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On Wednesday Sept 17th, the Primary Money Market Fund froze redemptions. A run on the fund had reduced its assets from $63 billion the previous Friday to $23 billion by the close on Tuesday. Word had gotten out that the fund held $785 million in short-term Lehman debt that was going to be written down to zero. The Primary Fund was managed by The Reserve, the first company to create money market funds in the early 1970s and was one of the oldest of all funds. It was also the first in money market fund history to break the buck for retail investors. While one other money market fund, the Community Bankers U.S. Gov't Money Market Fund, broke the buck in 1994 by paying out only 96 cents on the dollar, this only affected institutional clients. Once it opened again, the Primary Fund planned on returning 97 cents on the dollar.
The previous week had witnessed $80 billion in withdrawals from the $3.5 trillion total in the U.S. money fund market. While this may not seem to be a lot, it was the biggest week for withdrawals since money market funds began. On Monday, troubled bank Wachovia announced that it would pump money into three Evergreen funds to prevent them from breaking the buck, following 20 fund companies that had had to take similar measures in the previous thirteen months. Then on Wednesday, system wide money market withdrawals ballooned to $89 billion in a single day or 2.5% of total deposits (20 times the usual rate). The next day Putnam announced it was closing its $12 billion Prime Money Market Fund because of "significant redemption pressure".
This blow up in money markets, like every other facet of the current credit crisis, was apparently not anticipated by the Federal Reserve or the U.S. Treasury. However, once the problem became obvious to even an intellectually challenged five year old, they both did act swiftly, albeit perhaps not legally, to counteract it. On Friday, the Fed announced plans to inject liquidity into money market funds by extending nonrecourse loans (this means taxpayers get stuck paying off the debt if it goes bad) to banks to finance their purchases of asset-backed commercial paper from money-market managers who face redemption pressures. For its part, the U.S. Treasury announced it had established a money market guaranty program lasting one year for up to $50 billion. The assets would come from the Exchange Stabilization Fund and represented its entire holdings. This U.S. government entity was created in 1934 to conduct interventions in foreign exchange markets. The use of this fund for its intended purpose requires the consent of the president, but not congressional approval. Of course, bailing out domestic money market funds had nothing to do with its intended purpose.
This was not the first time that extra legal or questionably legal measures have been used by the U.S. government to deal with the credit crisis, and it is highly unlikely that it will be the last.Once this threshold has been crossed, it can't be determined how far a government will go with its "emergency measures". When all the power centers of a country agree that it is OK to break the law, there are no longer any of the checks and balances in the system that ordinarily limit government action. But why get bogged down with legal niceties? As long as the U.S. doesn't need to maintain a functional economy or keep the country a desirable destination for desperately needed foreign capital, this cornerstone of all successful economies can be ignored.
NEXT: Bailing Out Henry Paulson - and Wall Street Too
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