Overview

The views expressed in this commentary are those of Hoisington Investment Management
Company, the sub-advisor to the Fund, and may differ from the views of Wasatch Advisors.

The U.S. Treasury Fund seeks to provide a rate of return that exceeds the rate of inflation over a
business cycle by investing in U.S. Treasury securities with an emphasis on both income and
capital appreciation.

Details of the Quarter

In the three months ended September 30, the Fund returned 5.84%, compared to 3.74% for the
Barclay’s Capital U.S. Aggregate Bond Index. The yield on 30-year Treasury bonds was 4.05 %
at the close of the quarter, down from 4.31% a year ago. Thus, for the latest 12 months, a drop in
bond yields meant that the market value of the portfolio increased, enhancing the coupon
(interest) on the Treasury bonds held in the Fund. The lower Treasury bond yields reflected very
depressed economic conditions.

The Federal Reserve reported that as of June 30, 2009 total U.S. debt was $52.8 trillion. Total
U.S. debt includes government, corporate and consumer debt. Importantly, however, it does not
include a few trillion in “off balance sheet” financing, contingent unfunded pension plans for
corporate and state and local governments, or unfunded liabilities of the U.S. government for
such items as Medicare, Social Security and other programs. Currently, gross domestic product
(GDP) stands at $14.2 trillion, so there is approximately $3.73 in debt for every dollar of output
in the United States, a level unprecedented in our history. Normally, debt levels as a percent of
GDP would be uninteresting and immaterial. However, the current level of debt is unique in two
ways. First, the asset side of the balance sheet purchased by the debt is falling in price. Second,
the money that was borrowed to purchase those assets was often fraudulently expended—neither
the borrower nor the lender really expected the debt to be serviced. Rather, each party expected
the asset price to rise and extinguish the debt.

This type of financial arrangement was correctly analyzed by the famous American economist
Hyman Minsky in his paper, “Financial Instability Hypothesis,” in which he described three
phases of debt financing. The first is “hedge finance,” where the lender expects both principal
and interest to be repaid. The second is “speculative finance,” where the lender has a reasonable
expectation that interest on the loan will be paid but repayment of the principal is not as certain.
The third case, where the lender expects neither the principal nor interest to be returned, is
referred to as “ponzi finance.” This was typified in the last business cycle by loans issued

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without documentation, no down payment home loans, extremely low capitalization rates on
commercial real estate, and the high leverage borrowing ratio of private equity funds. Even ponzi
finance works as long as asset prices are rising. But once the bubble is pricked, debtors are left
with declining asset values that preclude the rollover of their obligations.

Presently, in this worst of all post-war recessions we are witnessing the collapse of asset prices
that were inflated by the speculation of earlier years. The aftermath of that speculation and its
impact on the economy has been thoroughly studied prior to our present business cycle by the
economists of yesteryear who marveled at the mania in the collective mindset of private citizens
and their elected representatives who produced such bubbles. The most famous of these
economists was Irving Fisher (1867-1947), who in 1933 wrote about the problem of over-
indebtedness (Irving Fisher, 1933, Econometrica, “The Debt-Deflation Theory of Great
Depressions”). He stated flatly that over-indebtedness was the difference between normal
business cycles (recessions), which occur frequently through “over-production, inventory
misjudgment, or commodity price fluctuations” and extreme business cycle fluctuations
(depressions). Based on his analysis of the great depressions of 1837, 1873, and 1929 he outlined
a pattern of economic developments that will take place when the debt cycle is broken.
Seemingly old news, but it is interesting to apply his sequence of events to today’s economic
developments as there are disturbing similarities.

Fisher posited that debt liquidation leads to distress selling, contracting bank deposits and
declining velocity of money, † all of which contribute to the fall in price levels. This accurately
describes today’s circumstances. Distress selling is rampant, with home foreclosures reaching
all-time highs. Additionally, rapidly rising foreclosures in commercial real estate are causing the
closing of financial institutions and the liquidation of their portfolios. Money supply (M2),†† an
imperfect measure of bank deposits, has been essentially flat over the last six months even
though the monetary base is 100% higher than it was a year ago. Further, the velocity of M2 has
contracted at a 12.7% rate over the past two years. The Personal Consumption Expenditure
Deflator (goods purchased by consumers) has fallen from a 2.7% growth rate 12 months ago to a
yearly increase of only 1.3% presently, and appears to be heading for a zero reading in 2010.
GDP has recorded its greatest contraction since the 1930s, and probably is not yet at its lowest
level for this cycle.

Fisher then noticed that this distress selling would lead to a fall in the net worth of businesses, a
decline in profits, and a reduction in employment. Fisher may have been talking about 1929 and
the 1800s, but that is precisely our present situation. Despite a 19% gain in stock prices this year,
the S&P 500 Index‡ has declined about 30% from its peak and stands lower than it was a decade
earlier. Corporate profits are down approximately 13% on a year-over-year basis, and in 2008

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S&P 500 profits fell for the first time since 1933. The net worth of hundreds of banks and other
large corporations has fallen below zero, with some surviving only because of a massive rescue
effort by the federal government. Despite these efforts, consumer net worth has fallen, price
levels of homes are down about 30% from their peak levels, and business net worth has been
impaired by an almost 39% decline in commercial real estate from its peak levels. Industrial
production is down 13.3% since its peak, the largest 20-month decline in the post war period.
Including potential revisions, the U.S. has lost eight million jobs in this recession, and currently
17% of the labor force is either underemployed, partially employed, or out of work seeking
employment.

Fisher seems to be not so historical as prescient. He states that all the above problems create
disturbances in the rate of interest, particularly the fall of nominal money rates and the rise of
real interest rates (the nominal interest rate minus the inflation rate). The federal funds rate is
now effectively zero, and yet with the steady downward movement in price indices, real interest
rates are rising. This, of course, is of concern to debtors.

The uncomfortable conclusion of Fisher’s analysis is that major business cycle fluctuations are,
in fact, caused by over-indebtedness and the fall in asset prices. Our present situation appears to
mirror the exact sequence of events that have occurred in previous depressions. This suggests
that our current “great recession” may morph into a more serious and elongated downward
business cycle.

The federal government’s promise to extricate the U.S. economy from this recession involves
more spending (increasing public debt) and more subsidies for consumers, such as car rebates
and home buying incentives (more private debt). In other words, more debt is supposed to solve
the problem of over-indebtedness. The truth is that this policy merely indentures citizens further
without providing any income for repayment of debt. In previous letters we have discussed the
fact that the government spending multiplier is zero (read Professor Robert Barro’s book,
Macroeconomics—a Modern Approach, p. 370). This means there is no long-term income
benefit from stimulus programs. According to the latest academic research, the most recent $800
billion stimulus plan will boost economic activity in the short run, but will surely depress
economic activity over time. The government problem is complicated by the fact that the tax
multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time.
More recent research (Barro & Redlick, September 2009, “NBER Working Paper 15369”)
suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%.
With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes
to pay for this higher level of expenditures, which will further depress aggregate spending and
output.

P.O. Box 2172 • Milwaukee, WI 53201-2172 • www.wasatchfunds.com

Phone: 800.551.1700

Wasatch Funds are distributed by ALPS Distributors, Inc.

From a fiscal policy perspective the outlook for economic growth appears to be one of stagnation
for several years due to the size of the federal debt, which is expected to rise 35.7% from 2008
levels to 76.5% of GDP over the next 10 years according to the Office of Management and
Budget. This exercise in government spending is, of course, an exact replica of the Japanese
experience from 1989 to the present. Japan’s debt to GDP ratio has gone from about 50% in
1988 to about 178% today, and yet nominal GDP is no higher than it was 17 years ago, and
Japan’s employment stands at 20-year-ago levels. It is somewhat unsettling that as of the last
employment report the United States employed 131 million people, a level that was first reached
in 2000, which means the United States has had no net job gains for almost 10 years. Indeed, it
appears that the fiscal chain around the free market neck is sufficiently onerous to restrain
growth for several years. The promise of the government to revive growth through increased
indebtedness is, indeed, an impossible promise.

As Fisher stated, the write-down of debt and distress selling tends to destroy money deposits and
lower the velocity of money. Despite the historical evidence of that fact, our current Fed
authorities appear to be oblivious to the lessons of the past. Their initial reaction to the liquidity
crisis has to be applauded for their heavy work in insuring the liquidity of the financial system.
Similarly, the expansion of their bank balance sheet to $2.1 trillion from $1 trillion was the
precise reaction needed to counter the emerging deflation of asset prices. However, their actions
increased inflationary expectations, and they have encountered a plethora of critics. In
responding to this criticism the most recent statistics suggest that they are beginning to lose the
fight against deflationary impulses. Consider that the monetary base rose 1000% in the three
months ending December 2008, but has been held essentially flat since then.

The Fed’s purchases of assets to increase this base automatically created deposits that positively
charged the money supply growth to a 15.2% six-month growth rate. If the economy were
operating near full capacity, a healthy banking system would take these deposits and multiply
them roughly nine times—that circumstance could be inflationary. Unfortunately, the banking
system is not healthy, as evidenced by the fact that we have closed 95 banks this year, more than
the cumulative total of the past 15 years, and another 416 banks are on a list destined to become
extinct. With consumers’ asset prices falling so rapidly and banks increasingly afraid of failure,
banks are more interested in collecting loans than in lending. So with fewer consumers now
credit worthy, loan volumes are collapsing. As loans are paid off, deposits are destroyed, and the
money multiplier‡‡ that should stand at nine has gone to zero. This is evidenced by the fact that
the six-month change in M2 has fallen to a 1% growth rate, meaning that monetary stimulus is
on hold. Get set for negative GDP in 2010.

P.O. Box 2172 • Milwaukee, WI 53201-2172 • www.wasatchfunds.com

Phone: 800.551.1700

Wasatch Funds are distributed by ALPS Distributors, Inc.

The inflation outlook from the monetary and fiscal standpoint looks truly deflationary, yet some
believe that dollar weakness will reverse this circumstance and create inflation. This is unlikely.
First, our imports are about 13% of GDP, and even if the dollar were to halve in value, the price
of imported goods would not only have to compete with U.S. producers, but also their price
adjustment would have to offset the other 87% of factors included in the pricing indices. Second,
unlike the 1930s, a 50% decline in the dollar would be difficult to engineer. Fisher recommended
to Roosevelt that the U.S. should exit the gold standard, which he did in April of 1933. That was
a fixed exchange rate system, and within three months the dollar lost more than 30% against the
gold block countries and fell to 60% of its former value within the next five months. This spurred
our exports and provided some price inflation (2.9% per year, GDP deflator) for the next four
years. Then in 1937, the tax increases (the next policy mistake) reversed the positive growth rate
of the economy and drove price levels and economic activity downward again. However, even
with that small period of price increases the overall price level never recovered from the 25%
decline that occurred from 1929 to 1933, and thus deflation reigned. Today, the declining dollar
is a good thing in terms of our trade balance, but the modest change will be insufficient to offset
the negative forces of insufficient domestic demand.

Next year the core GDP deflator will fall to zero, with the possibility of negative levels.
Likewise, long-term interest rates, which are highly sensitive to inflation, will continue to move
toward lower levels. As stated in previous letters, we see no reason why longer dated Treasury
interest rates will not mirror those of Japan, which provides a modern signpost for a deflationary
environment. Currently, the Japanese 10-year note stands at 1.3% and the 30-year bond yields
2.1%.

We continue to believe that in today’s environment long-term U.S. Treasury bonds make
attractive investments for patient, long-term investors.

We appreciate your investment in the Wasatch-Hoisington U.S. Treasury Fund.

Sincerely,

Van Hoisington

P.O. Box 2172 • Milwaukee, WI 53201-2172 • www.wasatchfunds.com

Phone: 800.551.1700

Wasatch Funds are distributed by ALPS Distributors, Inc.

**The Barclays Capital U.S. Aggregate Bond Index (formerly the Lehman Brothers Aggregate Bond Index) covers the U.S.
investment grade fixed rate bond market, including government and corporate securities, agency mortgage pass-through
securities, and asset-backed securities. To be included in the index the security must meet the following criteria: must have at
least one year to final maturity, regardless of call features; must have at least $100 million par amount outstanding; must be
rated investment grade or better by Moody’s Investors Service, Standard & Poor’s, or Fitch Investor’s Service; must be fixed
rate, although it can carry a coupon that steps up or changes to a predetermined schedule; must be dollar-denominated and must
be nonconvertible. All corporate and asset-backed securities must be registered with the SEC; and must be publicly issued. You
cannot invest directly in this or any index.
†
The velocity of money (V) is defined as the rate at which money circulates, changes hands or turns over in an economy.
††
M2 money supply consists of currency and checking accounts, consumer-type time and savings accounts and equivalent near
monies, while M3 money supply consists of M2 plus business-type time deposits and less liquid near monies. Both M2 and M3
exclude monies and near monies owned by the Treasury, depository institutions and foreign banks and official institutions and
IRA and Keogh balances owned by consumers.
‡
The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged
but is a commonly used measure of common stock total return performance.
‡‡
The money multiplier measures how much the money supply increases in response to a change in the monetary base.

U.S. Treasury Fund Top 10 Holdings as of June 30, 2009§ Percent of

Security Name Net Assets
U.S. Treasury Strip, principal only, 11/15/27 29.38%
U.S. Treasury Bond, 4.75%, 2/15/37 19.03%
U.S. Treasury Strip, principal only, 2/15/37 16.13%
U.S. Treasury Bond, 4.50%, 2/15/36 12.53%
U.S. Treasury Bond, 4.50%, 5/15/38 7.70%
U.S. Treasury Bond, 5.25%, 2/15/29 6.31%
U.S. Treasury Strip, principal only, 5/15/39 3.69%
U.S. Treasury Bond, 5.375%, 2/15/31 2.57%
U.S. Treasury Bond, 4.375%, 2/15/38 1.06%
Total 98.40%
§
Portfolio holdings are subject to change at any time. References to specific securities should not be construed as
recommendations by the Fund, its Advisor or Sub-Advisor.

Wasatch Funds are distributed by ALPS Distributors, Inc.

WAS001574 1/20/2010

P.O. Box 2172 • Milwaukee, WI 53201-2172 • www.wasatchfunds.com

Phone: 800.551.1700

Wasatch Funds are distributed by ALPS Distributors, Inc.