Capital Markets

Liquid Paper: How Fed Backstop Will Work

The Commercial Paper Funding Facility is the latest effort to unlock the credit markets.
Alan RappeportOctober 7, 2008

The Federal Reserve’s announcement Tuesday that it created a Commercial Paper Funding Facility to buy short-term commercial debt from companies struggling to find financing is meant to give firms some much needed liquidity. Indeed, the nearly $100 billion market for such credit has largely dried up.

As Congress debated legislation on its $700 billion rescue package to buy toxic securities, many companies were busy focusing on commercial paper, which they issue to pay for short-term operations. But with money markets and other investors reluctant to buy, many firms found themselves stuck.

Last week, for example, new research by Greenwich Associates found that 45 percent of large U.S. companies say they are finding fewer buyers for their commercial paper and more than 70 percent of the 291 companies surveyed say their cost of issuing the short-term debt is increasing, with 22 percent saying it is up “significantly”. Meanwhile, a JPMorgan Chase report noted that the volume of commercial paper outstanding fell by almost $95 billion for the week ended October 1, though about two-thirds of that decline was in the paper of financial-services firms.

The blocked market for commercial paper has been causing problems for all kinds of companies. Mark Hogard, CFO of First Capital, a factoring company, told last month that he expects the firm to be hit by the rise in the cost of capital raised through commercial paper. Although it isn’t a direct issuer of commercial paper, the company’s lenders pass along the cost of commercial paper they issue to back loans to First Capital. “So when commercial paper [borrowing rates rise], that increases the cost of borrowing for us,” he says.

The same has been true for Paul Bowers, finance chief of Southern Company, an electric utility, who told last week that the company has seen rates rise on its short-term debt —commercial paper and daily tax-exempt floating rate notes or “daily floaters.”

“Our treasury department has to be on their toes every morning, assessing the market and the needs of the business, and just re-upping and replacing 24-hour notes,” he says.

The Fed’s latest move marks a massive expansion on its decision last month to buy short-term debt from Fannie Mae and Freddie Mac, the two mammoth mortgage lenders the government bailed out in July. At that time the Fed also said it would extend nonrecourse loans —at the primary credit rate —to U.S. depository institutions and bank holding companies to finance their purchases of “high-quality asset-backed commercial paper from money market mutual funds.”

Now the Fed will create a “funding backstop” to U.S. issuers of commercial paper through a special purpose vehicle. The SPV will buy three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Fed will finance the SPV with the help of the Department of Treasury.

“By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market,” according to a Fed statement. “Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper.”

The SPV will buy from U.S. corporate three-month, asset-backed paper with sufficiently high ratings (at least A1/P1/F1 by a major rating agency). For paper that’s not asset-backed, firms will need to find other ways to secure it with the Fed. Although it is still sorting out which of the different methods are acceptable, the Fed suggested that firms will need to pay an upfront fee, obtain a guarantee for its obligations, or provide collateral or some other type of security that satisfies the Fed.

A single issuer will only be able to sell a maximum amount of commercial paper equivalent to the average amount that it had outstanding in August 2008, less any amount outstanding held by investors. The SPV is slated to stop buying commercial paper on April 30, 2009 unless it is extended, and the Fed will continue to fund it until the underlying assets that it holds mature.

Some observers, such as Dale Oesterle, a law professor at Ohio State University, have been championing such action for weeks, contending that the commercial paper market had to be unhinged form the failing mortgage market. Writing on his blog , Oesterle argued, “It would free up the commercial paper markets for all operating companies; and it would let the MBSs [mortgage backed securities] markets in subordinate securities clear.”