Fed to buy massive amounts of short-term debt

By Jeannine Aversa, AP Economics Writer

WASHINGTON (AP) -- The Federal Reserve announced Tuesday a radical plan to buy massive amounts of short-term debt in a dramatic effort to break through a credit clog that is imperiling the economy.

Invoking Depression-era emergency powers, the Fed 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.

In more normal times, about $100 billion of these short-term IOUs were outstanding at any given time, sold by companies to buyers that included money market mutual funds, pension funds and other investors. But this market has virtually dried up as investors have become too jittery to buy paper for longer than overnight or a couple days.

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 Fed said. The action makes the Fed a crucial source of credit for nonfinancial businesses in addition to commercial banks and investment firms.

The Fed's action initially helped lift investors' spirits, although concerns about the economy dampened their enthusiasm. The Dow Jones industrials -- which gained about 145 points just after the open -- fell nearly 63 points in midday trading. Monday, a huge selloff put the Dow below 10,000 for the first time in four years.

Concerns about the credit markets pushed investors into longer-term Treasury bonds, considered a secure place to park money in times of turmoil. The rush to safety drove yields lower, though.

Credit markets themselves eased slightly, however, after the Fed's move raised hopes it would quickly relieve the short-term funding problems plaguing some companies.

European stocks posted modest gains on hopes that central banks around the globe would coordinate on rate cuts. Share prices in Britain and in Germany, Europe's largest economy, rose. Iceland, however, is facing the prospect of bankruptcy, according to the Prime Minister Geir H. Haarde, after its banks went on a buying spree across Europe, accumulating massive debts in the process.

The Fed said it is creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program up and running soon, Fed officials said.

Fed officials said they'll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify.

"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. As the market for commercial paper shrank, the Fed said rates on the longer-term debt "increased significantly," making it more expensive for companies to borrow.

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. Fed officials would not say how much but believed it would be substantial. The money would not come from the $700 billion financial bailout President Bush signed into law on Friday.

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 amount of such a fee has not yet been determined.

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.

The Fed said it planned to stop buying commercial paper on April 30, 2009, unless the Federal Reserve board agrees to extend the program. The Fed created a separate entity to pool and hold the commercial paper it buys. The Fed said this should allow the central bank to more easily manage the program and better control risk.

There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market as of last Wednesday, according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2 trillion.

Pressure also is growing on the Fed to reverse course and order a deep reduction in its key interest rate, now at 2 percent. Such a move would be aimed at reviving the moribund economy by encouraging consumers and businesses to boost their spending. Many predict the Fed will act on or before its next meeting on Oct. 28-29. And, some believe it could be part of a broader coordinated move with central banks in other countries.

The White House said President Bush spoke Tuesday with leaders of Britain, France and Italy about measures the United States is taking and the importance of countries working together.

The finance ministers of the G-7 -- the U.S., France, Germany, Italy, Japan, the United Kingdom and Canada -- will meet in Washington at the end of this week and the White House says Bush is open to the idea of a leaders' summit on the economy, as suggested by French President Nicolas Sarkozy.

Fed Chairman Ben Bernanke may offer clues on the Fed's next move when he speaks Tuesday afternoon on the economic outlook and developments in financial markets.

President Bush also was set to talk about the government's bailout effort, which lets the government buy rotten mortgages and other bad debts from banks and other financial institutions. By getting these bad debts off bank's balance sheets, they might be in a better position to raise capital and more willing to lend to each other and to customers.

As the number of failed banks has gone up sharply this year, Sheila Bair, head of the Federal Deposit Insurance Corp., wants to boost fees to financial institutions to replenish the insurance fund that backs the nation's deposits. The increase would double the average paid by U.S. banks and thrifts next year.

The Fed pledged Monday to take "additional measures as necessary" to battle the worst credit crisis in decades.

Treasury Secretary Henry Paulson has tapped a former Goldman Sachs executive to be director of the government's bailout program. Neel Kashkari, who has worked with Paulson at the department since July 2006, was chosen Monday as the interim head of the government's unprecedented effort to unclog the credit markets.

Kashkari, who was a vice president in Goldman's San Francisco office before joining the department, is one of four former executives from the firm now working feverishly to resolve the financial crisis.

The lending lockup is a key reason why the U.S. economy is faltering. Unable to borrow money freely or forced to pay a high cost to borrow, employers are cutting jobs and reducing capital investments. Consumers have retrenched.

Associated Press writers Madlen Read and Tim Paradis in New York and Ben Feller in Washington contributed to this report.