Kyle Bass was one of the handful of hedge funders who made a fortune betting against housing during the subprime bust, and since then he’s been stalking his next big “career trade.”
For years now, his big target has been Japan, a country with a debt-to-GDP ratio of over 200% and a shrinking/ageing population. He’s convinced that it’s only a matter of time before the country implodes in a massive sovereign debt crisis that sends bond yields soaring, while the yen becomes worth less than confetti.
Back in early 2010, there was a story about how he took out a mortgage in yen, because he was so sure that it was going to implode, thus meaning he’d get his house for free.
Well, it hasn’t exactly worked out that way he planned (yet).
Since the beginning of 2010, the exchange has gone from about 92 yen against the dollar to just 80. Kyle Bass’s mortgage has gotten way more expensive.
Of course, the mortgage was probably all for show, a clever marketing move that’s augmented his regular media and conference appearances where he touts the big end-of-Japan trade.
Here’s how he described Japan in a letter last December:
Madoff’s scheme collapsed for one primary reason — he had more investors exiting his scheme than entering. As soon as this happened it was over. According to this most recent census, the Japanese population peaked within the last few years at 127.9 million and has since lost 3 million. Japan has one of the most homogeneous — and some might even call it xenophobic — societies of any developed nation in the world. It is no secret that there is no love lost between the Japanese and their neighbours, and therefore, immigration is an unlikely answer to a dwindling populace.
It is indisputable that Japan has the worst on balance sheet debt burden in the world (roughly 229% of GDP).
The European debt crisis will simply act as an accelerant to the Japanese situation as it will most likely change the qualitative thoughts of JGB investors. We believe that the sequence of events is set to begin in the new few months.
So basically he thinks it’s a giant Ponzi scheme, and that it’s only a matter of time before the market “wakes up”, smells the coffee, and the whole thing implodes.
But not only has his mortgage gotten more expensive, per the chart above, his fund seems to be doing very badly.
According to the website ValueWalk, citing sources, his fund lost 29% of its value in April, and has really been getting clobbered since inception. We haven’t been able to confirm the losses (Update: Now confirmed), though a trader we talked to thinks the numbers pass the smell test, given how Bass has structured his trades, and given the performance of said instruments (a series of currency and bond derivatives designed to profit in a Japanese demise), over the past year.
But still, the general thinking on Bass is that he’s not wrong, he’s just early. After all: 229% debt to GDP!
Back in April, Harvard Business School actually did a case study on the trade and basically said just that: Japan may not blow up imminently, but it’s only a matter of time before it will.
Of course, there are two problems with that.
1) Kyle Bass’s fund may not have years and years worth of investor cash to burn through while waiting around.
2) The entire premise of the trade might be wrong, and it will never happen.
The second reason — that the premise is totally screwed up and that Japan will never implode — is what we’re going to focus on here.
It’s worth nothing that for years people have been making this bet. Kyle Bass is the latest to step in front of what’s been dubbed “The widowmaker“, so-called because of the number of investors who have gotten pummelled trying to short JGBs (Japanese Government Bonds).
But hey, just because something hasn’t worked int he past, it doesn’t mean that it won’t work at some point in the future. Bass is hoping that he got the timing right, and what gives him hope in the timing is that we’ve seen the first sovereign blowups in Europe, and that that will cascade into sovereign blowups elsewhere, and when people see the country with the worst debt-to-GDP in the world, they will pounce.
The problem is that the analysis is totally simplistic and incorrect.
To start, debt-to-GDP (which is the number that in Bass’ mind really damns Japan) is a lousy measure of anything. It’s flawed right from the get-go, given that it’s measuring a stock (total debt) to a flow (a country’s national income for the year).
But beyond that, debt-to-GDP just doesn’t tell you anything about interest rate risk or credit risk.
We pointed out in this chart that for major economies, there’s actually a slight negative correlation between debt-to-GDP and yield on the national 10-year bond.
Photo: Bloomberg, Business Insider
In the US, it’s well known that rates have gotten lower and lower while the national debt has blown through the roof.
So right off the bat, trying to bet against a country based on its debt-to-GDP is a losing idea.
But still, people are convinced that for the US and Japan, it’s just a matter of time.
In Japan, the story that bears like Bass tell themselves is that Japan has a huge well of domestic savings, and that those savings go into Japanese Government Bonds, but that now that Japan is running a trade deficit, those savings are getting depleted, and the country will need to look for outside borrowers, and those borrowers won’t be eager to lend to Japan at the pathetic 0.83% rate on the Japanese 10-year, and that when those foreign borrowers demand market rates, Japan will blow up because there’s just SO much debt that an increase in rates will wreck the country’s public finances.
But this too is nonsense.
There’s no connection between rate sustainability and domestic/foreign borrowing.
For example, in the US, the amount of debt held by foreigners has exploded over the last few decades, but it hasn’t created any upward pressure on rates.
And it’s well known that the majority of Italy’s public debt is held domestically, but that hasn’t prevented the country from teetering on the brink of crisis.
So the whole foreign/domestic borrowing thing is a canard, although it does warrant the question of why it doesn’t matter. After all, it does seem logically like it should be problematic that Japan would have to borrow more and more from abroad.
Here’s how to think about it…
Foreign ownership of debt is not a function of the country going cap in hand all around the world, looking for investors to buy their bonds. It’s a function of trade. When a country runs a trade deficit, it basically means it’s spending more on goods from the rest of the world, than the rest of the world is spending on goods from said country.
So it stands to reason that if Japan is buying a lot from the rest of the world, then there are a lot of yen floating around the world: More yen wind up in places like China, the Mideast, the US, Europe, etc.
What happens to those yen? Well, some will get spent on other things, but in the end, they’ll all wind up in bank accounts somewhere, and somehow they’ll find their way into a Japanese Government Bond, so that the holder of said yen might get some yield. Now theoretically if someone had a bunch of yen, they might prefer to buy German bonds or US bonds, and that’s fine, but then there’s another private holder of yen who has to make a decision about where they’re going to place their currency. Eventually, that currency will find its way home, and the cycle is complete.
This is the key idea that Bass is missing, and why his trade is never going to pay off. For a country that borrows in its own currency, government spending finances borrowing! If Japan spends 100 billion yen on something, that’s 100 billion yen out there in the world that will eventually wind up in a financial institution, where ultimately 100 billion yen worth of JGB will be purchased. It’s the same with the US of course, and it’s this idea that Bill Gross didn’t get when he famously asked: Who will buy our debt after QE2 runs out? It caused him to get crushed on the Treasury boom of 2011.
But what about Europe?
The problem in Europe is that the cycle is broken. When the Spanish government spends money, that money doesn’t necessarily end up in bank accounts where the money will be paired with Spanish debt. Instead, a lot of it leaks to bank accounts in Germany, where it goes to buying German debt. Or maybe it goes into French debt. Spanish government spending doesn’t help finance Spanish government debts.
This is why Richard Koo’s modest proposal to save the Eurozone is to ban countries from selling sovereign debt to anyone that’s not domestic, so that the cycle of spending and borrowing would stay domestic.
Europe’s problem really isn’t about sovereign debt. It’s about the fact that countries don’t have their own currencies, and are thus totally flawed.
It’s fun to look at a chart like this, showing that only Japan has more debt than Greece, and to conclude that it’s going to implode, but extrapolating from Europe to anywhere else, where countries borrow in their own currencies, and have their own central banks, is a recaipe for disaster.
Photo: Harvard Business Review
No doubt Kyle Bass will keep pumping his Japan trade for a while, but the logic is badly flawed, and it is never going to pay off for him.
Added: And there’s one more thing to think about, which we should have said originally. True sovereign bustups are not the result of accounting or numbers, but the result of some kind of social/political disfunction. Japan is arguably the most stable society in the world, with low unemployment and a functioning economic and political culture. Thanks to the country’s population dynamics, Japan isn’t a growth dynamo, but there aren’t even the vaguest hints of instability. It’s not the kind of place where you’d see a meltdown.