Fed Plan To Buy Commercial Paper: Where Does It End?

Here is the full text of the Fed's announcement that it is going to start buying Commercial Paper: 

(From the Federal Reserve): "The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility. 

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households. 

By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households." 

The phrase to zero in on is: "eliminating much of the risk that eligible issuers will not be able to repay investors," which means that the Fed isn't just buying some debt to add liquidity to the market they're telling investors that they don't have to worry about losing money because certain commercial paper transactions will be backed up by the U.S. Government. 

Anyone see a problem with this? The Fed stepping in to effectively guarantee commercial transactions? Anyone consider what kind of long-term moral hazard it could introduce, and what kind of irresponsible behavior it could encourage in the present now that some people are able to lend without the risk of losing money? 

Yes, yes, I know only the companies with the strongest credit ratings, collateral, etc, who pay fees can participate, but having Fed backing is still an explicit guarantee that will make it easier to place the paper. After all it was the Fed said it was going to eliminate the risk in this market, not me. 

Long-term I have to wonder where this nation's economy is going on a structural or policy basis as the Government steps in time and time again (do we even need to say that the Auto Industry is next?) to subsidize, back-stop or in other ways bailout various companies, markets and industries. Can we even call ourselves a free-market capitalist nation anymore after the events of the past 4 weeks, especially when it's going to take years for the government to unwind itself from private industry after the current round of bailouts, subsidies, rescues, etc?  

While I understand that in some instances intervention is needed, I think you have the balance that against the risk of introducing extreme moral hazards, and the fact that you can't "intervene or legislate away" the root causes of the current crisis: bad risk management, over-leverage, under-capitalization and investors losing money. Throwing money at symptoms whilst ignoring the root causes is nothing more than throwing good money after bad. 

Finally thought(s): the size of the commercial paper market (by many accounts) is in $1.3-$2 Trillion dollar range, how much money is the Fed going to have to put into this market in order to truly impact it and what will that do the dollar, the national debt, etc? What happens if the Fed guaranteeing the debts of certain issuers results in even more money flowing into this market? What happens if the Fed's intervention creates two tiers of commercial paper: the stuff backstopped by the Fed and everything else, could that cause the bulk of the money to flow to the former this creating another "clog" in the market? 

Sources

The Federal Reserve: "Board announces creation of the Commercial Paper Funding Facility (CPFF) to help provide liquidity to term funding markets" -- October 7, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.