecordsupportingBOJpurchasesofforeignassetsas atoolofmonetarypolicyandhaspubliclyurgedtheBOJtodoasmuchaspossibletoenddeflation. Weseethepresenceofgovernmentministersatthepolicymeetingsalongwithverbalinstructionsas part of the reason the BOJ chose to ease twice in rapid succession in September and October. Even more interesting to us was the unprecedented joint statement issued by the BOJ and government, cosignedbyBOJGovernorShirakawaandMinisterMaeharaandhiscolleague,FinanceMinisterJojima. ThestatementlaidoutindirecttermsthecommitmentoftheBOJtouseextraordinarymeasurestoend deflation. This comingling of authority comes at the direct expense of the BOJs independence independencethatwillbefurtherunderminedwhentheBOJGovernorandtwodeputygovernorsare replacedinMarchandAprilof2013. In addition to the actions of the current government, there is ongoing discussion amongst opposition partiesoftheneedtorewritethelegislationthatgovernstheBOJtoincludeexplicitinflationtargetsof 2%to3%aswellasamechanismfortheDiettohaultheBOJGovernorinfrontofacommitteeonceper

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yeartoexplainhissuccessorlackthereofwithregardtohittingtheinflationtarget,andfirehimifhe fails. We are witnessing nothing less than the steady cooption of monetary policy by the parliament and fiscalauthorityofJapan,andconsequentlytherevocationoftheBOJsindependence.Whatitpresages ismoreandmoreaggressiveactioninordertorealizethebroadlypopulargoalsofaweakeryenand higherinflation.Japanhasnowreachedamultidecadeinflectionpoint.Theeverstrengtheningyenwill reverseandbegintoweaken.CapitalflightoutoftheyenwillintensifyandthenJapaneseinterestrates willbeginto rise.Evidenceofthese projectionshasbeguntosurfacein thelastfewmonthsofM&A activity. Softbank, controlled by one of Japans wealthiest individuals, has just announced that it will spend$20billiontopurchaseastrugglingUSwirelesscarrier.InJuly,Dentsuannounceditsacquisition ofAegisMedia,aBritishadvertisingcompany,for$5billioninoneofthelargestadvertisingdealsever. Thesmartmoneyisbeginningtoleaveatjusttherighttime.
JapansSoftbankSnapsUpSprintin$20billionDeal1
JapanesemobileoperatorSoftbankCorpsaiditwillbuyabout70 percentofSprintNextelCorpfor$20.1 billion,givingSoftbankthe AmericantoeholdithaslongdesiredandSprintthecapitaltoexpanditsnetworkandpotentiallybuypeers. ThedealforthethirdlargestU.S.wirelesscarrierrepresentsthemostaJapanesefirmhasspentonanoverseasacquisition. AnnouncedbySoftbank'sbillionairefounderandchiefMasayoshiSonandSprintChiefExecutiveDanHesse atapackednews conferenceinTokyoonMonday,thetransactiongivesSoftbankentryintoaU.S.marketthatisstillgrowing,whileJapan'smarketis stagnating. Butthe55yearold[Masayoshi]Son,ararerisktakerinJapan'softencautiousbusinesscircles,isbettingU.S.growthcanofferrelief fromcutthroatcompetitioninJapan'ssaturatedmobilemarket.

Dentsu ofJapantoBuyAegisofBritainforAbout$5Billion2

Dentsu,aJapaneseadvertisingpowerhousethathasstruggledtoexpandinternationally,madeabigleapintoWesternmarketson
Thursday,sayingithadagreedtobuyAegis,anagencycompanybasedinLondon. Theplannedacquisition,valuedat3.167 billion($4.92billion),isoneofthelargesteverintheadvertisingbusiness,rivalingthe purchaseofYoung&RubicambytheWPP12yearsagoandadealfortheparentcompanyofLeoBurnettbyPublicis Groupe in2002. Internationalexpansioniscritical,becausetheJapaneseadmarkethasbeenshrinkinginrecentyears.Dentsu thisyearacquireda boutiqueagencyinNewYork,MLRogers,andBos,withofficesinTorontoandMontreal.

1.Reuters,10.15.12 JapansSoftbankSnapsUpSprintin$20billionDeal. 2.NewYork TimesDealbook,07.12.12 Dentsu ofJapantoBuyAegisofBritainforAbout$5Billion.

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Atthispoint,adeclineintheyenwillnothelprestorecompetitivenessoftheJapanesesteelcompanies, electronics companies or the shipyards. This will be the case regardless of how long the Senkaku standofflasts.NowisthetimetobeshorttheyenastheproblemsJapanfacesarenowintractable.For themostpart,wehavestayedawayfromdeltaoneyenpositions(untiljustrecently).Japanhasnow reachedthecriticalturningpointthathasbeendiscussedfordecades.

DispellingtheMythsofJapaneseSelfFunding
Japan has the worst onbalancesheet financial situation of any country in the world today. This is no secret.ManytheoriesastowhyJapanmightbeabletohangonfrequentlypropagatethroughoutthe financialmarkets.Afterspendingyearscloselystudyingthevarioustheories,wewilldiscussthemost frequentobjectionsinthissection. Myth#1:JapansCurrentAccountSurplusAllowsJapantoSelfFinanceitsDeficit Firstandforemost,wetendtohearthatsince93.8%ofJapansdebtisheldinternally,andthat95%of that93.8%isheldinstitutionallythatJapanismuchbetteroffthanthosecountriesthatfinancemoreor mostoftheirdebtsexternally.ThethesisfurtherexpandsthataslongasJapanhasacurrentaccount surplus,theywillbeabletocontinuetoselffinancetheirfiscaldeficit. Wetendtofindbroadstatementslikethistoexhibitacolossalnaivet.Howcanonemakeastatement like this without taking into account the amplitude of the fiscal deficit and the current account? The plainandsimplefactisthatthisstatementthathasbecomeaxiomaticthroughrepetitiveuseispatently false as Japan stands today. We expect Japans current account surplus to amount to less than 1% of GDP this year and that it will decline into deficit next year, while the fiscal deficit is running at a sustained10%ofGDP.Wedidntneedtogetoutourcalculatorstodeterminethatthemathdoesnt work. The bottom line is that Japan has reached a secular turning point in its trade balance and current account,followingdecadesofsurpluses.ThecurrentdisputewithChinahasonlyservedtoaccelerate theprocess.Investorscannolongermaketheblanketassumptionthatacurrentaccountsurpluswill provideafundingsourceforfinancingfiscaldeficitsintoperpetuity. 20
HaymanCapitalManagement,L.P.2012

Myth#2:TheBOJisnotMonetizingDebt

ThisfiscalyeartheBOJwillbuyatleast56%ofgovernmentbondsissued(approximately29trillionof 44.5 trillion in total new issuance) in order to finance the current fiscal deficit (not to mention its purchases of corporate bonds, stocks, REITs, ETFs and loans). In fiscal 2011, Japan ran a 44.3 trillion deficit(excluding11.6trillionofbondsissuedforthereconstructioneffort)andtheBOJpurchased9.9 trillionofgovernmentsecurities.UndertheAssetPurchaseProgramwhichbeganinOctober2010,the BOJ has amassed over 60 trillion in government bonds, corporate bonds, stocks and loans. In SeptembertheBOJincreasedthetotaltargetedsizeofthisprogramto80trillionfrom70trillion,and thenjustlastmonththeyincreaseditagainto91trillion.Thepunchlinehereisthattheyarealready unabletoselffundasitstandstoday.Theselffundingaxiomappearstobeamirage.

JapaneseAggregateDebtMonetization(Billions)
65,000 60,000 55,000 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0

Source:BankofJapan. Amountsshownareaggregateamountspurchasedunder theBOJAssetPurchaseProgram.

Recently,aHaymanCapitalrepresentativehaddinnerwithakeymemberoftheBankofJapanandwas affordedtheopportunitytoquestionhimabouttheexpansionoftheBOJsbalancesheettopurchase Japanese Government Bonds (JGB) (monetizing debt). The BOJ representative had just finished a statement where he denounced monetization of debts when we asked him how he defines monetization (we define it as central bank balance sheet expansion in order to purchase sovereign debt).Afteralongpause,hesaidItisonlymonetizationwhenthemarkettellsusitismonetization. Whenyieldsgoup,notdown,whenwebuybonds,thenthemarketsayswearemonetizing.Whenwe pressed further, he acknowledged it was out of the hands of the BOJ and entirely up to market psychology.Wow,wewonderhowthatmakesJGBinvestorsfeel. 21
HaymanCapitalManagement,L.P.2012

Myth#3:RetailInvestorsWillAlwaysSupporttheJGBMarket Interestinglyenough,retailinvestorscontinuetoexittheJGBmarketplacewhichisleadingtheMinistry ofFinance(MOF)toengageindesperateadvertisingcampaignstoencourageretailinvestorstobuy JGBs.Asthepopulationretires,itislogicalthatparticipantswilldissave(orharvest)moresavingsthan theywillincrementallyaccumulate.

Hereistheaggressivemarketingscheduleandsomephotosofthecelebritieschosentohelppromote JGBinvestment(pulledrightfromtheMOFswebsite):

The2012/2013JGBMarketingExtravaganza Summer Autumn Winter Spring Hakuho (69th Yokozuma;thehighestrankinsumowrestling) Homare Sawa (womensfootballplayer) AKB48 (idolgroup) KiyoshiHakahata (professionalbaseball manager)

ChampionSumoWrestler

PopBandAKB48

Source:http://blogs.wsj.com/japanrealtime/2012/05/29/japangetsakb48bondgirlsonthecheap/ .JapanMinistryofFinance.

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AReviewoftheAgeOldLessonofPonzi
JapanHoldsAdultDiaperFashionShow What did Bernie Madoffs titanic Ponzi scheme teach the world? A key takeawayshouldhavebeenthatyoucan makeoutlandishpromisesforthefuture as long as you maintain one key ingredient: more victims entering the schemethanexiting.Japanisfacingthat veryrealsituationaswesittoday.After nearly a century of relatively steady
JapanesemodelthelateststylesofadultdiapersduringaTokyoshow heldin2008.Beforetheshow,playersactedoutskitsdemonstrating howtohelplovedonesusetheproducts. Lastyear,in2011,salesofadultdiapersexceededthoseforbabiesfor thefirsttime.Overthelastdecade,saleshavemorethandoubledand currently exceed $500 million annually. Japanese companies are clamoringtogrababiggerpieceofthegrowingmarketasthenumber of Japanese citizens over 65 hit a record 23.3% of the population in October2011.
Source: Bloomberg, 05/10/2012 Elderly at Record as Japan Stores Chase $1.4 Trillion. USAToday,09/2/2008JapanHoldsDiaperFashionShowforAdults.

population growth, Japans population has reached a plateau, having been essentiallyflatsincetheearlypartofthe lastdecade(withinamargin+/25bps), and every indication is that the population curve has reached its crest and is poised for a longterm secular decline.

JapanesePopulationEnteringSecularDecline
130,000 125,000 120,000 115,000 110,000 105,000 100,000 95,000 90,000 85,000 80,000
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 2080 2085 2090 2095 2100
Source:UnitedNations Department ofEconomicandSocialAffairs.

Actual Forecast

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JapaneseDeathRateNowExceedsBirthRate (Figuresper1,000)
30 Livebirthrate 25 20 15 10 5 0 Deathrate

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Source:StatisticsBureau ofJapan.

2010

Mr.Madoffandhispredecessor,Mr.PonzihavetaughtusthattheJapanesegovernment,withanaging anddecliningpopulation(whichequals(i)lesstaxpayerseachyear;(ii)morepension/socialsecurity recipientseachyear;and(iii)lessmarketparticipantsavailabledomesticallytofundthegrowingdeficits resultingfromitems(i)and(ii)),faceasystemicbreakdownunlessmoreexternalinvestorsareenticed to purchase JGBs (which actually may happen at higher interest rates, which the government cannot afford).


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JapansPerfectRecipeforDisaster
Letsreviewthesituation: 1) Japanpersistswithoneofthelargeststructuralfiscaldeficitsintheworld. 2) Theagingpopulationhasstrangledtaxrevenuesandinflatesexpenditureonagrowingbasis. 3) WeareoftheopinionthatthefragilityoftheAsianeconomyasawhole,andmorespecifically thatofJapan,willsubvertJapansabilitytoimplementtheirnewlypassedconsumptiontaxrate hike.Simplyput,webelieveitcannotandwillnothappen. 4) TheflowofnewdomesticbuyersisdryingupsofastthattheBOJisontracktobuyamajorityof newissuancethisyear. 5) DespitethemassiveinterventionbytheBOJastrongcurrencypersistsandthetradebalanceis insuchstructuraldeclinethattheentirecurrentaccountthreatenstoturnnegativenextyear. 6) Theincumbentgovernmentisinsuchdisarrayithasjustappointedthe5thfinanceministerof their3yearsinpower(the10thJapanhasseensince2006)andwillbeforcedintoanelection soon. 7) DiplomaticrelationswithJapansthreelargestneighbors:China,SouthKoreaandTaiwanhave beenthrownintochaosoverdisputedterritoriesintheSouthChinaSea. 8) Japanese nominal GDP will contract in 2012 for the 4th year out of the last 5, during what is clearlyasynchronizedglobalgrowthslowdown. AndyetJapaneseinterestrateriskispricedclosetothealltimelows?Thisisanexampleofperhapsthe greatest suppression of volatility in modern financial markets. Like all bubbles, the suppression of volatility and the suspension of disbelief is strongest right before the reversal of fortune. The quantitative data and trends are already well established. All that is missing is the qualitative shift in marketappreciationoftherisk.WeholdtheviewthattheBlackScholesoptionpricingmodelandthe Black swaption pricing model each dramatically misprice risk at secular turning points. Two key ingredients of these formulas are the risk free rate and volatility the latter of which is based on historicaldatawhichquicklybecomesirrelevantwhenabondcrisismanifestsitself. WebelievethatJapanisteeteringontheprecipiceoffinancialcollapse,andanynumberofdatapoints or events in the coming weeks and months could be the proverbial tipping point. It could be as 25
HaymanCapitalManagement,L.P.2012

significant as a negative structural current account, a revocation of BOJ policy independence, or even political and economic conflict with regional neighbors or perhaps something as innocuous as ratings actions or Basel III regulations that force financial institutions to reduce their hugely concentrated exposuretoJGBs. Whatwedoknowisthatwhenitdoesbreakloose,20yearsofsuppressedspringloadedinterestrate volatility on the back of the largest peacetime accumulation of sovereign debt will afford no time to readjustportfoliostogetoutoftheway.

Pleasedonotworry
Its all good. Direct from the Ministry of Finance website (translated using Google Translate; please excusetheJapanesetoEnglishtranslation):

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As an attachment to this letter, we have provided an update on the latest developments in the Non Agency Residential MortgageBacked Securities (RMBS) market (Appendix A), which remains a key areaoffocusforourfirm.Giventhemacrobackdrop,wecontinuetoinvestinNonAgency(Subprime andAltA)RMBS,distressedliquidations,eventdrivencredit,selectequities,andofcoursewecontinue tomaintainsignificantpositionsinbothJapaneseratesandcurrency.Wetendtoexpectabenigngrind ofaninvestmentenvironmentuntilsignificantvolatilityrearsitsuglyheadonceagain.Wehavebeen fortunatetohavehadagoodyearthusfarin2012despiteourdogmaticviewsonJapanandtheglobal sovereignsituation. We will continue to work diligently and tirelessly to navigate the volatility and instability in the marketplace, with our key goals, first and foremost, of preserving your capital, and second, of generatingaboveaverageriskadjustedreturns. BestRegards, J.KyleBass ManagingPartner
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Suchanoffermayonlybemadetoeligibleinvestorsbymeansofdeliveryofaconfidentialprivateplacementmemorandumor othersimilarmaterialsthatcontainadescriptionofmaterialtermsrelatingtosuchinvestment.Theinformationandopinions expressed herein are provided for informational purposes only. An investment in the Hayman Funds is speculative due to a varietyofrisksandconsiderationsasdetailedintheconfidentialprivateplacementmemorandumoftheparticularfundandthis summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summarymayconstituteaviolationoffederalorstatesecuritieslaws.

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AppendixA:AnUpdateonRMBS
OnaMorePositiveNote: HousingandSubprime&AltA(NonAgency)RMBS
ItisnosecretthatU.S.housinghasshownsignsofstrengththroughout2012,withsomeportionsofthe market bouncing significantly off of the bottom as distressed inventories have begun to clear. Improvement is even more pronounced for lowerpriced properties where homes below 75% of the median price have increased almost 6% yearoveryear. A combination of higher rent prices, better credit availability, improving inventory levels and low mortgage rates have all helped to stabilize the market.ThemostrecentindefiniteQEprogramunleashedbytheFederalReserveonSeptember13th has already had a profound impact on Agency MBS spreads (see chart below). This is making the affordabilityofhomeownershipversusrentingevenmoreattractiveandwillbringadditionalfirsttime buyers into the market. While twenty and thirtysomethings across the country have surely enjoyed livingwiththeirparentsforthelasttwoorthreeyears,theopportunitytobuyahomeat2004prices witha3.0%mortgagerateshouldsoundlikeamuchmorecompellingopportunitytothevastmajority. It is worth noting that although the average subprime mortgage rate is just under 6%, the level of refinancingactivityhasbeennegligibleinthissectorandisexpectedtoremainlowgoingforward.The possibility of refinancing activity increasing at some point in the future provides an effective free call optiontotheNonAgencyRMBSinvestor.

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SpreadBetweenFNMA30yrCurrentCouponand10yrTreasuryRates

NonAgencycollateraltrendscontinuetoimproveasthepoorestqualityloansdefaultanddropoutof thesecuritizationpools.Forexample,theannualizedrateofAltAborrowersthatarefallingmorethan twopaymentsbehindontheirmortgageforthefirsttimehasdecreasedfrom12.5%in2010and9.6%in August 2011 to 7.8% in August 2012. Additionally, redefault rates after a borrower receives a modification continue to fall markedly which is a direct result of better loan modification programs (includingprincipalforgiveness),asevidencedbythechartbelow.

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Source:CoreLogic.

NonAgency RMBS is certainly a direct beneficiary of stabilizing home prices, lower modification re defaultratesandotherfundamentaltrends,buttherearesometechnicaltailwindsaswell.Thetotal existingsupplyofNonAgencyRMBStickedbelow$1trillionthisyear,andwebelieveitwilldeclineby another 20% by the end of 2013 leaving approximately $800 billion outstanding. Given the fact that thereisverylittlenonagencyissuancetoday(itisessentiallynonexistent)andfutureissuanceislikelyto beimmaterial,thesupply/demandimbalancewillberightedatsomepointinthefuture.Additionally, thebroaderimplicationofQEP(QEintoperpetuity)isthatAgencyMBSinvestorswillseekyieldinother assetclassesincludingNonAgencyRMBS.Thisimpliesafutureincreaseindemandatthesametime supplyisshrinking,andweexpectthatspreadswillcontinuetonarrow(i.e.bondpriceswillcontinueto rise)astheyoffersuperiorriskadjustedreturnscomparedtootherassetclasses.Overall,justasthere wasaperfectstormoflaxunderwriting,disintermediationofriskandlackofregulatoryoversightthat led to nonagency securities being overvalued before the financial crisis, the stars are aligned for a continuedrecoveryofthisassetclasstoday.

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Source:CoreLogic.

Aswehavecommunicatedtoyoupreviously,NonAgencyRMBScomprisesasubstantialportionofour portfolio.Webelievethatinaworldfraughtwithuncertaintyandinstability,andwithmarketsthatare subjecttothewhimsofthedailyheadlineroulettedictatedbypolicymakerstheworldover,theNon Agency RMBS market is the place for positivecarry asset allocation. We monitor this market closely, and should the dynamics change we will adjust our allocations accordingly, but for now we believe simplythatNonAgencyRMBSofferthebestriskadjustedreturnsthemarkethastooffer.


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