Mr. Kyle Bass is the managing member and principal of Hayman Advisors which he founded in late 2005 at Dallas, Texas. He himself seeded the fund with his savings of 10 million dollars and attracted about another 100 million dollars from investors whom he pitched with his gloomy diagnosis of the exuberant US mortgage sub-prime market. For the following four years the fund returned 20% in 2006, 216% in 2007, 6% in 2008 and 9% in 2009, and today the assets under management are approximately 740 million dollars.

He was recently profiled in Michael Lewis’ book Boomerang: Travels in the New Third World as one of the fifteen hedge fund managers to have rightly called the collapse of the US sub-prime mortgage market and backed it with a substantial wager. While Mr. Bass has indeed caught the attention of the media by his prognosis about the real estate meltdown (not to mention the accompanying eye-popping return of 216% ) and his other prescient call on the Euro-zone debt crisis, it is worth noting that his deep analyses for both the predictions were based on a decade long career in Wall Street where he sharpened his skills in recognizing distressed debt and special situations at the micro level.

Previous to forming Hayman Advisors, he spent four years as a Managing Director at Legg Mason advising event-driven and special situation investment strategies, and prior to that he worked at Bear Stearns in a similar capacity. Also, his BA from Texas Christian University was in Finance and Real Estate, thereby having provided him a down-to-earth understanding of the principles of real estate debt and equity financing, which obviously many high-level financiers in the private and public sector sorely lacked.

While he started his fund with the objective to create high risk-adjusted returns by taking advantage of special situations such as spin-offs, corporate turnovers, and restructurings, his almost immediate uncovering of the opportunity to short the mortgage market has become an ongoing theme that continues to find fault in the debt structure on a larger and global scale. Essentially, his hedge fund has become a thematic debt analysis think-tank, pronouncing the sub-prime meltdown as a symptom of much larger forces at play as evinced in the Euro debt crisis, which in turn is a symptom of the rich world’s creation of fiat currencies.

We will start by exploring his bet against sub-prime and understanding the detailed work that went in forming that opinion, how that further led him to discover debt problems globally, and his insistence on gold as a hedge against fiat currencies. In his own words, “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.” Of course, he adds, “Needless to say, we have focused on risk management by structuring our positions with the most asymmetric risk/reward scenarios possible.”

Subprime:

Towards the end of 2006, US house prices had been steadily rising at the unprecedented rate of 10% annually for 5 years in a row. Blinded by this recent rise and projecting it into the future, most institutional investors had latched onto the opportunity to make money by investing in securities based on pools of subprime loans.

There was a cohesive, Kool-Aid-drinking network benefiting from these loans: fees for the brokers and originators, securitizations fees for the investment bankers, analysis fees for the rating agencies, underwriting fees for the insurers (who unlike traditional insurers were selling insurance to third parties on the mortgages), and all the end buyers who were complacently collecting high interest on highly-rated debentures. According to Bass, what was being amazingly overlooked was that these loans were being extended so aggressively that (compared to even the traditional subprime borrower) the probability of them being repaid by the unworthy debtors was extremely low.

To substantiate his initial insight, he called on various players involved in the game ranging from residential lenders, mortgage servicers, and Wall Street trading desks among others. Alan Fournier of Pennant Capital assisted Bass with his research. Both Fournier and Mark Hart (of Corriente Capital Management) were two of the earliest believers of Bass’ assertion against the U.S housing market.

Furthermore, news reports were evaluated and even private detectives were hired to find out the main (worst) players to bet against. By following the leads from Wall Street underwriters, their research focused on finding the mortgage companies with loans at the highest risk of default. All the companies they identified were directly contacted for further investigation into the matter.

The in-depth investigation he conducted with Fournier and Hart led him to Quick Loan Funding and Daniel Sadek, the owner of this California-based mortgage lender. Bass contacted Quick Loan Funding personally and spoke with the senior loan officer, who seemed oblivious as to how all the loans they were generating to unworthy borrowers could end up in being bad for their expanding business. This phone conference cemented Bass’ determination of shorting the mortgages of Quick Loan Funding.

What further strengthened the claim of Bass was the research conducted by Joshua Rosner and Joseph Mason. Rosner of Graham Fisher & Co and Mason belonging to Drexel University published an 84-page research which concluded that S&P, Moody’s and Fitch had wrongly awarded AAA and BBB ratings to some billions of dollars of mortgage securities.

Having confirmed that the subprime mortgage was indeed a house of cards, Bass next figured out what would be the best way to trade his insight: Credit Default Swaps on mortgages. Once again, Bass conducted thorough research in order to entirely grasp how these mortgage bond derivative contracts worked. He studied and restudied “Collateralized Debt Obligations: Structures and Analysis”, a book by Frank Fabozzi on mortgage-backed securities.

Since the value of these derivative contracts was derived from home loan packages and these were commonly used as a way of hedging risk by insuring it, and since the mortgage market was then perceived as very low risk, the price to own these was very cheap and the leverage high. In short, these mortgage bond derivative contracts allowed for Bass to develop a strategy which was less risky yet had high profitability potential.

Bass deliberately eschewed the traditional method of shorting stocks in order to benefit from his analysis. The reasons for this were three-fold: (1) It came with the regular risk of losing more money than invested, (2) the CDS method was a lot more leveraged and could only lose the initial capital outlay (which in his case was still significant), and (3) since there was so much optimism about the housing market, it was a distinct possibility that some private equity fund or leveraged buyout firm would bid for the housing stocks driving them up.

Armed with conclusive research and an actionable trading technique, Fournier, Hart and Bass collectively worked to spread the word about the collapse of the housing market and to raise funds to execute the trade at a meaningful level. As part of this campaign, in August 2006 in New York in a room filled with high-ranking executives of a major investment bank, Bass presented his research about why he thought the U.S residential market was headed towards disaster. He explained in detail why he was interested in betting against them while they were confidently creating and trading securities based on sub-prime mortgages.

But with Wall Street bulge firms, domestic and foreign pension funds, and Japanese and German banks contradicting Bass’ conviction, and the investment-grade ratings of securities reassuring their decision of investing in such securities, Bass realized it would be impossible to convince the people in the room that his analysis is sound. His prediction that almost 1 trillion of these loans will be at extreme risk of default fell on deaf ears as the going was so good that everyone was in such a jovial mood that they did not want to even entertain the notion of such an unprecedented loss.

In any case, Bass went on to raise about 110 million dollars from various sources and began to short sell one and quarter billion dollars ’worth of subprime securities maximizing the derivative contracts’ leverage. To be on the safe side, he fully avoided any AAA rated securities. 75% of the subprime securities were BBB rated mortgage instruments, some of which included Sadek’s loans. Nomura Home Equity Loan was among the securities which were shorted as it had an instrument which was 37% based on loans issued by Quick Loan. Close to a third of the securities were of grade BBB-, some of which again had mortgages of Quick Loan Funding. Bass executed these transactions during August and September of 2006 when preliminary signs of foreclosures were starting to flash all across the country.

Greece:

Towards the end of 2008, as the full effects of the subprime crisis reverberated through the US and globally, Bass’ attention re-focused on the US government as it started to bail out the largest perpetrators of the mortgage mess. He soon realized that the 2 trillion dollar subprime crisis was not being dealt with outright honesty but simply being absorbed not only by the US government but governments of other rich countries too since the pool of mortgages was bought by foreign entities also.

As the governments took the bad debts on their own books, essentially making the private banking sector an extension of the governments themselves, he thought he should evaluate the data on sovereign debt while including the private banking loans and then compare it to their revenues. (Again, this harks back to a simple debt analysis for an operating company: is there enough revenue to cover debt servicing, accounting for a reasonable rise in interest rates?). To his surprise, there was no such data available!

It took Hayman analysts four months to put the data together. The results were, to say the least, staggering: From start of 2002 towards end of 2008, global debt had more than doubled from 84 trillion to 195 trillion dollars. The ratios of debt to revenue for developed countries were stratospherically higher than any historic norms. For example, Ireland’s debt was twenty five times its annual tax revenues, and France’s and Spain’s came in at a multiple of ten. In the case of Japan, Ireland and Greece, a small spike in interest rates would cause their whole incomes to go to servicing the interest parts of the debts only.

In contrast, US, despite its four-decade streak of limitless credit creation since it delinked the dollar from the gold standard, was actually one of the least levered countries and had significant (though not endless) wiggle room for interest rates — to ensure this is not an unqualified optimism about US, Bass recently classified US as the tallest person in a room of midgets.

At first incredulous of his own research, he sought out someone credible that would be willing to double check their numbers. He sought out to Harvard Professor Kenneth Rogoff, the leading authority on sovereign debt defaults. When he showed him the Hayman research, to his surprise, Rogoff’s responded, “I can hardly believe it is this bad”.

Having verified their research, before the end of 2008, Hayman Capital decided to once again use the levered strategy of derivatives to execute their wager. They started buying credit default swaps on sovereign debt of countries that came to be notoriously known as the PIIGS. For a country like Greece, which is making daily headlines today about its crisis, it only cost him 11 basis points to buy the derivatives. Naturally the insurance cost on these has gone up much higher since then, but if Greece does indeed default Hayman Capital stands to make close to 700 thousand dollars per every 1100 dollar bet they took.

Japan and Gold:

A corollary of Bass’ analysis of global debt is indeed that eventually as countries come dangerously close to a default, their cost of debt would increase as investors would demand a higher rate for the added risk – thereby causing a spiral effect where an increase in interest rates causes a country to devalue their currency which leads to more interest rate cost which leads to default.

A historical exception to this has been Japan where decades of deficit spending and central government borrowing have not led to currency devaluation or higher interest rate. As a matter of fact, Japan has enjoyed a near-zero or Zero Interest Rate Policy (ZIRP) for a decade.

Bass explains this anomaly by the high savings rate that has been prevalent among Japanese institutions and individuals. These savings in turn have been reinvested into Japanes bonds, accounting for 95% of Japanese debt to be held domestically.

According to his analysis, though, the situation in Japan is alarmingly changing. First, population growth in Japan peaked in 2004 and since then has been in a steady decline. Second, traditionally, there is no openness to immigration, therefore there will be no outside infusion in the population. Third, the composition of the population itself is biased towards senior citizens — 23% of Japanese are over 65 years of age, compared to 13% in the US and 8% globally. As the dynamics of Japan’s demographics play out, the government of Japan will have to seek out international markets to finance their debt. If they have to pay rates, say, comparable to AAA-rated France, all their income will go to servicing the debt.

While it not clear whether Hayman Capital has placed any trades on the Japan thesis, for overall currency devaluation and consequent inflationary pressures, they have been recommending gold and other scarce commodities as a hedge. Not surprisingly, the emphasis is on owning the actual commodities rather than any paper (fiat) security that represents an ownership interest in the commodities.

Update:

Hayman Capital released a letter to shareholders in November 2011, which summarized and updated his views on the current debt crisis. Tellingly, the letter is titled “Imminent Defaults”, as he sees his ongoing research being confirmed in today’s environment. What started in 2008 as sophisticated speculation about the global debt troubles, now takes on a more assertive tone.

According to the letter, the debts of the following countries are simply not sustainable anymore: Greece, Ireland, Italy, Iceland, Spain, Belgium, Portugal, and France (PIIIGSBF). Ditto for Japan. As for the US, it is fast approaching a “zone of insolvency” and the only way to avoid that outcome is through a combination of “massive” spending cuts and “severe” reduction in entitlements — “do not hold your breath”, he admonishes.

Again, he uses same criteria (with added generosity) to evaluate countries as one would to evaluate a corporate. A nation confronts an insolvency risk when (1) more than 10% of central government revenues are dedicated to servicing the interest part only of its debt, and (2) the total debt is more than five times the revenue.

As for Japan, with a 20X debt to revenue ratio and at 229% of GDP, he reiterates his earlier thesis that they cannot internally fund themselves because of declining savings rate — this time adding that the saving rate will go to zero by mid of 2012.

Specifically for the euro-zone, he also uses a new method to evaluate market-based ratings (relying on credit default swaps as indicators) in contrast to the ones granted by the rating agencies. The results show a wide differential between the agency ratings and the market perception of the ratings. For instance, the AAA agency rating of France deteriorates to a Baa3 rating, representing a nine notch differential. It is noteworthy that none of the countries undergo an upgrade or remain at the same rating in this exercise.

In regards to possible bailouts by IMF and the latest European version of the same, he accentuates that they are over-committed as is. This is reminiscent of his comment about IMF in October 2009: “You cannot borrow your way out of debt”.

He paints the overall global debt picture with new numbers: Since 2002 global credit has grown at an 11% annually compounded rate from 80 trillion to 200 trillion dollars, while GDP has only grown at 4%. Now the global debt to GDP percentage is at 310% and the only times it has ever gone over 200% is during major wars. In the final analysis, the quantitative characteristics point to imminent defaults. Now we just have to process it quantitatively and adjust to “new” economic realities.

QUOTES

“It may not be the end of the world, but a lot of people are going to lose a lot of money. Our goal is not to be one of them.”

“We walked Rogoff through the numbers and he just looked at them, then sat back in his chair, and said, ‘I can hardly believe it is this bad.’ And I said, ‘Wait a minute. You’re the world’s foremost expert on sovereign balance sheets. You are the go-to guy for sovereign trouble. You taught at Princeton with Ben Bernanke. You introduced Larry Summers to his second wife. If you don’t know this, who does?’ I thought, Holy sh_t, who is paying attention?”

“Here’s the only way I think things can work out for these countries. If they start running real budget surpluses. Yeah, and that will happen right after monkeys fly out of your ass.”

“I literally couldn’t wait one more day. I was so afraid that this was going to crack before I got the money raised. And remittance data comes out on the 25th day of every month and I couldn’t wait for one more bit of data to come out. So I was fearful that we had spent all this time doing work, in-depth research, and modeling mortgages and that, when I was meeting with investors, I said ‘We need to raise this right now.’”

“I never count my chickens before they hatch. Alright? In this business and doing this, basically investing in global capital markets, you have to be opinionated. But I don’t believe you can bring an ego into it. The moment you bring an ego or arrogance into finance, you’ll lose. You’ll be crushed under your own weight. You have to be able to admit readily that you’re wrong and learn from it and move on.”