Oct. 7 (Bloomberg) -- The Federal Reserve's decision today to buy U.S. commercial paper came after money-market mutual funds fled the market, cutting off a vital source of short-term corporate financing and pushing the economy toward a recession.

Money-market funds, the biggest buyers of commercial paper, reduced holdings of the highest-rated debt by $200.3 billion, or 29 percent, in the final two weeks of September, according to data compiled by IMoneyNet Inc. of Westborough, Massachusetts. Managers unloaded the debt to meet a surge in investor redemptions and to shift assets to Treasuries, which can be sold more quickly if withdrawals persist.

The funds' retreat helped drive the cost of issuing commercial paper to its highest level in eight months, squeezing companies, banks and public institutions that rely on the market to raise cash for expenses such as payroll. Combined with a pullback in bank lending, the commercial-paper freeze threatens to choke the economy.

``If you can't fund yourself, you can't run a company,'' Robert Kelly, chief executive officer of Bank of New York Mellon Corp., said yesterday in a speech to steel-industry executives in Washington. ``Credit availability is the main issue facing the world right now.''

The Federal Reserve said today it will create a special fund to purchase U.S. commercial paper. The central bank will also lend to the program at its target rate for overnight loans between banks.

Prevent `Disruptions'

The 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.

``The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy,'' the Fed said in a statement.

Commercial paper is debt that usually matures in less than 270 days. The increased availability of short-term financing in the past 20 years has made its use almost universal among U.S. companies, according to Anthony J. Carfang, a partner at Treasury Strategies Inc., a Chicago-based consulting firm.

``A lot of companies are going to get squeezed out of the short-term market and are going to be hitting the bond market,'' where costs are higher, Carfang said.

In the three weeks through Oct. 1, total outstanding commercial paper fell a seasonally adjusted $208 billion, according to the Fed.

Yields Fluctuate

The average yield that top-rated borrowers pay to issue overnight commercial paper rose to 3.95 percent on Sept. 30, the highest since January, according to data compiled by Bloomberg. Yields have since fallen to 2.94 percent, or 94 basis points more than the Federal Reserve target lending rate. Before August 2007, the gap was rarely more than 10 basis points.

Borrowers have been forced to rely more on commercial paper as lenders shunned longer-term corporate debt, preferring to invest in securities they can quickly convert to cash. Companies sold $14.7 billion of bonds in the past four weeks, the deepest slump in nine years, Bloomberg data show. Last year, sales averaged $22.4 billion a week.

The Fed's purchases in time may coax money funds back into the commercial paper market, said Mark MacQueen, partner and portfolio manager at Sage Advisory Services Ltd. in Austin, Texas, which oversees $6 billion.

Reassuring

``It will reassure money-market funds that CP is a safe place to invest,'' MacQueen said. ``I don't think that's going to happen overnight, though.''

At the beginning of September, U.S. money-market funds, which control $3.35 trillion, held more than 63 percent of outstanding unsecured commercial paper and 39 percent of asset- backed commercial paper, according to Alex Roever, a New York- based analyst at JPMorgan Chase & Co.

Investors use money-market funds as a safe place to park cash until it's needed for other investments or expenses such as college tuitions or vacations. Like bank accounts and Treasury debt, the funds can be quickly tapped and earn interest. The funds may invest only in top-rated securities that mature in 13 months or less.

While money funds were selling commercial paper in the past few months, the exodus accelerated after the bankruptcy of Lehman Brothers Holdings Inc. on Sept. 15 and the breakdown of the nation's oldest money-market fund the next day.

The $62.5 billion Reserve Primary Fund announced Sept. 16 that losses on debt issued by Lehman had reduced its net assets to 97 cents a share, making it the first money fund in 14 years to break the buck, the term for falling below the $1 a share that investors pay. Over the next two days, investors pulled $133 billion from U.S. money-market funds, according to IMoneyNet.

Record Run

The record run abated only when the Treasury said it would use an existing $50 billion emergency pool to guarantee money funds against losses. The program opened Sept. 29. The Federal Reserve also moved to slow the flood out of the short-term debt market by lending $152.1 billion to money funds in exchange for asset-backed commercial paper.

In the week after Lehman went bankrupt, AT&T Inc., the largest U.S. telephone company, was unable to sell commercial paper at maturities longer than overnight for two days. AT&T debt has the highest rating from all three major ratings firms.

Banks Under Stress

Massachusetts today delayed the sale of $750 million in short-term notes for the second time in two weeks and asked federal officials for a short-term loan if it is unable to complete the deal. The state is rated two steps below AAA.

While almost all highly rated non-bank borrowers are still able to renew, or roll over, short-term debt, JPMorgan's Roever said banks may find it increasingly difficult to do so. Among those, European banks may be most vulnerable because of their higher dependence on unsecured debt, he said in an Oct. 3 research note.

Money-market mutual funds have recorded net deposits in recent days, yet withdrawals have continued from funds that invest in corporate debt.

Retail and institutional prime funds have lost $376.4 billion since Reserve Primary broke the buck, including $4.5 billion yesterday. Prime funds attempt to match their returns to the prime lending rate by investing in corporate debt.

Managers of prime funds have added more selling pressure by replacing commercial paper with safer and more liquid holdings, like Treasuries, even when redemptions don't force their hand.

The proportion of top-rated commercial paper in institutional prime funds dropped to about 30 percent of assets on Sept. 30 from 36 percent on Sept. 16. Prime retail funds increased their holdings of U.S. Treasuries to 5 percent from none a year ago.

Shorter Maturities

Many funds have also moved to much shorter maturities, affecting what companies are able to issue.

Issuance of commercial paper due in one to four days has averaged $145.3 billion a day since Sept. 15, compared with $87.7 billion a day in August, Fed data show. Sales of issues with longer maturities have averaged $31.2 billion a day, compared with $45.5 billion in August and $53.8 billion in 2007.

After falling to $21.3 billion on Sept. 29, longer-term lending has since increased to $44.4 billion on Oct. 3, according to Fed data.

Assets in Ridgeworth Capital Management Inc.'s Prime Quality Money Market Fund have dropped by 18 percent to $8.49 billion in the past six months. Michael Sebesta, head of money-market funds at the Columbus, Ohio-based company, said much of the money has moved to the company's Treasuries-only and government agency-only funds.

Prime Quality also sold financial commercial paper, he said, buying safer debt issued by industrial companies, and shortened average maturities by several days across all its commercial paper.

``We're being somewhat defensive and making sure we have ample liquidity to meet investor needs,'' Sebesta said in an interview.

To contact the reporters on this story: Christopher Condon in Boston at ccondon4@bloomberg.net; Bryan Keogh in New York at Bkeogh4@bloomberg.net

Last Updated: October 7, 2008 17:25 EDT