Thought of the Day

                                                                                                                                                            Sydney M. Williams
                                                                                                                                                            December 30, 2009

Another ‘dog bites man’ story is being served up on Bloomberg this morning – “U.S. Treasuries are experiencing their worst annual loss since 1978!”

At the end of 2008, while credit conditions had notably improved, fear continued to grip markets. The Ten-Year Treasury, which at the end of 2007 was yielding 4.04%, was yielding 2.11% on December 31, 2008. Even more dramatically, 90-Day Treasury Bills fell in yield from 3.17% to 0.11%. Fed funds began 2008 with a 4.25% yield (higher than Ten-Year Treasuries!) They exited the year yielding 0.25%. In short, Treasuries benefitted from a flight to safety, as equity, corporate bonds and commodities tanked during the most frightening credit crisis I have ever experienced.

It is unsurprising, then, that as credit conditions and confidence returned, risk assets would once again gain favor. Treasuries, which had been stand-out performers in 2008, became losers in 2009.

In 1978 the United States was in the early clutches of an inflationary cycle that would only be snuffed out when Fed Chairman Paul Volcker raised Fed Funds to 20% in June 1981. President Reagan was willing to take a short but deep recession in order to kill inflation which, if left alone, would have proved calamitous.

While inflation does not appear to be a concern of many in Washington or even among strategists on Wall Street, the amount of borrowing remains dizzying. The Treasury has indicated that both Fannie Mae and Freddie Mac have unlimited support, theoretically suggesting they have an unlimited ability to incur losses – losses which would be funded by the American tax payer. Ostensibly the grant was provided to keep mortgage rates from soaring, but there is little question that the upcoming mid-term elections factored into the equation. GSEs have been, are, and will be political bodies. Also, the Wall Street Journal reports today that GMAC has asked for and will receive an additional $3.5 billion on top of the $12.5 billion they have already been provided. In times of trillion dollar deficits, a billion may not seem like much, but it is. It takes about 2000 years to consume a million days, and a billion is a thousand times bigger!

The moral hazard of encouraging big banks to get bigger, without far more onerous capital rules, risks far larger bailouts than we experienced in September 2008. It may be the easy way out for the moment, but it sets a dangerous precedent. Banks, or government entities, that are too big to fail are too big. The longer this borrowing binge persists, the more painful and difficult will be the purgation. It takes a rare politician who is willing to knowingly induce recession to prevent worse down the road.