Kyle Bass covers three critical topics in this excellent in-depth interview before turning to a very wide-ranging and interesting Q&A session. The topics he focuses on are Central bank expansion (with a mind-numbing array of awe-full numbers to explain just where the $10 trillion of freshly created money has gone), Japan's near-term outlook ("the next 18 months in Japan will redefine the economic orthodoxy of the West"), and most importantly since, as he notes, "we are investing in things that are propped up and somewhat made up," the psychology of negative outcomes. The latter, Bass explains, is one of the most frequently discussed topics at his firm, as he points out that "denial" is extremely popular in the financial markets.
Simply put, Bass explains, we do not want to admit that there is this serious (potentially perilous) outcome that disallows the world to continue on the way it has, and that is why so many people, whether self-preserving or self-dealing, miss all the warning signs and get this wrong - "it's really important to understand that people do not want to come to the [quantitatively correct but potentially catastrophic] conclusion; and that's why things are priced the way they are in the marketplace."
2:40 Bass begins
3:15 Central Bank Expansion
"We've essentially printed $10 trillion in the last few years"
"The first $5 trillion replaced the lost equity in the leveraged financial system and the second $5 trillion is making its way into deposits and expanding the monetary base"
"This is unprecedented... and it's not going to change."
The numbers that Bass reels off are incredible...
"What we've seen is a massive credit-led boom (+11% CAGR) and that can't last forever"
11:00 "The next 18 months in Japan will redefine the economic orthodoxy of the West"
"Japan is so far off the bell-curve that no one wants to talk about it"
"if you repeat things enough, everyone will believe them."
There are three key myths about Japan that Bass shows are simply false but remain repeated for the comfort of the cognitively biased investment community:
- The current account allows the country to self-finance its deficit
- The Bank of Japan is not monetizing debt
- Retail investors will always support the JGB marketplace
From the nation's own largest institutions forced to sell assets to the crushing demographics, Bass explains - in greater clarity than the soundbite-idiocy we get each night from Abe/Kuroda/Aso etc...
The smartest money is leaving Japan in a hurry already - Q4 2012 was the largest M&A quarter ever for Japanese firms buying foreign entities - Western productive assets - (just as was seen in Mexico before their crisis) as they try to get out of JPY
25:00 The Psychology of negative outcomes
"as an investor and a fiduciary, I get paid not to be an optimist or a pessimist; I get paid to be a realist"
"Denial" is extremely popular in the financial markets.
Simply put, Bass explains, we do not want to admit that there is this serious (potentially perilous) outcome that disallows the world to continue on the way it has. and that is whay so many people, whether self-preserving or self-dealing, miss all the warning signs and get this wrong.
"no one is ever going to tell you something is wrong"
"we have blind faith in the people running our institutions...that they can figure things out. They are a mental crutch to insure and placate depositors and investors that everything is going to be ok"
"we are running a huge economic experiment," and you can't control it all since there are too many variables
Once you understand the psychology of the participants, the key is to understand their actions based on that.
"It is the qualitative shift in the market participants' belief systems that literally flips a switch overnight"
Bass reminds us of Taleb's work on central planning: "if you suppress volatility long enough, then when the 'event' happens it is greater than the sum total of all the suppressed vol over time."
He warns - these shifts happen so fast that you will never get hedged or out of the way in time...
32:00 Q & A begins
First he discusses the naysayers on a Japanese bear thesis
"I would like to live in a world where it's all rainbows and unicorns and we can make Krugman the President - but intellectually it's simply dishonest"
"If you were advising Abe, what would you say?" - "Quit!"
41:00 General China discussion (in the context of the Japanese-China rhetoric)
43:30 Iceland - not as great as some would suggest
"China is building an embassy in Iceland that can fit 500 people in it. Iceland only has a population of 300,000!"
"You have a roach motel of a country; the New York Times and Krugman saying it's "The Model"; but they still haven't addressed the problem of their debt."
46:35 Do you worry about the US?
"I quit worrying about them because it's just a waste of time - I always leave DC demoralized"
"The central bank is the great enabler of congressional profligacy"
48:00 How does the small investor play the Japanese market - Bass responds that they can't and shouldn't. Shorting JGB futures means high carry costs and negative convexity
And our favorites question!!
49:00 Why can't the Central Bank just buy all the JGBs and then forgive them?
A speechless Bass responds...
52:00 Bank VaR and under-capitalization
Well worth an hour of your time before the FOMC tomorrow...