UPDATE 1-US commercial paper market contracts for 3rd week-Fed

(Adds analysts quotes, background)

By Chris Reese

NEW YORK, Oct 2 (Reuters) - The U.S. commercial paper market contracted dramatically for a third straight week as business lending and borrowing effectively shut down, Federal Reserve data showed on Thursday.

The weekly drop was the largest in at least seven years for commercial paper, which is a vital source of short-term funding for daily operations at many companies. Over a quarter of the market has disappeared since the start of the global credit crisis in the summer of 2007.

For the week ended Oct. 1, the size of the U.S. commercial paper market fell by $94.9 billion to $1.607 trillion, from $1.702 trillion the previous week, Federal Reserve data showed. That brings the cumulative shrinkage of this market to $208 billion in the last three weeks, including the previous week's $61.0 billion fall.

Banks' distrust of lending to each other has pretty much seized up interbank lending markets, with many hoarding cash for fear that some short-term loans might not get repaid. Analysts say similar fears have clogged the commercial paper market.

"There is almost no area of credit markets or even of the banking system where companies are raising money -- banks are not lending, it's just unbelievable," said Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co. in New York.

And the dire situation for company funding could get worse, Crescenzi warned.

"Commercial paper matures on average within 30 days to 45 days. There are lot of rollovers to come. It could be very, very problematic if this isn't fixed soon," he said.

Congress is expected to complete action this week on a $700 billion Wall Street bailout bill that would buy bad mortgage-related assets from banks. The bill is intended to unlock credit markets and possibly divert a deep economic downturn.

"This is a direct link between the credit market turmoil and the real economy," said Lou Brien, market strategist at DRW Trading in Chicago.

In addition to the government rescue plan, the squeeze on commercial paper market also bolsters the case for the Federal Reserve to further cut their recommended overnight lending rate between banks, from the current level of 2 percent, Crescenzi said.

"The (commercial paper) declines add to the urgency for fixes to the credit crisis and bolster the case for a Fed rate cut," he said.

As an example of how the lock-up in commercial paper is hurting companies, the Wall Street Journal reported on Thursday that USA Today publisher Gannett Co Inc (GCI.N) had drawn on a $3.9 billion credit line due to the stalled short-term credit markets. (Additional reporting by Richard Leong and John Parry: )