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November 30, 2011

Men prefer a false promise to a flat refusal. Quintus Cicero Imminent Defaults
We write to you today to provide our thoughts on the most likely path of global debt and the potential consequences of a cluster of sovereign defaults. We see an interesting relationship between the dual aspects of the situation the quantitative and the qualitative. First, the quantitative data sets are simple facts which are easily analyzable. Second, and much more open to debate, are the qualitative thoughts and reactions of market participants to that data. Often when there is a large and rapid change in a market dynamic to a new paradigm there is a chorus of analysts proclaiming that nothing has changed, yet undeniably the market indicates it has. We believe that in many cases the quantitative data leads the qualitative change in opinion to such a degree that it may look like nothing has changed in the data to drive the change in opinion. In most cases this is merely the market catching up with the fundamentals. Once the quantitative data points get as bad as they are today in many nations, the qualitative beliefs and actions of the participants can rapidly change a situation from benign or stable to full crisis (think Italy). It is the beliefs of the participants that are most important in times like today. The data sets are large and slow moving, but the qualitative interpretation of them is far more mercurial. We operate under the assumption that most participants are educated and informed, and, therefore the quantitative analysis should already be done. However, it is clear that some previously unquestioned qualitative beliefs are hard to shake. One of the axioms that we have been developing at Hayman is a more precise definition of debt sustainability. Debt sustainability is often defined as the ability of a country to meet and service its debt obligations without requiring debt relief or accumulating arrears. The non linearity of the relationship between expenses (primarily the delta in interest expense) and revenues is a concept we spend a lot of time on. When a nations debts become many multiples of central government revenues, a non linear relationship develops that becomes insurmountable because expenses grow faster than revenues even in inflationary or growth environments. We believe the debts of the following nations, among others, are not sustainable in the current economic environment: Greece, Italy, Japan, Ireland, Iceland, Japan, Spain, Belgium, Japan, Portugal, France, and, have we mentioned Japan? The United States is quickly approaching the zone of insolvency but can avoid it with

massive spending cuts and severe reductions in entitlements into the future (but don't hold your breath). While there are many inputs that are functionally relevant, we look for a couple of warning signs. We move a nation out of the risk free category as soon as they spend more than 10% of their central government revenues on interest alone. We also worry about debt loads that represent more than 5x the revenue of the responsible government. When these and other characteristics are met or exceeded, it can quickly move the country into checkmate.

Global Debt Saturation

Since 2002, total global credit market debt has grown at more than an 11% compound annual growth rate (CAGR) from $80 trillion to approximately $200 trillion. Over the same time, global real GDP has only grown at approximately a 4% CAGR.

Total Global Debt (Left Axis) and Global Debt/GDP (Right Axis) ($ in Trillions)
$220 $200
Total Global Debt (Trillions of Dollars)

350% 340% 330% 320%

Global Debt / GDP

$180 $160 $140 $120 $100 $80 $60 $40 $20 $ 2002 2003 2004 2005 2006 2007 2008 2009 2010

310% 300% 290% 280% 270% 260% 250% 240%

Public Debt Securities

Private Debt Securities

Bank Assets

Debt/GDP (Right Axis)

As it stands today, total credit market debt is 310% of GDP. We are saddled with the largest accumulation of peacetime debts without any playbook for what happens next. Throughout history, whenever total credit market debt breached 200% of GDP, it was commonly due to deficit spending fueled by borrowing as nations prepared for and then fought wars. To the victor went the spoils (and 2
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debt pay downs) and to the loser went defeat and default. Given the enormity of the debt burdens of the PIIIGSBF (Portugal, Italy, Ireland, Iceland, Greece, Spain, Belgium and France) coupled with those of Japan (and at some point the US), lending schemes designed to lend more into an intractable debt problem are destined to fail miserably. There is no savior large enough with a magical pool of capital to stave off this unfortunate conclusion to the global debt super cycle. We think hard defaults are imminent. For those of you that arent following European rates closely, please see the charts below. After reviewing the history of rates in EMU member countries, one key takeaway is that the markets have told participants that the EMU has ALREADY BROKEN UP.

Greek 2 Year Government Bond Yield

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Portuguese 2 Year Government Bond Yield

Italy Germany 10 Year Government Bond Spread

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Many absolute levels as well as spread levels are higher and wider than pre Maastricht extremes. This indicates something that the politicians, bankers, and regulators dont want to acknowledge: They have already lost control, and they will not be able to put this genie back into the bottle. It is already over for the EMU, they just do not want to admit it. Below we compare Moodys official sovereign ratings to the implied default ratings derived from market trading levels of sovereign debts the marketplace ratings.

Country Austria Belgium Cyprus Estonia Finland France Germany Greece Ireland Italy Malta Netherlands Portugal Slovakia Slovenia Spain

Moody's Rating Aaa/Stable Aa1/Rvw Dng Baa3/Rvw Dng A1 /Stable Aaa/Stable Aaa/Stable Aaa/Stable Ca/Developing Ba1/Negative A2/Negative A2/Negative Aaa/Stable Ba2/Negative A1 /Stable Aa3/Rvw Dng A1 /Negative

CDS Implied Rating Baa3 Ba2 B3 Baa2 Aa3 Baa3 A2 C B2 Ba2 Ba1 A3 B3 Ba1 Ba2 Ba2

Notch Difference Nine Ten Six Four Three Nine Five One Four Seven Five Six Four Six Eight Seven

Needless to say, a seven notch differential prompted a three notch downgrade for Italy. When there is a 10 notch differential (Belgium) or even a 9 notch differential (France), expect a multi notch downgrade in the very near future.

The Mirage of the IMF and EFSF (and whatever the next vehicle is called)
Recently, rumors circulated in the press of a EUR 600 billion loan ($794 billion) being readied by the IMF for Italy, which would (theoretically) provide the country with another 12 18 months of runway to sort out its intractable debt problems. I suppose it was only a matter of time another bazooka with an eye popping headline number put forth to calm the market participants. It is unconscionable that 5
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anyone thinks that lending more into this debt problem solves anything, but in the true spirit of Keynes and White, Lagarde and Draghi are attempting to placate the market with optics. The problem is that the optics have now broken down. The optics of an EFSF levered CDO idea are collapsing as one of the largest guarantors of early EFSF bonds Italy is now looking to be a recipient of aid. Recently, the EFSF had to purchase its own bonds as there were no takers for 20% of a EUR 3 billion issue. Imagine how they will do when they attempt to issue EUR 200 billion more (answer: poorly, if it happens at all). One other point to ponder is the fact that sovereign bond managers take career risk by simply owning these toxic securities (therefore they wont do it). Again, there is a need to fully comprehend the enormity of the circular reference involved with the IMF and EFSF schemes being contemplated. The EFSF is a combination of a handful of debtor nations that are out of money. The mechanism is only as strong as its weakest link, and the links are crumbling. How will EFSF bonds trade in the marketplace when, in the first issue, there are a group of guarantors and a single recipient while in the second issue there will be differing guarantors and recipients (where a prior guarantor is now a recipient)? For all intents and purposes, the EFSF mechanism is dead on arrival. It is amazing to us that this idea continues to be pursued by the Eurocrats in their 17th emergency summit on December 9th. Now, let's discuss the IMF. Perhaps this would be a workable temporary mirage in the near term assuming the IMF had the funds at its disposal to make such a promise. As it turns out, that assumption is way off the mark. Currently, IMF resources fall significantly short of the rumored Italian loan amount, and further increases to IMF funds exacerbate the circular reference problem of heavily indebted nations providing money that they do not have to bail each other out. Even former IMF chief economists agree that the IMF was never designed to make even a medium sized loan. The IMF was designed to assist small third world countries with balance of payments problems. The IMF was not designed to act as a lender of last resort for profligate debtor nations in Europe or Japan. It may seem bizarre given some suggested IMF action, but the socialization of global losses run up by profligate developed nations cannot be found in the IMF mission statement. According to data provided on the IMFs official website, there is only approximately $385 billion of remaining firepower currently available to provide aid to member nations (referred to by the IMF as its forward commitment capacity)1. In other words, a loan the magnitude of the rumored Italian loan would exhaust currently available IMF resources more than twice over. Including total committed capital under the IMFs New Arrangements to Borrow (NAB) (assuming activation could be expeditiously approved and funded), total forward commitment capacity would increase by $153 billion, to approximately $538 billion (excludes commitments from Greece, Ireland and Italy). Even still, the Italian loan would fully exhaust the committed (funded and unfunded) resources of the IMF and still leave a hole of $256 billion. We are reaching the point at which the amount of funds required to continue delaying the inevitable is simply becoming too large. As more countries require aid and thus are unable to provide aid, the burden

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on the remaining contributing nations grows. If Italy, currently the seventh largest contributor to the IMF as measured by both its quota and its lending commitments under NAB, is too big to save, what is to become of France (fourth in terms of quota and fifth in terms of NAB commitment)? Or worse yet, Japan (second in terms of both quota and NAB commitment)? Imagine a team of mountain climbers all strapped together for safety as they ascend a treacherous peak. While they are all holding on to the mountain there is no additional strain placed on each other. Now consider what happens if one climber, lets call him Stavros, slips and loses his grip. He places added strain on the remaining climbers. One climber might not make a difference, but as Seamus, Pablo and Jose each lose their grip they not only add extra total dead weight to the team but also increase the amount each other climber has to carry, until finally Francois, Luigi and Takehiro let go and poor Jurgen, and Uncle Sam are left trying to keep the whole team on the mountain. The IMF has already made a mockery of its own policies by making a commitment to Greece that was 3,200% of the Greek's SDR quota.2 With the Troika owning 40% of Greek sovereign debt, a 100% write down (complete loss) of the remaining public sector debts will not bring Greece into "debt sustainability". It appears to us that the IMF and the ECB might have to take a loss on their Greek debt as well. Just think, the ECB has been purchasing Greek bonds in the open market since May 2010. Greek 10yr rates were as low as 6.34% while the ECB was initially purchasing bonds. The ECB and IMF now own 40% of the outstanding debt of Greece and Greek 10yr rates are now at ALL TIME HIGHS of 31.98%. If the ECB can't hold back Greek rates, what makes anyone believe they can do anything for Italian rates (where Italy's debts are $3 trillion while Greece was a paltry $500 billion)? The bill is due and payment time is now. The world sits with nearly $200 trillion of total credit market debt (on balance sheet excluding contingent liabilities arising from social welfare programs and the like). One more dollar worth of global credit market debt produces almost no additional utility via GDP growth. Below we present the largest contributors to both the IMF New Arrangements to Borrow and the EFSF in order of total commitments, largest to smallest.

IMF New Arrangements to Borrow United States Japan China Germany France United Kingdom Italy
How do the optics of these schemes look to you?

EFSF Germany France Italy Spain Netherlands Belgium Greece

The commitment as a percentage of the quota fell to 2,400% this year after IMF raised its quota for Greece.

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IMF Facilities Committed and Outstanding as % of Countries Quotas

3000% Total Committed Total Outstanding 2500%

Total Outstanding and Committed Credit Lines as % of Aggregate IMF Funding Capacity
Total Credit Outstanding 7% Total Undrawn Commitments 22%
Arrangements to Borrow from Members, $573,494


Member Currencies, $414,900



Draft Contribution to Eurozone 35%

IMF Funding Sources ($ in millions)


Seychelles Armenia Georgia Kenya Macedonia Moldova Ghana Djibouti Guinea Bissau Grenada Burundi Angola Malawi Nicaragua Kosovo Yemen Mauritania Zambia Iceland Burkina Faso Cote d'Ivoire Sierra Leone Congo, Rep. Afghanistan Portugal Greece Poland Solomon Is. Ukraine Dom. Rep. El Salvador Congo, DR Mexico Antigua Liberia Maldives Colombia Comoros Pakistan Romania Ireland Togo Honduras Sri Lanka Jamaica Latvia Benin Tajikistan Mali Iraq Haiti Sao Tome St. Kitts Bosnia


Pre or Post ?
After perusing about as many opinions on the current debt crisis as is humanly possible, it becomes clear that the consensus solution involves the idea that the ECB takes the gloves off and freely prints euros to solve the debt problems of Europe. The consensus argues that when the pain becomes most acute and unbearable (i.e. threatens the breakup of the EMU), the ECB will jump in and print money until all problems go away. The qualitative inputs here have become predictable as we have all been programmed to think that we will always be saved from default in a post Lehman world. The Eurocrats know full well that they dont have any spare capital to recapitalize their entire banking system in a post default world, nor to adequately recapitalize them pre default. Instead, EU member nations know that they will be required to print money in order to re capitalize their systems. The $18 trillion dollar3 question for the EMU periphery is: Should they (National Central Banks or the ECB) print before or after a default? We think they print post default as they come to the realization that printing pre default without addressing the toxic debt problem would rewind the clocks back to the days of Von Havenstein and then you know who.

The total credit market in the European periphery is $18 trillion (source: IMF).

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The Importance of Psychology Self Deception

Whether it is Kahnemans availability heuristic (wherein participants asses the probability of an event based on whether relevant examples are cognitively available), the Pavlovian pro cyclicality of thought, or the extraordinary delusions of groupthink, investors in todays sovereign debt markets can't seem to envision the consequences of a default. The psychology of the situation is crucial to understanding why and how the gap between perception and reality can be so large. Participants havent contemplated hard defaults (until most recently) because they have been conditioned to believe they cannot occur because it is against the interests of too many powerful parties. They believe that there is no upside to thinking this scenario all the way down through the logical steps due to the fact the last few steps are so painful for everyone (both financial and non financial). Developed Western sovereigns haven't defaulted since WWII and current generations have not experienced a cluster of defaults or any developed default in their lifetime. However financial history has shown repeatedly that waves of default are commonplace across a longer time horizon. As events transpire, investors will be forced to accept developed defaults with enormous loss severities. The risk free rate won't be risk free any longer. The very foundation of the collective financial education will be proven to be flawed. The Value at Risk (VAR) models that Wall Street continues to use today will blow apart once again. The models that currently provide us with some of the most mispriced anomalies in the history of finance because of their reliance on historical implied volatility as substitute for true risk will be rendered useless. It is analogous to driving a racecar using the rear view mirrors.

Japan Will Soon Be on the Front Page

Madoff's scheme collapsed for one primary reason he had more investors exiting his scheme than entering. As soon as this happened, it was over. According to the most recent census, the Japanese population peaked within the last few years at 127.9 million and has since lost almost 3 million. Japan has one of the most homogeneous and some might even call it xenophobic societies of any developed nation in the world. It is no secret that there is no love lost between the Japanese and their neighbors, and therefore, immigration is an unlikely answer to a dwindling populace. Even if immigration was encouraged, such an influx would depress carefully balanced wages and would further disrupt the three jewels of Japanese corporate culture (seniority based wages, employment for life, and company unionism). It is indisputable that Japan has the worst on balance sheet debt burden in the world (roughly 229% of GDP). Japan has the worst debt dynamic (total debt outstanding as a multiple of central government revenues) of any country in the world (at a staggering 20X). They now have more people leaving the workforce than entering. Soon they will have more people dis saving than saving. Without re hashing our entire thesis here, the funding mechanism (including Japan's current account surplus) is dwindling and in fact, we forecast the trade component of the current account to be negative for FY2011. Personal savings of the Japanese population is forecast to be below zero by the middle of 2012. Their ability to fund themselves internally is coming to an end. We believe that Japan would have a bond crisis of its own within the next two years without the current European debt crisis. The 9
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European debt crisis will simply act as an accelerant to the Japanese situation as it will most likely change the qualitative thoughts of JGB investors. We believe that this sequence of events is set to begin in the next few months (beginning with defaults in Europe). Attached, please find several recent articles showing the initial stresses beginning to show in the JGB and swaps marketplace.

The Problems Between Kaiserville and Medland

Recently, Larry Lindsey, former Director of the US National Economic Council at the White House and a trusted friend, penned a satirical piece that warrants inclusion into this letter. With Larry's permission, we are pleased to share it with you. Kaiser on the Hill The European Finance Ministers meeting hardly qualified as King of the Hill, maybe Earl of the Hill, and had it not been for the actions of the worlds central banks, equity markets would be headed south today. The central bank action certainly qualifies as doing the urgent. Odds were we were days from a major European bank collapse and heading that off was both urgent and important. But the underlying sovereign debt crisis remains. Hopes now focus on a deal in which centralized fiscal control is a quid pro quo for increased ECB purchases of peripheral debt. We consider the underlying dynamics of this by examining what happened in Medland and Kaiserville, who were locked in a currency union known as the Uberalles. Medlands economy was 60 percent private sector, 40 percent public sector. It financed its public sector with a 25 percent income tax on all workers and a 20 percent VAT levied on the private sector. The VAT left the private sector with only 48 percent of GDP to pay its workers and investors, so total income tax collections were 22 percent of GDP. Coupled with VAT collections of 12 percent of GDP, revenues were 6 percent of GDP short of the 40 percent of GDP being spent. In addition, the accumulated debt of Medland was up to 100 percent of GDP, on which it had been paying a 4 percent interest rate, just equal to its nominal growth rate. That interest was being paid to the banks in Kaiserville who owned Medlands bonds. Recently they got nervous and demanded a higher interest rate which would put Medlands debt position in a clearly unsustainable position and provoke both a sovereign crisis and a banking crisis. The Prime Ministers of Medland and Kaiserville and the head of the Uberalles Central Bank (UCB) agreed on a Grand Plan to fix the problem. The Medland VAT would be raised by 10 points to generate the 6 percent of GDP needed to fix the primary budget deficit. In return the UCB would buy enough Medland debt to stabilize the Medland interest rate at 4 percent. The sovereign bond crisis was averted and markets rallied as the banks in Kaiserville would no longer take losses on their bond holdings and it looked like Medvilles fiscal problems were solved. But the higher VAT posed a problem. In many countries higher VATs are passed on to consumers in the form of higher prices. But the UCB favored price stability and there was sufficient slack in the Medland economy that firms lacked pricing power. Medland companies 10
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could only respond by cutting costs (in this case wages) from the old rate of 48 to the new rate of 42, which is what they had left after the higher VAT. Income tax collections on private sector workers immediately dropped from 12 to 10.5, so state revenues declined and the primary deficit reappeared. With after tax wages now down, demand for private sector goods and services dropped by 7 percent. Layoffs rose. Both VAT and income tax receipts began to drop. Worse for the long run, Medlands most productive private sector workers and entrepreneurs began leaving as their current compensation was now unattractive relative to both the public sector and to Kaiservilles private sector and their prospects were bleak. The banks in Kaiserville quickly sensed something was wrong and began to sell their Medland bonds to the UCB. Their rationale was simple. If Medland should default or be restructured, the UCB would not take a haircut. This meant that the more bonds the UCB bought, the greater the haircut would be on private sector bond holders. The rush for the exit quickly became a stampede as more banks caught on and sensed that the UCBs interest rate stabilization policy was their best chance to head for the exits. The Grand Plan was coming apart and UCB money creation through the purchase of Medland debt did not solve the problem. Medlands fundamental problem was that its unproductive public sector was too large and its tax wedge on its private sector to onerous. Restructuring a countrys or a companys finances buys time, but unless its fundamentals are also restructured, it returns to the same problem.

If we are correct regarding our hypothesis on the outcome of the debt crisis, the world will have its social fabric ruffled or even torn for a period of time. Be mindful that we are not talking about the end of the world as we know it; we are simply saying that it will be a different and slightly more difficult place to live in for those of us in the developed and indebted West. We will all wake up in the days, weeks, and months afterward and go to work, continue to invest, and live our lives. I am eagerly awaiting the day to finally arrive when our fiduciary duty compels us to worry less and invest more. It is our job as a fiduciary to avoid nursing 50%+ losses because we failed to believe that a cluster of sovereign defaults was even possible (let alone probable). We urge you to consider the ramifications of our thesis being correct, preparing yourself for the worst while hoping for the best. As one of my closest friends advises me; "Trade as you like, divest accordingly."


J. Kyle Bass Managing Partner

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

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