A D VI S 0 R S. L. P.

October 2, 2009

"You cannot spend your way out of recession or borrow your way out of debt. II - Daniel Hannan, Member of the European Parliament

Dear Investors:

There have been many significant global developments since our March letter. Governments around the world are running fiscal deficits at levels never before seen, while central banks have loosened monetary policy and are printing money at a record pace. While the US appears to have avoided a systemic implosion, the question becomes at what cost - now and in the future? In this letter, we address:

• The "good" news and bad news of the current economic situation;

• Areas of opportunity;

• The implications of global and US monetary policy;

• The current state of the US housing market and expectations for the future;

• The International Monetary Fund's policy prescription for dealing with troubled economies;

• The boom and potential bust in China;

• The looming debt crisis in Japan; and

• How the fund is positioned to capitalize on these issues.

The purpose of this letter is not simply to communicate how the fund is positioned, but also - and possibly more importantly - to stimulate thought and discussion about the "big picture" implications of these issues. We believe that we are in the midst of a once-in-a-lifetime (literally) economic shift that has affected or will affect everyone. While there are certainly hardships and challenges ahead, we also see opportunities.

2101 CEDAR SPRINGS ROAD, SUITE 1400 DALLAS. IX 75201 TEl. 21'4-347-8050 FAX 214-347-8051

The "Good" News?

The "good" news is the recession is officially over. Real GDP dropped only 4% peak-to-trough, S&P 500 revenues dropped only 18%, and home prices dropped only 31.3% nationwide. Broad-based unemployment (including the underemployed) reached 17.0%, which translates into 17.4 million Americans out of work and another 9.2 million working part-time jobs that are insufficient to pay their bills.' After losing an average of 578,346 jobs every week since October 2008,2 the headline unemployment figure improved in July from 9.5% to 9.4%. Never mind that in August the Bureau of Labor Statistics ("BLS") revised their prior estimates, and a portion of the "improvement" in July was achieved by adjusting the total size of the labor force (think increasing the denominator to reduce the percentage) and unemployment continued its upward trajectory to 9.7% in August and 9.8% in September. We are left wondering how broad based unemployment went from its most recent trough of 7.9% in December 2006 to 17.0% currently, while total retail sales declined only 3.6% over the same time period."

Source: Mike Keefe, The Denver Post. Reprinted with permission.

Bernanke and crew have done a masterful job of pulling out all of the stops (and then some) to save the US and world banking system from collapse. Having gone from potential collapse to valuations well above the 10-year averages, the S&P 500 now trades at 2x book value and 20x EPS and credit spreads relative to Treasuries are back to pre-Lehman levels.

Where We are Bullish

There are great businesses which have too much leverage, which are being or will be recapitalized through consensual restructurings or Chapter 11 bankruptcies. These "capital transformation investments" usually involve buying senior debt and working with the company's stakeholders and management to craft a plausible

1 According to the latest data available from the BLS, 15.142 million Americans are included in the labor force and are classified as "unemployed." Another 2.219 million would like to work, but have not searched for a job in the last four weeks. An additional 9.179 million are classified as "part-time for economic reasons," meaning currently employed parttime as an alternative to not working at all.

2 Average Initial Jobless Claims since the first week of October, as published by the Department of Labor. 3 Source: Bloomberg.


© 2009 Hayman Advisors L.P.

capital structure to return the entity to health and growth. As the capital markets have recovered, money is flowing and many private equity players are prepared to invest in their existing portfolio companies after or in conjunction with a debt restructuring. It is in these types of situations that we see great opportunity. Our investments are focused on asset-heavy businesses where we can buy into the right portion of the capital structure in advance of the restructuring. On the back end, we will likely end up owning some amount of senior debt with attractive current pay characteristics and in certain circumstances end up holding equity in the company for little, if any, real cost. This is one area where we are acutely focused and we believe presents the most asymmetric returns for being invested on the long side.

If the story could just finish here with such a happy ending - unfortunately, here is where the really bad news begins.

Never Before and Hopefully Never Again

Western democracies, communistic capitalists, and Japanese deflationists are concurrently engaging in what 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 easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero).

There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation:

History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.

According to the current Office of Management and Budget ("0MB") projections, US federal expenditures are projected to be $3.653 trillion in FY 2009 and $3.766 trillion in FY 2010 with unified deficits of $1.580 trillion and $1.502 trillion, respectively. These projections imply that the US will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed. One has to ask whether the US reached the critical tipping point? Beyond the quantitative measurements associated with government deficits and money creation, there exists a qualitative aspect to such a scenario that may be far more important. The qualitative perceptions of fiscal and monetary policies are impossible to control once confidence is lost. In fact, recent price action in metals, the dollar and commodities suggests that the market is already anticipating the future.

M1 money supply is the most liquid measure of money outside of tangible currency. The chart below illustrates M1 growth of the world's major currencies since 2007.


© 2009 Hayman Advisors L.P.

Ml Growth of Major World Currencies (December 2006 = 100%)

160% .-------------------------------------------------------------------~



U) r-. r-. r-. r-. r-, r-. r-. r-. r-. r-. r-. r-. co co co co co co co co co co co co m m m m m m m m
9 9 a ~ 9 a 9 ~ 9 a ~ 9 9 9 a ~ 9 a 9 ~ 9 a ~ 9 9 9 a ~ 9 a 9 ~ 9
u <: 1:. a. >- <: t>O C. > u <: 1:. a. >- <: t>O C. > u <: 1:. a. >- <: t>O
OJ .!!l OJ ra ra :J ~ :J OJ U 0 OJ .!!l OJ ra ra :J ~ :J OJ U 0 OJ .!!l OJ ra ra :J ~ :J
Cl u.. ::?! <C ::?! ~ <C <Il a z Cl u.. ::?! <C ::?! ~ <C <Il a z Cl u.. ::?! <C ::?! ~ <C
Source: Bloomberg. The greatest concern is that, with the exception of Japan, the major global currencies have experienced money supply growth between 15-55% in less than three years, and Hayman believes that the primary reason Japan's money supply has not increased is that for the last decade Yen have fled the Japanese economy in search of higher-yielding assets (widely known as the "Yen carry trade").

To put this into perspective, imagine a game of Monopoly where the participants are playing with one bank of 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 God-like fashion (with a little ecclesiastical white-out), the central banker decides to add two more banks of money to the game that are distributed to the participants as the central banker deems fit. Under this scenario, did the real value of anything change? Does the bartering for property increase or decrease prices? Did each unit of money become worth more or less? How does the central banker decide to allocate the extra money? Is it a fair process? Depending on how you were positioned prior to the additional "banks" of money being injected into the game and how you played the rest of the game, you either feel fortunate (if you were about to go broke) or cheated (if you had played the game prudently). As a player in today's real-life Monopoly game, how are you positioned?

Below is a more detailed assessment of what we are seeing domestically and internationally, and how we have positioned your capital so that you may emerge from the "game" a winner.


© 2009 Hayman Advisors L.P.

Why Hasn't the Money Supply in the US Increased More Significantly?

The Federal Reserve has engaged in roughly $1.2 trillion worth of quantitative easing (a nice way of saying "printing money") this year, including Federal Reserve purchases of both Treasury and Agency securitles:" however, seasonally adjusted M1 and M2 have only increased $73.2 billion and $109.9 billion, respectively.' That being the case, perhaps printing money is not such a terrible thing - it has driven rates down, made mortgages more affordable and has not blown up the dollar money supply. From a quantitative perspective, we are concerned about the potential money supply growth that could occur quite rapidly as a result of the money printing that has already occurred.

To understand the monetary impacts of quantitative easing, one must understand the relationship between the monetary base and the money supply in a fractional reserve banking system. The monetary base is not money supply; rather it is the foundation on which the money supply is built. In short, the monetary base consists of two key components: tangible currency and banking reserves. Banking reserves represent the money that banks are required to hold against deposits. Depending on the specific nature of the deposits, the reserve requirement is typically only 10%. This means that for every dollar a bank receives in deposit, it can loan out $0.90. This $0.90 then gets deposited elsewhere, and $0.81 can be re-Ient. The $0.81 then gets re-deposited into the system and another $0.73 is lent out, and so on. This is how the money supply accumulates to a multiple of the monetary base.

Under normal circumstances, banks typically hold only the minimum required reserves because any excess can be lent out at a profit. Since the collapse of Lehman, however, banks have been accumulating excess reserves. As the Federal Reserve has engaged in quantitative easing, this freshly printed money does not find its way into the money supply but instead stacks up at the banks. Excess reserves in the US banking system currently stand at $855 billion, up from $2 billion just twelve months ago. Even though they are not required by the Federal Reserve to hold these excess reserves, banks are not lending because they are either capital constrained or concerned about additional losses deteriorating their existing capital. Additionally, the Federal Reserve has agreed to pay banks a small rate on their excess reserves of 0.25%.

Since September 2008, the banking system has built up excess reserves to levels unprecedented in the postWorld War II history of the US. The chart below shows the composition of the monetary base from 1959 to the present.

4 Agency securities refer to those issued by Ginnie Mae, Fannie Mae, Freddie Mac or the Federal Home Loan Banks. 5 Source: United States Federal Reserve; Bloomberg.


© 2009 Hayman Advisors L.P.

US Monetary Base (January 1959 - August 2009) (Dollars in Billions)


$1,600 $1,400 $1,200 $1,000

$800 $600 $400 $200


• Other / Adjustments

• Vault Cash (Not used for Reserves) -----------------------+1

• Excess Reserves

• Required Reserves

• Currency

en 0 N C'Il LI'I r-. co 0 .-< C'Il LI'I Ul co en .-< C'Il '<t co r-. en .-< N '<t LI'I r-. en 0 N C'Il LI'I r-. co LI'I Ul Ul Ul Ul Ul Ul r-. r-. r-. r-. r-. r-. r-. co co co co co co en en en en en en 0 0 0 0 0 0 en en en en en en en en en en en en en en en en en en en en en en en en en en 0 0 0 0 0 0 .................................................................................................................................. NNNNNN .................................................................................................................................................................................................................................................................................................................... ..... 00 m 0 Lon ..... 00 m 0 Lon ..... co m 0 Lon ..... co m 0 Lon ..... 00 m 0 Lon ..... 00 m 0 Lon ..... co 000'-<0000'-<0000'-<0000'-<0000'-<0000'-<000

Source: United States Federal Reserve; Bloomberg.

The threat to the money supply occurs if banks decide they are comfortable with deploying those excess reserves or lending them out. If this were to happen, it would not increase the money supply by $855 billion; rather it would increase the money supply by some multiple of that. Historically this multiple is conservatively around 7x, which implies a potential increase in the money supply of approximately $6 trillion. The chart below shows the banking reserve multiplier dating back to 1959. The reserve multiplier shown represents the ratio of checkable deposits to banking reserves. Notice the multiplier has collapsed from its (recent) historical norm of around 7x down to under 1x due to the banks holding excess reserves rather than lending and relending them into the economy as they typically do.

Banking Reserve Multiplier, shown as Checkable Deposits/Banking Reserves (January 1959 - August 2009)






-- Required Reserve Multiplier

----- lO-yr MA

-- Total Reserve Multiplier

----- 10-yr MA





en 0 N '<t Ul co 0 .-i C'Il LI'I r-. en .-i N '<t Ul co 0 N C'Il LI'I r-. en .-i C'Il '<t Ul co
LI'I Ul Ul Ul Ul Ul r-. r-. r-. r-. r-. r-. co co co co co en en en en en en 0 0 0 0 0
en en en en en en en en en en en en en en en en en en en en en en en 0 0 0 0 0
.-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i .-i N N N N N
........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........
.-i .-i en r-. LI'I C'Il .-i .-i en r-. LI'I C'Il .-i .-i en r-. LI'I C'Il .-i .-i en r-. LI'I C'Il .-i .-i en r-.
0 .-i 0 0 0 0 0 .-i 0 0 0 0 0 .-i 0 0 0 0 0 .-i 0 0 0 0 0 .-i 0 0
Source: United States Federal Reserve; Bloomberg.
© 2009 Hayman Advisors L.P. The Federal Reserve has said repeatedly that it can withdraw this excess money from the system without a problem. Consider for a moment what that would entail - the Federal Reserve selling its holdings of Treasuries and Agency securities into the market. These sales would put significant upward pressure on rates, which could be very damaging to what will likely be a fragile recovery. Since the onset of the Agency purchase program, the Federal Reserve has purchased more than 100% of the net issuance of both Agency debt and Agency MBS. Imagine what will happen when the only buyer in the market place becomes a seller, especially if China is no longer interested in buying any Agency securities. Interestingly, the chart below, which shows foreign official institutions' purchases and sales of Treasury and Agency securities, illustrates that as foreign institutions are selling Agency securities to the Federal Reserve, they are using the proceeds to cover a substantial portion of their Treasury purchases. In other words, the Federal Reserve Agency purchase program is, indirectly, funding a Treasury purchase program.

Foreign Official Institutions' 2009 Vear-to-Date Purchase I (Sale) of Treasury and Agency Securities (Dollars in Billions)


• Year-to-Date Agency Purchases/ (Sales)

• Year-to-Date Treasury Purchases/ (Sales)







$(40,000) -'------------------------------

Source: Federal Reserve.

What if the "v-shaped" recovery that appears to be priced into the markets takes hold? As banks' confidence in the recovery strengthens, they should become more willing to lend. As they all rush to deploy the excess money they are sitting on, the multiplier could increase very quickly. Do you trust the Federal Reserve et al. to select the precise timing of when to withdraw the money from the system, such that a recovery is sustained and inflation does not take hold? We believe the market, in its forward-looking nature, does not. We believe that neither the Federal Reserve nor the Treasury has the will power to force long rates higher in the midst of a fragile recovery. Therein lies the qualitative aspects of the perceived dangers of the actions by the Federal Reserve and other central banks that will cause a rush to hard assets even before the quantitative aspects of money printing take over. We are today in the midst of what economists often refer to as the "Golden" period where everything feels good and the long-term effects of deficit spending and money printing have not been realized. This period typically lasts 12-18 months.


© 2009 Hayman Advisors L.P.

A Little Hair of the Dog. Anyone?

During the housing crunch that began in 2007, the government (via FHA, Fannie and Freddie) essentially became the entire mortgage market. These combined agencies wrote/guaranteed over 90% of the total loans made during the first half of 2009 with FHA loans becoming an increasingly larger share of the pie (FHA loans were 17.9% of total 2009 mortgage loans as of 6/30/09).6 It is no secret why FHA loans have increased wildly in popularity this year. FHA loans only require a 3.5% down payment and the government is offering a tax credit of $8,000 to first time homebuyers. With the $8,000 tax credit, a first time homebuyer could fund their entire down payment on a house costing $230,000 or less. Sound familiar? Once again, home buyers are able to purchase a house with no skin in the game, and we all know how that movie ends. Looking at housing data, it is proven time and time again that a low down payment is one of the greatest predictors of defaults. This time, it will not be Wall Street holding the bag. It will be the US taxpayers that will ultimately pay the price. The following advertisement from the FHA's website is particularly interesting:

Purchase or Refinance FHA HOME LOANS

Do as I Say. not as I Do - The International Monetary Follies

The International Monetary Fund ("IMF") was founded almost 60 years ago by 45 member countries to provide a framework of international cooperation that would attempt to avoid a repeat of the economic policy mistakes during the 1930s. While the IMF advances a broad range of policy initiatives, its key function is to provide stability to the international financial system through "rainy day" funds for fiscally irresponsible countries. Today the IMF membership includes 186 countries with each country assigned a quota linked to its relative size in the world economy. A member's quota resembles its financial and organizational relationship with the IMF, including its commitment obligations, voting rights and borrowing limits and represents a substantive ability to pay.

The largest contributors to the IMF are the US and Japan with each country committing an additional USD$100 billion in 2009. The US and Japan, the two largest debtor nations in the world, currently run large deficits and therefore are saddling their own citizens with additional debt to fund these commitments. Wait a minute - the two most indebted nations in the world are the largest contributors to the IMF, even though they have to borrow to contribute? No need to worry. As one influential politician told us a few months ago, "It's not real money. It's just a journal entry." At least they earn a whopping 0.24% per annum on their IMF commitments!"

6 Source: Inside Mortgage Finance.

7 Source: IMF. Represents Adjusted Rate of Remuneration for the week of 9/21/09 - 9/27/09. 8

© 2009 Hayman Advisors L.P.

In September 2009, China created much fanfare by committing USD$50 billion to the IMF, but the Chinese commitments are in the novel form of 5-year bonds with a market rate of return (it makes you wonder what China's definition of "market" will be). Perhaps China recognizes that its citizens deserve compensation for their generosity and that the IMF's business model needs an injection of market discipline. As a matter of fact, in preparation for the upcoming G20 summit, it was reported by Caijing Magazine that Chinese Central Bank Governor Guo Qing Ping said on September 15 that the IMF should set specific goals and timetables to transfer voting rights from developed to developing nations.

As large economies and contributors, the US and Japan possess outsized influence at the IMF that enables them to steer its lending practices. They attempted to impose a facade of commercial discipline on the IMF by establishing lending limits based on the size of members' quotas and covenants on each member loan. The IMF, however, with implicit permission from the US and Japan, routinely ignores these guidelines. For example, until March 2009, the IMF's cumulative lending to any individual borrower was limited to 200% of the borrower's quota at the IMF (Why set quotas when you can borrow multiples of them?). When it became obvious that the financial crisis would require numerous bailout loans in excess of the 200% limit, the IMF simply chose to move the goalposts by increasing the borrowing limits to 600% of the borrowers' quota." Still, the IMF cannot restrain itself from ignoring even these higher limits to lend whatever is necessary to bailout creditors (i.e. the international banks) as demonstrated in the following table.

IMF Loan Commitments and Borrowings Shown as Percent of Borrower's Quota (As of September 10, 2009) 1400%







Source: IMF.


-Total Commitments Under Stand-by Agreements
_ Outstanding Borrowings from the IMF
- Undrawn Flexible Credit Line
Borrowing Limit Until March 2009
--Borrowing Limit Since March 2009
--Quota - - - -

- - -
I I I I - - -
I I I I •
I I I I • • When we spoke with policy makers in the US that act as the conduit between Washington and the IMF, they were baffled to learn how the IMF has chosen to systemically exceed the quota ratio lending limits. Our policy makers are committing funds to bailouts without recognizing that the size of loan relative to the size of the economy makes repayment highly unlikely.

8 Source: IMF Public Information Notice no. 09/40.


© 2009 Hayman Advisors L.P.

Latvia - A Case Study of an IMF Bailout

While the IMF attempts to impose covenants on loans in the form of fiscal austerity measures and macroeconomic targets, they rarely enforce these conditions as evidenced by the case of Latvia. Latvia has a population of approximately 2.2 million people and reported a GDP of approximately $34 billion for 2008. So far in 2009, the Latvian GDP has shrunk to an approximate run rate of $28 billion. Below is a chronology of the sheer ridiculousness of Latvia's IMF-Ied bailout."

November 2008

• Standard & Poor's cuts its ratings on Latvia to BBB-

• Latvia projects a 2009 budget deficit of less than 2%

December 2008

• Latvia enters into a $10.5 billion bailout (almost one third of its GDP, approximately 100% of initial budgeted 2009 revenue and nearly 130% of the updated 2009 budgeted revenue10), $2.4 billion of which was in the form of a standby credit agreement from the IMF, and receives its first disbursement with the remainder to be made in nine installments subject to quarterly reviews

• The IMF credit agreement amounts to a whopping 1,200% of Latvia's IMF quota

• IMF bailout is predicated on Latvia maintaining a budget deficit of no more than 5%, assumes unemployment rates to average 9% for 2009, and assumes that real GDP will shrink by 5%

February 2009

• Latvia's Prime Minister and cabinet resign

• Unemployment hits 9.5%

March 2009

• Latvia's new Prime Minister takes office

• IMF withholds 2nd installment of bailout plan as Latvia fails to implement necessary conditions to meet loan terms

• Unemployment reaches 10.7%

May 2009

• Latvia reports an 18% decline in GDP for the first quarter of 2009

• Unemployment reaches 11.3%

9 All data pertaining to Latvia bailout chronology was sourced from the IMF and Bloomberg.

10 Source: "Latvian Saema Passed 2009 Budget in Final Reading," The Baltic Course, November 17, 2008. "Latvian Parliament Passes Amendments to 2009 State Budget, Eurofound, June 16, 2009.


© 2009 Hayman Advisors L.P.

July 2009

• Latvia and the IMF renegotiate the bailout package and now preliminarily agree to a revised 10% budget deficit for 2009 (no apparent penalty was charged for this "renegotiation")

• Latvia July new car sales drop 86.6% from July 2008

• Unemployment reaches 11.8%

August 2009

• Latvia reports an 18.7% decline in GDP for the second quarter of 2009

• Latvia and the IMF renegotiate bailout package (again, for the third time, with no additional covenants, prepayments or increases in interest expense) and agree to a 13% budget deficit for 2009

• Unemployment reaches 12.3%

September 2009

• Latvian Financial and Capital Markets Commission reports nearly 25% of all loans are delinquent with almost 14% overdue by more than 90 days

• According to Latvia's State Employment Agency Director Baiba Pasevica, from September 2008 to September 2009, the unemployment level in Latvia has increased approximately 250%

• According to the chief economist at Swedbank (one of Latvia largest lenders), by the middle of 2010, Latvia's gross domestic product (GDP) will have contracted by 25%, compared with the highest point it reached in 2007, and will be back to 2004 levels

To put this into perspective, imagine Latvia is a person with a $10,000 credit line from a bank and income of $285,000. Now Latvia finds out that he is getting a pay cut and expects to only make $250,000 this year. It is important to note here that $250,000 is his total income, not disposable income. As is the case with any household, he has certain expenses that he simply cannot cut. Additionally, his credit score declines, and at the same time, his family's bills are coming in higher than expected. Recognizing the implications of his situation, he applies for additional credit. Fearing the worst, Latvia is elated to learn that he has been granted credit in the amount of $240,0001 In return for the bank's additional risk, it sets certain legally-binding financial limitations to make sure Latvia is as prudent as can be with the new funds. As the months pass, the situation worsens for Latvia and his family. He takes another pay cut and learns that his income will only be $200,000. His family's expenses are spiraling out of control, and he lets the bank know he cannot even come close to complying with the financial restrictions previously set by the bank. He is scared that the bank will call its loan back immediately, but to his pleasant surprise, the bank lifts the restrictions, keeps the credit line the same and charges the same rate as before. Would your bank be as accommodating as the IMF?

Latvia failed to comply with virtually all of the material financial covenants and its prospects continue to worsen, yet the IMF continues to fund a large loan to Latvia that will likely never be repaid. As frequently stated, "you cannot borrow your way out of debt." It is only a matter of time before Latvia recognizes this folly and the international coalition of lenders led by the IMF will be left with a $10.5 billion IOU. If Latvia never repays its loan from the IMF, then the US, Japan, and other developed countries that fund the IMF's activities on non-commercial terms are simply writing charity checks to fund creditor bailouts. The IMF preaches against


© 2009 Hayman Advisors L.P.

exactly this type of behavior to its troubled borrowers in an example of "do as I say, not as I do" policy. We believe the IMF should force restructurings and/or devaluations and then loan money to troubled nations, as they should have learned in the case of Argentina early in this decade.

China - Exploding Like a Fire-Cracker?

Despite the historic size of the fiscal stimulus injected into the US, UK and Japanese economies, it is the cagey communists in China that take the cake with a massive USD$586 billion of fiscal stimulus (for an economy one third the size of the US) and an explosion in monetary policy.

Many economic and political strategists have suggested that a growth rate of at least 8% is needed by China just to maintain stability as it seeks to modernize the western half of the nation still stuck in the Middle Ages. Maintaining stability and order is the absolute priority, and strong GDP growth is viewed as the essential tool to achieve it. As such, the Chinese government surpassed even the Federal Reserve and Bank of England in responding to the crisis with free money.

The People's Bank of China (PBoC) expanded Chinese M1 money supply by a staggering 28.7% year-over-year from September 2008 to September 2009.11 On top of this core money supply increase, the Chinese government was also able to direct its banks to expand lending in order to keep the velocity of that money from falling like it has in the US. Unlike in the US, where FDIC insured institutions have seen a decrease in total assets between September 2008 and todav," the Chinese banking system has grown at an extraordinary rate. Total Chinese banking assets were approximately RMB 57.5 trillion at the end of June 2008, and had grown to over RMB 73.7trillion by the end of June 2009.13 This increase represents almost 54% of Chinese GDP - equivalent to the US increasing total bank assets by USD$7.5 trillion in a single year.

With this tsunami of money and credit creation, it is not surprising that China has been able to increase the level of fixed-asset investment and boost industrial production and retail sales (which represent wholesale to retail sales rather than final sales to consumers) from the levels seen during the trough in economic growth late last year. The real economy has been unable to absorb all of the inflow, and the PBoC has suggested that up to 20% of the new credit has flowed into asset speculation" (i.e. 20% of the RMB 18 trillion went directly into the stock market, speculative real estate investments, etc.). Evidence of this is clear from the 80% rebound in the Shanghai Stock Exchange Composite Index from its low in October 2008 (despite profits declining by almost 30%) as well as a rebound in property prices to previous inflated levels that leave the ratio of median price to median income in China at 7x that of the US (and we are well aware of how bad our US housing problem is). We wonder what the encore in 2010 will have to be to sustain such "growth." We believe the data set to watch is not their stock market, bond market or GDP; rather, it is their cost of food, which currently represents 40% of household expenditures. Food price inflation could be the tipping point for China.

Aggressive loan growth of this type usually creates real non-performing loan ("NPL") problems. But in this case, the expanded lending has brought a temporary reprieve for troubled borrowers with non-performing loans at

11 Source: Bloomberg.

12 Source: Federal Deposit Insurance Corporation. 13 Source: China Banking Regulatory Commission.

14 http://www.telegraph.co.uk/finance/financetopics/financiaIcrisis/6011674/Credit-tightening-threatens-Chinas-giantPonzi-scheme.html


© 2009 Hayman Advisors L.P.

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 underwriting standards are all but non-existent, it is pretty hard to default or be delinquent on a loan when it can be constantly refinanced or termed out to an even larger one. We have adapted an ancient proverb originally published by Erasmus around the year 1500 to describe this phenomenon: A rolling loan gathers no loss. The current situation is only sustainable as long as credit continues to expand at a dizzying pace. It feels eerily similar to credit markets in the United States in 2006-2007.

In China, asset prices are rising, but the prices for consumable goods and services are plunging. This situation is being exacerbated by the continued weakness in exports (down 23.4% year-over-year, the sixth month this year with a 20%+ decline"), which suggests that there is simply too much manufacturing and industrial capacity in China. Imports have recovered modestly from their lows at the beginning of the year and, in terms of volume, have exceeded last year's levels. The domestic demand for raw materials may have driven a rebound in commodity prices, but recent official comments about curbing domestic cement and steel production may be a signal that the stock piling is slowing down.

The key 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 profit maximization and the investment in assets that genuinely generate income sufficient to service the debt? Or is China compounding the existing problem of overcapacity by building more and more real estate assets, factories and infrastructure when a huge inventory overhang already exists? We believe it is the latter.

To us, one of the most compelling sets of data points to come out of China is the substantial drop in prices for goods and services (Purchasing Price Index (-11.4% year-over-year), Wholesale Prices (-7.1%), and Producer Price Index (-7.9%)) in an environment where not only money supply, but also credit, investment and "retail" sales are increasing at double-digit percentage rates." This downturn started after the financial collapse last September and has not responded to any of the fiscal and monetary stimulus so far.

15 Source: Bloomberg. 16 Source: Bloomberg. 17 Source: Bloomberg.


© 2009 Hayman Advisors L.P.

Chinese YoY Change in Consumer, Wholesale and Purchaser Prices (June 2008 - August 2009)

20% ,-----------------------------------------------------------------

--Consumer Price Index

15% +--------::;;01~!!!!!!!!!!!!!!1-=::------------- --Purchasing Price Index of Raw Materials, Fuels and Power --Wholesale Price Index

10% i,jjiiiiiic:::::-- ....... ;;;;;;;;:---,----- -- Producer Price Index

-15% ~----------------------------------------------------------------

Source: Bloomberg.

If the world's most aggressive fiscal, monetary, credit and investment expansion can, at most, deliver trend growth while increasing deflationary pressures, we are skeptical of its sustainability. At some point the liquidity spigot must be turned off, and the resulting change in momentum will be a massive shock to the system.

However, in an economy where the government exerts substantial control over credit allocation, investment and particularly domestic savings, the potential to keep the balls in the air is greater than that of a more open system. We believe there is an NPL time bomb waiting to go off in the Chinese banking system, driven by the over expansion of credit into non-economic investments and hidden by massive liquidity injections and yet more credit expansion. All the while domestic capital is prevented from leaving the country and forced into the hands of the domestic banks where the credit machine can spin around and around, ever larger for some time yet. Likewise the continued external demand for Chinese goods, services and assets (as represented by the net inflow of foreign capital which is clearly apparent in the build-up of foreign exchange reserves) allows the government to maintain the currency controls that prevent domestic capital from escaping the country in any meaningful way.

As such, it is crucial to identify the catalyst that will 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 down 17.52% year-over-year) and trade surplus income (down 19.3%) could place pressure on this structure." If this structure were to unravel, we believe that the Chinese monetary and banking systems could face substantial devaluation and default pressure.

18 Source: Bloomberg.


© 2009 Hayman Advisors L.P.

We believe that the Chinese end-game is to keep the stimulus flowing until there is either a danger sign of real CPI inflation or the rest of the world's economies return to the pattern of growth and consumption that we have seen for the past six years. Along the way, lip service has been paid to the restructuring of the Chinese economy in order to increase domestic consumption, but without substantial social reform and re-distribution of wealth, there will not be the level of domestic demand and consumption required to allow the kind of growth seen in more developed economies.

The best case scenario for China is that the current stimulus buys enough time for the developed world to return to 2006/2007 levels of demand for Chinese goods, services and assets. Along the way the Chinese will slowly attempt to rebalance their economy in favor of domestic demand; however, danger to this recovery narrative does exist. The relative resilience of emerging markets (and China in particular) has been a source of optimism and bullish sentiment for equity and fixed-income investors in the developed world. If the bright shining light of Chinese growth turns out to be the flaming destruction of a meteor crashing to earth, this could be the shock that instigates another round of frenzied risk aversion in global markets.

Japan - Land of the Setting Sun

Japan is one peculiar case where decades of chronic deficit spending and central government borrowing have not led to material currency devaluation and high (nominal) interest rates. An anomaly of developed economic history, Japan experienced more than a decade of low (near zero "official") interest rates and almost nonexistent growth in both real and nominal terms, while continuing to grow its central government's debt burden at an accelerating pace. Cultural forces spawned the generally accepted belief among Japanese citizens that it is their patriotic duty to lend their government money. Combined with an abnormally high savings rate (when compared to the rest of the developed world), this ideal allowed the Japanese government to fund 95% of all of its bond sales by selling them directly to Japanese institutions and individuals. The ability to fund almost entirely by selling bonds to their own citizens allowed rates on Japanese Government Bonds ("JGBs") to remain low as they did not have to compete for international capital; however, if net new issuance of JGBs outstrips economic growth, this model eventually becomes unsustainable. We believe that Japan has reached its inflection point in 2009. A review of Japanese demographic trends shows why this model may be closer to breaking than many may realize. First and foremost, Japan's population is in secular decline. The National Institute of Population and Social Security Research ("IPSSR") estimates that the Japanese population actually peaked in 2004 and is now on a long-term negative trajectory. Please see the chart below:


© 2009 Hayman Advisors L.P.

Japanese Total Population (1950 - 2050E) (In Thousands)


--Actual (Census)

----- Projected (iPSSR) -~~----------~ ... ;;o:---------

...... ......






... ...



0 '<t co N 1.0 0 '<t co N 1.0 0 '<t co N 1.0 0 '<t co N 1.0 0 '<t co N 1.0 0
Lll Lll Lll 1.0 1.0 I' I' I' co co en en en 0 0 .-i e-i e-i N N I'Y'I I'Y'I I'Y'I '<t '<t Lll
en en en en en en en en en en en en en 0 0 0 0 0 0 0 0 0 0 0 0 0
.-i .-i .-i .-i e-i .-i .-i .-i .-i e-i .-i e-i .-i N N N N N N N N N N N N N
Source: National Institute of Population and Social Security Research. Perhaps of even greater importance than the total population is the composition of the population. The following chart shows the percent of the population aged 65 or older projected out to 2050. In an ideal world, a population under a common economy will reproduce at a rate that keeps the senior proportion roughly constant, especially in a society whose public retirement program utilizes pay-as-you-go funding. Currently seniors make up 22.8% of Japan's population (versus 12.9% in the US and 7.6% globallv)." The DECO estimates that the ratio will reach 29% by 2020 and will continue to grow thereafter.

Percent of Population Aged 65 or Older (1950 - 2050E)

40% ~-----------------------------_-=-

--Japan --


35% r-- ~,

--United States ..,-


30% r-- --World ,-


25% +-----------------------------------~~-------------------


20% +---------------------------/----~~----------_~---~--~--~£


~, --

15% +--------------~~~----_~-~~-----,--=~-~=-


10% i ~ ~ _-- ,-

~ --

5% ~---- .. -===::::~~~~~~~~~::~==~-----------

Source: OECD. Solid lines denote historical actuals. Dotted lines denote 2009 - 20S0 estimates.

The impact of this trend is twofold: (i) the central government and ultimately Japanese workers will carry an accelerating social security burden which will require some combination of increased with holdings (effectively higher taxes) and further debt issuance; and (ii) the positive savings rate that Japan has enjoyed for decades will turn negative. In fact, the chart below illustrates that Japan's household savings rate as a percent of disposable

19 Source: DECO. Percentages represent 2009 estimates.


© 2009 Hayman Advisors L.P.

income and pension payments has been on a general downtrend since 1981 (admittedly interspersed with upward movements in some years) and has now fallen to 2% from a peak of over 18%.

Annual Household Savings and Savings Rate (FY 1980 - 2007) (JPY in Trillions)

¥SO.O 20%
¥4S.0 _ Annual Net Savings (Left Axis) 18%
--Savings Rate (Right Axis)
¥40.0 --Savings as % of GOP (Right Axis) 16%
¥3S.0 14%
¥30.0 12%
¥2S.0 10%
¥20.0 8%
¥1S.0 6%
¥10.0 4%
¥S.O 2%
¥- 0% Source: ESRI; Japanese Ministry of Finance.

In the course of our discussions with our investing peers as well as analysts across the major broker-dealers, we often hear the large pool of Japanese savings referenced as the reason Japan will be able to continue to sustain this model. The problem is that all the current savings pool allows is the rolling of existing government debt, as all the savings to date are presumably already invested. The best the central government could hope for from the current pool of savings is some reallocation toward a higher weighting of JGBs, which would come at the detriment to other securities (corporate bonds and equities). For domestic household savings to continue to support net new JGB issuance, there must be net new savings as well. As a greater percent of the population reaches retirement age, savings will actually become negative, creating a pool of JGB sellers - not buyers. The demographic and savings trends suggest that this is not far off. Are you willing to lend the profligate Japanese government money for 10 years at 1.3%? As prudent fiduciaries, we certainly are not.

Interestingly, the Government Pension Investment Fund ("GPIF"), Japan's public pension fund and historically the biggest individual net buyer of JGBs, said in June that it may become a net seller of securities this fiscal year (ending March 2010) in order to pay benefits." Granted, the amount the GPIF is talking about selling, on a net basis, is only JPV 4-5 trillion - not enough to materially impact the markets. The trend, however, is of more importance than the nominal amount. Another key statement made by GPIF President Takahiro Kawase was that the fund should only need to sell JPV 4-5 trillion because the additional shortfall will be made up from maturing government bonds. In the case of a borrower being a consistent net issuer of debt, there is no distinction between the lender becoming a seller of debt and ceasing to roll near-term maturities. Currently GPIF holds 19.6% of its assets in a type of JGB called a FILP bond ("Fiscal Investment and Loan Program"]." While not considered "General" JGBs, FILP bonds represent 15% of total central government debt and 19% of total JGBS.22 GPIF owns 19% of all FILP bonds outstanding and for years had been a net purchaser. What

20 Source: "GPIF: may become net seller in 2009/10," Reuters, July 8,2009. "World's Biggest Pension Fund May Sell Japanese Bonds," Bloomberg, June 15, 2009.

21 Source: GPIF.

22 Source: Japanese Ministry of Finance.


© 2009 Hayman Advisors L.P.

happens to demand for these bonds when the most substantive holder becomes a net seller? What happens as private funds and savers are faced with the same funding issues as GPIF?

Just how big is the problem? As the chart below shows, Japan's central government debt as a percent of GDP has increased from 99%, which is a dangerous number in and of itself, to a staggering 170% in the last ten years (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.

Japanese Central Government Debt I GOP (FY 1996 - 2009E)

220% ,-------------------------------------------------------------


160% +--------------------------------~----~~~~~~~~=--------

140% +------------------------~--~~~=---------------------------- 120% +-----------------~----~~------------------------------------ 100% +--------~----~~~-------------------------------------------

80% +--~--~~=--------------------------------------------------


200% I-- -Total Central Govt. Debt/GOP 180% I-- -Hayman Estimate

60% +---.----.---.----.---.---.----.---.---,,---.---.----.---.---,

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

Source: Japanese Ministry of Finance; Bank of Japan; Hayman estimates.

Any rational person (we'll leave it to you to decide whether we at Hayman qualify) would expect the compounding impacts of issuing debt to service debt and fund budget shortfalls to lead to an exponential rise in interest expense which would only exacerbate the problem of needing to convince more buyers to lend the government money at less than 1.5%. In reality, simple financial alchemy and arithmetic allowed total debt to increase while interest expense paid by the Japanese government actually declined markedly. Through zerointerest-rate-policy instituted by the Bank of Japan ("BOJ"), the government was able to issue an aggregate of JPV 365 trillion of General JGBs while annual interest expense declined from JPV 11.0 trillion to JPV 7.0 trillion between 1991 when government interest expense was at its peak through 2006 when it reached the trough. Rates declined enough to more than offset interest expense incurred as a result of new debt issuance. As it becomes cheaper to borrow, how much of your own personal balance sheet are you willing to bet on rates remaining low indefinitely? Below is a comparison of JGB issuance to government interest expense.


© 2009 Hayman Advisors L.P.

Japanese Net General JGB Issuance and Interest Expense (FY 1983 - 2009E) (JPY in Trillions)

¥SO.O ¥4S.0 ¥40.0 ¥3S.0 ¥30.0 ¥2S.0 ¥20.0 ¥1S.0 ¥10.0

ss.o ¥-

- - General JGB Issuance (Right Axis)
- --Interest Expense (Left Axis)
/' "
/ I\. J
/ /
" ,
I _ iIoo. --'1
I I I • I I I I I I Source: Japanese Ministry of Finance; Hayman estimates.

¥13.0 ¥12.0 ¥11.0 ¥10.0 ¥9.0 ¥8.0



As an aside, this analysis considers only General JGBs and does not consider FILP bonds or other borrowings of the central government. The inclusion of those debts, for which we have detailed data back to 1996, paints an uglier picture in terms of true debt issuance. The key thing to note about the chart above is that interest expense has begun to explode again. As older debts have rolled to newer debts at the new lower rates, the nominal impact of zero-interest-rate-policy appears to have run its course. Since debt has been so cheap, the Japanese government has been able to borrow like an American subprime homebuyer in Las Vegas. Japan continues to borrow at significantly below-market rates and has set itself up to be dealt a potentially fatal blow with any slight uptick in rates.

The next chart shows that, in terms of government bond rates, Japan has milked zero-interest-rate-policy for all it's worth. Hayman believes the piper must be paid in the near future.

BOJ Discount Rate and Central Government Bond Yields (March 1983 - June 2009)

9% ,------------------------------------- 8% +----------~---------

7% t-------~~~~~~---------

6% +-------r~-~,_~~-3~~----

S% +-~----r_-~~~~=-~~~~~~~~- 4% +----~--~#_~--~~MH~~---~~~--------------

3% +- ~--~~--~=.~pL~~~~----3~~-----------


1% t-


- BOJ Discount Rate

-Implied Sovereign Interest Rate



ron "<t en 1.0 I' co en 0 .... N ron "<t en 1.0 I' co en 8 .... N ron ('5 en 1.0 E:; gg ~
co co co co co co co en en en en en en en en en en 0 0 0 0 0
en en en en en en en en en en en en en en en en en 0 0 0 0 0 0 0 0 0 0
.... .... .... .... .... .... .... .... .... .... .... .... .... .... .... .... .... N N N N N N N N N N
Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl Nl
Source: Japanese Ministry of Finance; Bank of Japan; Bloomberg. July 1991 marked the beginning of a series of cuts in the BOJ discount rate toward 0.1%, which was reached in September 2001. As to be expected, JGB yields followed suit and continued declining even after the BOJ rate


© 2009 Hayman Advisors L.P.

flattened. JGB yields effectively bottomed out in 2003 and have moved more-or-Iess sideways since then. Even if the BOJ were to cut the discount rate to zero tomorrow (from a whopping 0.10% today) the impact on government borrowing costs would be de minimis.

Considering the demographic challenge facing the country and the fact that the BOJ maxed out on rate cuts years ago, there is a frightening scenario unfolding whereby JGB issuance will continue to be significantly positive while domestic demand for the bonds turns secularly negative. There are no further good tools available to keep the government's interest costs from growing, further increasing the need to issue more debt. 18% of tax revenues are already used just to pay interest expense," We can sympathize with former Minister of Finance Shiochi Nakagawa, who appeared drunk at a G7 news conference last February. You too might have a few too many drinks if you were responsible for Japan's budget.

It is also worth pointing out that approximately 26% of Japan's total central government debt (including all government bonds, financing bills and other borrowings) matures within one year. This means that a 1% increase in interest rates would massively increase the borrowing costs of JPY 223 trillion of government debt within the next twelve months."

What will happen to rates when the central government asks to borrow more money from its citizens, who are themselves becoming net sellers and net consumers? Ultimately Japan will have to compete for capital internationally. Will a 1.3% 10-year bond be attractive? We don't think so, and judging by the new advertisements in Japanese taxi cabs encouraging citizens to continue purchasing government bonds, it appears that the Japanese government shares our concerns .

• ~1J: ~f~ 5-1 :""7"1 /'" ~1fc·Jl.i§: L.,

'it t.:: if/) 1: tt Iu fJ' ?


f..I "~I' .~'.. .::".II~ I':""~ ••• (,:. .. , .=

~" ...

I· ~I ~~. I .. :.... 11. iIIId.fl. 1,;1 hi -I .01:,,"

11bi1 • .:: ... n

.~. 'P'IIII 1..1

1.11J~ ..

1:1 ,11-rl.r IUllllllltjl ~ Ili'D.:II~ .....

According to Bloomberg, the Ministry of Finance says in the advertisement, "Government bonds are worth another look." The ad features a picture of former NHK anchor Junko Kubo, 37.

23 Source: Japanese Ministry of Finance.

24 Source: Japanese Ministry of Finance; Hayman estimates.


© 2009 Hayman Advisors L.P.

While our discussion of Japan up to this point has focused on their sovereign debt burden and implications for interest rates, it is also important to focus on the state of the Japanese economy and the Yen. During the course of the recession, quarterly seasonally adjusted GDP declined 8.4% peak-to-trough (calendar first quarter 2008 to first quarter 2009) in real terms. As of the latest quarter, GDP is still off 7.9% from its peak. To put it in perspective, the peak-to-trough decline, which spanned four quarters, wiped out 17 quarters of GDP growth, or everything since the fourth quarter 2003. We have arguably just lived through the greatest Asian boom in history, and Japan never got off its back. How do you think the country will do now with double-digit output gaps and structural demographic issues coming to a head?

Examining the major components of GDP reveals the primary drivers of the decline. Private consumption, which is the largest component at 58% currently, declined 2.8% peak-to-trough. Government consumption (not investment), the second largest component at 18.8%, grew by 0.6%. Private non-residential investment, representing 13.1% of GDP, declined 20.4% over the peak-to-trough period (and declined further last quarter). Now we are getting somewhere, but it still does not explain an 8.4% decline in GDP. Gross exports currently represent 12.4% of GDP and declined a staggering 36.2% peak-to-trough. For those of you keeping score at home, the decline in gross exports comprised 72.4% of the total GDP decline.

The chart below illustrates not only that the bulk of the GDP decline has been a result of export decline, but also that any growth seen over the last twenty years has been driven almost exclusively by exports and government consumption. In fact, 32.7% of GDP growth from December 1989 to the peak was due to growth in exports.

Real GDP and its Primary Components, Quarterly, Seasonally Adjusted (December 1989 = 100%)

300% ,-------------------------------------------------------------------




- Private Consumption

- Government Consumption

- Private Investment

- Public Investment



Source: Japanese Ministry of Finance.

Like it or not, Japan is an export economy. The persistent strengthening of the Yen recently and its reputation as a "safe haven" currency are puzzling. As the Yen strengthens against the currencies of its major trading partners (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 government consumption) of the last twenty years shuts down.


© 2009 Hayman Advisors L.P.

The Democratic Party of Japan ("DPJ") took power from the Liberal Democratic Party ("LDP") in a landslide victory in the August 2009 general election. The DPJ leader, Yukio Hatoyama, has outlined policies focusing on fiscal stimulus and domestic consumption with a disregard for the importance of exports. Relative to the policies of the LDP, he has placed emphasis on distribution and welfare. Among his (admittedly noble) initiatives are increased child benefits, free public high school education, and an abolition of highway tolls. Mr. Hatoyama believes they can fund these programs without tax hikes and without increasing the fiscal deficit via budget reforms and efficiency improvements in deployment of public funds. He has yet to provide substantive details with respect to these plans."

Given the DPJ's focus on the Japanese domestic consumer, Mr. Hatoyama has made public statements in support of a strong Yen as it theoretically drives prices down and increases purchasing power. This is true for trade-balanced economies and net importers. The flaw in Mr. Hatoyama's logic is that in order to promote domestic consumption (without firing up the leverage machine), they will need income growth which requires growth in corporate gross profit and dividends. All else equal, a strong Yen will punish Japanese exporters which will create significant headwinds for income growth.

Many of the DPJ's initiatives are not scheduled to be implemented until the next fiscal year (beginning April 1, 2010). In the mean time, Japan's fiscal 2009 budget (ending March 31, 2010) should concern investors who regard Japan as a "safe" destination for capital. Revenues are expected to be JPY 51.0 trillion, down nearly 10% from two years ago (this does not include JGB or FILP debt issuance, which the Ministry of Finance includes in their budget as revenue). Expenses including interest are expected to be JPY 91.6 trillion. The implied deficit is JPY 40.6 trillion, or 44% of government expenditures." Interestingly, the Bank of Japan ("BOJ") has authorized itself to purchase JPY 21.6 trillion Yen per year of JGBs. Never mind the JPY 1 trillion of financial institution stocks that the BOJ is authorized to purchase through April 2010, or the JPY 3 trillion of commercial paper and JPY 450 billion of corporate bonds authorized for purchase between October and December ofthis year.27 Japan is on full tilt with the government buying all classes of financial assets in an attempt to prop up their house of cards.

When we connect all of the proverbial dots, we expect either higher rates in Japan, a weaker Yen, or (most likely) some combination thereof. A persistently strong Yen will keep pressure on exports which will result in lower GDP and lower government tax revenues, which will lead to greater debt issuance. Now that zerointerest-rate policy has reached the extent of its potential benefits, the compounding impacts of issuing more debt will increase Japan's interest expense burden (and consequently the deficit) even further. Soon the issuance of JGBs will be met with a lack of domestic demand, and rates will feel significant upward pressure. The Japanese government can either allow rates to rise, which they probably know they cannot afford, or they can increase quantitative easing to attempt to keep rates low. We believe the net result of all of the above will be higher rates and a weaker Yen.

25 Source: "DPJ Policy Implementation Could Inflate Japan's Fiscal Deficits; Compensating Measures Will Be Key," Standard and Poor's, August 31, 2009.

26 All fiscal 2009 budget data sourced from the Japanese Ministry of Finance and adjusted to reflect comments in Finance Minister Yosano's speech on April 27, 2009 regarding incremental stimulus spending.

27 Source: Bank of Japan.


© 2009 Hayman Advisors L.P.

Capitalizing on Our Views

To summarize our views, we believe that global currency printing will inevitably lead to high levels of inflation - outright currency debasement. Historically, it has taken 18 months to two years to take hold, but we believe that it could be sooner due to the size of both monetary and fiscal stimulus as well as the coordinated global nature of the actions.

We are not particularly bullish on the world macro environment or the US consumer for that matter, but we continue to invest slowly and defensively.

Based on our thesis of impending inflation and competition for sovereign capital as world governments run huge fiscal deficits (and sell debt to finance them), we are investing cautiously in credit. In the core Hayman portfolio, we are invested in short duration credit and mortgages. Hayman has built a mortgage position equal to approximately 50% of assets under management. The core strategy is to invest in mortgage-backed securities that are very high in the capital structure, have relatively short weighted average lives and that provide attractive risk-adjusted yields based on our assumptions. Our underwriting standards take into consideration a range of macro variables including further home price depreciation, maintained stress on consumer balance sheets and a prolonged downturn in the labor market. Additionally, we look at a broad array of pool-specific traits and servicing techniques when determining value. We believe that certain securities remain attractive due to many of the traditional mortgage-backed buyers shying away from the market which will provide opportunity going forward. Additionally, Hayman has added corporate credit positions, primarily high-yield bonds and bank loans, equal to approximately 25% of assets under management. We target two types of situations - short duration performing credits that provide current income and distressed credits with solid asset coverage. While we expect corporate defaults to remain elevated, we will continue to selectively invest in corporate credits that meet our criteria.

We believe global OECD rates will begin their ascent over the next 18-24 months and that the best convexity for rates is in Japan. We have also allocated a portion of the portfolio to precious metals and are seeking out unique opportunities in natural resources. Many of our larger positions tend to have the same kind of asymmetrical risk/return characteristics that we strive to build into the portfolio.

Hayman continues to believe that the transfer of private debt onto the public balance sheet in the form of deficit spending and government guarantees is unsustainable. The creditworthiness of many major economies in Western Europe, Asia and North America has been substantially affected by the rapid accumulation of new debt in the name of stimulus spending and bailouts; however, in the short term, the central banks of the world have committed to funding the issuance of new sovereign debt directly through quantitative easing (in the US, UK and Japan) and indirectly through repurchase agreements with favorable terms (Eurozone and elsewhere). This has 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 Bank's outstanding liquidity injections, despite representing only 1.9% of Eurozone GDP. The debt financing position of sovereign governments has become very dependent on historically loose monetary policy. We believe that in the event this monetary policy is actively tightened or indeed not actively loosened further, the ability for sovereigns to fund themselves at the current rate of deficit spending is questionable. Unless a new dose of fiscal sobriety emerges around the world, central banks will have to choose at some point between the integrity of the money supply, and the borrowing needs of sovereign governments. We are positioned for both outcomes.


© 2009 Hayman Advisors L.P.


J. Kyle Bass Managing Partner

The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. The information and opinions expressed herein are provided for informational purposes only. An investment in the Hayman Funds is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.


© 2009 Hayman Advisors L.P.

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