Fed Takes Radical Step To Unthaw Credit

The Federal Reserve; currency; money
The Federal Reserve announced Tuesday a radical plan to buy massive amounts of short-term debts in a dramatic effort to break through a credit clog that is imperiling the U.S. economy.

The Federal Reserve will buy "commercial paper," a short-term financing mechanism that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls.

The $99.4 billion daily market for this crucial financing, which relies on investors rather than banks, has virtually dried up. That has made it increasingly difficult and expensive for companies to raise money to fund their operations. Commercial paper is a way of borrowing money for short periods, typically ranging from overnight to less than a week.

The unstable situation has left many companies vulnerable. The notion under the plan is for the government to provide a "backstop" that would give companies a new place to get cash, the U.S. central bank, known as the Fed, said. The action makes the Fed a source of credit for nonfinancial businesses in addition to commercial banks and investment firms.

The Fed said it is creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies.

"The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors" have become increasingly reluctant to buy commercial paper, especially longer-dated maturities.

The Treasury Department, which worked with the Fed on the program, said the action is "necessary to prevent substantial disruptions to the financial markets and the economy." The Treasury will provide money to the Federal Reserve Bank of New York to support the new program, the Fed said.

If a company's commercial paper is not backed by assets or other forms of security acceptable to the Fed, the company could pay an upfront fee, the central bank said.

The Fed said it hoped its effort would jolt the commercial paper market back to life.

"This facility should encourage investors to once again engage in term lending in the commercial paper market," the Fed said. That should eventually spur financial companies to lend to each other and to their customers, including consumers, the Fed said.

To help ease credit stresses, the Fed announced Monday it will provide as much as $900 billion in cash loans to squeezed banks. It said 28-day and 84-day cash loans being made available to banks will be boosted to $150 billion apiece. Those increases will eventually bring the amounts outstanding under the program to $600 billion.

"I think we're in a very serious situation, that's clear," Julia Coronado, an economist with the investment bank Barclays, told CBS' The Early Show.

Coronado added that while a recession seems imminent, a depression is unlikely. "We have to believe when the U.S. Treasury and the Federal Reserve and central banks around the world are throwing their weight behind this, that is will have some effect," she said.

Loans that will be made available in November to banks also will be increased to $150 billion each. That makes a total of $900 billion in credit potentially outstanding over year-end, the Fed said.

The Fed also said it will begin paying interest on commercial banks' reserves, another way to expand the central bank's resources to battle the credit crisis.

In the $700 billion bailout bill President George W. Bush signed Friday, Congress gave the Fed the power to pay interest on those reserves for the first time. The law accelerated the effective date to Oct. 9 of this year, rather than October 2011.

The move also will encourage banks to keep excess reserves at the central bank because they will now be earning interest on the money. That will help give the Fed more control over interest rates and more leverage to battle the credit debacle. Under the current formula, the Fed would pay interest of roughly 1.25 percent on excess reserves. A different rate would be paid for required reserves.

"Together these actions should encourage term lending across a range of financial markets in a manner that eases pressures and promotes the ability of firms and households to obtain credit," the Fed said.

A growing number of economists and investors believe the Fed will be forced to do an about-face and lower its key interest rate, now at 2 percent, on or before its next meeting on Oct. 28-29.

Such a move would revive the central bank's rate-cutting campaign, which had been halted in June out of concerns that those low rates would worsen inflation. Since then, however, economic and financial conditions have dangerously deteriorated, while inflation pressures have calmed a bit.

Any reduction to the Fed's key rate would cause a corresponding drop in commercial banks' prime lending rate, now at 5 percent. The prime rate is used to peg loans to millions of consumers and businesses.