Federal Reserve to Buy Commercial Paper to Free Up Frozen Market

By , Money Morning •

By Jennifer Yousfi
Managing Editor

In a bold move to provide stability to the frozen short-term credit markets, the U.S. Federal Reserve yesterday (Tuesday) announced new measures aimed at boosting liquidity and allowing corporations to maintain daily operations.

But the U.S. markets were less enthusiastic about the Fed’s new measure. Slight gains in early morning trading quickly reversed course to plunge much lower.

At the New York close, the blue-chip Dow Jones Industrial Average Index plunged 508.39 points, or 5.11%, to close at 9,447.11. The tech-laden Nasdaq Composite Index plummeted 108.08 points, or 5.80%, to close at 1,754.88. And the broader Standard & Poor’s 500 Index dived 60.66 points, or 5.74%, to finish the day at 996.23.

The S&P 500 closed below 1,000 for the first time since 2003.

The Dow is down 29% year-to-date, while the S&P 500 is down over 32% over the same time period. With such huge declines, 2008 marks the worst year for the domestic markets since 1937, Bloomberg News reported.

“Capital markets are very tight right now,” Douglas Christopher, a partner at Crowell Weeden & Co. in Los Angeles, told Bloomberg. “Companies that need external financing or are perceived to need external financing are going to be given a discount in the current environment.”

The Fed’s Latest Gambit

The new Commercial Paper Funding Facility (CPFF) will provide a backstop to the commercial paper market that has been brought to a standstill, even for those firms far removed from the financial sector.

“The immediate threat to the real economy is that large corporations are having difficulty obtaining funds via the commercial paper market,” Mark Gertler, a New York University economist, told Bloomberg.

The commercial paper market reached a three-year low of $1.6 trillion as money-market fund managers, typically huge buyers of commercial paper, became extremely risk averse after a handful of funds “broke the buck.” In a flight to quality mainly into U.S. Treasuries, money market funds liquidated commercial paper holdings by $200.3 billion, or 29%, in the final two weeks of September, according to data compiled by IMoneyNet Inc., Bloomberg reported.

Auto manufacturers, utilities and others make use of short-term lending in the commercial paper market – borrowing money for periods ranging from just overnight to three months – to cover occasional gaps in daily cash flows. The commercial paper market is vital to the ongoing operations for many large corporations, which use the short-term funds to make payroll or pay bills.

“By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market,” the U.S. Federal Reserve said in a statement released yesterday (Tuesday) morning.

“An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households,” the statement concluded.

The CPFF will remain in place until Apr. 30, 2009, at which point the Fed Board of Governors would need to vote to extend it if necessary.

“While we have continued to fund without disruption, the Fed announcement today is an important development that will help restore confidence in the market and facilitate more lending,” General Electric Co. (GE) spokesman Russell Wilkerson said, Bloomberg reported. “This is a positive move and we applaud the Fed's decisive action.”

GE is the largest domestic commercial paper issuer through GE Capital, its financial subsidiary.

Gloomy Economic Outlook

Speaking yesterday afternoon at the National Association for Business Economics 50th Annual Meeting in Washington, D.C., Fed Chairman Ben S. Bernanke tried to strike a reassuring tone that the recent economic measures enacted by the government would have the intended effect, while also acknowledging the dire economic data.

“Over all, the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased,” Bernanke said in his speech.

Some analysts felt this was an indication that the Fed would move to cut interest rates at the next Federal Open Market Committee meeting slated for Oct. 28 – 29.

“The steps being taken now to restore confidence in our institutions and markets will go far to resolving the current dislocations in the markets. I believe that the bold actions taken by the Congress, the Treasury, the Federal Reserve, and other agencies, together with the natural recuperative powers of the financial markets, will lay the groundwork for financial and economic recovery,” Bernanke said.

Britain’s Own Bank Bailout

Meanwhile, the global impact of the credit crisis is hitting British banks hard. In the United Kingdom, Prime Minister Gordon Brown’s government is preparing a rescue package in response to diving British bank shares. Royal Bank of Scotland PLC (ADR: RBS) Barclays PLC (ADR: BCS), HBOS PLC (OTC ADR: HBOOY) and Lloyds TSB Group PLC (ADR: LYG) are all in need or recapitalization, The Wall Street Journal reported.

It is unknown if Britain’s largest bank, HSBC Holdings Ltd., would need government assistance. Its capital position is currently seen as the strongest.

The U.K. government plans to announce its plan today (Wednesday).

News and Related Story Links:

  • The Financial Times:
    Fed to start buying commercial paper