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THE BROYHILL LETTER

“The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tem-
pered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt.”

– Cicero, 55 BC
Executive Summary

A generation of reckless debt accumulation has left us at a difficult crossroads. Markets have grown entirely dependent
upon an extraordinary degree of government stimulus to remain afloat. But that stimulus is not without cost and is ulti-
mately dependent on investor confidence and willingness to finance careless spending. History suggests that there is a limit
to such deficit spending and the cost of abusing this privilege will end tragically. As a percentage of total global defaults,
sovereign debt defaults remain at a generationally low level. That can change, especially when one considers the record
amount of sovereign debt issuance by governments in mature economies. Indeed, the database compiled by economists
Carmen M. Reinhart and Kenneth Rogoff spanning eight centuries of government debt and default, suggest as much.

“We find that serial default is a nearly universal phenomenon. Major default episodes are typically spaced some years (or decades) apart, creat-
ing an illusion that “this time is different” among policymakers and investors. A recent example of the “this time is different” syndrome is
the false belief that domestic debt is a novel feature of the modern financial landscape. We also confirm that crises frequently emanate from the
financial centers with transmission through interest rate shocks and commodity price collapses. Thus, the recent US sub-prime financial crisis
is hardly unique. Our data also documents other crises that often accompany default: including inflation, exchange rate crashes, banking crises,
and currency debasements.”
-This Time is Different (Carmen M. Reinhart and Kenneth Rogoff)

My Big Fat Greek Default

It took time for investors to realize the magnitude of the mortgage meltdown and ensuing credit crisis. As late as 2007, Fed
Chairman Ben Bernanke assured investors that the subprime problem was “contained.” One year later in 2008, Lehman
Brother’s CEO Dick Fuld blamed ruthless short-sellers for the collapse of Lehman’s stock and confirmed the strength of
the company’s balance sheet just days before filing for bankruptcy. So excuse us if we are tempted to chuckle when
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George Papandreou, Greece’s Socialist prime minister, blames

“speculators” for the “unprecedented attack” resulting in the
strangulation of the Greek economy,” does not leave us par-
ticularly confident. Neither does Joaquin Almunia’s assurance
(EU Commissioner for Economic and Monetary Affairs) that,
“There is no bailout problem. In the euro area, default does
not exist.” In fact, we’d politely suggest that Mr. Almunnia
consult his history records – our count has European nations
defaulting on their debt a stunning 73 times since 1800, with
Greece in default more than 50% of the time!

Given the size and the maturity profile of the country’s debt,
combined with the absence of monetary policy as a tool to re-
flate the local economy, external assistance is needed to avoid
crisis. But financial rescue packages come with difficult fiscal
demands at a time when Greece is already facing a backlash
from unions and civil servants. Importantly, any assistance
must be significant in size, as well as quick and efficient in or-
der to prove successful. Unfortunately, history suggests poli-
cymakers will miss at least one of these targets at first blush
and initial attempts will likely prove too little, too late. We
consider the EU’s ringing endorsement of Greece’s fiscal plan
as strike one. Strike two will likely be an insufficient response
aimed at calming investors’ nerves and reducing volatility.
Any subsequent market reaction would thus be short term in nature, ultimately leading to increased risk of contagion as
sovereign balance sheets become a growing theme across the globe. Let’s briefly review a few of the other usual suspects
across the investment landscape.

This is What it Sounds Like When PIIGS Cry

The Maastricht Treaty, which laid the foundation for the creation of the Euro, states that no country within the EU shall
have an annual budget deficit in excess of 3% of GDP to ensure that the region’s strength is not undermined by a member
nation’s excessive spending. A great concept in theory, however, execution has proved more difficult in practice, as shown
below. Every one of these PIIGS (the acronym Wall Street has lovingly granted to Portugal, Italy, Ireland, Greece and
Spain) has blown right through this spending limit, resulting in ballooning deficits and excessive levels of debt.

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In our opinion, Spain poses an even greater threat to the strength of

the Eurozone and the Euro given the country’s much larger economy,
much larger housing bubble, and much greater levels of leverage than
most of the developed world. Spain is still wrestling with the collapse
of a decade-long housing boom that has hurled the broader economy
into a deep recession, sent tax revenues plummeting and social wel-
fare costs soaring. Spanish housing indices reached greater heights than
most other global housing bubbles, yet have declined only single digits
from their peak. The bubble looks even more extreme when viewed
as a ratio to rent, where The Economist puts the market 55% above fair
value.

Capital Economics warns that the share of state debt maturing this
year is even higher in Spain (17%) than in Greece (12%), heightening
the Spanish government’s sense of urgency. While Debt/GDP levels
do not appear as stretched here as some of the neighboring piglets,
it doesn’t take a stretch of the imagination to see Spanish debt ratios
climbing steadily higher as the government is again forced to come to
the rescue of still-overleveraged financial institutions facing additional
losses from still-overvalued housing markets. Oddly enough, Spanish
Development Minister Jose Blanco, is on the tape as we write this, label-
ing the current downward pressure on the Euro and on their sovereign
debt as a conspiracy or attack. What’s that smell, you ask? There ap-
pears to be a whiff of contagion in the air. Or perhaps it’s just Club
Med’s version of the Tequila Crisis – The Paella Panic!! Gluskin Sheff
economist David Rosenberg summarizes the risk quite succinctly:

“The bottom line is that even if the fiscally-challenged countries of Europe do not end up defaulting, or leaving the Union, the reality is that
they will have to take draconian measures to meet their financial obligations. Devaluation was the answer in the past in Greece but it cannot rely
on that quick fix this time around without leaving EMU and if it did, then that could make it even harder to service its Euro-denominated
debts — at least not without a restructuring. And, if Greece did attempt at a debt restructuring, rest assured that Italy, Spain, Portugal and
Ireland would be next — we are talking about a combined $2 trillion of potential sovereign debt restructuring that would more than triple the
$600 billion direct cost of the Lehman bankruptcy.”

Bonds - Moore Bonds

Beyond the PIIG pen, Britain is at risk of becoming an “earlier

adopter” of sovereign debt crises within the G7. Standard &
Poor’s placed the UK’s triple-A credit rating on negative outlook
last year, adding that a downgrade could follow if a credible debt-
reduction plan wasn’t put in place. The world’s largest bond
manager, PIMCO, has been somewhat more direct, putting the
odds of a downgrade at 80% based on the country’s debt tra-
jectory and inability to adjust. This “inability to adjust” is best
showcased by the Brit’s “inability to budget” – amazingly, the
UK even failed to put aside money in the fat years. It ran a
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a budget deficit of 3% at the peak of the boom

when even Spain was running a surplus of over
2% at the time.

Britain is in particularly bad shape because tax rev-

enues are highly leveraged to the global economic
cycle - financial services provided more than a
quarter of all revenue in the boom. Needless to
say, it is “a tad less” today and likely to remain so
for some time. Yet while revenues have declined,
the debt of bubbles past lingers in the form of
mountains of bad assets. The five largest banks in
the U.K. still hold over 6 TRILLION pounds of
assets on their books - about FOUR times GDP and bringing an all new meaning to the phrase “too big to fail.” Despite
our best efforts to rein in Wall Street, we are sowing the seeds of the next crisis as these large institutions pose massive risks
to their home countries. In the event of another exogenous shock to the system, we have grave concerns around markets
ability to stomach additional fiscal stimulus.

Turning Japanese

The Japanese are no strangers to deficit

spending and government borrowing,
neither of which have done anything to
drive economic growth for over a decade,
despite near zero interest rates. The IMF
estimates Japan’s gross public debt will
reach a staggering 227% of GDP this year.
Curiously, the island nation has managed
to avoid both a painful currency devalu-
ation and ballooning interest rates while
growing its debt burden at an accelerating
pace. Contrary to what economic theory
might suggest, we surmise that Japan was
able to pull off this feat only because its
domestic saving pool was large enough to
cover the shortfall. Over 90% of all Japa-
nese Government Bonds (JGBs) are held
domestically, as aging Japanese citizens
shunned risk and willingly lent money to
their government. This cannot continue,
as the country tipped into outright demo-
graphic decline in 2005. Households have
already stopped adding to their piles of
near-zero-yielding JGBs as the elderly are
spending down their assets in retirement -
the savings rate will soon crash below zero
creating a growing pool of JGB sellers.
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In a recent letter to investors, Kyle Bass, the astute CIO of Hayman Advisors who purportedly has mortgaged his own
home in Japanese Yen, offered up the following cheery outlook:

“Considering the demographic challenge facing the country . . . there is a frightening scenario unfolding whereby JGB issuance will continue to be
significantly positive while domestic demand for the bonds turns secularly negative. There are no further good tools available to keep the govern-
ment’s interest costs from growing, further increasing the need to issue more debt – 18% of tax revenues are already used just to pay interest
expense . . . It is also worth pointing out that approximately 26% of Japan’s total central government debt matures within one year . . . When
we connect all of the proverbial dots, we expect higher rates in Japan, a weaker Yen, or (most likely) some combination thereof.”

Land of the Free, Home of Moral Hazard

The bright spot in our story today is that despite Washington’s populist rhetoric and excessive ranting and raving, the US
is actually better positioned than most of our developed world peers. As a good friend once eloquently described it for
us, we just may be the tallest midget in the room. But before we get too excited about being the all-star center of the G-7
Dwarfs basketball team, we should note that most government statistics grossly understate total liabilities. If we include
off-balance sheet items such as social security, pension and healthcare liabilities (not to mention the gargantuan debt loads
of Fannie and Freddie) the outlook quickly goes from gloomy to ghastly.

Deleveraging has a long way to go at home and in most of the developed world. This process is made more difficult as
sovereign debt has risen just as fast as private debt has declined, effectively moving the debt burden from the private sector
to the public sector, or more precisely to the taxpayers. Economists Carmen Reinhart and Kenneth Rogoff warn that at
ratios of Debt/GDP above 90%, economic growth rates fall considerably. In other words, and despite popular belief, you
cannot borrow your way to wealth and prosperity. There is a limit to how much debt growth can drive GDP growth – the
so called “zero hour” which may very well have been reached.

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When recently asked about the risk of the Unit-

ed States of America losing her credit rating,
Treasury Secretary Tim Geithner responded,
“That will never happen to this country.” Oddly
enough, Moody’s fired off this warning just last
week with regard to America’s AAA credit rating:
“Unless further measures are taken to reduce the
budget deficit further or the economy rebounds
more vigorously than expected, the federal fi-
nancial picture as presented in the projections
for the next decade will at some point put pres-
sure on the triple A government bond rating.”
Please understand that we are by no means sug-
gesting that Moody’s is competent enough to
analyze risks before they become readily appar-
ent, but we would suggest that their comment
was more reasonable than Geithner’s response.
Consider that the portion of America’s debt
maturing in under a year has jumped from 30%
to over 40% in the past two years. Failure to
raise as much money as planned at any auction
would therefore send shudders through global
financial markets. And while the White House
optimistically forecasts our budget gap falling to
about 4% of GDP by 2013, based on contin-
ued strong economic growth and the successful
implementation of a spending freeze, the IMF
is somewhat more realistic. Lower growth fore-
casts at the IMF result in a deficit rising to 7%
of GDP and a debt ratio above 100% over the
Source: Barry Bannister, Stifel Nicholaus
same time period.
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A Crisis of Confidence

Contrary to recent experience, fiat

money has been a rather poor store of
value over long periods of time. Trust
in fiat money is difficult to establish
and even more difficult to maintain
when pieces of paper have no underly-
ing unit of value. That trust, built over
generations, can be destroyed over-
night when governments engage in
the type of behavior that has become
increasingly common in the wake of
the Great Contraction – profligate
spending, exploding deficits, unfunded
promises, and policies which obstruct
investment and productivity through
unpredictable regulations and increas-
ing taxes

We are not yet at the end of the road,

although we can hear the fat lady sing-
ing more clearly today. Our problems
are not insurmountable, but they re-
quire immediate attention. Simply
hoping that we will grow our way out of the remnants of crisis will cost us dearly. The key conclusion policymakers should
learn from the work of Reinhart and Rogoff is that seldom in history have countries grown their way out of deep debt
burdens. Reversing a crisis of confidence and strengthening sovereign balance sheets requires smart policies from strong
leaders. Sadly, we have neither. Perhaps Paul Broyhill was on to something when he suggested it would take a “one-term”
president willing to make unpopular short-term decisions to restore the long term health of our great nation. I’d still like
to believe that America would appreciate such character when they saw it and re-elect him for a second term, but I recog-
nize that this is wishful thinking, particularly as we have yet to find him.

Bottom Line

Given the tendency for fiscal budgets to deteriorate in the aftermath of crisis due to declining tax receipts, and the lack of
political will to face the problem of excessive debt and excessive spending, there are two potential escape routes from our
debt trap. The first is default. But so long as the dollar serves as the world’s reserve currency (which should not be ex-
trapolated into perpetuity), we put the odds of a technical default somewhere between slim and none (our developed world
peers are not so lucky). Which brings us to option two – the printing press and massive monetization of debt. Clearly the
lesser of two evils and the odds on favorite for those looking to place their bets. The rationale is quite elementary once you
realize that politicians are not all that different from teenagers. They both have a remarkable ability to postpone difficult
long term decisions and take the easy way out today. In other words, the path to the printing press is so irresistible because
it postpones the economic pain and continues to the kick the can down the road for the next generation.

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From an investment perspective, this realization has important implications. First, avoid long-term fixed interest securi-
ties (except for temporary, deflation-driven rallies over the next few years). Nassim Nicholas Taleb, author of “The Black
Swan,” said “every single human being” should bet U.S. Treasury bonds will decline, citing the policies of Federal Reserve
Chairman Ben S. Bernanke and the Obama administration. Aside from the occasional flight-to-safety rallies driven by peri-
odic credit fears in the near term, we concur. Second, avoid cash. Like Treasuries, the dollar should benefit from the same
intermittent credit pressures related to ongoing deleveraging, but the long term trend remains lower for the tallest midget
in the room. Third, be very selective with regard to equity markets. Secular bull markets are meant to be owned. Secular
bear markets should be rented at best. Or perhaps more importantly, buy stocks only when they are priced to deliver attrac-
tive rates of return. We understand that we are not stating any groundbreaking investment insight here, but the potential
for inflation to destroy equity valuations, makes overpaying all the more costly in such an environment. Finally, accumulate
real assets such as commodities, resources, and related securities – and especially precious metals. This massive expansion
of government liabilities will undoubtedly undermine the value of the U.S. dollar relative to real goods and services; but the
greenback’s performance relative to other currencies is entirely dependent upon the enthusiasm of our developed world
peers for a similar bout of fiscal negligence. As Greenlight Capital’s witty CIO, David Einhorn recently remarked:

“When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the
“stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the
dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one
these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both
earn no yield.”

- Christopher R. Pavese, CFA