Financial Markets FAQs  

On September 19, the U.S. Department of the Treasury announced an emergency, temporary guaranty plan to protect shareholders of money market mutual funds from losses if their funds are unable to maintain a $1.00 net asset value ("break the buck"). ICI engaged in detailed discussions with the Treasury and the U.S. Securities and Exchange Commission on the plan, and on September 21 and 22, Treasury issued further clarifications. While many details remain uncertain, the following questions and answers outline the major features of the plan as they now stand:

What does the guaranty plan cover?
The guaranty plan is designed to protect current shareholders of money market mutual funds if their funds cannot maintain a $1.00 net asset value (NAV). Funds must elect to enroll voluntarily in the plan and pay a fee for coverage. If a fund enrolls, its shareholders will be protected for assets they have in their accounts as of the close of business on Friday, September 19.

What funds are eligible to participate?
The latest Treasury guidance says that "All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940 and are publicly offered and registered with the Securities and Exchange Commission will be eligible to participate in the program." The guidance also clarified that tax-exempt money market funds would be eligible to participate.

Why is the guaranty limited to accounts and assets as of Friday, September 19?
The decision to limit the guaranty program to the value of accounts at the close of business on September 19 arose from grave concerns that ICI raised with the Treasury over the plan's potential effects on flows among funds. Recently, large institutional shareholders, who hold almost two-thirds of assets in money market funds, have been moving money from general-purpose money market funds into funds that invest primarily in Treasury securities. The guaranty plan raised fears that this flow of funds would suddenly reverse if general-purpose funds joined the guaranty plan. By limiting the protection to account balances as of September 19, Treasury's amendments should alleviate that problem.

Why should I invest now in a money market fund if I've missed out on the guaranty plan?
Money market funds have long provided investors with capital preservation along with competitive rates of return. Money market funds are strictly regulated by the U.S. Securities and Exchange Commission and operate under tight requirements for the liquidity, creditworthiness, and diversification of their assets. In 25 years, $325 trillion in assets have flowed in and out of money market funds with only two break-the-buck episodes. Those same regulations are in place for all investors, whether they are covered by the guaranty plan or not.

Does Congress have to approve this guaranty plan?
No. The guaranty plan was designed by the Secretary of the Treasury and approved by the President under authority of the Exchange Stabilization Fund.

Money market funds have $3.4 trillion in assets. The plan is funded with $50 billion. Is that enough?
We believe that large redemptions and other recent strains in money market funds have been caused primarily by lack of active trading in the money markets, principally in markets for asset-backed commercial paper and agency paper. The Federal Reserve took additional steps on September 19 to improve liquidity in those markets. If those steps continue to succeed in unlocking these markets, we have every hope and expectation that this insurance pool will never be drawn.

How long does the guaranty last?
Treasury intends for the plan to last no more than one year.

Are retail and institutional shareholders all covered? What about foreign shareholders?
The plan will cover all shareholders, retail and institutional, domestic and foreign, in the eligible funds that enroll.

What about foreign-domiciled funds?
Only U.S.-registered funds that operate under Rule 2a-7 and are publicly offered are eligible for the plan.

How do money market funds enroll in the plan?
That is still to be determined. Treasury has not yet opened enrollment in the plan.

What will the plan cost? Who will bear the fees?
Treasury has not yet specified the fees for coverage, nor whether fees will be paid from fund assets or by fund management.

How will the coverage work?
If a covered fund cannot maintain a $1.00 NAV, and the fund sponsor chooses not to provide credit support to avoid breaking the buck, the fund board would notify the guaranty program that it has determined to liquidate the fund. The fund would then close and liquidate. The Treasury guaranty plan would pay the fund the difference between a $1.00 NAV and its shareholder payout; the fund would distribute that payment to shareholders.

What should I do if I'm concerned about the safety of my money market fund?
Contact the fund company for its latest available information on fund investments. Funds will decide whether to enroll in the guaranty plan after Treasury formally announces operational details, fees, and the enrollment process.

Source: http://www.ici.org/home/faqs_guaranty_plan.html#TopOfPage

How will the government's takeover of Fannie Mae and Freddie Mac affect mutual fund shareholders?
Shareholders in money market funds and bond funds may benefit, because the Treasury Department's action will make funds' investments in the mortgage giants' bonds and other debt securities more secure.

Shareholders in equity funds that own Fannie and Freddie stock could see further losses in their funds' values. The Treasury Department's plan puts existing holders of common and preferred shares first in line to absorb the companies' business losses. Of course, mutual funds are generally highly diversified across a range of stocks. Therefore, declines in Fannie's and Freddie's stock could be offset if the government action builds confidence in the financial markets and other stocks gain in value.

Any decline in funds' net asset value (NAV) is not likely to be precipitate. Funds adjust their NAV every day, and so any earlier declines in the price of Fannie and Freddie shares is already reflected in fund values.

How much of Fannie's and Freddie's debt was held by funds?
As of March 31, 2008 long-term mutual funds held about $370 billion in debt and mortgage pools issued by Fannie and Freddie, according to Morningstar data. Exchange-traded funds, closed-end funds, and unit investment trusts had additional, but much smaller, holdings.

Will the debt of Fannie and Freddie remain qualified for money market fund investments?
Yes, so long as the companies' credit ratings are not reduced. That's not likely. Even before the takeover, Fannie's and Freddie's paper was rated highly enough to qualify as investments for money market funds. And the government takeover should make the debt more secure, because it is now effectively backed by the credit of the U.S. government.

How much stock did mutual funds hold in Fannie and Freddie?
As of March 31, 2008 mutual funds held $27 billion in common and preferred stock in the two companies. That valuation is based on their prices at the time, when Fannie Mae common stock was trading at $26.32 a share and Freddie Mac common stock was priced at $25.32. The value of funds' holdings has changed, of course, as the stock prices changed and as funds traded in and out of the stocks.

Source: http://www.ici.org/home/faqs_fannie_freddie.html#TopOfPage

What are municipal bonds?
Municipal bonds ("muni bonds") are debt securities issued by state and local governments, or their authorized agencies, to borrow or raise money for public purposes such as building schools, highways, or hospitals. When you purchase a municipal bond, you lend money to the "issuer" (i.e., the government entity that issued the bond), which, in turn, pays a set amount of interest while you hold the bond and returns your principal investment on a specified maturity date.

A primary feature of many municipal bonds is that the interest income an investor receives is generally exempt from federal income tax. The interest may also be exempt from state and local taxes if the investor lives in the state where the bond is issued. Municipal bonds, therefore, also are known as tax-exempt bonds.

Because they offer tax-free income, municipal bonds generally have annual yields below those of corporate bonds or U.S. Treasury bonds. These low yields allow state and local governments to borrow money for public projects at below market rates.

How are municipal bonds traded?
The municipal, or "muni," market does not operate via a centralized exchange. Instead, it is an over-the-counter market-a network of dealers and brokers that connect buyers and sellers. Some bonds are "actively traded," meaning that they are traded on a regular basis. However, many investors buy and hold their bonds until they mature, so certain municipal bonds may not trade for months or years at a time.

Securities dealers that trade municipal securities must register with the Municipal Securities Rulemaking Board (MSRB), which sets the rules for the municipal bond market subject to the oversight of the U.S. Securities and Exchange Commission (SEC).

Who owns municipal bonds?
Individual, or "retail," investors are the largest holders of municipal securities. They hold 35 percent of municipal bonds directly and another 36 percent indirectly through mutual funds, closed-end funds, UITs, and ETFs. According to ICI's most recent data, investment companies of all types hold $907 billion, or 36 percent, of the $2.5 trillion municipal bond market. Mutual funds alone account for 32 percent of all U.S. municipal securities, totaling over $809 billion. Closed-end funds hold 4 percent, totaling $89 billion; municipal bond UITs hold $8 billion; and ETFs that track municipal bond indices hold $575 million in assets.

How are municipal bonds regulated?
Unlike registered investment companies, issuers of municipal securities do not have to file registration statements with the SEC. However, information about these issuers, including details of their financial condition, is available from various sources.

What is the role of credit rating agencies related to municipal bonds?
One way to evaluate a municipal securities issuer is to examine its credit rating. Credit rating agencies assign credit ratings based on their analysis of an issuer's ability to make interest payments and repay principal in a timely manner. (Credit rating agencies also grade corporate bonds, but their analysis of corporate bonds differs from their analysis of municipal bonds.)

Bonds rated BBB or Baa, or better, are characterized as "investment grade," meaning that they have a high probability of being repaid and have few speculative features. Municipal bonds with lower or no ratings carry higher risks, but may also pay the investor higher interest rates to compensate for that risk.

In addition to the ratings provided by credit rating agencies, most institutional investors, including investment companies, conduct their own credit analysis.

What is bond insurance?
Bond insurance is a type of credit enhancement. A bond insurer unconditionally and irrevocably guarantees that interest and principal will be paid as scheduled-on time and in full-even if the bond issuer defaults. If a bond carries insurance, it typically is insured in the primary market, at the time of issuance, but it may be insured at any time in the secondary market. For some small municipal issuers, access to capital markets is made more affordable by the use of a credit enhancement like bond insurance.

Many of today's municipal bonds are insured by monoline insurers, or insurers that back debt securities only and are not exposed to risks from any other lines of business. They may, however, be exposed to other forms of risk (i.e., interest rate risk, market risk, etc.) Monoline insurers must meet the requirements of insurance regulators in every state where they do business. They are closely monitored by the major credit rating agencies.

Monoline insurers conduct an underwriting process before insuring a municipal bond: the insurers examine the issuer's tax base (if applicable) and operations, regional economy, financial condition, existing debt, expected future borrowing, and spending requirements, as well as the legal provisions securing the bonds.

Bond issuers, or the investment banks and securities dealers that sell the bonds, typically pay the insurance premiums. There are no direct charges for investors, but the investor may earn less income than if the bond were not insured because of the added protection provided by the insurance.

Why do bond issuers buy insurance?
Bond issuers use bond insurance because it improves the credit quality of a bond, making it easier to sell. Bond insurance boosts credit quality by offering protection against default or downgrade if a bond issuer cannot meet its obligations to pay interest and principal to bondholders.

Insured municipal bonds are rated based on the credit of the insurer (based on its claims-paying ability) rather than the underlying credit of the issuer. Historically, this has improved the credit rating of the bond. A higher credit rating allows the issuer to benefit from lower financing costs because bonds with high ratings-and, therefore, greater security-pay lower interest rates. This also leads to enhanced liquidity for insured bonds because there is greater demand among investors for highly rated securities.

Accordingly, an issuer may seek bond insurance for a number of reasons. If a bond issuer's credit would not earn a high rating, bond insurance could improve the credit quality of the bond. But even highly rated bond issuers use bond insurance-to lower the costs of borrowing.

How are monoline insurers rated?
Credit rating agencies frequently evaluate bond insurers' claims-paying ability-through detailed analyses of financial resources, operations, and exposures-and publish regular reports on each insurer. Credit rating agencies look at key indicators, including the quality of the insured portfolio, capital adequacy, financial performance, operating efficiency, risk management, liquidity of assets, reinsurance, business viability, ownership, and the skill and experience of management.

What happens if a monoline insurer is downgraded?
Because an insured bond carries the rating of the bond insurer, the bond's rating will be downgraded when a monoline insurer is downgraded. With a lower credit rating, the market value (i.e., price) of the underlying municipal bond could fall because the perceived risk of owning the bond has increased. The presence of an insurance policy alone does not guarantee a municipal bond's price in the secondary market. As with any other security, the actual price is determined by the market at the time of resale. Municipal bonds sold prior to maturity may be worth more or less than their original cost. Generally, if the price of a municipal bond drops, higher yields will follow.

As noted above, however, some issuers obtain bond insurance primarily to lower their costs of borrowing. If these issuers carry a credit rating independent of the credit rating from the monoline insurer, market participants may "look through" or disregard the downgrade of the insurer. Depending on the market at the time of resale, this might enable the issuer to maintain a higher trading price.

Presently, the credit ratings of certain insurers are under review due to subprime lending exposure that threatens their ability to pay claims. This, in turn, has resulted in some rating downgrades. Municipal bond funds and money market funds holding municipal bonds face certain regulatory requirements regarding the quality of the securities held in their portfolios. These funds also state in their prospectuses that they will only hold securities of a certain quality. If these funds hold securities that have been downgraded because they are insured by downgraded monoline insurers, the funds may have to determine whether they can continue to hold those bonds.

In the long term, the inability of monoline insurers to maintain high credit ratings may restrict the supply of high quality, short-term securities for municipal money market funds and other municipal bond funds.

What is the credit quality of most of the underlying municipal bonds?
Monoline insurers typically insure only municipal bonds that are of investment-grade quality on their own. The underlying bonds may or may not be rated by a credit rating agency. A bond without a rating does not necessarily carry a higher level of risk; it simply means that the issuer did not apply for an underlying rating (a rating on the uninsured bond), possibly because it did not want to incur the additional cost.

What other types of municipal securities are insured by monoline insurers?
In addition to traditional municipal bonds, monoline insurers provide insurance for variable-rate demand obligations (VRDOs) and tender option bonds (TOBs). Monoline insurers also insure structured finance bonds and certain international debt securities.

What are variable rate demand obligations and tender option bonds?
Variable-rate demand obligations (VRDOs) are debt securities that bear interest at a floating, or variable, rate adjusted at specified intervals (daily, weekly, or monthly) according to a specific index or through a remarketing process. Holders can redeem these securities at designated times. Issuers offer VRDOs in order to access the short-term market to obtain lower interest rates. Tender option bonds (TOBs) are similar to VRDOs but are synthetically created by a bond dealer with long-term bonds purchased in either the primary or secondary markets. Both VRDOs and TOBs are short-term, tax-exempt instruments whose yield is reset daily or weekly based on an index of short-term municipal rates.

VRDOs and TOBs are purchased at par, the face value of the security. Each structure includes a liquidity facility which provides a "put" or demand feature. This allows the bondholder (e.g., a fund) to put the security back to the remarketing agent and receive face value plus accrued interest with specified notice. A remarketing agent-a bank or other entity-helps to make a market for the securities and ensures that a holder's put is honored by reselling the products, holding them in its own inventory, or arranging for the holder to be paid from the bank liquidity facility. In addition to providing a source of cash to satisfy redemptions by fund shareholders, these liquidity features operate to shorten the long-term bonds' maturity and make them appropriate for a money market fund.

What is the credit quality of VRDOs and TOBs?
Most VRDOs and TOBs are highly rated due to credit enhancements (such as bond insurance or letters of credit), which guarantee timely principal and interest payments, as well as the liquidity facility, which provides payment for tendered bonds. In most cases, the liquidity facility requires that the municipal bonds maintain certain credit ratings. Consequently, like insured municipal bonds, VRDOs and TOBs may be affected when monoline insurers are downgraded. For example, a downgrade of the monoline insurer may trigger a "termination event" that releases the liquidity facility from its obligation to buy back the security.

Funds are taking action in advance of this possibility. Some funds are unloading the securities from their portfolios by exercising the put feature to the remarking agent, thereby receiving par and accrued interest for the security. Other funds are obtaining changes to their contracts with liquidity providers to preserve the liquidity facility regardless of the monoline insurer's rating, by linking the termination events to the credit rating of the underlying issuer and/or the monoline insurer.

A money market fund that holds VRDOs or TOBs in its portfolio may have to review whether it may continue to hold securities that are enhanced by the downgraded monoline insurer.

What is an auction rate security?
Auction rate securities (ARS) are municipal securities with a variable interest rate that is set periodically through a "Dutch Auction" process. Auctions are typically held every 7, 28, or 35 days, and interest on these securities is paid at the end of each auction period. ARS trade at par and are callable at par on any interest payment date at the option of the issuer. Although ARS are issued and rated as long-term municipal bonds (20 to 30 years), they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset mechanism.

During the auction, a broker-dealer submits bids, on behalf of current and prospective investors, to the auction agent-typically a bank. Based on the submitted bids, the auction agent will set the next interest rate by determining the "clearing rate," the lowest rate to clear the total outstanding amount of ARS. The program documents for an ARS also define situations under which a "maximum rate" is used for the next interest rate period. Generally, the maximum rate is a multiple of a specified index or a fixed rate.

Unlike TOBs and VRDOs, ARS holders do not have the right to put their securities back to the issuer; so a bank liquidity facility is not required. As a result, money market funds cannot hold ARS because SEC rules restrict them to securities with a final maturity of 397 days or less. In addition, because ARS do not carry a "put" feature, they are very sensitive to changes in credit ratings and normally require the highest ratings to make them marketable. This is usually achieved with bond insurance. Thus, when a monoline insurer is downgraded, investors are less likely to participate in an auction for the ARS, reducing demand for the securities.

Typical investors of ARS include corporate and high net worth individuals, bond funds, and bank trust departments.

What is a failed auction?
An auction fails when there are more shares offered for sale in the auction than there are bids to buy shares, or if the clearing rate of the auction would be above the maximum rate defined in program documents. A failed auction does not mean the security goes into default, because the issuer continues to pay interest at the maximum rate; however, existing holders of the securities who wanted to sell them generally are not able to do so in that particular auction. Auction failures are the result of limited liquidity in the market for the particular ARS and not necessarily the result of an event of default by the issuer.

Source: http://www.ici.org/home/faqs_muni_bond.html#TopOfPage

How does an investor sign up to participate in the Treasury's Temporary Guarantee Program for Money Market Funds?

While the program protects the shares of all money market fund investors as of September 19, 2008, each money market fund makes the decision to sign up for the program. Investors cannot sign up for the program individually.

How will investors know if their money market fund participates in the program?

Investors should contact their money market fund directly to determine if it is participating in the program.

What type of funds does the program cover?

All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940, are publicly offered, are registered with the Securities and Exchange Commission and maintain a stable share price of $1 will be eligible to participate in the program. This includes both taxable and non-taxable funds.

Is an investor in a fund that is managed like a money market fund but that is not registered with the SEC covered?

No, the program only covers money market funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940, are publicly offered, are registered with the Securities and Exchange Commission and maintain a stable share price of $1 will be eligible to participate in the program. This includes both taxable and non-taxable funds.

When will my fund be covered by the program?

Each fund must decide to participate in the program. If your fund participates in the program, your investment as of September 19, 2008 will be covered.

How much of an investor's money market fund is insured? What happens if the number of shares held in an investor's account increase above the level at the close of business on September 19, 2008? What happens if the number of shares held in an investor's account decreases below the level at the close of business on September 19, 2008?

The program provides a guarantee based on the number of shares held at the close of business on September 19, 2008. Any increase in the number of shares held in an account after the close of business on September 19, 2008 will not be guaranteed. If the number of shares held in an account fluctuates over the period, investors will be covered for either the number of shares held as of the close of business on September 19, 2008 or the current amount, whichever is less.

Examples include:

1. If an investor owned 100 shares in a money market fund as of close of business September 19, 2008, but owns 50 shares on the day the guarantee payment is made, after the fund breaks the buck, then that investor will be guaranteed for 50 shares. 

2.  If an investor owned 100 shares in a money market fund as of close of business September 19, 2008, but owns 150 shares on the day the guarantee payment is made, after the fund breaks the buck, then that investor will be guaranteed for 100 shares. The fund, upon liquidation, will distribute proceeds to the shareholder for the additional 50 shares, at net asset value. 

3.  If an investor owned 100 shares in a fund as of close of business September 19, 2008, subsequently sold 50 shares and later bought 25 shares, the investor owns 75 shares on the day the guarantee payment is made and will be guaranteed for 75 shares. 

4.  If an investor owned no shares in a fund as of close of business September 19, 2008, but owns 100 shares on the day the guarantee payment is made, none of the investor's shares are guaranteed by the program and the investor will receive the net asset value directly from the fund.

What if another fund in an investor's fund family breaks the buck before this program starts? Is the investor covered?

The program provides a guarantee on a fund-by-fund basis up to the amount of shares held as of the close of business on September 19, 2008. The performance of a different fund, even one in the same fund family of the investor's fund, doesn't affect the investor's fund's eligibility. Investors should contact their fund to determine if their fund participates in the program.

When does the program terminate?

The program is designed to address temporary dislocations in credit markets. The program will be in effect for an initial three month term, after which the Secretary of the Treasury will review the need and terms for the program and the costs to provide the coverage. The Secretary has the option to extend the program up to the close of business on September 18, 2009. In order to maintain coverage, funds would have to renew their participation in the program after each extension. If the Secretary chooses not to extend the program at the end of the initial three month period, the program will terminate.

Who provides this guarantee? Are investors able to get all of their money back whenever they want?

The U.S. Treasury Department, through the Exchange Stabilization Fund, is providing this guarantee. In the event that a participating fund breaks the buck and liquidates, a guarantee payment should be made to investors through their fund within approximately 30 days, subject to possible extensions at the discretion of the Treasury.

Is shareholder in a fund that broke the buck before September 19, 2008 covered?

No. This does not meet the program's eligibility criteria noted above.

What should shareholders in a participating fund that breaks the buck do? Who should they call?

If your fund enrolled in the program you will be covered and do not need to take any action. Shareholders should contact their fund directly.