An Explanation Of The Fed's Commercial Paper and Coordinated Rate Cut Policy

Lenders are so concerned about a borrowers solvency even in the short-term that no one is making even the shortest loan.
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The Federal Reserve will create a special fund to purchase U.S. commercial paper after the credit crunch threatened to cut off a key source of funding for corporations.

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 Fed Board invoked emergency powers to set up the unit, the central bank said in a statement released in Washington.

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.

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.''

So -- the Fed is going to but commercial paper. So -- what does that mean exactly?

An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting prevailing market interest rates.

Commercial paper is not usually backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.

A major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months (270 days), making it a very cost-effective means of financing. The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.

So -- why would a corporation need to issue this paper? There are lots of reasons. For example, a retail store (like Sears) has two big sales periods -- Christmas and back to school. So twice a year they get a big cash infusion and the rest of the time their sales are hit and miss. Let's suppose a store like Sears wants to get ready for back to school. But for whatever reason they've drained their Christmas profits. How can they buy merchandise to sell? They issue commercial paper.

This market is vital for all sorts of reasons -- inventory and payroll being two of the biggest.

Let's add another concept to the mix: time. Ever wonder why the yield curve is shaped like this?

Time. If you lend money to someone short-term there are fewer things that can go wrong that would prevent them from not paying you back. But if you lend someone money for a long time there are more things that can go wrong. To compensate you for the increased risk of lending someone money for a longer period of time, lenders demand a higher interest rate for longer loans.

So, commercial paper should carry a really low yield because it is issued for a short period of time. With me so far?

Lately, short term rates have been spiking. This seems odd, especially when short term rates are supposed to be lower that long-term rates. Why are short-term rates spiking? Lenders are concerned that borrowers won't be able to pay back a loan even in the short-term. Hence they are asking for a higher interest rate to pay them for a short-term loan. In addition, people are unwilling to buy this paper. In market terms "there is no bid." People are so concerned that even top quality credit risks will announce a writedown in their assets -- and therefore be unable to pay back a loan -- that no one is buying any commercial paper.

At the same time, commercial paper is vital to the economy; every large company depends on it for one reason or another. Therefore, this market has to work.

That is why the Fed is now buying commercial corporate paper:

Opening up another front in the battle to end the credit crunch, the Federal Reserve announced Tuesday it will buy unsecured commercial paper in an effort to restart a market that's ground to a virtual halt in recent weeks over concerns about the financial sector.

"This is a transparent step that should help to pump liquidity into a mature market that had seized alarmingly fast in just a week," according to Harm Bandholz, UniCredit economist.

Will this move work? Is it even legal? There are questions that will be answered in time. Right now the Fed is trying to do anything it can to keep the economy from slipping further into a recession.

The Unified Rate Cut

I say round 2 because this is the first step of a coordinated effort by all the central banks in the world (or at least the really big ones) to make a coordinated effort to stave off the credit crisis. Why the coordinated effort? Because the problems are now worldwide. Consider the following news from last week:

The governments of Belgium, the Netherlands and Luxembourg took partial control late Sunday of struggling bank Fortis NV, while Britain seized control of mortgage lender Bradford & Bingley early Monday.

The German government and the country's banks and insurers agreed on a 50 billion euro ($68 billion) rescue package for commercial property lender Hypo Real Estate Holding AG after an earlier bailout faltered.

Germany's financial industry agreed to double a credit line for Hypo Real Estate to 30 billion euros, Torsten Albig, a spokesman for Finance Minister Peer Steinbrueck, said late yesterday in an e-mailed statement. The federal government's guarantee for the credit line remains unchanged, Albig said.

The government and the Bundesbank have said that Hypo Real Estate, Germany's second-biggest property lender, is too big to fail. They met with banks and insurers in Berlin all day yesterday to discuss a revamped rescue package after private banks on Saturday withdrew their support for a 35 billion-euro rescue package brokered a week ago.

Additionally, the European Central Bank joined with the U.S. Federal Reserve in doubling the credit swap line that makes dollars available to cash-hungry banks from US$120 billion to $240 billion. The Bank of England doubled dollar availability to US$80 billion, while other central banks offered smaller amounts.

Yesterday, the Fed announced it would now start lending to private companies:

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets. The 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 Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

Britain's banks will get an unprecedented 50 billion-pound ($87 billion) government lifeline and emergency loans from the central bank after the freeze in credit markets threatened to bring down the financial system.

The government will offer to buy preference shares from Royal Bank of Scotland Group Plc, Barclays Plc and at least six other banks, and provide about 250 billion pounds of loan guarantees to refinance debt, the Treasury said in a statement today. The Bank of England will make at least 200 billion pounds available. The plan doesn't specify how much each bank will get.

The emergency action came after the FTSE 350 Banks Index fell almost 20 percent in the past month. Prime Minister Gordon Brown is following U.S. President George W. Bush, who approved a plan last week to spend $700 billion to prop up financial institutions with untested measures as equities plunged around the world.

``The global market has ceased to function,'' Brown said today at a press conference in London. ``The banking system must be sounder, and that is why we are putting the capital in.''

None of these plans/efforts is doing what it is supposed to do: calm the markets and bring a sense of confidence back to the market. The bottom line is clear: despite all of these efforts, the short-term lending markets have completely frozen because no one trusts anyone's officially stated balance sheet numbers regarding what they are worth. This is called "counter-party risk." It simply means that lenders are so concerned about a borrowers solvency even in the short-term that no one is making even the shortest loan.

We've seen a lot of one-sided action. But now the central banks are doing things together:

Joint Statement by Central Banks

Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent. The Committee took this action in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures.

From the US perspective this is largely symbolic. US Interest rates are already 0% ofter adjusting for inflation. However, this is important for the European Central Bank, as Trichet has been very hawkish on inflation until very recently.

I say round 2 because there are now a number of coordinated policy measures various central banks could take together. For example, The ECB could create its own bail-out fund to match the US' and then coordinate the two funds actions to really start helping the battered institutions.

Either way I do think this is good news because the big policy makers realized one very important thing: we're in this thing together now.

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