Fed Program That Calmed Debt Market Faces a Test

By LIZ RAPPAPORT This week brings one of the first tests of success for a key Federal Reserve program that has calmed the short-term credit markets. About $230 billion of three-month debt that the Fed owns, in the form of commercial paper, is set to mature by Friday. The questions are: Will companies like General Electric or GMAC, which issue this short-term debt to pay their bills and meet other near-term obligations, return to the open market rather than roll over their debt with the central bank, which costs a lot more? Can the still-fragile market absorb so much three-month debt in a single week without sending interest rates much higher? And is the Fed winding down this key program? The Fed launched the Commercial Paper Funding Facility on Oct. 27 to buy short-term debt directly from companies amid the credit market's seizure, following Lehman Brothers' collapse. At the time, money-market funds, which are the main buyers of this debt, were hoarding cash to meet redemptions and companies couldn't obtain loans for much more than 24 hours, and at rates as high as 7% or more. Jeffrey Immelt GMAC says it is evaluating all of its funding options, while General Electric Chief Executive Jeffrey Immelt said last week the firm was cutting back its reliance on the commercial-paper market. As of this past Thursday, the Fed held $350 billion of paper in the facility. That is close to 21% of the $1.7 trillion market. "Unwinding the Fed's programs is meant to be a natural process, and this is an early test of that," said Lou Crandall, chief economist at Wrightson ICAP. Some analysts predict the Fed may see its CP purchases cut by half as issuers work their way back into the open market. It is unlikely all the issuers will roll over their debt for three months as some choose to sell at shorter maturities, of one or two months. Others, like banks, may entirely buy back their debt using cash they have obtained by borrowing at lower rates, using debt guaranteed by the Federal Deposit Insurance Corp. Thursday evening the Fed will report its holdings for the prior week. Certainly, the CPFF program, along with several others, has helped smooth the problems in the short-term credit markets. Money-market funds have been buying higher-yielding assets rather than just the safest short-term Treasury bills, which yielded them 0% for several weeks. Investors have moved into "prime" money-market funds, which buy higher-yielding assets. Money-fund managers no longer fear the possibility of "breaking the buck," or having the value of each share fall below $1, given the myriad government programs that ensure liquidity to meet any surge in redemptions. Commercial-paper rates have also fallen to the point where borrowing from the Fed has become less appealing because it costs more than the open market does -- a phenomenon the Fed engineered. In the open market, companies can issue three-month debt at rates around 1% or less, where the Fed's rates are 1.24% for unsecured commercial paper or 3.24% for paper backed by assets' cash flows. The Commercial Paper Funding Facility isn't scheduled to expire until the end of April, but as Federal Reserve Chairman Ben Bernanke explained in a Jan. 13 speech in London, "unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities." The Fed's balance sheet has already shrunk since the start of the year, from $2.26 trillion on Dec. 31 to $2.04 trillion as of last Thursday. That said, it's still massively oversized from under $900 billion prior to Lehman's bankruptcy filing last September. About $60 billion of the shrinkage came from allowing an older, now unnecessary, liquidity facility to expire. About $135 billion is due to a decline in short-term lending facilities, which were heavily used by banks and other financial institutions to get through year-end funding pressures, according to Fed data. The remainder was due to modest ups and downs in a variety of facilities, and some currency valuation adjustments. Write to Liz Rappaport at liz.rappaport@wsj.com