WASHINGTON – The Treasury Department announced Sunday night that tax-exempt money market mutual funds will be included under its temporary $50 billion insurance program for money market funds that it unveiled Friday, providing urgently-sought relief to market participants.
The announcement, a reversal of the previous stance the department had taken, came after the Treasury received many panicked phone calls from market participants over the weekend, warning that if tax-free funds were not included in the program, investors would withdraw their money from the funds in record numbers when markets reopened.
In order to obtain money to pay for the redemptions, it was expected that the managers of tax-free funds would exercise the put options on their funds’ underlying variable-rate demand obligations, forcing banks to take back the securities and causing havoc in the banking industry, sources said.
In its one-page announcement, Treasury said that while the specific details of the temporary guarantee program are still under development, the program will be designed to cover shareholders for the amounts they held in tax-free and taxable money market funds as of the close of business Friday.
Further details on other aspects of the program, and the required documents for funds to participate, will be provided in the coming days, the treasury said.
Treasury officials originally excluded tax-free funds from the federal insurance program because under federal tax law, most tax-exempt bonds cannot receive a federal guarantee and retain their tax-exempt status.
While some market participants had suggested that Treasury might need legislation to include tax-free funds in the insurance program, a knowledgeable source said Sunday that the department will issue regulatory guidance as early as Monday that states the federal guarantee restriction will not apply to the tax-free funds.
According to Morningstar Inc., there are 279 tax-free money market funds that hold $553 billion of assets.
The $50 billion of guarantees for money market funds comes from Treasury’s existing Exchange Stabilization Fund, which consists of U.S. dollars, foreign currencies and others and has been used in the past to provide emergency financing to foreign governments. President Bill Clinton deployed about $20 billion from the fund to provide aid to Mexico in 1995. The Treasury secretary has "considerable discretion" under the law to tap the fund, according to the Treasury Web site.
The Federal Reserve also opened its discount window to financial institutions to enable them to purchase certain assets from money market funds.
The administration's actions are aimed at stopping investors from pulling money out of their money market funds, which are not insured by the Federal Deposit Insurance Corp.
The administration also made clear over the weekend that it plans to spend up to $700 billion to purchase mortgage-backed assets from troubled financial institutions.
The Investment Company Institute and several mutual fund research analysts applauded the administration's temporary guarantee plan for money market funds on Friday.
"The steps [Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke] have taken should help fee up trading in commercial paper and other key markets in which money market mutual funds and others participants," ICI president and CEO Paul Schott Stevens said Friday. "We believe these actions will go a long way toward restoring order in the markets and building investor confidence after a period of extraordinary turmoil that has affected money market mutual funds and other financial products."
"The federal response by and large should stem the outflows at any money market fund shop that announces they are going to participate in the program," said Lawrence Jones, senior mutual funds analyst at Morningstar. "Given the federal response, I'd be surprised if we see too many more money market funds break the buck."
The Reserve Primary Fund, which had $62 billion in taxable assets as of June 30, fell below $1.00 to 97 cents on Tuesday as the fund, managed by Reserve Management Corp., was forced to write down debt from Lehman Brothers Holdings Inc., which declared bankruptcy on Monday.
The Putnam Prime Money Market Fund, with $15 billion in assets, was closed to redemptions on Wednesday after experiencing "extreme redemption pressure," Putnam wrote in a statement to investors.
"The tsunami is just starting to recede a bit so you may see some casualties wash up on the beach," said Peter G. Crane, president and CEO of Crane Data LLC, a money market research firm.
Reserve Primary Fund is the only money market fund known to have broken the buck, but a lot of fund managers might be seeing "0.998s" when calculating the net asset value of their funds, he said, adding that money markets may be getting an injection of equity from their parent companies rather than halting redemptions or dropping the NAV. Crane estimates that money market funds lost six to seven percent of their value last week.
But the temporary guarantee drew concerns from some corners of the market. The American Bankers Association told Paulson and Bernanke, in a letter sent to them Friday, that it is deeply concerned about the program, which it warned could undermine the banking system.
"The debt instruments in a money market fund will pay a higher interest rate, and therefore the fund pay a higher interest rate, than a bank deposit or short-term [certificate of deposit]," ABA president and CEO Edward Yingling said. "The ability of banks to attract and keep deposits is being compromised in a profound fashion."
Some mutual fund analysts also expressed concern. "From my own personal point of view, I don't like the idea of an FDIC type of program. I think that creates a moral hazard," said Jeff Tjornehoj, senior research analyst at Lipper. "If a manager of money market funds feels that there's a backstop then what's to stop him or her from reaching for yields in areas that might look speculative?"
But David Wyss, senior economist with Standard & Poor's, said the government would likely force to close any fund that receives protection. "There is a penalty here," he said.
Paulson outlined the rescue plan Thursday for lawmakers and briefed reporters on it Friday. He said the Treasury is working on a legislative proposal that would allow the federal government to buy mortgage-backed securities -"the underlying weakness in out financial system today."
Under the plan, Treasury would provide funding for the mortgage giants Fannie Mae and Freddie Mac to increase their purchases of mortgage-backed securities. The legislation will also expand the Treasury's MBS purchase program announced earlier in September.
"This is what we need to do," Paulson told reporters on Friday. "We've worked with Congress on a number of steps all of which were important leading up to this, but this the way to stabilize the system and get at the root cause."
Paulson said he hopes Congress will vote on the legislation next week. Congress is scheduled to adjourn on Sept. 26, but members in the House and Senate have said they could stay in session beyond the recess date to pass the Treasury's proposed legislation and to monitor market conditions.
Lawmakers were clearly concerned. Sen. Richard Shelby, R-Ala, the Senate Banking Committee's ranking minority members worried the proposal could cost $1 trillion. And committee chairman Sen. Christopher Dodd, D-Conn., said the administration officials will have to work with Congress. Some lawmakers over the weekend were demanding that the administration restrict the compensation of the executives of companies that participate in the federal bailout program.
The bailout is not likely to affect the triple-A rating on U.S. debt, credit analysts said. Guido Cipriani, senior vice president at Moody's Investor Service said the government bailouts are not "fundamentally undermining the medium-term strengths of the U.S. economy."
"We continue to say that the U.S. debt rating is unambiguously a triple-A with stable outlook," he said.
In a Sept. 17 research note, credit analysts with Citi said the current banking crisis does not compare in severity with other banking crises.
"The injection of capital into Fannie Mae, Freddie Mac and American International Group Inc. have increased the potential fiscal cost to more than 4 percent of GDP," analyst wrote. "This is considerably less than previous financial crises but more expensive the U.S. [savings-and-loan] crisis."
Cipriani said Treasury securities enjoy "unparalleled access" and have given the U.S. a source of funding other countries did not have during their banking crises.