Fed Attempts to Thaw Credit Market

In an attempt to restore the flow of credit and give the flailing economy some good news, the Federal Reserve stated Tuesday that it will begin buying short-term …

In an attempt to restore the flow of credit and give the flailing economy some good news, the Federal Reserve stated Tuesday that it will begin buying short-term debt typically used by companies to fund their daily operations. This short-term debt is called commercial paper, and it is often used to fund essential day-to-day business functions, such as purchasing supplies and making payroll. Without the availability of funds with which to conduct these activities, many businesses are essentially paralyzed.

To combat the issue of the credit freeze, the Fed and the U.S. Treasury Department together will fund a new entity called the Commercial Paper Funding Facility.

This facility should encourage investors to once again engage in term lending in the commercial paper market,” the Fed said in a statement. “An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.”

The facility was created in part because many investors have moved away from investing in corporate debt, according to Reuters. The facility will begin by buying back some of the debt, which should help to get credit flowing again.

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The central bank will buy three-month unsecured and asset-backed commercial paper from eligible companies. They plan to buy as much of the debt as is needed to get the market functioning, which may add up to as much as $1.3 trillion, according to MSNBC. Companies with commercial paper neither backed by assets or other forms of security acceptable to the Fed will be able to pay an upfront fee for the services.

Commercial paper, traditionally, is a way to borrow money in the short-term, with loan terms lasting anywhere from overnight to less than one week, according to MSNBC.

While it was once was a thriving market, with around $100 billion in outstanding IOUs, the demand for commercial paper is now nearly non-existent, as investors have rarely held on to commercial paper for longer than a day or two.

The extremely tight standards now associated with bank lending and disruptions in the commercial paper market have made it difficult for businesses to obtain a proper amount of working capital, according to Bloomberg.com. The squeeze is being felt by operations as small as mom-and-pop companies all the way up to the State of California. California Governor Arnold Schwarzenegger sent a letter to the Treasury last week requesting an emergency loan of $7 billion in order to be able to conduct essential business for the month, such as paying employee salaries.

While it is hoped the Fed’s move will restore some confidence in the short-term funding markets, others see it as another desperate spending spree, especially because it is coming just days after the massive $700 billion bailout package was made law.

Despite an initial increase in the U.S. stock market in the wake of the announcement, jubilation was short-lived and the market has since showed little spark. Still, addressing one of the central issues in the economy—the frozen credit market—could show some improvement in the long run by allowing money to flow more freely throughout the economy once again.

The Fed’s program will continue buying commercial paper until April 30, 2009, and can be continued if an extension is granted at that point, according to Reuters.

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