Updated from 7:22 a.m. EDT

The Federal Reserve on Monday announced a new mechanism through which the government can buy massive amounts of unsecured short-term debt in an effort to unclog credit markets in the U.S.

The Fed said the commercial paper funding facility will buy three-month unsecured and asset-backed commercial paper directly from eligible issuers, including nonfinancial businesses, as well as commercial banks and investment firms. Many companies rely on the short-term financing mechanism to finance their day-to-day operations.

The Treasury Department will make a special deposit at the New York Fed to support the facility. The Treasury believes the facility is needed to prevent "substantial disruptions" in the economy and financial markets, as money market mutual funds and other investors have become increasingly wary of buying commercial paper in recent weeks, the Fed said.

"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," the Fed said in its statement. "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."

Meanwhile, the Fed on Monday took two steps to boost liquidity amid the stalled credit markets, saying it would begin paying interest on bank reserves it holds and increasing the size of a securities lending auction program.
This article was written by a staff member of TheStreet.com.

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