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Kyle Bass of Hayman Capital was on Canada’s Business News Network discussing global sovereign debt woes. Bass became famous after his very high profile success in betting on the collapse of the U.S. housing market. After the housing market collapse in the U.S., Bass and Hayman turned their attention to the developed world sovereign balance sheets. Bass’ view is that the crisis from the subprime mortgage collapse never ended and the bad assets were largely transferred to sovereign balance sheets.

I have closely tracked Bass’ comments over the last few years due to his ability to articulate his thesis, while not resorting to hyperbole or faith based investing. Bass’ central thesis can be summarized in a single question: “Does Debt Matter?” Bass and Hayman clearly do think that debt does matter.

Over the past decade global GDP has grown 4 percent annually, whereas global credit has grown 11 percent annually to over $200 trillion. This mismatch simply means that incremental debt is not fueling adequate growth. As debt requires interest payments, inadequate GDP growth creates a debt sustainability issue.

Bass assumes that a European recession is in the works and a weak 2012 is a certainty. The fundamental issue in Europe is that the Eurozone countries have not recapitalized its banks. Debt levels will only grow after banks are forced to recapitalized. Austerity measures in 2012 will slow the economy, thus slowing tax receipts.

Click to enlarge images

Source: Bloomberg

Bass: “Europe's banks have three times as much leverage from equity to assets that U.S. banks have. Spain, by looking at a snapshot on a piece of paper, looks like they might have a manageable scenario, but when they recap their banks they won't have a manageable scenario and they have to recap their banks and so do the rest of Europe."

Troubling for U.S. investors is Bass’ increasingly bearish tone on the U.S. due to fundamental political gridlock. Hayman has held the view that Europe’s debt problems will accelerate Japan’s debt problems, but the U.S. will be the last to go. The U.S. and the dollar will prove to be safe havens until markets turn to the U.S. debt problems. Bass’ view has been that entitlements need to be addressed but the political gridlock in Washington has inhibited any progress. Over 57% of our 2011 budget is spent on healthcare, social security and income security (unemployment benefits). These so-called mandatory items must be addressed in order to reduce the deficit and ultimately the country’s debt levels.

2011 Budget

Source: Office of Management and Budget

Investing Strategy

In Bass’ must watch Americatalyst 2011 interview, Bass urges individual investors to remain very cautious into 2012 and be more conservative than you think you might need to be. As painful as holding large amounts of cash is, I think that Bass’ view should be at least considered. My view is that most U.S. investors have a long held belief that they need to be fully invested. I believe that hedging equity portfolios with covered calls and protective puts is a must for long biased investors.

In addition to a hedged equity portfolio, I believe that investors should own precious metals including gold, silver and palladium. Investors should use the pullback in precious metals markets to build positions.

Source: Remain Very Cautious Into 2012 - Kyle Bass