Fed to Purchase U.S. Commercial Paper to Ease Crunch

By Craig Torres

Oct. 7 (Bloomberg) -- The Federal Reserve will create a special fund to buy U.S. commercial paper, seeking to unblock the financing tool that drives everyday commerce for American businesses.

The Treasury will make a deposit with the Fed's New York district bank to help set up the new unit. The central bank will also lend to the program at policy makers' target rate for overnight loans between banks, the central bank said in a statement released in Washington. Fed officials said they intend to set up the fund soon, while declining to specify a date.

``Disruptions in the commercial paper market and tightening of bank lending standards have made it more difficult for businesses to obtain the working capital they need,'' Fed Chairman Ben S. Bernanke said today in remarks before the National Association for Business Economics in Washington. The central bank ``will continue to use the tools at its disposal to improve market functioning and liquidity.''

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.

Stemming Panic

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 Fed Chairman Ben S. Bernanke. ``The immediate threat to the real economy is that large corporations are having difficulty obtaining funds via the commercial paper market.''

The Fed Board invoked emergency powers to set up the unit, the central bank said. Fed officials in a conference call with reporters didn't say how much top-rated commercial paper will be purchased. Companies use commercial paper, or debt maturing in nine months or less, as a form of IOU to pay for day-to-day activities such as payrolls and rent.

The central bank's special purpose vehicle will be big enough to backstop the entire market, one official said on condition of anonymity.

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

Short Time Frame

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.

Bernanke, U.S. Treasury Secretary Henry Paulson, European Central Bank President Jean-Claude Trichet and their Group of Seven major-nation counterparts plan to meet on Oct. 10 in Washington.

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. The purchases should help issuers extend the maturity of their borrowing, an official said.

``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. spokesman Russell Wilkerson said. ``This is a positive move and we applaud the Fed's decisive action.'' The company is the biggest U.S. commercial paper issuer through its GE Capital finance unit.

Yields Down

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.

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 fell. The Standard & Poor's 500 Stock Index tumbled 5.7 percent in New York. Yields on benchmark 10-year notes climbed to 3.51 percent from 3.45 percent late yesterday.

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.

`Funding Backstop'

``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.

The Fed's move is ``very unusual, very aggressive and a very bold step,'' said Chris Varvares, president of St. Louis-based Macroeconomic Advisers LLC, a forecasting firm. Assuring that corporations can fund their short-term cash needs ``is absolutely essential.''

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