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Fed Takes Another Step to Bolster Credit Market

New facility will buy commercial bonds to boost businesses

October 7, 2008

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The Federal Reserve Board has taken yet another step to restore confidence to the battered credit market. The agency has announced the creation of the Commercial Paper Funding Facility (CPFF). The new facility will purchase commercial bonds, pumping much needed liquidity into the financial system.

The step is designed to address a principle concern of the unfolding credit crises--the fact that businesses are unable to borrow short term funds to finance their operations. Without access to that cash, companies will be forced to layoff workers and suspend operations, eventually shutting down the entire economy.

The Fed says the new CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants.

The step was taken with the full support of the U.S. Treasury Department, which believes the step is necessary to prevent substantial disruptions to the financial markets and the economy. It said it will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities.

As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day.

A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households, the Federal Reserve said.

The Fed says the new facility will eliminate much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations. It's hoped this facility will encourage investors to once again engage in term lending in the commercial paper market.

"Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households," the Fed said in a statement.

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