NEW YORK (MarketWatch) -- The U.S. government acted Friday morning to prevent a broad collapse in the money-market industry as the $3.5-trillion sector saw hundreds of billions of dollars head for the exits.

The Treasury Department said it will insure any publicly offered money-market fund, both retail and institutional, that pays a fee, while the Federal Reserve will buy agency discount notes from primary dealers, acting as a backstop when and if money-market funds want to sell their assets.

The Fed also announced plans to inject liquidity in what was in danger of becoming a frozen credit market. It will extend nonrecourse loans to banks to finance their purchases of asset-backed commercial paper from money-market managers who face redemption pressures. This is designed to stem the anxiety that these funds were experiencing that they need cash to deal with withdrawals.

"The Fed is trying to stop what was appearing to be a run on money funds," said Josh Feinman, chief economist at Deutsche Bank's DB, -1.89% DB Advisors.

A run would have seen forced selling across the sector, he added, dramatically reducing prices and "further constricting another artery of the credit market -- and a very crucial one."

Fund assets sold at cut prices also would have pushed the net asset value of money-market funds to below $1 a share.

"There credit issue was contained -- the problem was the liquidity issue," said Michael Kim, associate director at Sandler O'Neill & Partners.

There is hope, however, that the government's moves have restored confidence. "It's very early, but we are beginning to see clients who were planning to go into our Treasury funds go into our prime funds today," said Mary Athridge, spokeswoman at Legg Mason Inc. LM, +12.50%

"Things look much more like a normal day in September," commented Deborah Cunningham, chief investment officer at Federated Investors. FII, -1.75%

Money-fund woes

At the $12.3 billion Putnam Primary Fund PPMXX, managed by Great West Lifeco Inc.'s GWLI Putnam Investments, there were so many redemptions that the firm was forced to liquidate the fund Thursday. See full story

The problems at Putnam threatened to spread across the industry, with nearly $90 billion of net investor cash pulled out Wednesday -- the largest single-day drop in history, according to iMoneyNet -- and Thursday saw net outflows of $56 billion.

The money-market fund industry has shrunk by more than $220 billion in just more than a week.

"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 said.

It's not clear how much mutual-fund companies will have to pay to participate in the plan. Feinman, Cunningham and officials at several other mutual fund companies said that full details of the plan are yet to come from the government.

But, said Feinman, "Ultimately, I think money market funds will come under greater scrutiny," as a result of today's actions.

“ 'There's no reason to think that we won't go back to normal operations.' ” — Deborah Cunningham, Federated Investors

Cunningham said she thought Friday's actions will all be short-term. "There's no reason to think that we won't go back to normal operations," she said.

The money-market crisis was triggered by Primary Fund RFIXX, the first money-market fund launched in 1971 by industry pioneer the Reserve.

Primary Fund's net asset value, or NAV, fell Tuesday to 97 cents a share -- effectively "breaking the buck." Money-market funds typically maintain a NAV of $1 a share.

The $64 billion fund held $785 million of commercial paper issued by Lehman Brothers Holdings Inc. LEHMQ, spurring selling in the Primary Fund's assets of about $26 billion in less than 48 hours. See full story

As of Wednesday's close, two other Reserve funds had broken the buck: Yield Plus Fund RYPQX was also at 97 cents a share, while International Liquidity Fund, available only to offshore investors, dropped to 91 cents a share. The Reserve said Thursday that it was freezing its assets. See full story.

Legg Mason also faced redemptions pressures on Thursday.

It was forced into support agreements for extra cash to ensure that two funds -- Liquid Reserves Portfolio CILXX, and Western Asset Institutional Money Market Fund INMXX -- kept their $1-a-share NAVs, and acquired two letters of credit to make sure another fund, Citi Institutional Liquidity Fund, kept its AAA rating. The latter is only available to offshore investors as well.

Buying time

The government's moves were designed to give Congress time to put together what is shaping up as the biggest bailout of toxic debt in U.S. history. See full story.

Other efforts announced include a program designed to buy up bad assets from financial institutions and a temporary ban on short sales in nearly 800 financial stocks instituted by the Securities and Exchange Commission. See full story.

To shore up the mortgage market, Treasury is also expanding its mortgage-backed securities purchase program. Mortgage finance giants Fannie Mae FNM, and Freddie Mac FRE, -0.64% will increase their purchases of the debt.

The SEC, joining British regulators, temporarily banned all short sales in 799 financial companies through Oct. 2. Many analysts blame concerted short selling for driving down share prices of financial-market participants.

Not everyone is impressed with the government's moves.

"Today's action will undermine the role of banks during this current crisis and has the potential to have an extremely negative impact,'' said Edward Yingling, chief executive of the American Bankers Association. "Our bankers are, understandably, very upset."

Bankers are unhappy because now that money-market funds are also government-insured, banks may face greater competition for customer deposits.