Rushing to save money-market funds
In effort to calm critical part of the broader financial system, Fed and Treasury take three-pronged measure to stabilize troubled funds.
NEW YORK (CNNMoney.com) -- Coming to the rescue of a bedrock of American investing, the Treasury Department and the Federal Reserve took three big steps Friday to shore up the $3.3 trillion U.S. money-market fund industry.
Investors have been fleeing money-market funds after a week of chaos on Wall Street that included the bankruptcy of Lehman Brothers, an $85 billion government bailout of American International Group and a sweeping plan for the federal government to buy up financial companies' troubled mortgage debt.
Money-market funds are typically a safe investment popular with American consumers and companies alike, but redemptions have severely strained fund families and global financial markets.
In response, the Treasury said it would insure up to $50 billion in money-market fund investments at financial companies that pay a fee to participate in the program. The initiative, which lasts for a year, will guarantee that the funds' value does not fall below the standard $1 a share.
"Concerns about the net asset value of money-market funds falling below $1 have exacerbated global financial market turmoil and caused severe liquidity strains in world markets," the Treasury Department said in a statement.
At the same time, the Fed took two steps to stabilize the debt products in which money-market funds invest. The value of this debt plummeted this week as the funds rushed to sell their holdings to meet investor redemption demand. Money-market fund holders cashed in a record $169 billion in the past week.
First, the Fed will lend an unlimited amount of money to banks to finance their purchases of high-quality asset-backed commercial paper from money-market funds. Money-market funds hold approximately $230 billion in this type of debt.
In an unusual move, the Fed is lending the funds on a "non-recourse" basis, meaning if the value of the commercial paper - short-term debt issued by companies - declines in value, the agency will absorb the loss. However, senior Fed staffers said they do not expect to take any losses because the debt should regain its value once the markets stabilize.
Second, the Fed will purchase short-term debt issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks from investment banks, which should also inject liquidity into the market. Money-market funds hold about $69 billion of such debt.
Money-market experts say investors shouldn't panic. They felt most funds were safe even before Friday's government action, which will only add more confidence in the investments.
"I am very hopeful that this move with provide investors a high level of comfort," said Connie Bugbee, managing editor of iMoneyNet, which follows money funds. "The combination of this move and the next two days, when purchasing or selling money fund shares is not an option because it's the weekend, should be enough to calm the waters."
Money-market funds have been under pressure for the past year as the credit crisis swept Wall Street. But the tension soared this week amid a new round of trouble.
In ordinary times, investors turn to money-market funds as a stable place to stash extra cash in their brokerage or retirement accounts. They usually offer higher interest rates than many bank accounts, such as money-market accounts. For instance, the yields on JPMorgan Chase money-market account ranges from .15% to .40%, while Vanguard offers money-market funds with yields ranging from 1.63% to 2.25%.
Money-market funds can offer higher yields because they invest in assets ranging from Treasurys to short-term corporate debt, the latter of which comes with higher rates but more risk.
But unlike bank products, money-market funds are not covered by the Federal Deposit Insurance Corp. Investors can lose money, and this week, those in one fund did.
The Reserve Fund announced Tuesday that it had to cut the price of shares in its primary fund to 97 cents and investors who wanted to withdraw money would have to wait a week for the proceeds.
Other mutual fund companies have had to take emergency maneuvers to stabilize their money-market funds. Under siege from redemptions, Putnam Investments said Thursday it would close its institutional prime money-market fund and return all proceeds to investors at $1 a share.
Meanwhile, Legg Mason announced it would inject up to $630 million into three funds to allow them to maintain their $1-a-share value. Other fund companies - including Wachovia's Evergreen Investments and Frank Russell Funds - announced earlier this week their parent companies also would put money into the accounts.
By Friday, federal officials worried that the strain on money-market funds had become too great and threatened the world's financial system.
"Money-market funds play an important role as a savings and investment vehicle for many Americans; they are also a fundamental source of financing for our capital markets and financial institutions," the Treasury Department said. "Maintaining confidence in the money-market fund industry is critical to protecting the integrity and stability of the global financial system." 
