Hayman Capital Management by zerohedge

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Hayman Capital Management
    “It occurs at first very slowly, then all at once.”
                                                 — Ernest Hemingway describing the process of going broke

   In late December 2011, Hayman Capital founder and portfolio manager Kyle Bass was reviewing
Japanese government budget projections for 2012. According to government projections, government
spending would fall slightly, from ¥70,863 billion in 2011 to ¥68,390 billion.

   The projections appeared contrary to Hayman Capital’s views on Japan, where the fund had built
a bearish position. Japan had the world’s highest debt burden, whether expressed as a percentage of
GDP, or as a percentage of government revenue. Guided by recent global events, Bass forecast that
Japan would soon experience increases in interest rates, a devaluation of the currency, and,
eventually, a restructuring of the country’s debt.

    As Bass reviewed the projections, he fixated on government spending on pensions. A central
premise in Hayman Capital’s position on Japan was that this spending would continue to rise, given
Japan’s rapidly aging population. Bass was thus surprised to see the government report a planned
decline in Social Security expenditures in 2012, to ¥26,390 billion, from ¥28,707 billion in 2011. This
decline in payments explained much of the change in projected expenditures between 2011 and 2012.

    As Bass studied the new data, he wondered whether it was time to revisit his bearish views, or
alternately whether there was more hidden in the numbers.

Hayman Capital Management, L.P.
   Based in Dallas, Texas, Hayman Capital Management was an event-driven hedge fund that
sought to generate above average risk-adjusted returns with low correlation with peer funds.
Hayman Capital invested primarily in short-duration credit and event-driven equities. At the same
time, the fund sought exposure to asymmetrically priced “tail” events “identified and accumulated
prior to the general market.”

Professor Robin Greenwood, Research Associate Julie Messina (MBA 2001), and Research Associate Jared Dourdeville prepared this case with
generous assistance provided by Mayuka Yamazaki, Research Associate at the Harvard Business School Japan Research Center (JRC). HBS cases
are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of
effective or ineffective management.

Copyright © 2012 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized,
photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
212-091                                                                        Hayman Capital Management

    Bass had founded Hayman Capital Management in December 2005 after 11 years of experience in
financial services. A college diver at Texas Christian University, Bass had started his investing career
at Prudential Securities. Soon after, Bass moved to Bear Stearns in Dallas to cover event-driven hedge
funds. At Bear Stearns, Bass developed expertise in event-driven “special situation” investing, and,
at age 28, became among the firm’s youngest ever Senior Managing Directors.

   In 2001, Bass was recruited by Legg Mason to build a new Texas office for Institutional Equity
Sales. When Legg Mason merged with Citigroup in late 2005, Bass formed Hayman Capital, and in
February 2006, launched the Hayman Capital Master Fund (HCMF), the primary investment vehicle.
The fund was seeded with $5 million of savings accumulated over his financial career, and $28
million contributed by former clients.

    When HCMF was launched in 2006, the residential housing boom in the United States was
nearing its peak. Intrigued by the boom in structured products based on residential mortgages, Bass
had come to believe that many of these instruments were aggressively priced relative to
fundamentals. Historically, home prices had closely tracked inflation, except during the 2001-2006
period, during which residential prices rose significantly as reflected in the Case-Shiller U.S. National
Home Price Index, which rose from 108 at the beginning of 2001 to a peak of 191 in early 2006.
However, Bass believed that many structured securities relied on housing prices continuing to rise.
At the same time, Bass had observed that housing markets in some parts of the United States had
already started to turn. As global credit markets repriced these securities in 2007, Hayman’s positions
became a source of significant profits. That year, HMCF returned over 200%, net, to investors. A
special purpose vehicle formed to invest exclusively in subprime securities returned over 440%.

    By the end of 2011, Hayman Capital employed 23 people, including eight investment
professionals, and managed $943 million in HMCF (See Exhibit 1). In December 2011, HCMF’s core
portfolio focused on a variety of credit investments, special-situation-related equities, and precious
metals. At the same time, the “tail” portion of the portfolio included positions in foreign currencies,
interest rates, and sovereign debt.

   In forming the fund’s views on tail risk, Bass relied on a combination of in-depth data analysis
and common-sense. Said Bass, “These results are the product of many sleepless nights, intense
governmental action, and countless discussions among our investment team with regard to our
macro views. Needless to say, we have focused on risk management by structuring our positions
with the most asymmetric risk/reward scenarios possible.” Bass also felt it was important to
appreciate the lessons of financial history. In coming to his views on sovereign debt, for example,
Bass was fond of statistical work by economists Carmen Reinhart and Kenneth Rogoff, who had
analyzed defaults and debt over eight centuries.

   Among the fund’s sovereign debt positions, the largest comprised a series of bets on Japanese
government bonds and the Japanese exchange rate. These positions formed the core of Hayman’s
new special purpose vehicle “Japan Macro Opportunities Master Fund” (JMOMF), which Bass had
started in July 2010, and which was co-managed by Richard Howard. Bass and Howard believed that
a confluence of factors and pricing made shorting JGB futures incredibly attractive. Howard argued
that “it can take much longer than might be expected for the decay in Japan’s fiscal condition to
materialize, but once it does, it will unravel very quickly.” Bass summarized: “there has never in
history been a situation more asymmetric than Japan is today. All of the convexity in the world lies

Hayman Capital Management                                                                      212-091

Japanese Post-War Economic History
    In the decades following World War II, Japan transformed itself from a war-torn country to the
second largest economy in the world, a position it held from 1968 until 2010 when it was displaced by
China. From 1956 to 1973, the Japanese economy grew at an average rate of 9.2% per year. During
this time Japan expanded its manufacturing base, and the economy became heavily export-oriented.

   By the mid-1970s Japan was no longer experiencing double-digit growth, but its real GDP growth
rate of approximately 4% through the late 1970s and early 1980s was still significantly above that of
many other developed nations’ economies (See Exhibit 2 for Japanese key macroeconomic data 1980-

    In 1985, Japan produced ¥321 trillion of GDP (approximately US$13,384 per capita). Starting that
year, the Yen began to appreciate rapidly, with the exchange rate falling from 259.5 Yen/USD in
February 1985 to 121.9 Yen/USD in November 1988 (see Exhibit 3). The yen’s appreciation hurt
Japanese exports, and was soon evident in the trade balance—exports fell from 14.7% of GDP in 1984
to 11.1% in 1986. In response, the Bank of Japan lowered the official discount rate from 5.0% to 2.5%
to stimulate the economy.

    With low interest rates in Japan compared to other developed countries, and continuing moves to
deregulate the international flow of capital, Japanese investors swapped yen for other currencies to
purchase assets overseas. These flows kept the currency weak relative to the dollar, fostering an
increased trade surplus. At the same time, low interest rates encouraged investors to “reach” for
yield in riskier corporate debt securities and land, and a financial bubble formed. Commercial land
prices more than tripled between 1985 and 19901. The Nikkei 225 stock index, which summarized the
stock prices of the largest public companies in Japan, rose from 7,116 in December 1980 to over 30,000
at its peak in 1989 (see Exhibit 4).

   In an attempt to restrain speculation, the Bank of Japan raised interest rates five times between
April 1989 and August 1990, from 2.5% to 6.0%. The government also placed restrictions on bank
loans used for buying real estate.

   After reaching a peak of 38,915 on December 29, 1989, the Nikkei fell abruptly on rumors that the
Bank of Japan would continue to raise rates beyond 6.0%. Land prices began falling soon after. By
1992, the Nikkei was 60% below its 1989 peak. The Bank of Japan’s response was somewhat delayed
(there was one last interest rate increase in August 1990), but by 1991 the BOJ had lowered interest
rates to mitigate financial damage (see Exhibit 5).

    The bubble’s collapse in the early 1990s was followed by a period which became known as Japan’s
“lost decade”, because of the slow economic growth, declining stock and land prices, and a battery of
half-hearted policy responses from the Bank of Japan and Ministry of Finance (MOF). Japanese banks
suffered in the fallout, since many of the loans they had issued during the bubble had used land as
collateral. Reluctant to acknowledge losses, in many cases, banks continued to roll over loans to
“zombie” firms. These companies, which under normal circumstances might have gone out of
business, were kept afloat by government and bank support. At the same time, Japan continued to be
home to many world-class businesses, mostly exporters, which continued to have positive cash flows
and pay down debt. In aggregate, however, private debt contracted.

   Following a number of experiments with non-conventional monetary policy, the central
government raised spending in an effort to stimulate domestic demand. The government central
budget went from a net surplus in 1990 to a deficit of ¥11.4 trillion (approximately 2.4% of GDP) in

212-091                                                                          Hayman Capital Management

1993 and ¥25.8 trillion (5.1% of GDP) in 1996. 2 The borrowed money was used for projects ranging
from propping up struggling firms and restoring bank stability to updating infrastructure and public
works. Although it was difficult to measure, increased government spending appeared to have a
minimal effect on the economy, with GDP growth averaging less than 1% over that period. And,
despite declines in interest rates from an average of 5.6% in 1991 to 0.2% in 2001, bank lending to the
private nonfinancial sector declined (see Exhibit 6). Yet, Japan’s debt-to-GDP ratio, which had
declined from 1988 to 1990, more than doubled between 1991 and 2001 (see Exhibit 7).

    Japan’s nominal tax revenues peaked in 1990, but declined thereafter, with government spending
taking the opposite pattern. The role of Japanese deficit spending in preventing more severe impacts
to the Japanese economy was a topic of lively policy debate, with some observers arguing that the
spending was too little too late, and others asserting that the debt growth would cripple the economy
in years to come. For example, Richard Koo, a longtime observer of Japan and chief economist at
Nomura Research Institute, had argued that government borrowing was necessary to counteract the
decline in private sector leverage, and that attempts to reduce deficits while the private sector was
deleveraging could precipitate “deflationary spirals”.3

   Despite increasing government demand for funds, interest rates remained low. The Bank of Japan
consistently cut interest rates after 1991 until reaching a low of 0.1% in 2001. Although the Bank of
Japan was legally independent of the Ministry of Finance, many observers claimed that the BOJ’s
ability to maneuver was limited.

    In 2007 and 2008, declining real estate prices in the United States triggered a global financial crisis.
Although Japanese banks were not significantly affected by the disruptions in credit markets, the
global recession, which continued through 2009 and 2010, reduced demand for Japanese exports,
hurting the country’s important manufacturing sector. The Nikkei fell by more than 55% from 18,138
in June 2007 to 7,568 by the end of February 2009. Nominal GDP in 2009 fell by 7% from its 2007 level.

   In an effort to stimulate the economy again, the government further increased spending (by 25%
as tax revenues fell 28%). The deficit increased from 6.0% of GDP immediately before the crisis in
2007 to over 14% in 2009 (see Exhibit 8).4 This was the first time the deficit would exceed tax

   By 2010, however, economic conditions appeared to be improving. Japan recorded real GDP
growth of 4% (nominal GDP growth was lower, because the country was experiencing deflation), the
highest the country had experienced in almost two decades.

    In the midst of this recovery, in March 2011, the country experienced a devastating earthquake.
The earthquake, which struck offshore the Tohoku region in northeast Japan, triggered a tsunami that
claimed over 15,000 lives,5 caused a nuclear meltdown at the Fukushima Daiichi Nuclear Power
Plant, and incurred damages estimated at between ¥20 trillion ($250 billion) and ¥25 trillion ($309
billion).6,7 Reconstruction costs associated with the earthquake and tsunami had significant impact
on Japan’s national budget and added significantly to the country’s debt burden.

   By the end of 2011, Japan’s general government debt-to-GDP ratio exceeded 220%, the highest in
the world.8 The consistently low interest rates had made maintenance of this large debt burden
possible, however with discount rates set at 0.3% in 2011, the government had little room to cut rates

Hayman Capital Management                                                                        212-091

Japanese Government Bonds
   As of 2011, Japanese Government Bonds (JGBs) were available in a variety of maturities extending
up to 40 years. Depending on the specific bond issue, rates were either fixed, floating, or indexed to
prices. Treasury discount bills (T-Bills, also called “discount short-term bonds”) were offered as well,
with maturities of one year or less. As of December 2011, approximately 82% of the public debt
securities were JGBs, with the remaining 13% short-term “financing bills.” The government also
borrowed modest amounts from other vehicles.9

    Historically, over 90% of Japanese government debt was bought by domestic investors, with the
largest holders being Japanese institutions (see Exhibit 9). While in 2011 Japanese households owned
less than 4% of JGBs directly, they owned more than half indirectly because deposit-taking
institutions such as banks channeled household savings back into JGBs. 10 Japan’s historically high
household savings rate and corporate savings rate (primarily derivatives of significant current
account surpluses) had helped the government to sustain a high debt burden, as incremental units of
public debt had historically been absorbed domestically with little impact on interest rates. Many
observers attributed to high household savings rates combined with a lack of willingness to buy
international assets.

    Bass argued that demand for JGBs was in part driven by psychological factors: “What one asset
has earned a 20-year pro-cyclical, ‘Pavlovian’ response associated with safety and even more safety?
The buyers and owners JGBs have never lost money in the purchase of these instruments as their
interest rates have done nothing but fall for the better part of the last two decades.” This view was
partly confirmed in a survey Bass commissioned of Japanese retail investors, in which he asked them
why they purchased JGBs. The majority of these investors cited “principal protection” as the reason;
among the other reasons, a few investors cited their patriotism.

   Even absent psychological considerations, domestic demand for JGBs could be expected to change
going forward because of the aging Japanese population. According to data from the Japanese
census and projections from the National Institute of Population and Social Security Research, the
Japanese population peaked in 2004 and would continue to decline into the foreseeable future. 11
Furthermore, the percentage of citizens age 65 or over could be expected to increase, compounding
the already existing age group disparity in the country. As of 2010 the OECD estimated that 22.8% of
the Japanese population was over the age of 65 - almost twice the percentage of elderly in the U.S.
and that of the OECD average (see Exhibit 10).

   As the Japanese workforce neared retirement, it seemed likely that many would switch from being
net savers to net spenders, drawing down their bank and pension funds. 12 The Bank of Tokyo-
Mitsubishi projected that net household savings would become negative by 2014 or 2015. 13 As early
as April 2010, Bloomberg reported that Japan Post Bank – the state-owned bank affiliated with the
postal system-- planned to cut their budget for government bonds by 30% in 2011. 14 As of September
2011, the Japan Post Bank was the single largest holder of JGBs, owning 16% of all outstanding bonds.
Finally, in February 2011, Japan’s Government Investment Pension Fund (GPIF), the world’s largest
pension fund, announced that it would likely become a net seller of JGBs in order to meet increased
cash outflows.15 With over ¥108 trillion of assets under management, the GPIF had historically been a
net buyer of JGBs, holding 9.4% of all outstanding JGBs as of September 2011.

212-091                                                                        Hayman Capital Management

The Yen
   The Japanese yen was the official currency of Japan, and the third most traded currency in the
foreign exchange market after the US dollar and the euro. Between the end of World War II and
1971, the value of the yen had been fixed at 360 per US dollar by the Bretton Woods system. When the
United States abandoned the gold standard in 1971, the yen appreciated to 308 yen per US dollar, a
rate fixed by the Smithsonian Agreement with the United States. In early 1973, the agreement was
abandoned, and the currency was allowed to float. Nevertheless, concerned that a strong yen would
impact exports, the government continued to intervene in the foreign exchange market.

    By 2011, the yen was considered to be one of the “reserve currencies” by central banks around the
world. And, because of its “safe-haven” status, the currency tended to appreciate during times of
global economic uncertainty. Although the Japanese economy fared poorly during the 2008 financial
crisis compared to its G-7 counterparts, the yen appreciated.

   Throughout the 2000s, the yen was popular as a so-called “funding currency” among foreign
exchange traders, because of its low interest rate and stable exchange rate. In a “carry trade”, a trader
would borrow Japanese yen at a low rate, and use it to purchase a currency with a higher interest
rate, such as the Swiss franc or Australian dollar. As long as the yen did not appreciate too much, the
trader would earn profits when the interest rate spread was positive.

Global Economic Events 2007-2011
   Following a dramatic run-up between 2001 and 2006, US housing prices collapsed in 2007 and
2008. The value of mortgages used to finance home purchases, and structured products based on
those mortgages, collapsed alongside. Losses on associated mortgage-backed securities damaged the
balance sheets of US financial institutions, rendering a few insolvent. Financial markets panicked. In
the fall of 2008, global investment bank Lehman Brothers failed. Soon after, global credit markets
froze, and stock markets around the world followed suit.

    In response to events in the financial sector, the U.S. government announced a number of
emergency measures – starting with the Emergency Economic Stabilization Act in October 2008,
which authorized up to $700 billion in funding for the government to deal with the financial crisis.
On February 17, 2009, U.S. President Obama signed the American Recovery and Reinvestment Act,
which directed US$787 billion towards infrastructure, education, health, and energy, federal tax
incentives, and expansion of unemployment benefits and other social welfare provisions. As a result,
total U.S. government debt increased by US$1 trillion in FY2008, US$1.9 trillion in FY2009, and
US$1.7 trillion in FY2010.16 By February 2012, gross debt stood at $15.4 trillion, approximately 102%
of GDP.17 The impact of the added debt on capital markets was, however, softened by large
purchases of U.S. Treasuries by the Federal Reserve though its asset purchase programs.

    As fears for the worst in the U.S. financial sector began to subside in mid-2009, investors turned
their attention to sovereign debt markets. Bass and his team at Hayman Capital were early to
recognize the potential consequences. Particularly relevant in Bass’s mind was the idea that total
government liabilities should include the assets of a country’s banking system, as he guessed that
governments would transfer private liabilities to public balance sheets in order to keep financial
systems afloat. By late 2008, Hayman Capital had bought credit default swaps on Greece, Ireland,
Italy, Portugal, Spain, and Switzerland. These instruments were designed to pay off if a government
were to experience a credit “event,” such as a debt write-down.

Hayman Capital Management                                                                         212-091

    As fears for the worst in the U.S. financial sector began to subside in mid-2009, investors turned
their attention to sovereign debt markets. Greece was the first country to raise flags. In 2009 its debt-
to-GDP ratio had reached 113%. This prompted the ratings agencies to downgrade Greek debt,
resulting in increased scrutiny on other Eurozone nations, especially Ireland, Portugal, and Spain,
and later Italy. Shortly thereafter, a Eurozone review of Greece’s accounting procedures revealed
that its 2009 budget deficit exceeded 12.7%, instead of the 6.7% originally reported. 18 In the face of
rising civil unrest, the Eurozone (the countries in Europe that had jointly adopted the euro as a
currency) and the International Monetary Fund (IMF) provided an initial €22 billion safety net to
Greece, followed by €30 billion of emergency loans. As concerns continued to mount, borrowing
costs for many countries—and especially countries that were running larger debt/GDP ratios—
increased significantly. Exhibit 11 shows 5-year credit default swap (CDS) rates during this time.
Exhibit 12 shows that Italy and Spain, countries with similarly high debt-to-GDP ratios and budget
deficits, also experienced increases in their CDS rates.

Hayman Capital’s Views on Japan
    As Bass surveyed global sovereign debt markets in late 2011, Japan stood out. With a debt-to-GDP
ratio of over 200%, Bass wondered what had allowed the country to borrow at such low interest rates.
He argued, “if you plugged in the data into a sovereign credit analysis, you came up with the credit
rating of Jamaica, which is B minus.” Bass felt that it was only a matter of time before other investors
would recognize this, at which point Japan would be forced to pay “international” interest rates.

    In understanding sovereign debt sustainability, Bass believed that there were two critical ratios.
First, the ratio of sovereign debt to central government revenue could not be too high, with the exact
number depending on the government’s flexibility in raising revenue or cutting spending (see
Exhibit 13). Second, interest expense could not be too large a percentage of central government
revenue (see Exhibit 14). Bass believed that “central government revenue is a more precise measure
of a government’s substantive ability to pay creditors.” Adding, “we find that when debt grows to
such levels that it eclipses revenue multiple times over, there is a non-linear relationship between
revenues and expenses in that total expenditures increase faster than revenues due to the rise in
interest expense from a higher debt load coupled with a higher weighted-average cost of capital and
the natural inflation of discretionary expenditure increases.” Bass called this the “Keynesian

    Part of Bass’ thesis on Japan hinged on demographics. The average age of the Japanese
population was projected to increase significantly, with potentially one third of the population past
retirement age by 2050. The potential decline in the Japanese labor force would not only reduce the
productive capacity of the economy but could also limit organic demand growth. In countries with
robust demographic profiles, the rate of GDP growth matched or exceeded the growth in social
security expenditure, allowing a sustainable fiscal environment. In Japan however, Bass believed that
stagnant nominal GDP levels and declining tax revenues would only increase the gap between what
was needed to fund social security expenditures. He cited a Goldman Sachs research report in which
double-digit Japanese fiscal deficits were projected to continue at least into the mid 2010s (see Exhibit

   Bass was well aware that over the years, many macro investors had lost money betting on
increasing interest rates in Japan. Among investors, the trade became known as “the widow maker”
because of its performance. Because of this, he and Richard Howard, the chief global strategist at
Hayman, thought hard about potential catalysts. Trying to explain why a credit “event” was
imminent, Bass wrote:

212-091                                                                        Hayman Capital Management

        “We focus on incremental sales or “flow” versus the “stock” of aggregated debt. To
    simplify, the available pools of capital are comprised of two accounts – household and
    corporate sector. […] As long as the sum of these two numbers exceeds the running
    government fiscal deficit, the Japanese government (in theory) has the ability to self-finance or
    sell additional government bonds into the domestic pool of capital. This is the key relationship
    the macro investors have missed for the last decade – it is not a question of willingness, but one
    of capacity. As the Japanese government’s structural deficit grows wider […], the divergence
    between savings and the deficit will increase.”

    Owing to the size of Japan’s debt, any changes in interest rates or asymmetries in debt maturity
structure would have very significant impacts on the national budget. Japan had primarily issued 10-
year and 5-year JGBs to finance the deficits it had been running since the early 1990’s; the average
maturity of JGBs was approximately 4.5 years. In 2011, however, Bass noted that the large percentage
of front-end loaded maturities would have immediate repercussions. ¥116 trillion of JGBs were
expected to mature in FY 2011 alone, corresponding to 18.2% of the total outstanding bonds. A
further ¥295 trillion of government debt was projected to be due by the end of 2012. 20

    In this situation, even a small increase in interest rates would have large budgetary consequences
as Japan refinanced its existing debt. Assuming that the current JGB interest rate of 1.03% applied to
all government borrowings totaling ¥958 trillion, Hayman calculations suggested the interest expense
in 2011 would consume over 23% of the government’s projected FY 2011 tax revenue, based on
approximately ¥42 trillion of tax receipts.21 Furthermore, it would only take a 2.52% rise in interest
rates, to an average of just over 3.55% for debt service, to consume 100% of government tax revenue. 22
Bass called this the “Keynesian end-point”, where interest on debt alone would exceed revenue.

   Hypothetically, robust GDP growth could mitigate the impacts of Japan’s debt burden, but by
Hayman’s estimates, it would take approximately 4.8% annual nominal GDP growth for Japan to stay
ahead of its debt. Japan’s GDP was expected to rise no more than 1.9% in 2012, after falling 0.8% in

   Conventional wisdom held that Japan’s high domestic savings rate had provided cover for deficit
spending, however, Bass believed that the recent increase in spending and decline in savings had
inverted this cover. Moreover, recent changes in the balance of trade due to the Tohoku earthquake
and tsunami had sped up the decline in Japan’s current account. The first major change has been the
abrupt closures of nearly all of the nuclear power plants. These closures forced Japan to import more
crude oil, LNG, and coal, without the benefit of corresponding additional exports. Second, prior to
the earthquake, many Japanese electronics and auto manufacturers were sole-sourcing parts within
Japan, but began sourcing parts over the ASEAN nations in an attempt to avoid a future disruption.
The cumulative effect of these two changes pushed Japan’s balance of trade from positive to negative.
Bass summarized the implications, “The balance of trade, coupled with the income account and the
equity account comprise the current account. We at Hayman believe that Japan will most likely
become a full capital importer, that is, a full negative current account, in the next 24 months.”

     If Japan were no longer able to source funding domestically, it would have to rely on
international capital markets with significantly higher interest rates. Excluding Japan, 10-year bond
yields in G-7 economies averaged 3.5% in 2011. But the issue was not simply increases in the cost of
debt; Bass believed that small increases in interest rates could leave the banking system with
significant near-term funding issues.

   Bass believed that the recent actions by the Ministry of Finance and Bank of Japan to curb the rise
of the yen represented the government’s acknowledgement of the gravity of the situation. 23 On

Hayman Capital Management                                                                         212-091

January 27, 2011 Standard & Poor's downgraded Japan’s long-term sovereign credit rating from AA
to AA- , the first such cut in nine years.24 Then on August 24, 2011, following the effects of the
Tohoku earthquake and tsunami, Moody’s downgraded its rating on Japan to Aa3. 25 Japanese
politicians soon acknowledged the potential repercussions of the downgrade. In November of 2011,
Hirohisa Fukii, a former Minister of Finance, said, “What’s happening in Europe could take place
someday in Japan. Politicians must understand that Japan has the world’s worst debt situation.” 26
Former Deputy Vice Minister of Finance official Takatoshi Ito went further, “Japan risks going down
the same road as Greece as the cost of funding the world’s largest public debt rises in years ahead.
When local investors reach their limit for funding the nation’s bonds, the Bank of Japan will either
have to monetize the debt or we will need foreigners to purchase bonds and yields will jump.”27

     Bass’s view was that things could change quite quickly. He referenced the 5-year CDS rates for
Greece, Ireland and Portugal, which increased very significantly in 2011. In comparing CDS rates for
Japan and Italy, he noted that until recently these two rates were generally within 100 basis points of
each other. Over a span of months as rumors surfaced in May 2011 about a potential debt crisis in
Italy, Italian CDS rates shot up from about 150 basis points in May to over 500 basis points by
September. In comparison, Japanese CDS rates remained stable over this same period, averaging
about 110 basis points. Similarly the implied yield on the Italian ten-year government bond moved
from around 4% to as high as 6.5% on November 25, 2011. If domestic investors became net sellers of
JGBs, then foreign buyers would have to come in to fill the gap. But foreign buyers would require
higher interest rates, much as they required higher rates on sovereign debt positions around the
world. The expectation of higher interest payments could quickly consume the government budget.
With this dynamic, Bass believed that investors’ initial beliefs could become a self-fulfilling prophecy.
At that point, “No matter how they attempt to quell the crisis, no matter where they turn, they will
realize that they are in checkmate.” Bass referred to this situation as being “springloaded,” with
interest rate volatility at a historical low just before exploding.

   A key tenet in Bass’s belief was that analyzing Japan was no longer purely an exercise in
quantitative analysis. He referenced psychologist Daniel Kahneman’s work on cognitive biases,
noting especially the “availability” heuristic in which people tended to predict the frequency of an
event within a population based on how easily an example can be brought to mind. He considered
the US experience during the housing bubble of the 2000s as a good example:

      “The US housing marketplace developed an axiom over time. Since housing prices had
   never fallen, housing prices could therefore never fall. This is exactly how repetitive events,
   whether it’s housing moving higher year after year, or JGBs going higher in price every single
   year, become cognitive biases. Then, at some point in time, they actually become axiomatic.
   These axioms are rooted in belief systems that are developed through inductive reasoning
   based upon repetition of perceived fact patterns. When these patterns move to excess and can
   no longer be sustained, they reverse themselves in a violent manner.”

    Some market participants believed that because Japan had control over its own currency, the
country could “inflate” its way out of the debt problem. Bass disagreed: “Throughout history,” he
explained, “there has rarely been a choice between inflation or default—most of the time, one actually
causes the other.” The mechanism Bass had in mind was that as a country attempted to “monetize”
the debt, the resulting increase in inflation expectations would push up nominal interest rates, as well
as increasing the interest rate risk premium. When this happened, interest payments on debt would
have to increase, creating further need for monetization, and ultimately, a restructuring. In arguing
this view, Bass cited work by economists Carmen Reinhart and Kenneth Rogoff, who had shown that
sovereign debt crises often precipitated inflation, exchange rate crashes, and banking crises. 28

212-091                                                                        Hayman Capital Management

    If Bass was correct about how events would unfold in Japan, there remained the question of how
to build the fund’s position. In theory, events could unfold in both the currency markets and in
interest rates. Thus, the fund could take on direct short exposure, perhaps by entering into swap
transactions in which the fund received floating payments in return for paying fixed payments.
Alternatively, the fund could purchase “protection,” perhaps through the use of derivatives. Bass
noted that some of these contracts could be mispriced, because the popular Black Scholes option
pricing model “misprices risks at secular turning points.” Bass explained: “Defining risk solely as
historical volatility is a mistake many risk and portfolio managers make. Using this model to price
options is akin to driving a racecar using the rear-view mirror.” Regarding JGBs, Bass argued that
“the underlying assets are the riskiest they have been in post-World War II history, while the price of
the optionality on this risk is the cheapest it has ever been.” Added Howard, “this is textbook market

   In early 2012, the yen was trading at 76.91 per US dollar. Ten-year JGBs had an implied yield of
0.19%, and implied volatility of yields was 2% (see Exhibit 16). The 5-year swap rate was
approximately 0.50% (Exhibit 17). Options prices, measured as basis points per year of interest rate
volatility, were lower in Japan than they had ever been-- at the money one-year options on 5-year
swap rates could be bought for approximately 40 basis points per year.

The Contrarian View
   Although some investors agreed that Bass’s predictions for Japan would ultimately prove to be
correct, they wondered about how events would play out in the short-run. The most popular
counterarguments were:

   The government’s large financial asset position: At the end of 2010, the government held
approximately ¥320 trillion in liquid financial assets. Of this, ¥240 trillion was invested in equity and
debt securities, while the balance of ¥80 trillion was held in currency and deposits. If needed, the
government could liquidate some of these investments as a short-term source of funding to meet
immediate obligations (see Exhibit 19).29 It was Bass’s and Howard’s position that “political realities”
would make the liquidation of these assets difficult until a crisis appeared. Moreover, both men felt
that Japan would need these assets to rebuild in the event that a crisis hit.

   The resilience of the Japanese people: Perceptions of what investors had believed was sustainable had
been proved wrong in Japan. Many observers pointed, as an example, to the resilience of the Japanese
people following the March 2011 earthquake and tsunami. Facing power outages, consumers and
firms immediately cut consumption voluntarily: total energy use in November 2011 was 9.8% lower
than in November 2010.30 Computer maker Fujitsu, for example, curtailed use of elevators, lights, air
conditioners, water heaters, and refrigerators. Carmaker Toyota virtually eliminated the use of air
conditioning, with its workers assembling cars at 84 degrees Farenheit through the summer. The
carmaker also moved workers’ “weekend” to Thursday and Friday, to reduce demand on those

    Soft landing. A strategist at a New York hedge fund explained this view: “the current account is
aggregate savings minus aggregate investment. If national savings exceeds domestic investment then
this excess savings flow abroad and the current account will be in surplus, and vice versa.” He
continued, “The exchange rate adjusts, as does the demand for funds…if rates on JGBs were to rise by
50 basis points, I suspect the Japanese would increase their savings to take advantage of the increase
in yields.” Bass, who had heard this frequently, disagreed, countered “if dissaving exceeds savings

Hayman Capital Management                                                                        212-091

while the government is running excessive fiscal deficits, the incremental need for capital becomes
overwhelming. There is no lack of demand for JGBs, but there may be a problem with capacity.”

    Tax and Pension Reform: Other observers remarked that Japan would be able to buy several years of
time by raising tax rates to reduce the deficit. While as of 2012 Japan’s tax rates were already high by
international standards (30% corporate tax, 40% income tax for the highest income bracket), in the
early 1980s Japan’s corporate tax was 42% and its highest-bracket income tax was 75% (see Exhibit
20).32 However, the Diet (Japan’s bicameral legislature) was considering an increase in the
consumption tax, which already brought in a sizeable fraction of government revenue. While tax
increases would run the risk of suppressing economic activity and increasing unemployment, Japan
had a history of being able to endure shared sacrifice for the good of the country.

   It had been widely recognized that tax and social security reform was necessary in light of the
changing population demographics. Japan’s public pension system was a Pay-As-You-Go (PAYG)
type, where pensions of retirees were financed by premiums paid by the current working generation.
With an aging population, this would place a disproportionate burden on the current generation of
workers. Some had suggested abolishing PAYG and replacing that system with a consumption tax
paid by the entire population. During the transition period, however, there would be an additional
burden associated with unfunded pension liabilities from previous generations and payment for
future pensions.

The Decision
    It was late December 2011, and Bass was feverishly digesting any new data that could change his
views on unfolding events in Europe and Japan. He returned to Japan’s central government budget
for 2012 (see Exhibit 21), trying to understand how government spending would evolve over the next
few years. “In many ways I hope we are wrong about Japan,” he mused, “I could easily be wrong
about the whole thing, but I haven’t been persuaded yet.”

212-091                                                                 Hayman Capital Management

Exhibit 1     Hayman Capital Management Investment Team

Team Member                                     Professional and Educational Background

Kyle Bass                                       Bear Stearns
Founder & Portfolio Manager                     Legg Mason
                                                B.B.A., Texas Christian University

Richard J.W. Howard                             Clark & Weinstock
Global Strategist & Co-Portfolio Manager of     Clayton Utz
Japan Macro Opportunities Fund                  B.Law, B.Commerce, Univ. of New South
Andrew N. Jent                                  CXO, LLC
President                                       FlashNet Communications
                                                B.B.A, Texas Christian University

Brandon Osmon                                   Countrywide Financial Corp.
Chief Risk Officer, MD – Financials             AmeriCredit Corp.
                                                B.B.A., University of Texas

Stephen Fitzpatrick                             Bear Stearns
MD - Trading                                    Legg Mason
                                                Wesley Capital Management
                                                B.S., Texas Christian University
Wes Swank                                       Citigroup
MD – Energy & Natural Resources                 M.B.A., Stanford University
                                                B.S.,Virginia Military Institute

Jeff Cate                                       Atlas Capital Management
Director of Research – Fixed Income             Highland Capital
                                                CIGNA Investment Management
                                                M. Finance, London Business School
                                                B.S., southern Methodist University
Esra Karakaya                                   Citigroup
Senior Analyst – Emerging Markets               M.B.A., Harvard University
                                                B.Sc., M.Sc., Stockholm School of Economics

Source:   Hayman Capital.

                                                                                                                                                                                       212-091   -13-

Exhibit 2        Japan Key Macroeconomic Data, 1980-2011

                                         Private        Govt.        Gross                                    Real                    Real
                                        Consum-      Consum-         Fixed                                 GDP in         GDP      GDP per       Stock of     Stock of    Consumer
               Nominal                       tion         tion        Invt.     Exports      Imports          2005      Growth      Capital       Money        Money           Price       Inflation
                  GDP     Population       (% of        (% of        (% of        (% of        (% of         prices       Rate      (US$ at          M1a          M2b         Index            Rate
    Year        (¥ trn)       (MM)        GDP)         GDP)          GDP)         GDP)         GDP)         (¥ trn)     (% pa)        PPP)        (¥ trn)      (¥ trn)   (2005=100)          (% pa)
    1980           250        116.8         54.9         13.9         31.3         13.5         14.2           296          NA       9,219            83          207          76.9              NA
    1981           264        117.5         54.3         13.9         30.3         14.4         13.6           303          3.0     10,321            91          230          80.6              4.8
    1982           277        118.3         55.5         14.1         29.1         14.2         13.4           312          2.8     11,189            96          247          82.8              2.7
    1983           284        119.1         56.2         14.3         27.6         13.6         11.8           316          1.6     11,738            96          264          84.4              1.9
    1984           301        119.9         55.5         14.1         27.2         14.7         12.0           324          3.1     12,468           103          282          86.3              2.3
    1985           321        120.8         54.7         13.7         27.3         14.1         10.7           339          5.1     13,384           106          307          88.1              2.1
    1986           334        121.2         54.4         13.7         27.3         11.1          7.2           352          3.0     14,035           117          336          88.6              0.6
    1987           348        121.7         54.8         13.8         28.1         10.2          7.1           369          3.7     14,880           123          373          88.7              0.1
    1988           381        122.3         53.8         13.4         29.8          9.8          7.5           397          6.8     16,362           133          410          89.3              0.7
    1989           413        122.9         53.4         13.2         30.9         10.3          8.7           420          5.3     17,777           136          458          91.3              2.2
    1990           447        123.5         53.4         13.1         31.7         10.3          9.3           442          5.3     19,372           142          496          94.1              3.1
    1991           472        123.9         52.9         13.2         31.3          9.9          8.2           455          3.3     20,585           156          508          97.2              3.3
    1992           478        124.3         53.6         13.6         30.2          9.8          7.6           458          1.0     21,176           162          508          98.9              1.7
    1993           480        124.7         54.4         14.1         29.0          9.1          6.8           458          0.2     21,612           173          519         100.1              1.2
    1994           486        125.0         55.3         14.7         28.3          9.0          7.0           451         -3.8     22,178           180          535         100.8              0.7
    1995           495        125.3         55.4         15.2         27.7          9.0          7.7           461          1.9     22,954           204          549         100.7             -0.1
    1996           510        125.6         55.5         15.4         28.2          9.7          9.2           477          2.7     23,960           224          562         101.1              0.3
    1997           518        126.0         55.4         15.4         27.6         10.7          9.7           479          1.6     24,694           243          579         102.8              1.7
    1998           503        126.2         56.1         15.9         25.8         10.8          8.9           468         -2.1     24,364           255          603         103.4              0.6
    1999           497        126.5         57.2         16.5         25.5         10.2          8.6           468         -0.1     24,655           285          624         103.1             -0.3
    2000           503        126.7         56.5         16.9         25.2         10.9          9.4           477          2.2     26,014           295          631         102.6             -0.5
    2001           502        127.0         57.3         17.7         24.3         10.5          9.8           482          0.4     26,651           335          644         101.8             -0.8
    2002           493        127.2         57.9         18.3         22.9         11.2          9.9           480          0.3     27,306           414          666         100.9             -0.9
    2003           491        127.4         57.6         18.3         22.5         11.9         10.2           485          1.7     28,055           432          678         100.6             -0.3
    2004           494        127.5         57.3         18.2         22.2         13.2         11.2           492          2.3     29,413           448          689         100.6              0.0
    2005           497        127.5         57.8         18.3         22.4         14.3         12.9           497          1.3     30,500           469          701         100.0             -0.6
    2006           500        127.5         57.9         18.1         22.7         16.2         14.9           501          1.7     31,888           483          708         100.2              0.2
    2007           504        127.4         57.3         18.1         22.6         17.7         16.1           507          2.2     33,496           483          720         100.3              0.1
    2008           500        127.3         58.3         18.6         22.4         17.7         17.5           500         -1.1     33,686           480          735         101.7              1.4
    2009           469        127.1         60.1         19.9         20.8         12.7         12.3           481         -5.5     32,130           483          754         100.3             -1.4
    2010           476        126.8         59.2         19.8         20.1         15.2         14.0           494          4.5     34,110           492          775          99.6             -0.7
    2011           472        126.5         60.3         20.7         20.6         15.3         16.1           494         -0.9     34,430           516          797          99.3             -0.3
a   Money M1 = Total Supply of Notes and Coins + Demand Deposits
b   Money M2 = M1 + Quasi Money where Quasi Money = assets with properties resembling those of M1

Source: Economist Intelligence Unit; Country Data – Annual Time Series; The Bank of Japan, http://www.boj.or.jp/en/statistics/index.htm/, accessed on March 12, 2012.
                                                                                                                                                                                       212-091   -14-

Exhibit 2 Continued

    Year                Current             Trade            Services           Income         Transfers         Capital &          Financial           Capital          Changes
                       Accounta            Balance                                                               Financial           Account           Account         in Reserve
                                               (A)                (B)               (C)               (D)        Accountb                 (E)              (F)             Assets
     1980                   -2.4               0.5               -2.5               0.1              -0.4             -1.4                0.5             -1.9                1.1
     1981                    1.0               4.2               -2.9               0.1              -0.4             -2.5               -2.0             -0.5                0.7
     1982                    1.6               4.1               -2.2               0.1              -0.4             -4.5               -3.4             -1.1               -1.2
     1983                    4.9               7.3               -2.1               0.1              -0.5              2.9               -4.1              1.2                0.3
     1984                    8.5              10.7               -1.9               0.1              -0.5            -15.7              -12.0             -3.7                0.4
     1985                   12.0              13.0               -2.3               1.6              -0.3            -13.0              -13.0              0.9                0.1
     1986                   14.2              15.1               -2.2               1.6              -0.3            -12.3              -12.2              0.4               -2.5
     1987                   12.2              13.2               -2.9               2.3              -0.5             -6.2               -6.0             -0.6               -5.5
     1988                   10.1              11.8               -3.9               2.6              -0.4             -8.3               -8.2              0.2               -2.1
     1989                    8.7              11.0               -5.1               3.2              -0.4             -7.5               -7.3             -3.3                1.8
     1990                    6.5              10.1               -6.2               3.3              -0.7             -4.9               -4.7             -3.1                1.4
     1991                    9.2              12.9               -5.6               3.5              -1.6             -9.3               -9.1             -1.2                1.1
     1992                   14.2              15.8               -5.6               4.5              -0.5            -12.9              -12.8             -1.4               -0.1
     1993                   14.7              15.5               -4.8               4.5              -0.6            -11.7              -11.5             -0.1               -3.0
     1994                   13.3              14.7               -4.9               4.1              -0.6             -9.0               -8.8             -2.0               -2.6
     1995                   10.4              12.3               -5.4               4.2              -0.7             -6.3               -6.1              1.1               -5.4
     1996                    7.2               8.8               -6.5               5.8              -1.0             -3.3               -3.0             -0.2               -3.9
     1997                   11.7              12.1               -6.3               7.0              -1.1            -15.1              -14.6              3.7               -0.8
     1998                   15.5              15.8               -6.2               7.1              -1.1            -17.1              -15.2             -1.4                1.0
     1999                   13.1              13.8               -5.9               6.6              -1.4             -6.3               -4.4              0.1               -8.8
     2000                   12.9              12.4               -4.9               6.5              -1.1             -9.4               -8.4              0.8               -5.3
     2001                   10.7               8.4               -5.2               8.4              -1.0             -6.2               -5.8              0.1               -4.9
     2002                   14.1              11.6               -5.1               8.3              -0.6             -8.5               -8.1             -0.3               -5.8
     2003                   15.8              12.0               -3.6               8.3              -0.9              7.7                8.2             -2.4              -21.5
     2004                   18.6              13.9               -3.7               9.3              -0.9              1.7                2.3             -3.6              -17.3
     2005                   18.3              10.3               -2.6              11.4              -0.9            -14.0              -13.5             -2.3               -2.5
     2006                   19.8               9.5               -2.1              13.7              -1.2            -12.5              -11.9             -4.2               -3.7
     2007                   24.8              12.3               -2.5              16.3              -1.4            -22.5              -22.1              1.6               -4.3
     2008                   16.4               4.0               -2.1              15.8              -1.4            -18.4              -17.8              4.7               -3.2
     2009                   13.3               4.0               -1.9              12.3              -1.2            -12.7              -12.2              1.4               -2.5
     2010                   17.2              78.0               -1.4              11.7              -1.1            -12.0              -11.6             -1.8               -3.8
    2011E                    9.6              -1.6               -1.6              14.0              -1.2              6.0                6.0             -1.8              -13.8

Notes: A + B + C + D (may not add up due to rounding) b E + F (may not add up due to rounding). Data from 1980-1984 from Bank of Japan, prior to the revision and is converted from US dollars back
to yen using the average exchange rates on Dec 30/31 for the current and year prior (mid-year convention). Some capital account transactions before 1985 were reclassified from Basic to Short-Term;
Capital Account is assumed to be the Overall Account (Basic Balance + Short-Term Capital + Errors & Omissions). Changes in Reserve Assets assumed to be the Balance of Monetary Movements in Gold
and Foreign Exchange Reserves.

Source: Ministry of Finance http://www.mof.go.jp/english/international_policy/reference/balance_of_payments/ebpnet.htm accessed on March 15, 2012.
Hayman Capital Management                                                                                                                                  212-091

Exhibit 3                                    Yen/USD Exchange Rate

Source: Global Financial Data.

Exhibit 4                                    Nikkei 225 Index versus JGB Index

                             45,000                                                                                              7,000

                                                                                                 JGB Total Return Index

    Nikkei 225 Index Value

                                                                                                                                         JGB Index Value


                                                                                                    Nikkei 225 Index




                                 0                                                                                               0







                                                                       Nikkei 225 Index           JGB Index

Source: Datastream and Global Financial Data.

212-091                                                                                                                                        Hayman Capital Management

Exhibit 5                                            Bank of Japan Discount Rate and 10-year JGB Yields





                          Percent (%)










                                                                            10-Year JGB Yields          Bank of Japan Official Discount Rate

Source: Bond yields from Datastream. Discount rate from Bank of Japan Time-Series Data Search, “The Basic Discount
        Rate and Basic Loan Rate”, http://www.stat-search.boj.or.jp/index_en.html accessed on February 29, 2012.
Exhibit 6                                            Japan’s Private versus Public Sector Debt


Debt (Trillions of Yen)

                          2,000                                                                                                                          Government


                                500                                                              GDP








Source: Bank of Japan Time-Series Data Search http://www.stat-search.boj.or.jp/index_en.html accessed February 29,
        2012. GDP data only through 2000 from Japan Cabinet Office National Accounts, Quarterly Estimates of GDP.
        http://www.esri.cao.go.jp/en/sna/sokuhou/kako/2001/qe011_68/gdemenue68_arv.html accessed February
        29, 2012. GDP data post-2000 data from http://www.esri.cao.go.jp/en/sna/sokuhou/qe/gdemenu_ea.html
        accessed on February 29, 2012.

Hayman Capital Management                                                                                                                       212-091

Exhibit 7                               Japan’s Debt-to-GDP Ratio


      Percent of GDP (%)









Source: International Monetary Fund (IMF) Data and Statistics, World Economic Outlook Database, September 2011
        edition. Downloadable at http://www.imf.org/external/pubs/ft/ weo/2011/02/weodata/index.aspx accessed
        on February 29, 2012.
Exhibit 8                               Japan’s Tax Revenues, Expenditures, and Deficit as a Percentage of GDP


  Percent of GDP (%)











Source: Japanese Ministry of Finance, Summary of Revenues and Expenditures in General Account,
        http://www.mof.go.jp/ english/budget/statistics/201006/ s201006_01a.pdf accessed on February 29, 2012.
        GDP figures from International Monetary Fund (IMF) Data and Statistics, World Economic Outlook Database,
        September 2011 edition, http://www.imf.org/ external/pubs/ft/weo/2011/02/weodata/index.aspx accessed
        on February 29, 2011.

212-091                                                                                                         Hayman Capital Management

Exhibit 9                                        Japanese Government Bonds (JGB) Holders, as of September 2011

Source: Japanese Ministry of Finance, “Highlights of Fiscal Year 2012 Government Debt Management”
        http://www.mof.go.jp/english/jgbs/debt_management/plan/e20111224reference.pdf accessed February 29,

Exhibit 10                                        Japan’s Population Over Age 65, as Percentage of Total Population

  Percent of Total Population Over 65 (%)



                                            15                                                                        OECD




Source: Organization for Economic Co-operation & Development (OECD).

Hayman Capital Management                                                                                                                                                                                                                               212-091

Exhibit 11                                                      5-year Credit Default Swap Rates, Selected Countries

                                                   3,500                                                                                                                                                                                   Greece
                       CDS Spread (Basis Points)

                                                       500                                                                                                                                                                                 Italy
                                                         0                                                                                                                                                                                  Japan





Source: Bloomberg.

Exhibit 12                                                      Sovereign Debt as a Percentage of GDP, Selected Countries

  Sovereign Debt as a Percent of GDP (%)



















Source: International Monetary Fund (IMF) Data and Statistics, World Economic Outlook Database, September 2011 Ed.
        http://www.imf.org/external/pubs/ft/weo/2011/02/weodata/index.aspx accessed on February 29, 2012.

212-091                                                                                    Hayman Capital Management

Exhibit 13     2010 Sovereign Debt as a Percentage of Revenue, Selected Countries

Source: International Monetary Fund (IMF) Data and Statistics, World Economic Outlook Database, September 2011 Ed.
        http://www.imf.org/external/pubs/ft/weo/2011/02/weodata/index.aspx accessed on March 15, 2012. Japan data
        sourced from Japan Ministry of Finance, “Japan’s Fiscal Condition (Dec 24, 2011)”,
        http://www.mof.go.jp/english/budget/budget/fy2012/e20111224b.pdf accessed on March 15, 2012.

Exhibit 14     2010 Sovereign Interest as a Percentage of Revenue, Selected Countries

Source: Moody’s Investor Service Country Credit Statistical Handbook (November 2011). Japan data sourced from Japan
        Ministry      of       Finance,       “Japan’s        Fiscal    Condition       (Dec       24,       2011)”,
        http://www.mof.go.jp/english/budget/budget/fy2012/e20111224b.pdf accessed on March 15, 2012. Japan
        revenue does not include bond issues.

Hayman Capital Management                                                                                         212-091

Exhibit 15        Japan’s Tax Revenues, Expenditures and Debt, 2008 – 2012 (¥ billion)

                                                              2008         2009          2010        2011E         2012E
Tax Revenue                                                53,554        46,103       37,396        40,927        42,346
Other Revenue                                                4,159        9,151       10,600         7,187         3,744
Total Revenues                                             57,713        55,254       47,996        48,114        46,090
Debt Service
-- Principal Repayment                                     10,863        10,757       10,840        11,590        12,090
-- Interest                                                  9,300        9,487         9,809        9,959         9,855
Total                                                      20,163        20,244       20,649        21,549        21,944
Government Spending
-- Social Security                                         21,782        24,834       27,269        28,708        26,423
-- Local Grant Allocations                                 15,614        16,573       17,478        16,785        17,143
-- Education/Science                                         5,312        5,310         5,586        5,510         5,638
-- National Defense                                          4,779        4,774         4,790        4,775         4,827
-- Public Works                                              6,735        7,070         5,773        4,974         5,302
-- Other                                                     8,675        9,742       10,754        10,111         9,056
Total                                                      62,897        68,303       71,650        70,863        68,389
Total Expenditure                                          83,060        88,547       92,299        92,412        90,333

Central Government Debt
Construction and Special Deficit Financing Bonds          545,936      593,971       636,312       675,540      708,855
Other Government Bonds                                    135,630      111,333       117,496       106,635
Total Government Bonds                                    681,566      705,304       758,308       782,175
Other Government Borrowings & Financing Bills             165,125      166,206       165,343       176,464
Total Government Debt                                     846,691      871,510       919,151       958,639

Notes: 2011 and 2012 government spending includes expenditures related to the Tohoku earthquake/tsunami. Other
Government Bonds include FILP Bonds, Subsidy Bonds, Subscription and Contribution Bonds, and Japan National Oil
Bonds. Total Government Debt excludes non-government debt carrying government guarantees. 2008 interest is based on
casewriter estimates.

Source: Japan Ministry of Finance. Revenues and Expenditures data from, “Japan’s Fiscal Condition (Dec 24, 2011)” and
        “Highlights        of       the      Budget       for       FY       2012         (Dec       24,       2011)”
        http://www.mof.go.jp/english/budget/budget/index.html accessed March 8, 2012. Debt data from,
        http://www.mof.go.jp/english/jgbs/reference/gbb/201112.html accessed March 8, 2012.

212-091                                                                                                                                                       Hayman Capital Management

Exhibit 16                                             Pricing of Interest Rate Volatility on the Japanese yen

                                        20                                                                                                                                           150
                                                                                                                                      Price                                          145
     Volatility or Implied Volatility


                                                                                                                                                                                           Option Price
                                        10                                                                                                                                           135
                                                                                         Volatility                         Implied volatility
                                        0                                                                                                                                            120









                                                                    Hist Vol(Price)(5D)               Implied Vol                 Price

Source: Bloomberg.

Exhibit 17                                             5-year swap rates








    Jan-07                                             Jul-07       Jan-08     Jul-08       Jan-09        Jul-09        Jan-10              Jul-10             Jan-11       Jul-11

                                                      5-year swap rate                                             Rolling 50-day historical volatility (daily)
                                                      Rolling 50-day historical volatility (annualized)

Source: Bloomberg.

Hayman Capital Management                                                                                                                                             212-091

Exhibit 18                                             Swaption pricing


   Annualized Cost of at-the-money option on

           swap rate (bps per year)


                                               100                                                              EUR


                                               60                                                               JPY













                                                                       1-yr option on 5-yr yen swap                        1-yr option on 5-yr dollar swap

                                                                       1-yr option on 5-yr euro swap

Source: Bloomberg. The figure denotes the cost, in basis points per year, of at the money options on 5-year swaps.

212-091                                                                                     Hayman Capital Management

Exhibit 19          Net Asset Position (trillions of Yen)

                                    2001    2002      2003      2004      2005     2006      2007      2008      2009     2010
Non-Financial Assets
 - Land                              153     147       143      139       135       135       136       133       127     125
- Produced Assets                    390     395       404      414       423       431       448       453       447     454
Total Non-Financial Assets           544     541       547      553       559       565       583       586       575     579
Financial Assets
- Currency & Deposits                201     181       163      149       135       124       106        90        80      79
- Loans                               38      36        34        40       41        34        26        21        28      32
- Securities Other Than Shares        54      66        75        92      112       126       129       141       126     128
- Share and Other Equities            76      79        81        89       99       101       115       100       108     114
- Other Financial Assets              77      86       106      125       139       149       150       132       148     141
Total Financial Assets               446     447       459      495       526       532       526       484       490     494
Total Assets                         989     988     1,005     1,047    1,084     1,097     1,109     1,070     1,065    1,073

- Loans                              194     198       198      199       195       189       179       172       169     166
- Securities Other Than Shares       524     555       594      649       686       691       704       733       761     820
- Shares and Other Equities           24      25        20        26       24        24        23        23        23      23
- Other Liabilities                   35      41        34        36       35        39        33        34        37      29
Total Liabilities                    777     819       846      910       940       942       939       961       991    1037

Net Assets                           212     170       160      137       145       155       170       109        74      36

Notes: Totals may not add up due to rounding. Over this period between 42-56% of financial assets were social security

Source: Japan’s Cabinet Office, Economic and Social Research Institute (ESRI) Statement of National Accounts, CY 2010.
        See: http://www.esri.cao.go.jp/en/sna/data/kakuhou/files/2010/24annual_report_e.html accessed on April 4,

Hayman Capital Management                                                                                                     212-091

Exhibit 20                     Japan’s Corporate and Income Tax Rates



   Percent (%)












                                              Corporate Tax Rate          Income Tax Rate for Highest Income Bracket

Does not include other taxes such as the business tax and inhabitant tax levied on corporations or social security tax levied on

Source: Casewriter estimates.

212-091                                                                                          Hayman Capital Management

Exhibit 21          Outline of Japanese Government’s FY 2012 Budget (General Account, Selected Slides)

                                     Outline of FY2012 Budget (General Account)

     1)    Allocating budget to the measure for the real revitalization of Japan to recover Japan’s economy and society.
     2)    Reviewing the existing budget based on the result of evaluation by the Policy Proposing Type Screening
     3)    Reducing public sector’s waste thoroughly.
     4)    Following the supplementary budgets for FY2011, focusing on measures for recovery and reconstruction from the
           Great East Japan Earthquake.
     5)    To maintain confidence of the bond market, maintaining Overall Expenditure Limit (approximately ¥68.4 trillion) and
           restraining the amount of new government bonds issuance (approximately ¥44 trillion).

                                   FY2011 Budget       FY2012 Budget          Δ          Notes
Revenues                                                                                 Medium-Term Fiscal Framework:
Tax Revenues                                                                             “Make every effort to ensure that the
                                            40,927            42,346           1,419
                                                                                         amount of new government bond
Other Revenues                               7,187              3,744        (3,443)     issuance in FY2012 does not exceed
Govt. Bond Issues                           44,298            44,244              (54)   that in FY2011 (approximately ¥44
- Construction                               6,090              5,909          (181)
- Deficit-Financing                         38,208            38,335              127
Total                                       92,412            90,334         (2,078)
Expenditures                                                                             Medium-Term Fiscal Framework:
Nat’l Debt Service                                                                       “Primary balance expense will not, in
                                            21,549            21,944              395
                                                                                         substance, exceed that of the previous
Primary Balance Exp.                        70,863            68,390         (2,473)     fiscal year.”
- Social Security                           28,708            26,390         (2,318)
                                                                                         Social Security excludes the amount
- Local Allocation                          16,785            16,594           (191)     required to ensure one-half support
- Education/Science                          5,510              5,406             104    for basic pension expense by the
- Public Works                               4,974              4,573          (401)     national government contribution in
                                                                                         FY2012. Temporary funding for basic
- National Defense                           4,775              4,714             (61)   pension (the gap between targeted
- Crisis Contingency Reserve                   810                910             100    one-half public contribution and that
- Transfers for Earthquake                         -              551             551    of 36.5% ongoing budget) in FY2012
                                                                                         would be financed by a government
- Other                                      9,301              9,252             (48)   compensation bond reimbursed by
                                                                                         fiscal revenues acquired by drastic
Total                                       92,412            90,334         (2,078)     reform of the taxation system.

Source: Selected slides adapted from Japan Ministry of Finance, “Highlights of the Budget for FY 2012 (Dec 24, 2011)”,
http://www.mof.go.jp/english/budget/budget/fy2012/e20111224a.pdf accessed on March 22, 2012.

Hayman Capital Management                                                                                      212-091


   1    The Japan Real Estate Institute (JREI) Commercial Land Price Index for 6 large cities.
   2    International Monetary Fund (IMF) database.
   3  Richard Koo, The Eurozone Crisis: Causes, Remedy and Misperceptions, Nomura Research Institute March
27, 2012.
   4    International Monetary Fund (IMF) database.
   5    Japanese National Police Agency.
   6 IHS Global Insight, “Japan’s Earthquake: A Macroeconomic Damage Assessment”, Country Intelligence

   7   Bloomberg, “Japan Sees Quake Damage Bill of Up to $309 Billion, Almost Four Katrinas,”
katrinas.html accessed February 23, 2011.
   8This refers to general government debt to GDP; Central Government debt was about 205%, and almost
215% including government guaranteed debt.
    9  Ministry of Finance Japan, “Central Government Debt (As of December                               31,   2011),”
http://www.mof.go.jp/english/jgbs/reference/gbb/201112.html, accessed April 2012.
   10   See Exhibit 9. Banks, including the Bank of Japan held 52.2% of all JGBs as of September 2011.
    11 The National Institute of Population and Social Security Research http://www.ipss.go.jp/site-

ad/index_english/population-e.html “Population Projections for Japan: 2006: 2055” (December 2006) at
http://www.ipss.go.jp/webj-ad/WebJournal.files/population/2008_4/05population.pdf       and   “Population
Projections for Japan: 2001 to 2050” (January 2002) at http://www.ipss.go.jp/pp-newest/e/ppfj02/top.html ,
accessed on March 14, 2012.
   12    Japanese social security payments begin at age 60 but some workers continue to elect working past this
    13  Bank of Tokyo-Mitsubishi, Economic Review (Vol. 5, No. 5, May 10,                                       2010),
http://www.bk.mufg.jp/report/ ecorev2010e/Ecoreview_20100520.pdf, accessed on February 29, 2012.
   14   Bloomberg, “Japan Post Bank cuts budget for government bonds by 30%” (April 1, 2010).
    15 Bloomberg, “World’s Biggest Pension Fund Will Likely Sell Japan Bonds” (February 24, 2011),

japanese-bonds.html accessed on February 29, 2012.
    16 U.S.     Department         of       Treasury,        Bureau         of       Public         Debt,
http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo5.htm accessed on February 14, 2012.
   17    U.S. Department of Commerce, Bureau of Economics Analysis, www.bea.gov accessed on February 14,
   18 Oxford Economics, http://www.oxfordeconomics.com/free/pdfs/greece_default(jan10).pdf accessed on

March 8, 2012.
   19 Goldman Sachs, “Japan Economics Analyst: JGB Supply & Demand – Clouds Gathering on the Horizon”

(October 20, 2009).
   20   Based on June 2011 date provided by the Japan Ministry of Finance.

212-091                                                                             Hayman Capital Management

      To obtain the average interest rate, Hayman used the interest expense budgeted forFY2012 of ¥9.85 trillion
and divided this by the total debt outstanding (¥958 trillion in December 2011).                            See:
http://www.mof.go.jp/english/jgbs/ reference/gbb/index.htm.
      Hayman projections were based off the total projected outstanding debt as of December 2012 and assumed
the redemption of debt stayed constant at a 1/60th forced amortization as per current Japanese law.
    23 On September 14, 2010, the Ministry of Finance intervened in the foreign exchange market to sell yen,

marking the first time in over six years that the government had openly worked to influence the yen’s value. On
October 31, 2011, the Bank of Japan conducted a record ¥8.07 trillion of unannounced sales following the yen’s
climb to a post-War-high of 75.35 against the US dollar. On February 14, 2012, the Bank of Japan announced a
further loosening of monetary policy through increased purchases of government bonds.
    24    Reuters,   “S&P      Cuts     Japan’s    Sovereign     Rating”  (January    27,    2011),
http://www.reuters.com/article/2011/01/27/us-japan-economy-debt-idUSTRE70Q23V20110127 accessed on
March 6, 2012.
    25 New York Times, “Moody’s Cuts Japan’s Rating One Notch Citing its Giant Debt” (August 24, 2011),

http://www.nytimes.com/2011/08/24/business/global/japans-credit-rating-cut-by-moodys.html accessed on
March 6, 2012.
    26 Bloomberg, “Japan’s Former Finance Chief says nation may be next Europe” (November 21, 2011),

http://www.bloomberg.com/news/2011-11-21/japan-may-be-next-europe-ex-finance-chief.html accessed on
March 6, 2012.
      Business Week (March 8, 2012): http://www.businessweek.com/news/2012-03-07/japan-posts-record-
current-account-deficit-on-energy-costs-1 accessed on March 30, 2012.
      Carmen Reinhart and Kenneth Rogoff, “This Time is Different: A Panoramic View of Eight Centuries of
Financial Crises” (March 2008), National Bureau of Economic Research Working Paper Series,
http://www.nber.org/papers/w13882.pdf accessed on March 15, 2012.
    29   Bank      of    Japan,    “Japan’s   International    Investment     Position     2010”,             at
http://www.boj.or.jp/en/research/brp/ron_2011/data/ron110826a.pdf accessed on March 19, 2012.
    30  The Breakthrough Institute, “New Data on Japanese Fuel Imports” (Feb 13, 2012),
http://thebreakthrough.org/blog//2012/02/new_data_japanese_fuel_imports-print.html accessed on March 6,
     31 Tundra     Headquarters,    http://www.tundraheadquarters.com/blog/2011/06/24/toyota-recovery-
earthquake-fast/ accessed on March 21, 2012.
      In 2012, Japan levied an additional business and inhabitant tax on corporations, raising the effective
corporate tax burden to 41-43% for some corporations. Japan levied an additional social security tax on
individuals, raising the effective individual tax burden up to 52% in the highest tax bracket.


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