Let CIT Fail: The Business Model Is Broken

The FDIC has spoken... and they are unwilling to guarantee CIT Group's (CIT) bond sales. This is an extremely positive step in the recovery process, in my opinion. Broken businesses MUST be allowed to fail.

From Bloomberg:

The Federal Deposit Insurance Corp. is unwilling to guarantee CIT Group Inc.’s bond sales because the commercial lender’s credit quality is worsening, according to people familiar with the regulator’s thinking.

The FDIC, which has backed $274 billion in bond sales under its Temporary Liquidity Guarantee Program since Nov. 25, is concerned that standing behind CIT debt would put taxpayer money at risk, said the people, who declined to be identified because the application process is private.

Credit Ratings and "Raw Material" Prices

Capital is a lender's raw material. As with any business, if the cost of your raw materials increase, your profitability will suffer (especially if you can't increase prices to offset the increase in costs). This credit crunch has significantly increased the cost of capital for lenders and banks across the board, regardless of credit quality. A lender lives and dies by its credit rating. Their credit rating dictates their cost of capital. Without access to cheap capital the business model breaks down.

CIT has been downgraded to "junk" status by all three credit rating agencies. Their cost of capital has gone through the roof and the FDIC is refusing to lend (no pun intended) a helping hand by guaranteeing their bonds. This is huge problem for CIT because the company has a $2.1 billion credit line maturing in April 2010. If CIT can't refinance this facility (which is looking more unlikely everyday), the company will default and it will set off a downward spiral that may be impossible to recover from.

CIT's Business Model is Broken!

I think that there is virtually no chance that CIT will recover from this. Like most other banks, CIT is paralyzed by the bad assets that are on its books. CIT is a "zombie bank". The company can't continue lending because its cost of capital is too high and it will eventually bleed to death from its deteriorating portfolio.

This is not something that happened overnight. CIT got greedy in the credit boom and they entered into bad reward-to-risk trades. Part of the blame can be attributed to the fact that CIT is a publicly traded company, that is in large part judged by its quarter-over-quarter asset growth. The only way you could grow assets the past few years was to be a market-taker. CIT knew that the risk was mispriced, but they bought it anyway (forbid they would not meet or beat the street's asset growth targets). By looking at a monthly chart (see below), you can see that no one was really fooled. The stock fell off a cliff in mid-2007 and it has never recovered.

CIT is NOT a "Value" Play

If you bought Citigroup (C) and Bank of America (BAC) back in March at $2 or $3, the trade has worked out pretty well for you. However, don't be fooled into thinking that the government is going to continue to support bad banks. The "systemic" risks were definitely mitigated by bailing out the large, "too big to fail" financial institutions... but CIT is not "systemically important" according to the FDIC.

CIT will likely be liquidated and sold off in pieces, but I think the equity is worthless. Don't be fooled, CIT is NOT a value play. If your currently long the stock, I would take your $1.30 and cut your losses...

Disclosure: No positions

Comments

[Jacky:]

@Paul

Thanks for your constructive advice. I think i have to monitor closely on the current news for latest update.

Jul 11 04:33 PM

[Lefly:]

You've got it backwards: the principal reason that CIT is struggling now is that the FDIC has been dragging its feet on approval for the TLGP application, which has led to an erosion of confidence from ratings agencies like Fitch (they've said so themselves)-- who have become over-reactionary, feeling heat from being basically the shills for bad investments.

It's a Catch-22: Effectively, CIT is being starved to death, because on the one hand, middle-market businesses are unable to borrow money from CIT, because its ratings have been cut; and its ability to issue bonds is hampered because the TLGP application has yet to be approved.

However, CIT could easily recover if the perception was that the Fed is going to support it. Its bond would have higher ratings, and it would be able to have access to liquidity.

Jul 11 06:14 PM

[Voice of co...:]

Of course the same rules should be applied to ALL companies, regardless!

Apparently, CIT didn't make a sufficient number of political contributions to enable them to be bailed out like the broke banks and investment firms.

Jul 11 08:53 PM

[Paul Price:]

CIT has too much risk and should be allowed to fail because it made bad/risky loans to small businesses.

NOW Comrade Obama wants to take $700 billion of taxpayer money to ... lend to small businesses through the SBA.

Brilliant!

Jul 12 08:41 AM

[wheelbarrel...:]

LOL is that Kudlow? Everywhere I look you're pumping stocks


On Jul 10 03:46 PM BPYHO wrote:

> I agree you definitely dont want to be long but think its a perfect
> trading stock and now is a good time to buy 1-2k of shares. One could
> bank a quick 10-25% profit. Next week the banks will put up better
> #'s then expected and the euphoria should propell this stock to close
> to 2$ regardless of the fundementals of CIT.

Jul 12 10:27 AM

[wheelbarrel...:]

GIve the man a cigar - yes the new theme is that the government can do it better ( pause for laughter).


On Jul 12 08:41 AM Paul Price wrote:

> CIT has too much risk and should be allowed to fail because it made
> bad/risky loans to small businesses.
>
> NOW Comrade Obama wants to take $700 billion of taxpayer money to
> ... lend to small businesses through the SBA.
>
> Brilliant!

Jul 12 10:32 AM

[BunkerBob:]

Good Article... their mgt team always had their own set of self-interest strategies. I'm glad they're going away.

Jul 12 10:38 AM

[Moon Kil Woong:]

Too bad we didn't get firm on insurers back when AIG was failing. Oh, I guess that's because Paulson who ran Goldman was in charge and they owed a brunt of their money to GS. I suppose CIT's real failure was that they didn't buy Goldman's bad assets.

I'm glad the government won't back GS. Unfortunately, I don't think this is due to an etical about face. Rather, I think it is mainly because the FDIC can't even afford to cover the banks anymore.

However saving AIG and not CIT is also, once again, a great demonstration of the arbitrary and capricious nature of government intervention. Perhaps with a dash of corruption and crony favoritism thrown in.

Jul 12 12:57 PM

[Graham Jervis:]

To the Author,

would you look into ZION, i think they are in a bit of a spot also, wouldnt mind an expert like yourself just confirming what i think is bankruptcy within a year.

Jul 12 02:28 PM

[spider42000:]

A good article generates a lot of good comment like this one did. An article on AIG would be of equal or greater interest, but more difficult its situation is not as transparent as CIT's

Jul 12 07:01 PM

[EttU:]

Both CIT and AIG should be allowed to go bankrupt, sooner better than later. But before doing it there has to away of clawing back the millions which their executives took out.

It would be nice if the GOV/we taxpayers get back apart of the $'s that were pumped into those company's. They played a huge part in destroying our economy and their names should be wiped clean off our public vocabulary.

Jul 12 08:27 PM

[Relative Le...:]

The CIT saga continues...the WSJ just posted an article titled "CIT Group Scrambles to Survive, Avoid a Run ".

Apparently, CIT has almost $4 billion of undrawn commitments outstanding. This is a huge problem since the company is having major liquidity issues right now. If weary borrowers all try to draw down at once (out of fear that CIT won't be able to fund), it would exacerbate CIT's issues and it may cause them to seek bankruptcy protection sooner rather than later.

Since banks typically don't have to reserve full capital for undrawn commitments, my guess is that CIT doesn't have $4 billion of availabilty right now. If enough borrowers draw down, CIT will eventually become a defaulting lender and the downward spiral will accelerate...

Jul 12 10:06 PM

[User 446166:]

There's always a FIRST !


On Jul 10 09:47 PM shrike wrote:

> Don't schedule the funeral for CIT yet - Goldman Sachs extended a
> $3 billion credit line to them last June and they rarely make loans
> to deadbeats.

Jul 13 12:34 AM

[Arthur Hau:]

Why is the FDIC looking at the credit rating of a bank to determine whether to lending money to it?

The FDIC was created to protect people who have deposited their money into commercial banks. Eventually, if CIT is liquidated by itself under the current mess, it is worth nothing and the FDIC is responsible for the loss of the savers.

On the other hand, why is the Fed doing nothing? The Fed is the lender of the last resort. It should be able to determine whether CIT's problem is a liquidity or a solvency problem. If it is the latter, then the Fed should nationalize CIT just like what Bank of English did to Northern Rock. And then it should clean up CIT's balance sheet, arrange for appropriate actions to help out current debtors and creditors, and eventually liquidate its assets. If it is only a problem of liquidity, the Fed should stand ready to back it up. In the long-run, CIT should be able to stand on its own feet.

Whether CIT is big or not big and whether CIT has a good or bad credit rating is not the key here. Citing the credit ratings of some private credit rating companies simply means that government agencies or quasi-angencies do not want to take any responsibility of their own actions. Don't government agencies have their own accountants, financial analysts, and economists who are capable of doing some research?

Jul 13 12:55 AM

[spope33:]

It's ironic that the Feds compain about banks who take TARP money and just sit on it rather than lend it out, yes there is no positive response to a bank like CIT who does lend it out to average mainstreet businesses.

Like they say, no good deed goes unpunished.

Jul 13 12:59 AM

[Mr. Ed, Jr.:]

Hopefully, we are at the end of the line (and America's patience) with propping up failed companies.

But, CIT also has the bad luck of being in a very bad place at a very wrong time: The administration needs to prove to an increasingly concerned citizenry that they really are capitalists, and CIT fits the bill as "just big enough to fail".

That will allow more politically connected competitors, like GE Capital, to pick up some of the slack, while providing the administration with the best argument it could have for increasing lending (and another layer of control) through SBA --that the government needs to "help out" now that CIT is gone.

More money for SBA loans just means more opportunity for the government to influence who succeeds and who fails. It means more opportunity for corrupt politicians (Yes, that is now, more than ever, redundant) to make their influence-peddling phone calls on behalf of campaign contributors. And absolutely no time to read the bills they are voting on, as if that matters any more. (By the way, bills are now being passed with more and more "holds" in them-- blank spaces to be filled in after the bill is passed. And Obama, who made a campaign promise that he would not continue with Bush's contemptible "signing statements", is now using signing statements.)

This government is all about getting its hooks into everything it can. Letting CIT go under because they "don't want to risk taxpayer money" is good for a laugh.

Slippery slope, indeed.

Jul 13 04:12 AM

[Jacky:]

CIT is saved!!! at least for the time being....

Jul 13 02:01 PM

[Relative Le...:]

Jacky - If by "saved" you mean an imminent bankruptcy filing...then, yes, "CIT is saved"...

Jul 13 02:59 PM

[pdub271:]

CIT is small enough to fail (in dollar terms), since they only need ~10 billion tops. But they're really important for small businesses in the short term. So why not spare some peanuts to help the recovery along, more bottom-up style? Screw AIG's debt to Goldman, we should have forced that to be written off. Goldman's riches from ruthless profiteering playing financial "hot potato" is far, far more than enough to cover CIT.

I mean, after blowing 700 billion on bail outs (not to mention 600+ billion more on health care....), are we really going to get all stingy with peanuts of 10 bil, and risk disrupting tons of small businesses during the most important part of the year for retail? Small businesses don't deserve any more disruptions caused by fat cat financials and bloated government spending and agendas.

Jul 13 10:57 PM

[wheelbarrel...:]

Here is your answer

AIG - huge obligations to GS that wouldn't get paid out if AIG failed so they get a bailout

WAMU - no counter party risk, not part owner of the Federal Reserve - bye bye

Wachovia - no counter party risk, not part owner of the Federal Reserve - bye bye

CIT - owes 3 billion to GS but GS is holding collateral so as long as GS can collect even if CIT goes BK they won't get a bailout either IMO


On Jul 13 12:55 AM Arthur Hau wrote:

> Why is the FDIC looking at the credit rating of a bank to determine
> whether to lending money to it?
>
> The FDIC was created to protect people who have deposited their money
> into commercial banks. Eventually, if CIT is liquidated by itself
> under the current mess, it is worth nothing and the FDIC is responsible
> for the loss of the savers.
>
> On the other hand, why is the Fed doing nothing? The Fed is the lender
> of the last resort. It should be able to determine whether CIT's
> problem is a liquidity or a solvency problem. If it is the latter,
> then the Fed should nationalize CIT just like what Bank of English
> did to Northern Rock. And then it should clean up CIT's balance sheet,
> arrange for appropriate actions to help out current debtors and creditors,
> and eventually liquidate its assets. If it is only a problem of liquidity,
> the Fed should stand ready to back it up. In the long-run, CIT should
> be able to stand on its own feet.
>
> Whether CIT is big or not big and whether CIT has a good or bad credit
> rating is not the key here. Citing the credit ratings of some private
> credit rating companies simply means that government agencies or
> quasi-angencies do not want to take any responsibility of their own
> actions. Don't government agencies have their own accountants, financial
> analysts, and economists who are capable of doing some research?

Jul 14 08:21 AM