Hands-on China Report Jing Ulrich March 10, 2009

Hands-on China Q&A with John Paulson

John Paulson President, Paulson & Co. The current financial crisis is undoubtedly without a recent precedent. Over the last several years, few people were able to predict the plunge in mortgage securities and resulting financial fallout as successfully as John Paulson, President of Paulson & Co. (Paulson). Founded in 1994, Paulson is the third largest hedge fund in the world, managing $29 billion as of the beginning of 2009. Protection trades hedging against a decline in the mortgage market brought sizable gains as the housing market deteriorated. Over the course of 2008, Paulson funds continued to show strong performance by hedging the portfolio against market risks. John Paulson recently spoke with us in Beijing to share his thoughts on investment opportunities against the current economic backdrop, and discussed Chinas role in shaping how the global economy and financial system is likely to develop in the aftermath of the current crisis. With a high level of savings and foreign reserves, China is in a favorable position to fund domestic stimulus programs and target strategic resources at cyclical lows. As the largest holder of US government debt, Chinas foreign reserve policy also has important implications for US Treasuries and commodity prices. The following Q&A presents a summary of his views. Jing Ulrich: Throughout this crisis, youve managed to successfully avoid financials, banks and homebuilders and you remain cautious about the economy. Are there any sectors and markets to own in the current environment? John Paulson: The global stock markets have fallen materially from their highs. This has created some very low valuations on many high quality companies. While the short term outlook is uncertain, if one takes a long term view then there are many buying opportunities today. I would focus on companies with low leverage and great business positions in the healthcare, consumer staples, and industrial areas. From a long term perspective, natural resources stocks also represent good buying opportunities. Long term demand growth will return as the global economy recovers and I expect inflation to increase, which should benefit real assets. As the following graph indicates, the mining index is down 77% from its peak around June 30. While prices could fluctuate in the short term, looking out 5 years, I think this will represent a highly attractive entry point.
SPDR METAL & MINING INDEX
$100.0 $90.0 $80.0 $70.0 $60.0 $50.0 $40.0 $30.0 $20.0 $10.0 6/30/08 7/30/08 8/30/08 9/30/08 1/30/09 10/30/08 11/30/08 12/30/08 2/28/09

Jing Ulrich Managing Director, Chairman, China Equities, J.P. Morgan +852 2800 8635 jing.l.ulrich@jpmorgan.com

-73%

Source: Bloomberg 0
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Hands-on China Report Jing Ulrich March 10, 2009

Jing Ulrich: As Chinese policymakers study the global financial crisis, what lessons do you think they are drawing from recent developments? John Paulson: This crisis has been precipitated by a breakdown in risk controls at financial institutions in the Western World. Banks expanded their balance sheet wildly with excessive leverage. An important lesson for China is to ensure that banks are well capitalized with common equity, limit use of derivatives, limit leverage, include off balance sheet liabilities when computing leverage, and restrict the range of bank investment to less risky areas. Jing Ulrich: China is the single largest holder of US Treasuries and given the size of its holdings, any diversification would be difficult to accomplish. Do you think that an increase in the proportion of gold reserves is advisable? John Paulson: Any investor in U.S. Treasuries must be concerned about the potential depreciation of the U.S. dollar. I think Chinese companies recent moves to acquire natural resource assets at cyclical lows while the U.S. dollar is still strong have been very smart. It would appear to be a good idea while the dollar is strong and commodity prices are low to diversify as much as possible into resource holdings. On an official reserve basis, China also has a very tiny allocation to gold as a percentage of total reserves (see graph below). It would appear to be a good idea to increase the gold reserves.

GOLD RESERVES AS A % OF TOTAL RESERVES: End 2007

Gold Share of Reserves
89.0% 37.0% 4.0% 3.0% 1.0% 2.0% 3.0% 4.0% 13.0%

100.0%
79.0%

90.0%
70.0%

80.0%
60.0%

70.0% 60.0%
40.0% 41.0% 41.0%

50.0% 40.0% 30.0% 20.0% 10.0% 0.0%

15.0% 28.0% 37.0%

United Venzuela Belgium Lebanon Spain Austria

Source: GFMS Gold Survey 2008 1

Switzerland France The Germany Italy United States Portugal

China China Japan India Russia Algeria Taiwan Sweden

62.0%

67.0%

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Admittedly, adding to gold reserves is difficult for China due to the limited amount of investable gold, as compared to the size of Chinas reserves. Its much easier for an individual or a fund to move into gold. We, for instance, have a 10% gold hedge in our main funds and also offer our investors the option of investing via a gold share class where the dollar exposure is hedged to the price of gold. Nevertheless, we think it is a good idea.

Hands-on China Report Jing Ulrich March 10, 2009

Jing Ulrich: There has been some encouraging news and data out of China that growth may have begun to stabilize in recent weeks, although conditions remain very challenging. To what extent can China lead a recovery in global growth? John Paulson: China is in an extremely favorable position, as it has high savings and reserves which it can use to stimulate the domestic economy. This will likely allow China to continue to grow, albeit at a more moderate rate, even as the rest of the world remains in recession. Jing Ulrich: Things seem to be getting worse in the financial services area how much worse is it going to get? Do you think we now know the true extent of the underlying problems? John Paulson: The problem with financials is that they are very leveraged and dont have enough tangible common equity to absorb anticipated losses. Large American and European banks have on average 40:1 leverage, defined as Total Assets / Tangible Common Equity. The Tier 1 capital ratios commonly used by banks present a misleading picture as to the capital adequacy of banks. The Tier 1 ratio includes preferred stock, hybrids and subordinated debt as capital and then risk weights assets, leading to a risk weighted asset number that is much less than the total asset number. This can lead to a situation where banks have high Tier One Ratios but very low tangible common equity ratios (see graph below). As a common shareholder, we only care about tangible common equity.

LEHMAN BROTHERS
Lehman Brothers
(as of August 31, 2008)

12.0%
11.0%

10.0%

8.0%

6.0%

4.0%
2.5%

2.0%

0.0% Tier 1 Ratio Tangible Common Equity / Total Assets

PAULSON & CO.

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Unfortunately, it appears we are only halfway through the credit correction with a lot of turmoil to come. The IMF estimates total credit costs in the U.S. will be $2.2 trillion. To date

Hands-on China Report Jing Ulrich March 10, 2009

financial institutions have taken $1 trillion of writedowns. $1 trillion divided by $2.2 trillion is 45%, thats how we came up with our halfway estimate (see graph below).

FINANCIAL SECTOR POTENTIAL LOSSES

2200 2000 1800 1600

Consum er Comm ercial

$2,200 bn

Realized Loss: 45% of IMF estimate

1400 1200 1000 800 600 400 200 0

Home Equity
IMF Forecast Jan 2009 Writedowns to Date Capital Raised
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Com mercial Real Estate $996 bn Prim e $939 bn

Subprim e Alt-A

Source: IMF, Bloomberg 3

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Financial institutions have raised about $1 trillion to replenish their balance sheets after taking writedowns, but the IMF loss estimates indicate they will still need to raise $1 trillion more. The private sector is reluctant to provide more capital as investors have lost large sums already in previous investments, leaving the government as the main source of capital. So far governments around the world, in the U.S., U.K., Germany, France and Ireland have been proactive in providing capital to institutions to prevent their failure. But public opinion and legislative bodies are reluctant to provide more taxpayer dollars to support banks. There is a risk as we go through the next half of the financial correction that the governments may not be able to solve every problem and that another sizeable institution like Lehman Brothers could fail, posing risk to the global financial system. The problem is not confined to the U.S. Many banks and countries around the world are facing solvency issues. Of particular concern is Eastern and Central Europe, who have debt of almost $2.4 trillion owed to Western European Banks. Most of the borrowing is in Euros and as their currencies depreciate, economies contract and earnings fall, its unlikely they will be able to service this debt. Who will provide help and in what form is not yet known, creating default risk. The magnitude of the problem is significant, as the $2.4 trillion is about 2x the size of the total subprime mortgage market in the U.S., where the financial crisis first erupted. The Eastern European crisis is now being compared to the Asian Crisis of 1998. Jing Ulrich: Do you see yourself buying back into financials in the next year, and if so, what would be the catalyst? John Paulson: At some point we do believe financials will represent a buying opportunity although it is still premature. Given the IMFs estimate of large additional losses, banks will
4

Hands-on China Report Jing Ulrich March 10, 2009

need to take substantial additional writedowns requiring the need for additional equity, which is likely to be dilutive to existing investors. We need to wait until more of the anticipated losses are realized before we would go long. Once losses are realized, however, we will be interested in providing equity capital to restructuring banks. Jing Ulrich: Is there still considerable downside for stocks, given the bleak economic backdrop and recent rebound in government bond yields? John Paulson: In the short term there could be additional downside because we dont know how deep or long the global recession will be. The economic news gets worse every day and we dont see signs of stability. At some point, though, the economies will bottom at which point the markets will recover. Clearly if one is a long term investor, there are many good buying opportunities today. Jing Ulrich: What are the best investment opportunities under current market conditions? John Paulson: Our primary focus is on the distressed debt market. Were buying distressed mortgages, bankrupt debt and distressed corporate debt. Frankly were projecting very high returns without taking equity market risk. Jing Ulrich: What economic, financial and technical indicators would you expect to flag a sustainable market recovery? John Paulson: In the U.S. we would need to see both a stabilization in housing prices and a higher realization of anticipated credit losses. Unfortunately, as we said, we think we are only in the middle of the cycle. Jing Ulrich: Many G20 governments are planning large infrastructure projects to try and give their economies a boost. Do you think this will be positive for commodities, and when can we expect to see the benefits filter through? John Paulson: I do think the long term outlook for commodities is bullish. The Asian economies and China in particular are posed for sustainable long term growth, which should translate into increased demand for commodities. Once we get through this short term correction, commodity demand will increase again, putting pressure on supply and causing prices to rise. This would indicate that the current decline in the value of commodity producers presents an attractive opportunity to acquire valuable assets at a cyclical low. Jing Ulrich: Despite low industrial and jewelry demand, gold prices are nearing the alltime high of $1032/oz as the number of investors loading up on gold as a safe haven asset expands rapidly. As U.S. and European policymakers consider bad bank proposals and other measures to restore confidence, does the source of support for gold remain intact? Is there an obvious level for profit taking? John Paulson: We believe one of the asset classes to benefit from the very expansive fiscal and monetary policies in the U.S. and other countries will be gold. The rapid expansion of U.S. sovereign debt and monetary supply may lead to diminished confidence in the U.S. dollar as a reserve currency. As investors lose confidence in the U.S. dollar and other paper currencies, gold is likely to be a primary beneficiary.

Hands-on China Report Jing Ulrich March 10, 2009

Jing Ulrich: With the US government printing a lot of money right now, when do you think inflation will come around? Is a huge expansion in fiscal policy inherently inflationary? John Paulson: It would appear that current U.S. government policies will ultimately be inflationary. However, the demand for dollars as a safe haven and the deflationary pressure from the recession have currently reduced inflation concerns, even as the money supply expands. However, as the economy recovers, fear subsides and U.S. Treasury funding requirements continue to grow, we believe inflation will set in and be difficult to contain. If I had to guess, I think the pressures will become more apparent in the second half of 2009 and accelerate as 2010 begins.

NET TREASURY FUNDING REQUIREMENTS

Net Treasury Borrowing Needs
$ billion 2,800

2,400

284% increase from 08 to 09

2,000

1,600

1,200

800

400

-400 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

*Refers to the government fiscal year that ends 9/30

PAULSON

Source: Whitehouse, Treasury Department

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Jing Ulrich: What are your thoughts on the Euro? John Paulson: The U.S., the U.K. and Europe are pursuing expansive fiscal and monetary policies. Thats why I am losing faith in paper currencies generally and hedging our currency exposure with gold.

Hands-on China Report Jing Ulrich March 10, 2009

About John Paulson

John Paulson is the President and Portfolio Manager of Paulson & Co. Inc. (Paulson). Paulson was ranked by Absolute Return Magazine as the 3rd largest hedge fund in the world managing approximately $29bn in merger, event and distressed strategies. In 2007 Paulson won the Arbitrage Fund of the Year, Best New Fund of the Year and Management Firm of the Year award by Absolute Return. In 2008, Paulson won the Event Driven Fund of the Year, Distressed Securities Fund of the Year and for the second time, Management Firm of the Year. Mr. Paulson received his Masters of Business Administration with high distinction, as a Baker Scholar, from Harvard Business School in 1980. He graduated summa cum laude in Finance from New York Universitys College of Business and Public Administration in 1978. Prior to forming Paulson in 1994, John was a general partner of Gruss Partners and a managing director in mergers and acquisitions at Bear Stearns.

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