US: Fed Targets the CP Market

Overview: The Federal Reserve has taken a drastic step in order to unfreeze the US commercial paper market. The central bank announced in a statement today that it will create a special purpose vehicle to purchase three-month secured and unsecured commercial papers directly from eligible issuers. This move comes in response to a sharp fall over the past two weeks in the amount of outstanding unsecured CP which has exacerbated the funding difficulties faced particularly by the financial sector, compounding the gridlock in money markets and its negative consequences for overall credit availability (see Flash Comment - Global: Crisis update - what's next? and Research - CP market and money markets gridlocked).

Details: The CPFF will be established as a credit facility to a special purpose vehicle (SPV) which will in turn purchase term commercial paper issued by eligible issuers. The Fed will lend to this SPV on an overnight basis and the Treasury will support the SPV with a special deposit.

The SPV will purchase USD-denominated commercial papers directly from eligible issuers at a spread over the 3 month OIS rate. This spread has not yet been fixed, but the Federal Reserve will set an 'appropriate' spread consistent with more 'normal market conditions'. The Fed's Terms and Conditions cite an example of 100bp - i.e. substantially lower than the current 3 month OIS – LIBOR spread of around 285bp.

Eligible commercial paper must be rated at least A1/P1/F1 by a major NRSRO and not rated below A1/P1/F1 by any major NRSRO. Note that eligible issuers do not need to be depositary institutions, but can also be ordinary corporate businesses with a sufficient rating. The commercial paper must be secured, either by fee, endorsement or guarantee, collateral arrangement or alternative terms of security.

The SPV will only purchase commercial paper issued by U.S. issuers (including U.S. issuers with a foreign parent). The SPV will accept both unsecured and asset backed commercial paper.

The SPV is restricted with a single issuer unable to place more CP in the SPV than the average amount of CP of that issuer outstanding in August 2008. Otherwise, there is to be no aggregate limit on the amount of commercial paper the SPV can purchase. The SPV will purchase commercial paper until April 30, 2009 although this termination date can be extended by the Federal Reserve Board.

Assessment and outlook: The Federal Reserve is continuously stepping up its efforts to ease money market constraints and avoid a major credit crunch for businesses and households. Again today's actions shows that the Fed does not regard lower Fed funds rates as the correct solution but that it will nevertheless takes what it considers to be appropriate alternative measures. However, we think there is still a risk that the Fed will be forced to cut rates further if financial conditions do not improve or the real economy deteriorates considerably.

In our view today's announcement is an important step in helping to stabilise the financial system. The drying up of the commercial paper market has been an important factor behind growing money market problems. If today's action is successful in easing the money market difficulties, LIBOR fixings will come down, swap spreads should narrow and treasury bond yields will increase as funds flows from safe havens relocate once again to more risky assets.

Danske Bank
http://www.danskebank.com/danskeresearch

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