Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Federal Reserve's Commercial Paper Funding Facility

Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Federal Reserve's Commercial Paper Funding Facility

Article excerpt

I. INTRODUCTION

The commercial paper market experienced considerable strain in the weeks following Lehman Brothers' bankruptcy on September 15, 2008. The Reserve Primary Fund--a prime money market mutual fund with $785 million in exposure to Lehman Brothers--"broke the buck" on September 16, triggering an unprecedented flight to quality from high-yielding to Treasury-only money market funds. These broad investor flows within the money market sector severely disrupted the ability of commercial paper issuers to roll over their short-term liabilities.

As redemption demands accelerated, particularly in high-yielding money market mutual funds, investors became increasingly reluctant to purchase commercial paper, especially for longer dated maturities. As a result, an increasingly high percentage of outstanding paper had to be refinanced each day, interest rates on longer term commercial paper increased significantly, and the volume of outstanding paper declined sharply. These market disruptions had the potential to constrain the economic activities of commercial paper issuers. Indeed, a large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and the difficulties they faced placing commercial paper further reduced their ability to meet the credit needs of businesses and households.

In light of these strains, the Federal Reserve announced the creation of the Commercial Paper Funding Facility (CPFF) on October 7, 2008, with the aim of supporting the orderly functioning of the commercial paper market. Registration for the CPFF began October 20, 2008, and the facility became operational on October 27. The CPFF operated as a lender-of-last-resort facility for the commercial paper market. It effectively extended access to the Federal Reserve's discount window to issuers of commercial paper, even if these issuers were not chartered as commercial banks. Unlike the discount window, the CPFF was a temporary liquidity facility that was authorized under section 13(3) of the Federal Reserve Act in the event of "unusual and exigent circumstances." It expired February 1, 2010. (1)

The goal of the CPFF was to address temporary liquidity distortions in the commercial paper market by providing a backstop to U.S. issuers of commercial paper. This liquidity backstop provided assurance to both issuers and investors that firms would be able to roll over their maturing commercial paper. The facility enabled issuers to engage in term lending funded by commercial paper issuance, which in turn enhanced the ability of financial intermediaries to extend crucial credit to U.S. businesses and households.

The CPFF did not address the solvency of issuing firms. Rather, the focus was on shielding the allocation of real economic investment from liquidity distortions created by the run on high-yielding money market instruments that had been triggered by the bankruptcy of Lehman Brothers. The facility was explicitly designed to protect the Federal Reserve from potential credit losses. Issuance to the CPFF was either secured by collateral or subject to an additional surcharge, which was calibrated to protect the Federal Reserve from any potential credit losses.

This paper offers an overview of the Commercial Paper Funding Facility. We explain the economic role of the commercial paper market as a source of funding for various financial intermediaries. We briefly review the events surrounding the turmoil that led to the creation of the CPFF. Our study also presents operational details of the CPFF and documents its usage and effectiveness. In addition, we discuss the economics of the facility in the context of the financial system and in relation to the Federal Reserve's role as lender of last resort. Also considered are issues associated with the risk of moral hazard that have been raised following the launch of the CPFF.

2. BACKGROUND ON THE COMMERCIAL PAPER MARKET

The commercial paper market is used by commercial banks, nonbank financial institutions, and nonfinancial corporations to obtain short-term external funding. …

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