The Fed’s Purchases of Commercial Paper Why and how did the Fed intervene in the commercial paper market during the 2008 credit crisis?

The Fed’s Purchases of Commercial Paper Why and how did the Fed intervene in the commercial paper market during the 2008 credit crisis?

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July 17, 2021
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The Fed’s Purchases of Commercial Paper

Why and how did the Fed intervene in the commercial paper market during the 2008 credit crisis?

Answer and ExplanationSolution by a verified expert

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Commercial paper refers to the money market security that is sold by large corporations so that they can get funds to meet debt obligations in the short term, and they are backed by the issuing bank or the company that guarantees to pay the face value on the maturity date.

Explanation
During 2008 and 2009, the Fed bought a huge amount of commercial paper, which it would normally not purchase. The strategy was implemented to offset the decline in the market demand for commercial paper because of the fear of the investors to default on commercial paper. Those fears were triggered by the failure of Lehman Brothers, which caused it to default on the commercial paper that it had previously issued. The investors made an assumption that if the asset quality of the Lehman Brothers was weak and therefore could not cover up for the payments made on the commercial paper, then other financial institutions that issued commercial papers and held mortgage-backed securities may also have a similar outcome.

Verified Answer
The Lehman Brothers faced a failure in the year 2008 when they defaulted the commercial paper that they issued, leading to a fear among the investors that the other financial institutions that held huge amounts of mortgage-backed securities may also default on their commercial paper. As a result, the investors stopped purchasing commercial paper in the secondary market, resulting in it becoming illiquid and making it increasingly hard for credit to obtain. The Fed bought a huge amount of commercial paper so that it can boost the confidence of the investors and restore liquidity in the market.

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