Commercial Paper Funding Facility (US)

In establishing the CPFF, the Fed relied on its authority under Section 13(3) of the Federal Reserve Act, which permits the Federal Reserve Board (the Board), in unusual and exigent circumstances, to authorize Reserve Banks to extend credit to individuals, partnerships, and corporations that are unable to obtain adequate credit accommodations. Federal Reserve counsel cited a litany of events^FDevelopments cited included: (1) that for the past year, “the CP market has been under considerable strain as money market mutual funds (MMMFs) and other investors have become increasingly reluctant to purchase CP”; (2) that financial systems in the US and abroad were under “extraordinary stress, particularly the credit and money markets”; and (3) that banks were “constrained in their ability to lend” and others were reluctant to lend to them (Alvarez et al. 2009). in its memorandum analyzing the deteriorating market conditions and found that they were directly affecting the broader economy “[b]y restricting the availability of credit” and “disrupt[ing] the commercial paper market and other forms of financing for a wide range of firms.” (Alvarez et al. 2009). Counsel then concluded that there was manifest evidence that “unusual and exigent circumstances” existed sufficient to support the Board’s authorization of the CPFF under Section 13(3) of the FRA and also “sufficient evidence to support a judgment that adequate credit accommodations for eligible issuers of term CP are not available from other banking institutions” (Alvarez et al. 2009).

The CPFF represented a shift in the Fed’s policy approach to the crisis because it was a direct effort to backstop a particular credit market that was failing. Further, through the CPFF, the Fed in effect extended its discount window lending well beyond the entities to which it traditionally lent—depository institutions and primary dealers—to provide liquidity to a wide variety of financial and nonfinancial entities of varying sizes. Given the limited tools available to the Fed, the CPFF in essence enabled it to utilize its pool of funds in a new way to combat the deepening crisis. 

A designer of CPFF comments that it was regarded by many Fed staffers as the program that most pushed the envelope of what was legal under FRA Section 13(3). This was because the Fed was effectively lending on a mostly unsecured basis and relying on accumulated upfront fees to cover potential losses. At the time, this structure was intensely debated.

Each week, the FRBNY loaned funds to CPFF LLC through the custodian, which would then transfer the funds to the LLC. The LLC would then purchase the CP, which operated as security for the loans, from the primary dealers (acting as the issuers’ issuing and payment agents). When the CP matured, the issuer paid the LLC the principal plus interest. CPFF LLC then repaid the FRBNY the principal of its loan and interest at the federal funds target rate on the original loan date. The US Treasury also made a special deposit of $50 billion to the FRBNY in support of the CPFF (Federal Reserve 2009a; FOMC 2008a).

The Fed had to build new legal, trading, investment, custodial, and administrative infrastructure for CPFF operations as well as establish essential financial and operational risk controls. Time was of the essence, so the Fed accessed market expertise and operational efficiencies through contracted third parties that regularly participated in the CP market:

• PIMCO advised the FRBNY in setting up the CPFF infrastructure and provided transaction agent and investment management services.
• State Street provided administrative and custodial services (in essence, it held the LLC in custody and performed all its administrative functions). The LLC had no employees.
• Primary dealers acted as agents verifying issuers’ eligibility. Since they had established relationships with the FRBNY and actively underwrote, placed, and made a market in CP, they were well suited to intermediate between the CP issuers and the Fed. Issuers were required to sell through a primary dealer even if the issuer normally issued its CP directly without use of an agent (Registration Instructions).
• Depository Trust Company, which traditionally cleared CP transactions for the primary dealers, CP issuing and payment agents (hired by issuers), and State Street, provided these services for the CPFF. This permitted the CPFF to purchase CP through the market’s standard clearing institution and provided same-day settlement, which made it a viable option for issuers facing unexpected liquidity needs (Registration Instructions).

Combining existing and new infrastructure and incorporating market expertise in this manner permitted the Fed to: (1) analyze a number of options in designing the facility, such as fees and managing credit risk, hypothetical losses, and moral hazard; and (2) design a structure that was consistent with market standards and easily accessible to a wide number of potential issuers (Adrian, Kimbrough, and Marchioni 2011). Use of experts also helped make the CPFF operational by October 27, 2008, just 20 days after its announcement.

The CPFF was intended to address the gap in funding caused by recent market disruptions, not to be an additional liquidity channel. Thus, the CPFF was originally available only to “legacy issuers,” any company that had issued CP before its inception, including those with a foreign parent. In January 2009, the Fed further clarified this eligibility criterion with respect to ABCP issuers. Such an issuer was deemed to have been inactive (and thus not eligible to participate in the CPFF) if the issuer had not issued ABCP to institutions other than the sponsoring institution for any period of three consecutive months or longer between January 1 and August 31, 2008 (FRBNY, CPFF: FAQs Jan. 23, 2009). This modification reinforced the original intent of the facility and sought to limit moral hazard by excluding issuances that “no longer had a natural investor base,” and mitigated the risk of funding issuers that the market had withdrawn from for reasons unrelated to the crisis (Adrian, Kimbrough, and Marchioni 2011).

In implementing the CPFF, the Fed decided that because of the broad nature of the CP market, to be an effective backstop the CPFF had to be accessible to a “large cross-section of the commercial-paper market while minimizing credit risk to the Reserve Bank” (Adrian, Kimbrough, and Marchioni 2011). CP issuers were a varied group of financial and nonfinancial entities. Issuers eligible to utilize the CPFF had to be US entities, and included US subsidiaries of foreign companies. However, any type of US company meeting the definition of “legacy issuer” could utilize the CPFF. A narrower facility—for example, one limited to financial entities—might not have addressed the issue of spillover to the real economy.

Because the group of potential issuers was much broader than the limited types of firms the Fed usually dealt with (depository institutions and primary dealers), it relied on its primary dealers, which had CP market expertise and knowledge of issuers, as intermediaries. The terms of the CPFF required issuers to sell through one or more primary dealer(s), even if the issuer normally issued its CP directly. In this way, there was one additional check on potential issuers’ creditworthiness.

US subsidiaries of foreign companies were eligible to borrow under the CPFF as long as they otherwise met the definition of “legacy issuer.” An analysis of the CPFF transaction data shows that, on average, European banks had borrowings of $145.5 billion, 57.3% of the average outstanding borrowings under the CPFF. A number of banks that were experiencing well-reported difficulties were among the list of top borrowers, including UBS, Dexia SA, Royal Bank of Scotland, and Fortis SA/NV (van Deventer 2011).

The wording of FRA Section 13(3) is broad and permits a Federal Reserve Bank discretion to determine whether it is “secured to [its] satisfaction” in acting under the section. CPFF design elements—having issuers preregister and be vetted, requiring use of a primary dealer, upfront registration fees, credit quality, pricing, and maximum issuance amount—were structured with the intent to protect the Fed from associated risks. Moreover, the legal staffs of the Board and the FRBNY were involved in providing advice regarding the design and implementation of the CPFF and concluded that the FRBNY could reasonably determine that its loans to the LLC would be adequately secured on several levels:

• Under the CPFF, the FRBNY’s loans to the LLC would be secured by all of the assets of the LLC, including the CP purchased, assets purchased with the accumulated upfront fees paid by the issuers, any uninvested fees, and any earnings. In addition, the CP eligible for purchase under the facility would be highly rated, and purchases would be subject to a discount from face value. Based on the sum of these facts, counsel concluded that the FRBNY could reasonably conclude that all loans to the LLC would be “secured to [its] satisfaction” with respect to all loans to the LLC.
• Counsel further determined that if individual purchases of ABCP were considered, the FRBNY could reasonably reach a similar conclusion because the ABCP was collateralized by the pools of assets underlying the ABCP, even though these pools might dip below the face value of the ABCP. Moreover, the risk of a drop in value was somewhat mitigated by the discount applied at purchase.
• With respect to individual purchases of unsecured CP, counsel found that the credit premium fee of 100 basis points charged acted as an insurance premium (Alvarez et al. 2009). This fee, together with the facility registration fee of 10 basis points on the Maximum Face Value charged to each issuer, provided a pool^FThe transcript from a Federal Open Market Committee (FOMC) meeting that occurred a week after the CPFF began preregistration reflects that, “[a]t the close of business last week [the first week of CPFF operations], 79 issuers had registered to use the facility, paying 10 basis points, or $580 million, to cover the potential issuance of commercial paper. The 10 basis point fee provides a little equity to get the program off and running” (FOMC 2008b). The CPFF also accepted participation in the FDIC’s Temporary Liquidity Guarantee Program in lieu of the credit enhancement fee. to compensate the FRBNY for any losses resulting from the CP.

Similar to a bank loan commitment fee, a facility registration fee of 10 basis points (0.1%) times the issuer’s Maximum Face Value was required for issuers seeking to utilize the CPFF. The fee was payable upon registration and nonrefundable, even if the issuer never issued CP under the CPFF. General Electric, whose GE Capital unit was the largest US issuer of CP in October 2008 (and traditionally a direct issuer), registered and announced plans to use the program that it called “good for the market and very important for the buyers of GE paper as it provide[d] a secondary market” (Layne 2008).

As was the market custom, the CP was purchased at a discount from face value. The CP purchased by the LLC was discounted based on a rate equal to a spread over the three-month OIS rate on the day of purchase. As shown in Figure 4, the spread for unsecured commercial paper was 100 basis points per annum and the spread for ABCP was 300 basis points per annum.

For unsecured CP, a credit enhancement fee of 100 basis points was charged on settlement. This was to compensate the Fed for the higher risk involved and to ensure that the Fed was “secured to [its] satisfaction” with respect to the unsecured CP, a requirement of FRA Section 13(3). However, this fee could be waived if the issuer participated in the FDIC’s TLGP (FRBNY 2009).

Fees under the CPFF were originally lower than market rates but were designed to be unattractive when the market recovered, creating a disincentive for issuers to continue to utilize the CPFF. As was expected, as the market recovered, usage of the CPFF declined. In extending the CPFF to February 1, 2010, the Federal Reserve explained “[i]nterest rates posted on the CPFF are at levels that are increasingly unattractive for many borrowers as market conditions improve, and accordingly usage of the CPFF is declining fairly steadily” (Federal Reserve 2009b).

Similar to a bank loan commitment fee, a facility registration fee of 10 basis points (0.1%) times the issuer’s Maximum Face Value was required for issuers seeking to utilize the CPFF. The fee was payable upon registration and nonrefundable, even if the issuer never issued CP under the CPFF. General Electric, whose GE Capital unit was the largest US issuer of CP in October 2008 (and traditionally a direct issuer), registered and announced plans to use the program that it called “good for the market and very important for the buyers of GE paper as it provide[d] a secondary market” (Layne 2008).

As was the market custom, the CP was purchased at a discount from face value. The CP purchased by the LLC was discounted based on a rate equal to a spread over the three-month OIS rate on the day of purchase. As shown in Figure 4, the spread for unsecured commercial paper was 100 basis points per annum and the spread for ABCP was 300 basis points per annum.

For unsecured CP, a credit enhancement fee of 100 basis points was charged on settlement. This was to compensate the Fed for the higher risk involved and to ensure that the Fed was “secured to [its] satisfaction” with respect to the unsecured CP, a requirement of FRA Section 13(3). However, this fee could be waived if the issuer participated in the FDIC’s TLGP (FRBNY 2009).

Fees under the CPFF were originally lower than market rates but were designed to be unattractive when the market recovered, creating a disincentive for issuers to continue to utilize the CPFF. As was expected, as the market recovered, usage of the CPFF declined. In extending the CPFF to February 1, 2010, the Federal Reserve explained “[i]nterest rates posted on the CPFF are at levels that are increasingly unattractive for many borrowers as market conditions improve, and accordingly usage of the CPFF is declining fairly steadily” (Federal Reserve 2009b).

CP eligible for purchase by the CPFF was only that rated A-1/P-1/F1, unsecured or asset-backed. Consistent with Rule 2a-7 (which provides restrictions governing MMMFs), per fund conventions, a split rating was acceptable if two ratings were top-tier. In the time between Lehman’s bankruptcy and the CPFF starting operations, outstanding CP dropped by $300 billion, and 70% of this decline was due to financial CP (Adrian, Kimbrough, and Marchioni 2011; Anderson and Gascon 2009). ABCP, which was widely used to finance consumer and commercial assets and which had experienced substantial contraction during 2007, experienced a much smaller drop, but maintaining this type of consumer and small business funding was perceived as key to containing the crisis. Since highly rated CP constituted nearly 90% of the market at the time, limiting the eligible CP to these criteria still enabled the Fed to backstop almost the entire market while also shielding the Fed from CP with greater credit risk (Adrian, Kimbrough, and Marchioni 2011).

When the CPFF was enacted, 75% of newly issued CP had a maturity of one to four days. Because the CPFF was designed to offer funding beyond what was already available in the market, its focus became term lending. Traditionally, CP has been more liquid at one- and three-month maturities, and since there were funding concerns for the approaching year end, the Fed decided that the CPFF would purchase only three-month CP. Further, providing term funding also helped to mitigate rollover risk. Issuers could place CP for longer periods than the short maturities that the market was then accepting, and the Fed believed that this would provide additional stability to the market because issuers did not have to immediately look to refinance such amounts (Adrian, Kimbrough, and Marchioni 2011).

The maximum amount of a single issuer’s commercial paper that CPFF LLC could own at any time was “the greatest amount of US dollar-denominated A-1/P-1/F1 commercial paper the issuer had outstanding on any day between January 1 and August 31, 2008.”  This amount was called the “Maximum Face Value.” If an issuer had more than one CP program, the Maximum Face Value would be the aggregate amount outstanding under all programs on a single day. In addition, by executing the CPFF Issuer Registration Form and Qualification Certification, the issuer agreed that while participating in the CPFF, it would not sell CP to the CPFF such that the total amount of CP outstanding (including CP held by the CPFF and other investors) would exceed the Maximum Face Value. These limitations helped to maximize availability of the CPFF.

The FRBNY administered the CPFF and provided three-month loans to the LLC. The LLC would then use the funds to purchase eligible commercial paper from eligible issuers through a primary dealer as issuing agent. The FRBNY’s loans were secured by the LLC’s assets, including the CP that it purchased, fees that it collected and any uninvested fees, and earnings and proceeds from investments. This structure was chosen because the Fed would be dealing in a security that it did not normally handle and with many types of entities that it did not normally lend to. (Adrian, Kimbrough, and Marchioni 2011).