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

From Bloomberg:

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?

First, here is a definition of commercial paper:

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:

Fortis nationalized:

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.

Germany injects 50 billion euros into Hypo Real Estate:

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.

The Fed and ECB doubled their credit lines:

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.

And today Britain announced a very bold plan:

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.

Comments

[handyallen1]

"the Fed is trying to do anything it can to keep the economy from slipping further into a recession." opps... too late gee why dont you ask that frigging genius greenspan who thought it was a good idea to give all the surpluses to the rich in tax breaks and lower the fed rate to zero and then blame minoritys for buying homes with the money the dishonest brokers sold them at usury rates republicans wont take responsibility for this or anything

[KillTheMessenger]

"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."

If you happen to be talking about the stock markets, I do not get a sense that that's even a realistic enough goal to be taken seriously.

If you happen to be talking about the short term lending market, the best any effort can aim to achieve is to lower the future risk for banks, to get everybody out of a statistical tail into the fat part of the risk distribution, so to speak. We shall find out how well that works.

[GJMandinka]

Yeah dumping more money into the system is going to restore lending confidence, how, exactly?
As long as banks know there is a lot of toxic debt out there and that nothing has been done to keep it from accumulating further, confidence will remain nil.
STILL, no one is pointing out the bigger issues. Laissez-faire policy is fundamentally flawed. As much as businesses might whine and complain about those terribly restrictive regulations; they are necessary and good. Over-consolidation (in any sector) is plainly stupid. Government needs to set firm limits on how much any sector can consolidate. Allowing any business to become so large it can threaten the stability of an entire economy is ridiculous. Globalization without regulation makes one country's stupid policy, everyone's problem. Finally, the relationship between government and business has to fundamentally change. Campaign finance laws have to exclude corporate dollars. Business does not need preferential treatment.

[ErnestineBass]

I'm curious about something, Bonddad.

In the past, some economists had complained that the Chinese yuan was grossly undervalued. Several weeks (months?) ago I heard that China had finally decided to revalue their currency. Is there any connection between that event and the current global economic meltdown?

[KillTheMessenger]

No. The Chinese can set the exchange rate at will. The only thing that will be affected are the prices of Chinese imports and US exports. And that will do mostly one thing: change the cost of things in China.

[avraamjack]

.
All great, but would it not make sense to use the .7 trillion to create 20 new banks?
.
All you need to create a bank is some office space and a few executives.
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New banks could immediately make credit available.
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Their stock could be sold to the public in 5 years.
.

[KillTheMessenger]

It still does not make sense, no matter how often you repeat it.

[olephart]

Actually it makes a lot more sense to bypass the failed Wall Street institutions and deal directly with their customers. I questioned the need for the bailout and suggested that we would be better off in a post Wall Street America. The need for capital for commercial dealings is obvious. The need for institutions to gamble in the securities industries is not. These institutions are bankrupt because of their greed, over leverage and criminal acts. The reason there is no market for their securities is that they have stolen so much from so many that no one will do business with them.

They do provide essential services for investors (including you and me) and business. These services can be split off from their investment side and sold to other institutions or restarted under new management with a new issuance of stock. The investment side with their bad paper can go in the dumpster with their stock. The Fed and Treasury can fund a new National institution for commercial dealings to provide the needed capital for business. The FDIC, Fed and Treasury can deal with smaller banks. Some would be closed and some would be given access to capital for local and regional lending. Strict oversight and regulation would again be instituted for those receiving Federal funding. The Government would in effect be involved in the capitalist system as private institutions have shown that they just can't handle it.

[Rule Of Law]

These services can be split off from their investment side ...

And the investment side can be relocated from Wall Street to Las Vegas where it properly belongs, and all who play there will know the odds are stacked against them.

[francoise]

"For example, The ECB could create its own bail-out fund to match the US' "

Yes, the European Central Bank could, but Germany's chancellor Angela Merkel is refusing.

Germany has a positive national treasory, Germans aren't individually in debt, Germany isn't stuck in any war, and German industry is providing Chinese assembly lines with machines and spare parts.

Why would the Germans, who have been working and saving while foreigners were going on holidays and wasting their money, pay for you and me ?

As Angela Merkel is reported to have said to the Europeans who've been pushing for a bailout : "Everyone owns his own sh*t"

[marinara]

Federal reserve vs. all life on earth. Ron paul is right, we are losing the battle vs. inflation. The fed buys more commercial paper and inflates the dollar. This doesn't help anyone in the long term, even the financial sector would be better off to just write down the bad paper. After losses are made real, real growth can begin.

[KillTheMessenger]

"we are losing the battle vs. inflation."

Inflation is not a battle. It's a number one can dial into ones system by changing the difference between economic growth and the cost of money. That is what the Fed has been doing all along. The problem with dialing in inflation this way is that people can get around it by lowering their savings rate to 0 or even making it negative, They can get around it for a little while, that is. After that grace period is over, all hell breaks lose. Which is exactly what is happening now.

[Tridoxies]

Ok, I get that we are all screwed together in one global melt down. But Bonddad - where is the FED getting all these crisp, new $$$ to loan and buy all this worthless paper? I don't understand if the FED has all this $$$$ to loan out, why does the taxpayer have to given Paulson $700 billion to play in the market?

Could it be that the FED is running amok at the printing press creating monopoly money? Tell me it is not so! Doesn't the world go....print money, devalue money, inflation makes money even more worthless, USA becomes a third world nation?

[jsarets]

It's dangerous to be halfway informed as you seem to be. Might as well learn the whole truth so that you don't come to the wrong conclusions from your partial understanding.

The sensational 42-minute animated presentation, "The Truth About Money" or "Money as Debt":

http://video.google.com/videoplay?docid=-9050474362583451279

The rigorous 215-minute documentary, "Money Masters":

http://video.google.com/videoplay?docid=-515319560256183936

Enjoy the power of understanding!

[glitzqueen]

Why don't they just make the SECRECY go away? All the rubbish hidden off balance sheets is causing the distrust. Surely it's far past time to expose the bankrupt, instead of throwing further good money after bad and letting them hide behind Bernanke, Paulson and their ilk across the Pond.

[ErnestineBass]

Hear! Hear! TOO MANY SECRETS.

[KillTheMessenger]

"Why don't they just make the SECRECY go away?"

There are very good reasons for economic entities to hide the details of their financial state. In case of a bank any sign of weakness could lead to the feared "run on the bank", thus breaking the neck of an otherwise possibly quite solid institution.

What people overlook is that there are plenty of privately owned corporations (yes, even relatively large ones) which do not publish any financial data at all because they don't have to.

It's really a choice. If you want your financial privacy, don't go public.

[BillZBubb]

The only thing that bothers me in all this is that right wing economics, even at this point, hasn't been totally discredited. It should have been demolished after Reagan left the US in perpetual debt. But, the voters bought the same snake oil from both Bush's. And apparently there are almost enough votes to elect "reformer" McCain--a guy up to his comb-over in the economic policies that got us into this mess.

The Democrats should have demanded a public admission by the Republicans that their "philosophy" has failed and that government regulation and intervention are not just acceptable but NECESSARY. Otherwise the public will still buy their baloney.

[KillTheMessenger]

It has been discredited decades ago. That it won't die has everything to do with people believing in magic and nothing to do with rational approaches to economics.

[Pdubya]

yes, we're in it together, whether we like it or not (I don't). But, the choice now is, do we leave it in the hands of the manufacturer's of this mess? Or shall we make a sovereign stand and lead the world again, but this time in economic freedom?

http://www.jbs.org/index.php/jbs-news-feed/3290

[Paul]

For those looking for darker scenarios, how about these:

Suppose Round 2 has no effect and the credit markets remain frozen.

1. Moslem Money
One group who did not buy into sub-prime loans were the folks with all that money in Dubai. What will they ask for if the world comes to their doorstep looking for money?

2. Chinese Cash
Who has all those dollars piled up from years of one-sided trade with the US? China. So what will they ask for in return for making their money available?

We may no longer calling the shots and this may be the logical outcome of globalization.

[zizyphus]

As some on the street are saying, "It's Dubai, Mumbai, Shanghai, or good-bye." Only Asian markets will have any money.

[Rule Of Law]

On PBS radio (KPFA) this morning, I heard that England had taken the bold step of Nationalizing some banks, giving the government and the citizens ownership until this crisis is over and the loans are paid back. It is based on a similar system that Sweden apparently used to resolve their financial problems in the early 90's, and worked so well that within 2 years, all debts had been repayed and the system restored to normal.

Why in America, are we the only ones stupid enough to give our money to the FED, through Paulson at Treasury, and get NOTHING--no equity, no guarantees, no return--while other countries can secure their Citizens futures in such intelligent and practical business ways? Why are we always the saps that get taken for a ride whether in this manufactured ripoff, or the Savings and Loan scam or any other recession/depression scenario that our all powerful Central Bank was supposed to eliminate? Who hates America so much that they steal from their own people time after time, and why do we stupidly continue to allow it?

[Zeje]

Because this is the land of the free. I'm free to screw you and you're free to screw me

[Rule Of Law]

That sure seems to be the way today. But that's not a country; it's a jungle.

[jhNY]

"We're in this thing together now"-- who do you mean? I'm a single person with no mortgage, under-employed, and I've got a lot of credit card debt. So when the government buys up mortgages, insurance companies and commercial paper, I'm benefitting directly how? And when the big banks and brokerages get what would have been all the discretionary spending money for the next 2 generation, I benefit directly how?

In an era when people imagine themselves to be in some kind of relationship with wealthy celebrities in the entertainment and business worlds, I suppose I should be satisfied vicariously that everybody else's ass is saved from the terrible fire in finance, but so far , nobody noplace has said one word which will result in anything benefiting me directly. So far, I'm reduced to trying to feel grateful and satisfied that somebody, not me, is get a helping hand.

When something happens in politics or the economy which will improve my personal circumstances, then I'll be more inclined to sing 'kumbaya' with all my fellow world citizens, but I've got a bad feeling I won't be raising my voice in song for some little while. Im completely soaked in the trickle-down, but it ain't raining...

[BillZBubb]

You benefit because although you are now under-employed, that is a long way better than being long-term unemployed. Believe me you do not want to see a total global economic meltdown. Life will become harder than you can even imagine.