By Neil Irwin and Steven Mufson
Washington Post Staff Writers
Tuesday, October 7, 2008; 12:31 PM

The Federal Reserve, in a bold new attempt to jump-start the lending that is the lifeblood of American business, said it will buy up the short-term debt that funds the daily operations of banks and ordinary businesses.

Using its emergency authority for the third time this year, the Fed will create a special entity that will purchase "commercial paper," the debt that companies use to fund their inventories, payrolls and other short-term cash needs. The Treasury Department will help fund the program.

Problems in the commercial paper market have been one of the most direct ways in which the financial crisis has threatened to affect the nuts and bolts economy. Banks and financial firms have become hesitant to lend, and companies have worried about raising the money needed to pay their bills.

Today's radical move by the Fed puts the central bank in the position of funding individual financial institutions and ordinary companies, even with "unsecured" debt, or that which is backed only by the company borrowing money, rather than with specific collateral.

There is no cap on the size of the program, senior Fed staffers said, other than the size of the total universe of eligible commercial paper: $1.3 trillion. Fed officials do not anticipate taking on anywhere near that much debt, but rather are hoping that private buyers of debt will feel newly confident knowing that the central bank is available as a backstop.

Critically, the Fed will buy debt that is for three-month terms. Lately, a wide variety of companies have only been able to borrow money overnight. That has put them in the precarious position of having their fates decided every evening, as lenders must again review whether to renew the loans.

By having the government ready to buy slightly longer-term debt, that source of uncertainty should be diminished, Fed staffers are hoping.

The $1.3 trillion of available commercial paper includes about $600 billion worth that is backed by collateral, such as a business's accounts receivable. The remainder includes another $600 billion issued by financial institutions that is not backed by collateral and $100 billion from non-financial companies that involves no collateral.

Companies that sell money to the Fed entity without collateral will have to pay an insurance fee to protect the government against the risk that they go under.

The Fed entity will pay interest rates that are lower than the extremely elevated rates of recent days, but still higher than what the companies could borrow at in normal times. That way, once financial conditions return to normal, the companies needing money will naturally migrate back to private markets so as to get lower borrowing costs.

The Fed program was instituted under an emergency authority it was granted during the Depression to lend to any "individual, partnership or corporation," in "unusual and exigent circumstances." It also used that authority to engineer a buyout of Bear Stearns in March and to take over insurance company American International Group in September.

With financial markets in near-meltdown, governments around the world have been scrambling to find new ways to infuse vast amounts of cash into banks and even directly to companies to help resuscitate the global financial system.

The Fed yesterday said it would push $900 billion into the U.S. banking system, a six-fold increase in its program of lending money to banks.

The measures followed similar efforts by other central banks and governments around the world over the weekend and yesterday to get financial institutions to stop hoarding money and start lending to one another and to their customers.

It wasn't enough. Stock markets began a steep tumble in Asia, where most national markets were down considerably, and then declines accelerated in Europe on fears of new bank failures. The French stock index tumbled 9 percent, the German index dropped 7 percent and the British benchmark index fell nearly 8 percent. Russia was off nearly 20 percent. In the United States, the Dow Jones industrial average fell 3.6 percent, closing below the 10,000 level for the first time since 2004. It had been down nearly twice that at one point before staging a late rally.

With the financial crisis now engulfing most of the developed world, a meeting scheduled for later this week in Washington of the International Monetary Fund and World Bank will probably turn into a summit that could provide a forum for coordinated action.

But there was little sign of coordination among European leaders, who could not agree over the weekend on a common approach to the crisis and who yesterday bickered over what sorts of protections they would offer investors and institutions.

In the United States, the Fed is hoping that its move into the commercial paper market will unfreeze lending. Another step it could take to try to jolt the financial system out of its current torpor would be to cut its target for short-term interest rates. The federal funds rate is currently 2 percent, and many financiers on Wall Street argue that an emergency rate cut, as early as today, would help the situation.

As recently as last week, there was no consensus at the Fed on whether additional rate cuts would make sense. Some leaders of the central bank worried that they would not serve their intended purpose of stimulating the economy as long as the credit markets were clogged. They feared that a rate cut could cause the dollar to drop and commodity prices to rise.

But in recent days, as the financial crisis has become more severe, an emergency rate cut, perhaps coordinated with other large countries, has become more plausible. Fed Chairman Ben S. Bernanke is set to deliver a speech today that will indicate his current thinking on rates.

Early today, Australia's central bank cut the country's benchmark lending rate by a full percentage point, to 6 percent, but the Bank of Japan left its key interest rate unchanged at 0.5 percent.

The deteriorating credit and economic picture has provoked an increasing amount of criticism of U.S. and European central bankers and has spread anxiety in financial markets that even the lenders of last resort might be stretched to their limits.

"The Federal Reserve balance sheet is about $1.2 trillion," said David Shulman, senior economist at the UCLA Anderson Forecast. "But we have an $11 trillion mortgage market, a $54 trillion credit-default-swaps market. The central banks are nowhere near large enough to handle this problem right now."

Edwin Truman, a senior fellow at the Peterson Institute for International Economics and longtime senior Fed official for international affairs, said that the Fed's rate cuts have had much less impact than intended and that the Fed needed to take action that would also bring down Libor rates, which are more closely linked to the rates businesses and consumers pay.

Economists also differ over the threats of inflation or deflation. Some fear inflation as a result of lower interest rates and a flood of money, much of it simply printed by the U.S. government, pushed into the financial system. That would have the effect of reducing the value of U.S. debts, harming countries like China but benefiting Americans.

Other economists say the world economy is on the brink of such a severe economic contraction that inflation should be far down the list of concerns. Investors and traders in commodities share that worry; yesterday, fears of global recession pushed crude oil prices down $6.07 to settle at $87.81 a barrel.

"We're facing the worst global downturn since the early 1980s, and you just don't have inflation in that environment," Truman said.

"The key thing is to restore confidence," said Liebert, the corporate treasurer. "Bernanke's been very proactive with the rescue plan, but investors have to feel that the worst is over. The headlines from Europe are unsettling the market now. A cut in interest rates right now are not going to help too much. The cost of capital is being inflated by the perception of risk."

In past financial crises in small countries, the IMF has often come to the rescue with a combination of capital and reassurance to investors and businesses. But the United States is too big for the IMF to bail out, and besides, a senior World Bank official said, the United States doesn't need more capital. Instead, the IMF will probably look for ways it can intervene in smaller industrial and developing economies to combat the effects of financial contagion.

"I think our role in this crisis is different from previous crises in that it started in the center of the financial system rather than the periphery," said Masood Ahmed, director of external relations at the IMF. He added, "in the end, this crisis is going to be sorted out by the policymakers of individual countries."

Staff writer Anthony Faiola contributed to this report.