Aug. 30 (Bloomberg) -- The U.S. commercial paper market shrank for a third week, extending the biggest slump in at least seven years and signaling that the Federal Reserve's attempts to lower borrowing costs have had a limited impact so far.

Asset-backed commercial paper, which accounted for half the market, tumbled $59.4 billion to $998 billion in the week ended yesterday, the lowest since December, according to the Federal Reserve. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest rated asset-backed paper due tomorrow rose today 0.11 percentage point to a six-year high of 6.15 percent.

Commercial paper outstanding has fallen $244.1 billion, or 11 percent, in the past three weeks, as the Fed's Aug. 17 reduction in the discount rate has yet to entice buyers back into the market. Yields of asset-backed commercial paper due tomorrow rose to the highest in six years as investors fled to the safety of Treasury bills.

``I don't think the Fed understands how critical the situation is,'' said Neal Neilinger, co-founder of NSM Capital Management in Greenwich, Connecticut, in an interview today. ``The market is going to overshoot itself and not lend money to people who deserve it.''

NSM helps manage Abacas Investments Ltd., a $1 billion structured investment vehicle funded by commercial paper. Neilinger wouldn't discuss Abacas's ability to fund itself.

Three-Week Decline

The 11 percent decline over three weeks is the biggest since 2000, according to data compiled by Bloomberg. Commercial paper hasn't fallen for three straight weeks since February. More than 20 companies and funds including Cheyne Finance and Thornburg Mortgage Co. failed to sell new paper as investors balked at buying short-term debt backed by mortgage assets.

The total fall in the commercial paper may end up at $300 billion, the amount of mortgages funded by asset-backed commercial paper, wrote Tony Crescenzi, chief bond market strategist for New York-based Miller Tabak & Co. LLC, in a note today.

Commercial paper is bought by money market funds and mutual funds that invest in short-term debt securities. In asset-backed commercial paper, the cash is used to buy mortgages, bonds, credit card and trade receivables, as well as car loans. Some of the programs are backed by subprime loans. Subprime loans are issued to borrowers with poor credit or high debt.

The fall was the slowest of the past three weeks, following the two previous declines of about $90 billion each. Outstanding paper for financial companies, not asset-backed, rose for the first time in five weeks by $3 billion to $781.5 billion.

``There's a little better functionality and if there is any glimmer of hope, that's where we're finding some,'' said Kevin Flanagan, fixed income strategist at Morgan Stanley in Purchase, New York, in an interview today.

Rate Cut Needed?

The Fed lowered the interest rate it charges to lend to banks to encourage buyers of commercial paper after the market seized up for Thornburg, Countrywide Financial Corp. and other mortgage lenders.

The Fed ``failed to bring money markets back to normal,'' John Lonski, chief economist at Moody's Investors Service in New York, said in an interview. ``Credit markets are obviously in need of a rate cut.''

In a sign that buyers are still favoring safer assets, an $18 billion auction yesterday for two-year U.S. government debt drew the most demand since 1992.

The sale drew $3.97 for every $1 sold, the most since at least 1992, according to Bloomberg data. For the past 12 sales, the bid-to-cover ratio has averaged $2.77.

Cheyne, Grampian

London-based Cheyne Capital Management Ltd., the hedge fund manager set up by former Morgan Stanley bankers Stuart Fiertz and Jonathan Lourie, said yesterday that a fund it manages has been selling investments to help repay commercial paper due through November. Cheyne Finance, a so-called structured investment vehicle, holds about $6 billion in commercial paper that is mainly tied to real estate.

Funds such as Cheyne Finance typically sell commercial paper maturing in less than 270 days and use the proceeds to purchase bonds with longer maturities. The profit typically delivered from this strategy is being cut by rising yields.

HBOS Plc, the U.K.'s largest mortgage lender, said last week that it would repay about $35 billion of commercial paper owed by its Grampian Funding LLC unit as contagion from the subprime mortgage slump drove up the cost of borrowing.

To contact the reporter on this story: Darrell Hassler in Chicago at dhassler@bloomberg.net.

Last Updated: August 30, 2007 14:48 EDT