Wednesday, October 8, 2008

Fed Considers Plan to Buy Companies’ Unsecured Debt

Fed Considers Plan to Buy Companies’ Unsecured Debt

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The Federal Reserve announced a radical new plan on Tuesday to jump-start the engine of the financial system.

The Fed said in a statement that it would begin to buy large amounts of short-term debt in an effort to stimulate the credit markets, which have all but dried up.

Under the program, the Fed said that it would buy the unsecured short-term debt that companies rely on to finance their day-to-day activities. “This facility should encourage investors to once again engage in term lending in the commercial paper market,” the Fed said Tuesday in a statement. “An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.”

While the move will put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up. The Commercial Paper Funding Facility, “will complement the Federal Reserve’s existing credit facilities to help provide liquidity to term funding markets,” the statement said.

Also on Tuesday, European Union finance ministers gathered in Luxembourg to seek common ground to buttress the continent’s banking system in the face of the financial crisis. Despite proposals from France and Italy, the European Union has eschewed any common fiscal approach to the crisis, mainly because Germany refuses to be drawn into a scheme for fear of being burdened with the costs of rescuing non-German banks.

The plan to buy commercial paper was formulated amid cascading losses in global stock markets, as the banking crisis spread across Europe and investors feared dire consequences for the world economy. The Dow Jones industrial average fell as much as 800 points before a late recovery, finishing down 369.88, below 10,000 points for the first time since 2004.

Even before bankers on Wall Street reached their desks on Monday, European stocks were plunging. The Russian stock market dropped 19.1 percent, the biggest decline since the fall of the Soviet Union. Major indexes in London and Frankfurt lost more than 7 percent; stocks in Paris fell by 9 percent. Stocks in Latin America and other emerging economies took their worst collective tumble in a decade.

Volatility reached the highest level in two decades, and oil prices fell below $90 for the first time since February.

The contagion moved to Asian with the Nikkei index of Japanese stocks closing down 3 percent and the Hang Seng index of stocks in Hong Kong fell 4.9 percent. But shares rebounded Tuesday morning in Europe, with the FTSE up 1.2 percent in London, the CAC 40 was up 1.7 percent in Paris, and the DAX in Frankfurt was slightly higher.

Investors around the world are worried about what the evaporation of credit will do to an already-weakened global economy.

“There is a growing recognition that not only has the credit crunch refused to be contained, it continues to spread,” said Ed Yardeni, an investment strategist. “It’s gone truly global.”

In the United States, consumers appear to be significantly curbing spending; last month, employers cut more jobs than any month in five years. The $6 decline in oil prices, which settled at $87.81 a barrel, stemmed in part from fears that demand will slacken in the face of a deteriorating economy.

The Fed plan is intended to renew the flow of credit on which the economy depends. Under its plan, the central bank would buy unsecured commercial paper, essentially short-term i.o.u.’s issued by banks, businesses and municipalities.

The market for that kind of debt has all but shut down in the last week, with many major corporations unable to borrow for longer than a day at a time, as banks become more fearful of giving out cash. The volume of such debt totaled about $1.6 trillion as of Oct. 1, down 11 percent from three weeks earlier.

These credit fears persisted over the weekend despite the $700 billion bailout package that Congress approved last week.

The cost of borrowing from banks and corporations remained high on Monday, increased in part by a series of high-profile bank bailouts in Europe, where governments scrambled to save several major lenders from collapse.

The United States government appears to be pressing ahead with other radical efforts to shore up the financial system, even wading into corners of the markets where it has rarely interfered.

Buying commercial paper could open the Fed to difficult conflicts of interest, because it would be juggling the goals of protecting its investment portfolio with its traditional goals of promoting stable prices and low unemployment.

“The Federal Reserve really would become the buyer of last resort, trying to jump-start the commercial paper market by taking on credit risk,” said Vincent Reinhart, a former top Fed official who worked under Alan Greenspan, a former Fed chairman, and Ben S. Bernanke, the chairman now.

The Federal Reserve has already stretched its resources to the limit by providing hundreds of billions of dollars in short-term loans to banks, Wall Street firms and money market funds.

On Monday, the Fed announced that it would once again redouble one of its key emergency lending programs, increasing the size of its Term Auction Facility to $600 billion, from $300 billion. On top of that, the central bank plans to provide an additional $300 billion to banks to meet their end-of-the-year cash needs.

Most of the loans are for 28-days and 84-days, the Fed said. Some are shorter — 13-day and 17-day loans. Aside from Monday’s auction, auctions for 28-day and 84-day loans are planned Oct. 20, Nov. 3, Nov. 17, Dec. 1, Dec. 15 and Dec. 29. Auctions for the shorter loans will be Nov. 10 and Nov. 24.

To pay for its burgeoning responsibilities, the Fed has no choice but to keep printing more money. To prevent that flood of new money from reducing the central bank’s overnight interest rate to zero, the Fed also announced on Monday that it would start paying interest on the excess reserves that banks keep on deposit at the Fed.

Paying interest on reserves allows the central bank to set a floor on interest rates and retain at least some control over monetary policy.

In its announcement on Monday, the Fed said it would pay an interest rate of 1.25 percent —three-quarters of a point below its target of 2 percent for the overnight Federal funds rate.

But the possibility of propping up the vast market for commercial paper could represent an undertaking even broader than the Treasury Department’s plan to buy as much as $700 billion in mortgage-backed securities.

In statements on Monday morning, the Federal Reserve and the Treasury said they were “consulting with market participants on ways to provide additional support for term unsecured funding markets.”

By referring to “unsecured funding markets,” policy makers signaled that they wanted to intervene directly in the credit markets. Officials said on Monday evening that they wanted to finish a plan as quickly as possible, perhaps as early as Tuesday.

But the effort is fraught with legal complexities. Though the Federal Reserve has sweeping power to create money and lend it out, experts said it was normally prohibited from buying assets that could lose money.

One way around that legal limitation would be to provide money to a separate legal entity that would do the buying and investing on the Fed’s behalf. That would be similar to Maiden Lane Funding L.L.C., a special-purpose entity that officials created last spring to hold $29 billion in hard-to-sell securities from Bear Stearns.

But so far, the myriad efforts by government regulators to shore up confidence have seemed to yield little relief among investors, some of whom believed the actions have taken on a haphazard air.

“People are slowly but surely coming to the realization that playing ‘Whack-a-Mole’ with each of these issues as they arise, on an ad hoc basis, doesn’t get the job done,” said Max Bublitz, chief strategist at SCM Advisors, an investment firm in San Francisco.

On Wall Street, Monday was a frightening day for investors — the type of day where a 369-point deficit in the Dow is considered a relief.

A broad sell-off began at the opening bell and intensified throughout the morning. After 2 p.m., the Dow was down a hair over 800 points, worse than the 777-point drop one week earlier.

But around 2:30, investors began to hunt for bargains, sending the Dow briefly back above the 10,000 mark, before finishing the day at 9,955.50. The broader stock market closed down 3.9 percent, as measured by the Standard & Poor’s 500-stock index. Shares of financial firms, manufacturing outfits and industrial companies all fell sharply. The Dow has lost 1,187 points, about 10.7 percent, and the S. & P. almost 13 percent in a week.

The sharp slide on Monday came despite assurances from President Bush that it would “take a while to restore confidence to the financial system.”

“We don’t want to rush into this situation and have the program not be effective.”

Following are the results of Monday’s Treasury auction of 72-day cash management bills and three-month and six-month bills.

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