“The commercial paper market is the thoroughfare where Wall Street merges into Main Street,” says former trader and hedge-fund manager Shah Gilani. The problem is the commercial paper market is dead. And the Fed can’t prop it up for ever. When the Fed’s commercial-paper buying scheme ends expect more bank failures.

This from Money Morning:

Neither banks, nor corporations, nor any other commercial paper issuers are able to raise significant amounts of money in the CP marketplace.

Almost all of the commercial paper being sold is only one-day paper. Because of systemic fear, one day’s risk is all most buyers are willing to stomach.

However, all CP issuers have long-term obligations, or liabilities that they need to continue to fund – in short bursts – by borrowing in the commercial-paper market. But there are no buyers, because buyers don’t want to lend to anyone on just their creditworthiness, and they don’t want to lend to anyone who is willing to back their CP with assets.

Why?

Because no one knows what those assets might be worth tomorrow. As far as the banks are concerned, it’s even worse than you think.

Not only did banks lend long to borrowers, banks borrowed short-term CP money to buy collateralized residential and commercial mortgage-backed securities for their own inventories or balance sheets.

Banks paid for these toxic assets by issuing commercial paper: They thought it was a great borrow-short/lend-long spread play. But when these short-term loans come due, they can’t “roll” them over.

Where are they going to get the money to pay back the investors who bought their commercial paper when it comes due – in one day, 30 days, 60, days, or however long they borrowed for? If no one will buy any more paper, that’s a big problem.

In fact, that’s a game-ending problem.

Enter the Fed, investor of last resort.

Between commercial-paper borrowings and floating-rate notes (which are similarly short-term borrowings, but for typically up to two years) for just financial institutions – not including industrial corporations and others – it is estimated that more than $1 trillion will have to be paid off by the end of 2009.

Now you know why the Fed has to backstop the commercial paper market. All these desperate short-term borrowers trying to fund long-term assets (loans and securities) will have to find other funding sources; all of which will be devastatingly more expensive than what they paid in the CP market.

As we’ve repeatedly pointed out, this credit crisis is exposing every weakness.

Source: Credit Crisis Update: An Inside Look at the Commercial Paper Debacle