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Commercial Paper Funding Facility: The Federal Reserve Becomes a CP Dealer

One-pager From the Fed

Here it is. That’s the Fed’s announcement of two new facilities.

The Commercial Paper Funding Facility (CPFF) will create credit, to be made available to a “Special Purpose Vehicle” (SPV), as authorized under Section 13(3) (the “unusual and exigent circumstances” section) of the Federal Reserve Act.

The SPV is authorized to purchase three-month dollar-denominated commercial paper from eligible issuers. There isn’t a lot of detail in the one-page Terms and Conditions document released by the Fed this morning, but what there is, I’ll explain to you now.

The “exigent and unusual” circumstances that the Fed is responding to relate to disorders in the capital markets where business corporations go to borrow short-term funds. This funding (“commercial paper”) is necessary to smooth out mismatches between revenues and expenses, including payrolls.

The dysfunction in the CP market is the reason why all the news media have been feeding you scare stories about your paycheck bouncing. And at the margin, these concerns are real. This isn’t something you can just ignore.

CP is normally about a $1.5 trillion market, but in recent weeks it’s shrunk precipitously as interest rates have risen, and a lot of money has become just plain unavailable for buying CP.

Where does the money come from? A lot of it comes from money-market mutual funds. And a lot of MM fund managers are very concerned that you, the public, will want to yank your money out the next time there’s a bit of panic. So they’re tending to hold cash rather than assets.

That means there’s that much less money available for companies to borrow on anything but an overnight basis.

The current state of play in credit markets, generally speaking, is that banks and other financial intermediaries have become extremely reluctant to lend money to anyone who doesn’t have risk-free Treasury securities as collateral for any period longer than overnight.

Into this breach rides the Fed. With this new CP facility, their intention is to make funding available to buy CP from qualified issuers who are having a hard time borrowing today.

CP comes in two flavors: asset-backed and unsecured. The new CPFF will be able to buy both kinds. Issuers must meet some standard credit-quality metrics, and unsecured issuers must also meet a range of security requirements, including the payment of upfront fees to the Fed.

There’s no restriction that the CPFF will only buy CP from financial companies or industrial companies. Everyone is eligible, subject to credit rating.

At what price will the Fed buy CP? They’re using a derivative of a market rate called three-month OIS. (Overnight-index swap spread rate. Don’t ask.) They haven’t decided how to set their prices, but they suggest that they will price 100 basis points above OIS on any given day.

That’s theoretically a penalty interest rate. The idea is that (as with the Fed’s discount window), the CPFF would only be used as an emergency backstop in case funds aren’t available otherwise. You’d never prefer to sell CP to the Fed if there were a private lender in the market, because theoretically the private rate would always be lower.

There are limits on how much CP any given issuer can sell to the Fed, and the whole facility is scheduled to expire on April 30, 2009.

So, there are some interesting questions around this.

First, what’s the problem it’s intended to solve? It seems to me that the CPFF will relieve the pressure on creditworthy borrowers for short-term cash, and thus forestall the potential for some really evil disruptions that can affect the Main St. economy. That’s good.

But can this facility address the basic reluctance of institutional money managers to buy CP in the first place? The answer is not necessarily yes. These fund managers may be perfectly relieved that the Fed has stepped into the vacuum they’ve left, and continue to sit on short-term cash.

If that happens, and I think it’s very likely, then we’re in a situation where the Fed will be mainlining risk-free capital into the economy, just to keep it going.

How can we ever bring that situation to an end? Well, the Fed could steadily increase the spread over OIS at which it bids for CP, and it can steadily reduce the amounts of its purchases.

That’s like taking the patient off life support. You don’t know that the patient’s heart will start beating on its own until you try it.

If you don’t find it a little hair-raising that I’m using metaphors like that to talk about the global financial system, you’re not paying attention.

To close this, I want to raise an issue that hasn’t gotten a lot of attention yet, but will become a big topic over the next several years and even decades.

This is the first major financial crisis that is being addressed primarily by way of the Bernanke Doctrine, and we have no clue yet as to the unintended consequences playing out before our eyes.

You know that Bernanke is a life-long student of the Great Depression, and has written extensively on the policy errors made by the Fed in the 1928-1933 period. He’s bound and determined not to repeat those errors.

The Bernanke Doctrine is that in times of acute financial stress, central banks must provide as much liquidity, as early as possible. A key objective is to prevent financial stresses from being transmitted to the real economy of goods and services, or from Wall Street to Main Street (assuming you’re not sick and tired of that metaphor).

And this doctrine has been applied over and over during the fourteen months since the credit crisis first ignited.

Well, one of the bizarre features of today’s world is extreme aversion to counterparty risk. People are going out of their way to avoid trading with anyone but governments or central banks.

Why? Well, maybe it’s because the Fed, the European Central Bank and others have stepped up to such a great extent. The normal process by which people evaluate counterparty risk and do business with each other, may have been circumvented because the Fed has made it possible not to bother with it.

Just a thought.

-Francis Cianfrocca

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