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The Fed's Commercial Paper Chase

By purchasing billions of dollars of short-term business loans, the Fed hopes to unlock a vital corner of the credit market

Cash-starved corporate finance chiefs breathed a sigh of relief as the Federal Reserve stepped in on Tuesday, Oct. 7, to purchase short-term debt that finances companies' day-to-day operations.

Under the move—perhaps the most dramatic step yet taken to unlock a seized-up credit market—the Fed will set up a separate entity known as a special purpose vehicle, which will issue loans at the targeted federal funds rate. Doing so will lubricate the crucial commercial-paper market—a funding mechanism that had become increasingly sclerotic since the bankruptcy of Lehman Brothers on Sept. 15, which spooked money-market funds, the biggest buyers of commercial paper, into safer government debt.

"The crisis that started with banking and the financial sector has moved into the real economy," says Drew Matus, U.S. economist at Merrill Lynch (MER). "It is making things difficult for real companies to access credit markets and fund ongoing operations."

"Like a Heart Attack"

The Fed's drastic move had a nearly immediate impact: Yields on top-rated overnight U.S. commercial paper dropped 0.74 percentage points, to 2.94%, according to Bloomberg Financial Markets. And rates on three-month Treasury bills—the ultimate safe asset to which big investors, like money-market funds, have been flocking—rose above 1.0% on Tuesday for the first time in weeks. Rising yields suggest demand for government debt is easing. Just Monday, yields were 0.43%.

Federal Reserve data show just how dire the situation has become. The week ending Oct. 1 saw a $95 billion reduction in commercial-paper debt outstanding, the biggest one-week decline in nearly a decade. After nearing $2 trillion at the end of 2006, the total commercial-paper market now stands at $1.6 trillion. It has dropped $200 billion just in the past month. "The shutdown of the commercial-paper market is like a heart attack—it can kill companies quickly," says Chris Garman, publisher of Leverage World, a publication that follows debt and credit markets closely.

Commercial paper is basically a short-term IOU used mostly to pay for daily expenses. The so-called CP market has grown by leaps and bounds over the past two decades, as the increasing sophistication of the financial sector has enabled more firms to issue such debt. (In 1980, for example, the total amount of outstanding commercial paper was just $124 billion.)

Relying on Revolvers

Because it is unsecured, commercial paper is reserved mainly for big companies with solid credit, such as Microsoft (MSFT), Procter & Gamble (PG), and Caterpillar (CAT). But with banks hoarding cash, even blue chip companies with good credit have been unable to borrow for longer than a day at a time. "All of a sudden, highly rated companies that relied on commercial paper were left hat in hand," says Matus at Merrill Lynch.

Shut out of the commercial-paper market, some companies, such as hotel giant Marriott (MAR), have turned to revolving bank lines of credit instead. Marriott Chief Financial Officer Arne Sorenson said during the company's earnings call Oct. 2 that the company drew on its $900 million revolver because it "decided it was prudent" to supplement the significantly reduced liquidity in commercial paper.

Some companies have taken even more radical measures to keep the lights on, as when Las Vegas Sands (LVS) CEO Sheldon Adelson lent his company $475 million of his own money earlier this month. While most commercial paper is issued by financial firms, such as GE Capital (GE), about 20% or so is borrowed by nonfinancial firms, such as industrials and service companies.

Peril in Rollovers

Commercial-paper defaults can reverberate through financial markets. In 1970, Penn Central Railroad's $82 million commercial-paper default precipitated what was then the biggest corporate bankruptcy in American history. It forced the Fed to step in and soothe market jitters. Of course, the commercial-paper market was much smaller and less sophisticated back then.

The declining Treasury yield was good news for cash-strapped CFOs. Companies generally "roll over" outstanding commercial-paper issues—that is, they sell new paper to pay off maturing paper. "This is good for the liquidity of all corporations," said Paul A. Farr, CFO of PPL Corp. (PPL), an energy company in Allentown, Pa.

"The Fed's action is great news," says Mark Hogard, CFO of First Capital, a firm that borrows from commercial banks to provide asset-backed loans to manufacturers and distributors. "This will help put dollars to work and relieve pressure."

"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 once again to engage in term lending in the commercial-paper market," a Fed statement said. Says Matus, the Merrill Lynch economist: "The fear that [companies] cannot roll it over goes away now."

But whether it's truly enough to get credit flowing again—and calm the nerves of investors—remains to be seen.

Boyle is deputy Corporations editor for BusinessWeek.

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