The U.S. Treasury on Tuesday granted the Federal Reserve 13(3) authority under Dodd-Frank that permits the central bank to take steps under exigent and unusual circumstances to stabilize financial markets and the economy.
The U.S. Treasury stepped forward with a $10 billion backstop to fund a Commercial Paper Funding Facility to restart the commercial paper market, the market for short-term unsecured promissory notes issued by companies. The policy objective is to support a wide range of economic activity, supplying credit and funding for auto loans and mortgages, as well as liquidity to meet the operational needs of a range of companies.
More importantly, the goal is to prevent a larger catastrophe that includes soaring bankruptcies, unemployment and underemployment. While we are encouraged by this policy step, the Treasury will need to step up with other funds and bridge loans to firms that do not meet the A1 top-rated paper that is required by the Federal Reserve act.
The commercial paper market is typically based on an unsecured, short-term debenture issued by a corporation to finance payrolls, accounts payable, inventories and short term-liabilities. The CPFF will address stress in credit markets that had built up to the point where Tuesday morning the commercial paper was essentially frozen. The primary policy goal in constructing the CPFF is to provide bridge financing to firms experiencing transitory dips in revenue linked to the public health emergency associated with the COVID-19 virus.
Wide range of federal funding is required
The CPFF is just one of many liquidity and lending facilities that the monetary and fiscal authorities will need to construct and utilize to prevent a collapse of the economy organized around small and medium size enterprises. Moreover, the federal government will quickly need to put into place a massive fiscal stimulus program equal to roughly 2% of gross domestic product that targets households and firms to prevent a complete shutdown of the domestic economy. In our estimation, a so-called “phase three stimulus” is likely a precursor to what will be a multi-trillion dollar effort to stabilize the economy before the risk of the coronavirus has passed.
During the 2007-2010 financial crisis the Federal Reserve created the CPFF following the collapse of Lehman Brothers, the bailout of AIG and the freezing up of global credit market. The CPFF was funded through a special purpose vehicle that purchased three-month unsecured and asset-backed commercial paper for eligible firms. Today, the Fed took a similar step by constructing a special-purpose vehicle.
How it works
The New York Federal Reserve will purchase from eligible issuers three-month U.S. dollar-denominated commercial paper through the New York Fed’s primary dealers. Eligible issuers are U.S. issuers of commercial paper, including U.S. issuers with a foreign parent company. The SPV will only purchase U.S. dollar-denominated commercial paper (including asset-backed commercial paper (ABCP) that is rated at least A-1/P-1/F-1 by a major nationally recognized statistical rating organization (NRSRO) and, if rated by multiple major NRSROs, is rated at least A-1/P-1/F-1 by two or more major NRSROs, in each case subject to review by the Federal Reserve.
The maximum amount of a single issuer’s commercial paper the SPV may own at any time will be the greatest amount of U.S. dollar-denominated commercial paper the issuer had outstanding on any day between March 16, 2019 and March 16, 2020. The SPV will not purchase additional commercial paper from an issuer whose total commercial paper outstanding to all investors (including the SPV) equals or exceeds the issuer’s limit.
Pricing will be based on the then-current three-month overnight index swap (OIS) rate plus 200 basis points. At the time of its registration to use the CPFF, each issuer must pay a facility fee equal to 10 basis points of the maximum amount of its commercial paper the SPV may own. The termination date will be March 17, 2021.
By ensuring the smooth functioning of the commercial paper market, particularly in times of strain, the Federal Reserve is providing credit that will support families, businesses and jobs across the economy.