Fed Announces the Creation of a New Funding Facility

In another effort aimed at calming the financial system, and break through a credit clog that has paralyzed the credit markets – the Federal Reserve announced on Tuesday that it would create a Commercial Paper Funding Facility [CPFF], with the Treasury Department’s assistance, to begin buying commercial paper.

The market for this crucial financing, where companies raise money to fund their day-to-day operations, has at this point dried up. According to Fed data, commercial paper market contracted dramatically for a third straight week last week. Money market mutual funds and other investors have become increasingly reluctant to buy commercial paper, especially at longer-dated maturities. As a result, notes the Fed in its statement, 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.

The CPFF, which the Fed and the Treasury see it as a necessary tool to prevent further disruptions to the financial markets and the economy, 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 Fed however, will buy only the highest-quality commercial paper at a spread over the three-month overnight indexed-swap rate. The debt would have to be secured to the Fed’s satisfaction through a fee.

The central bank’s unusual move to buy non-collateralized debt could help thaw frozen credit markets, restore credit flows and encourage investors to once again engage in term lending in the commercial paper market. Fed’s hope is that added investor demand will lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper.

The special purpose vehicle will stop buying commercial paper on April 30, 2009, unless the Fed decides to extend the program.

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