What Is Commercial Paper And Why Is The Federal Reserve Suddenly Buying It?

The Federal Reserve today announced the creation of something called the Commercial Paper Funding Facility (CPFF), that will buy commercial paper directly from issuers. So, you’re asking yourself, what is commercial paper? Why do I care that the Federal Reserve is buying it?

To put it simply, the commercial paper market works like a credit card for big companies. Some days they have money, and some days they do not. So if they need money Tuesday, but will have money Friday, they’ll go to the commercial paper market and borrow some money. Then on Friday they will pay back the money, plus interest. It’s usually all very calm and safe — but when large well-respected companies started failing and the people who had lent them money on the commercial paper market (money market mutual funds, for example) actually lost money on these “safe” investments — the pool of lenders dried up.

Now the Federal Reserve is stepping in to “inject liquidity” into this market.

Here’s how the Federal Reserve explains:

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 fact that the Federal Reserve has resorted to this move, which is of questionable legality and requires the use of a SPV (Special Purpose Vehicle), which is a separate legal entity that does the buying and selling on the Fed’s behalf, is well, scary — and could be a “broader” undertaking than the $700 billion bailout.

Under its plan, the central bank would buy unsecured commercial paper, essentially short-term i.o.u.’s issued by banks, businesses and municipalities.

The market for that kind of debt has all but shut down in the last week, with many major corporations unable to borrow for longer than a day at a time, as banks become more fearful of giving out cash. The volume of such debt totaled about $1.6 trillion as of Oct. 1, down 11 percent from three weeks earlier.

These credit fears persisted over the weekend despite the $700 billion bailout package that Congress approved last week.

The cost of borrowing from banks and corporations remained high on Monday, increased in part by a series of high-profile bank bailouts in Europe, where governments scrambled to save several major lenders from collapse.

The United States government appears to be pressing ahead with other radical efforts to shore up the financial system, even wading into corners of the markets where it has rarely interfered.

One thing seems clear, the “credit crunch” is not going away and it is spreading beyond the mortgage issue.

Press Release [FED]
Fed Announces Plan to Buy Short-Term Debt [NYT]
(AP Photo/Miguel Villagran)