The Case for a Sovereign Debt Default in Japan - Kyle Bass

Aug.23.10 | About: iShares MSCI (EWJ)

Hedge fund manager Kyle Bass, managing partner at Hayman Investments, earned his claim to fame by predicting the crash in housing prices and the financial crisis that would follow. Now, he has focused his cold stare on the bubbles in sovereign debt in developed economies. The folks at CNBC’s Strategy session interviewed Bass last week to give him a chance to restate his case for his biggest target: Japan.

Now that the U.S. dollar is hovering at 15-year lows against the Japanese yen, it is understandably difficult for anyone to believe that Japan’s sovereign debt bubble will blow anytime soon. Yet, Bass has the composed, patient, and deliberate demeanor of someone who is well-accustomed to explaining himself to a skeptical and doubtful audience.

Bass’s current investment position places 90% of his capital betting long the U.S. on special situations. Because he believes global GDP growth might soon drop to -4 or -5%, he is not long stocks. I believe the rest of his capital (“the tail”) is betting on sovereign defaults in Japan and Europe.

Bass describes the case against Japan in the video clip posted below. Here are some highlights:

Japan’s weakening fiscal situation

  1. 40 trillion yen in tax receipts is the same level from 1985 in nominal terms.
  2. Expenses have increased 200% since 1985 to 97 trillion yen.
  3. 1 quadrillion yen in total credit market debt = 190% of GDP (U.S. is at 113% of GDP).
  4. By themselves, interest expense, debt service, and social security are greater than revenue.

Japan will be forced to restructure within 1 to 2 years

  1. Japan debt largely self-funded by corporate and personal savings generated from trade surplus.
  2. Personal savings rate now zero and corporate savings rate has fallen to 4%.
  3. Japanese population is now in secular decline, working age population peaked last year.
  4. Without more people entering the system (“the Ponzi scheme”), Japan will be forced to look for external funding and pay 100-200 extra basis points.
  5. Every 100 basis points costs Japan 25% of revenue for debt service.

Bass notes that this all means Japan has reached the point of permanent structural deficit – debt grows exponentially, revenue growth stays linear, and servicing debt becomes impossible. The impact of a pop in Japanese sovereign debt will be quite dramatic. Japanese debt is the one place Japanese investors have never lost money. With real estate down 70% and the stock market down 75% (from their respective peaks?), everyone is crowded into Japanese debt.

Bass also spent some time discussing debt issues in Europe, the United States, and developed economies in general.

European stress test was not credible

  1. For context, note that U.S. bank balance sheets are 100% of U.S. GDP whereas European banks have balance sheets equaling 350% of European GDP – meaning they are significantly more leveraged.
  2. The U.S. stress test used 1 central regulator, failed 47% of banks, and required an immediate injection of $75B in capital.
  3. The European stress test used 26 organizations, failed 3 banks (92% passed), and required an injection of $3B (3.5B euro) in capital.
  4. While the largest concern for Europe is sovereign default, the stress tests did not include that scenario.

Finally, Bass’s overall outlook on sovereign debt in the world’s developed economies remains quite grim. In a different video clip (click here to view, starting about 2 minutes in), Bass provides various discouraging nuggets of data and info:

  • The U.S. Federal Reserve cannot move interest rates since 50% of U.S. debt rolls over every year. A hike in (short-term) rates would cause immediate and sharp pain.
  • The world has to create an additional $4.5 trillion in new debt to plug its fiscal holes. (He asked rhetorically “where is that money going to come from?”. He next essentially implied much of the money will get printed).
  • Last year, the developed world printed 12% of GDP or 40% of government expenditures.

Bass warned that a secular change is underway; the kind of change that happens once every hundred years. Yet, most investment decisions assume these events mark just another cyclical change.




Source: CNBC (August 17, 2010)

Disclosure: long USD/JPY, short EUR/USD