WASHINGTON - The Treasury Department sent waves of relief through the municipal market yesterday by making clear that tax-free funds can participate in its recently announced $50 billion temporary insurance program for money market funds without jeopardizing the tax-exempt status of the muni bonds they hold.
Treasury made the statement in a short release issued Sunday night and a two-page notice outlining the program that was released yesterday.
Not only did Treasury clarify that the program would apply to tax-free money market funds, a reversal of its previous position, but it also said the program would be limited to assets in money market funds as of the close of business on Friday, Sept. 19. That was seen as a concession to the banking industry, which had been concerned the new program would lead investors to move money out of certificates of deposit and into insured money market funds.
"I think everyone believes that it's a good idea," said Mary Jo Ochson, chief investment officer of muni money markets and bonds at Federated Investors in Pittsburgh. "The guaranty [program] is there as a backstop and it's just a way to calm the markets."
"This does not suggest in any way shape or form that the assets are impaired in the money markets," Ochson stressed. "Everything, I think, that we own is extremely high quality and minimal credit risk and probably the same thing can be said by all of the other funds out there. This was just a way to calm the markets from what obviously is a huge financial dislocation."
Asked about the likelihood that most money market funds will participate in the program, Ochson said: "No one has seen any details, so you can't say 100%, but I cannot see any reason not to participate in it. I'm assuming the fees are going to be very reasonable and that most funds will participate. I think it will be very successful."
The Treasury said in its notice that it will temporarily make available its Exchange Stabilization Fund, normally reserved for cases of foreign exchange intervention, to ensure money market funds are able to avoid "breaking the buck," which occurs when they are unable to maintain a $1 per share net asset value.
The move was made after the Reserve Primary Fund broke the buck Tuesday, after suffering heavy losses from investments tied to Lehman Brothers, which has filed for bankruptcy. Market participants began to fear that investors would begin to pull out of the funds, which, unlike bank or brokerage accounts, are not covered by the Federal Deposit Insurance Corp. or the Securities Investor Protection Corp.
In the notice, the Treasury said the program will not result in any violations of Section 149 of the tax code, which states that bonds cannot receive a federal guarantee and still retain their tax-exempt status.
When the temporary program was introduced last Friday, it did not include tax-free funds because of the tax law provision. However, after receiving numerous complaints from market participants who said that exclusion from the program would cause investors to withdraw their money from tax-exempt funds in record numbers when markets reopened on Monday, the department reversed itself.
Tax professionals and lawyers spent the weekend making the case to Treasury that the program would not amount to a federal guarantee on the tax-exempt bonds and should therefore include tax-free funds.
"We convinced them that these aren't guarantees, because if a bond goes into default, they may not have to make the fund whole, because the fund may have lots of other income and not otherwise drop below a dollar," said one knowledgeable market source close to the discussions. In actuality, the "guarantee" functions more like a put option than an actual guarantee, he said.
Others made the argument that since the federal government would be guaranteeing the funds and not the actual underlying bonds, there would be no explicit guarantee of the bonds, and, as a result, no violation of the tax code.
Overwhelmingly market participants argued that the Treasury could not take steps to stabilize money market funds without including tax-exempt funds. If tax-exempts were excluded, there could potentially could have been a run on tax-free funds, as investors sought to move their holdings to the taxable, guaranteed funds, further destabilizing the financial markets.
"If the issue was market stability, you couldn't provide this to taxable funds and leave out tax-exempt funds," said another market participant.
The Treasury did not provide a legal rationale for extending the guaranty program to tax-free funds and instead only stated in the notice that it "will not assert" that any tax-exempt funds opting into the program are in violation of Section 149.
Sources said the Treasury is not obligated to provide a legal basis for its actions, and given the importance of getting the news out as soon as possible to avoid market disruption, they likely avoided a complex legal argument that would have had to be thoroughly vetted by a team of attorneys, consuming valuable time.
In addition, the notice makes clear that except for this specific administrative proposal, "no inference should be drawn ... regarding any other federal tax issues." Sources pointed out that this will make it difficult for anyone to extrapolate the Treasury's position in this matter to other issues.
"It's better to say nothing than to say something and have people try and parse the words and figure out the inner meaning," said the knowledgeable source.
The program's restriction to assets in funds as of the end of Friday stems in part from a comment letter the American Bankers Association sent to Treasury, calling for limits to be placed on the money market guaranty program. In the letter, ABA officials argued that FDIC-insured banks would be at a significant disadvantage to federally guaranteed money market funds, which could offer a higher interest rate than bank deposits or CDs for the same nonexistent risk. "Simply put, the ability of banks to attract and keep deposits is being compromised in a profound fashion," the letter stated.
Senate Banking Committee chairman Christopher Dodd, D-Conn., has proposed legislation that would limit the federal guaranty program to $100,000 - the same amount of assets in funds as the FDIC insures in bank accounts. His proposal would make the program available for a period of six months to a year.