Big News Today: Fed Will Back-Stop Commercial Paper,Currently a $1.6 Trillion Market

A quick primer on commercial paper

1. Commercial paper is a money-market security issued by large banks and corporations. It is generally not used to finance long-term investments but rather to purchase inventory or to manage working capital.

2. Commercial paper essentially can be compared as an alternative to lines of credit with a bank.

3. Most commercial paper is issued by financial companies but as of the late 90's over 25% was issued by nonfinancial firms such as manufacturers, public utilities, industrial concerns and service industries.

The big news: Fed to Purchase U.S. Commercial Paper to Ease Crunch

Oct. 7 (Bloomberg) -- The Federal Reserve will create a special fund to purchase U.S. commercial paper after the credit crunch threatened to cut off a key source of funding for corporations.

The Treasury will make a deposit with the Fed's New York district bank to help set up the new fund. The central bank will also lend to the program at policy makers' target rate for overnight loans between banks. The Fed Board invoked emergency powers to set up the unit, the central bank said in a statement released in Washington.

Today's action follows a slide in the commercial-paper market to a three-year low of $1.6 trillion last week as investors fled even companies with few links to the subprime mortgage crisis. Companies from newspaper firm Gannett Co. to electricity producer Southern Co. have been forced to tap credit lines or forego raising debt because of the market's disruption.

The Fed's efforts are aimed at ``stemming the bank-run-like panic,'' said Mark Gertler, a New York University economist and research co-author with Bernanke. ``The immediate threat to the real economy is that large corporations are having difficulty obtaining funds via the commercial paper market.''

Fed officials in a conference call with reporters didn't say how much commercial paper, which hundreds of companies use to finance payrolls and meet other cash needs, it plans to purchase. The central bank's special purpose vehicle will be big enough to backstop the entire market, one official said on condition of anonymity.

Size of Sales

Issuers will be able to sell commercial paper to the Fed up to the average amount they had outstanding in August, an official said.

Policy makers began considering buying commercial paper several weeks ago as the market began to seize up, with borrowers increasingly only able to raise funds on a short timeframe, even just overnight, officials said. The Fed's unit will buy three-month commercial paper, which should help issuers extend the maturity of their borrowing, an official said.

Fed officials anticipate that yields will come down significantly as a result of their initiative.

Yields on top-rated overnight U.S. commercial paper dropped 0.74 percentage point today to 2.94 percent, according to data compiled by Bloomberg. Borrowing for seven days increased 1.25 percentage points to 4 percent.

Treasury Deposit

The Treasury's deposit with the Fed's special purpose vehicle will be substantial, officials said. The funds won't come from the $700 billion rescue plan authorized by Congress last week.

Stocks initially climbed and Treasuries sank after the Fed's announcement, while shares later turned lower. The Standard & Poor's 500 Stock Index was down 0.1 percent at 1,055.38 at 10:23 a.m. in New York. Yields on benchmark 10-year notes climbed to 3.51 percent from 3.45 percent late yesterday.

Today's announcement came hours before Fed Chairman Ben S. Bernanke speaks on the economic outlook at 1:15 p.m. in Washington. He and Treasury Secretary Henry Paulson held discussions yesterday as stock markets slid and money market rates climbed as the crisis deepened.

The Fed's new unit will buy three-month dollar-denominated commercial paper at a spread over the three-month overnight- indexed swap rate, which is a measure of traders' expectations for the Fed's benchmark rate.

Fed officials on the conference call indicated that they would like the facility to be a backstop, which would suggest the special vehicle's rate would be set at a slight penalty to normal market rates. They declined to answer a specific question as to whether the rate would be set above current rates, or below, which would constitute a subsidy for borrowers.

Fed to Consult

``The Federal Reserve will consult with market participants regarding appropriate spreads that are consistent with the facility serving as a funding backstop under more normal market conditions,'' the Fed said.

Commercial paper purchased by the vehicle must be rated at least A1/P1/F1, the Fed said. Issuers will pay the unit an upfront fee based on the commercial paper initially sold to the vehicle. The vehicle will cease buying commercial paper on April 30, 2009, unless the Board of Governors agrees to extend it.

The Fed will cap the amount of commercial paper each company may sell to the central bank.

The Fed yesterday said it will double its cash auctions to banks to as much as $900 billion, and telegraphed today's announcement by saying it was looking for other ways to alleviate liquidity strains.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net.

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