CIT's Debt Issues Show Why the Economy Won't Be Picking Up Any Time Soon

CIT is an example of the kind of problems still facing the economy. CIT has taken on legal counsel in order to determine whether or not it should go into bankruptcy. The problem, the company has $2.7 billion in debt coming due through year end and its credit-rating has been cut “deep into ‘junk’ territory.” It has been seeking liquidity help from the Federal Government but has not received approval yet.

Debt is the problem and it currently continues to haunt most businesses, governments, and individuals in the economy. It is a problem because this debt load has to work itself out. But, in working out the debt problem, the economy suffers and will continue to suffer.

The current debt crisis is so severe because of the credit inflation created by the U.S. Government over the last eight years or so. During expansions, credit inflations take place. This is what happens as the economy is stimulated and confidence in the private sector builds and things appear to be good and getting better. Credit inflations don’t have to directly result in general price inflation, although they can end up with this result.

In the 1990s as well as the 2000s we have had credit inflations where price increases have been relatively mild. In the 1990s we saw the stock market bubble and the credit inflation with respect to new ventures. However, during that decade we saw the federal government turn a deficit budget into a surplus budget by the end of the century. In the 2000s, we saw the housing bubble and the general credit inflation, but we also experienced a huge increase in government debt on top of everything else. Debt was good and most partook of it!

If the credit inflation during a period of economic expansion is not too excessive, then the following correction that must take place can be relatively mild and reasonable and the government can come in and reflate the economy so that the financial dislocation can be righted in a reasonable amount of time without too much “hurt” in the economy in general. Moral hazard is created, but what’s the problem with a little moral hazard? Right?

This is what happens in most minor recessions.

An exception occurred in the credit inflation of the 1970s. President Nixon was so paranoid about getting re-elected that he set about inflating the economy and connected this with taking the United States off the gold standard, floating the dollar, and freezing wages and prices. This philosophy was not abandoned by President Ford. Jimmy Carter just inflated, period. And, by the end of the decade, serious work had to be done to bring general inflation under control.

What happened in the decade of the 2000s was of a totally different nature. The debt structure that was created through this decade’s credit inflation could not be sustained. Debt was growing way more rapidly than the economy could support and the resulting imbalance was greater than at any time since the Second World War. Almost everyone was excessively over leveraged. The headlines focused first upon the subprime market and then upon Structured Investment Vehicles (SIVs) and the Collateralized Debt Obligations (CDOs). And, then it became apparent that this excessive leveraging had been going on everywhere in the economy. And, the federal government was right up there with everyone else.

There is too much debt out there! Yes, there is deficient aggregate demand, but that is not going to be corrected until the debt situation is corrected...no matter how much Paul Krugman and the Keynesian wing of the world cry out! People and businesses are going to have to get their balance sheets in order before private spending will really pick up. Unless, of course, the government is able to get a hyper-inflation going again which is the classic solution for an economy with too much debt.

There are three ways for economic units to reduce debt. The first is to sell assets and pay off the debt. However, if people are uncertain about asset values this solution to the debt problem is not going to work. Second, economic units can save out of income and revenues and pay down their debt. This, of course, is the soundest way to de-leverage, but it is also the slowest way to reduce the debt on a balance sheet. The third way to reduce debt is to renounce the debt: that is, declare bankruptcy. This solution does have repercussions, however, on the value of the assets of other people and other businesses.

A firm with too much debt can face another problem. Debt matures and sometimes has to be refinanced. The problem here is that a company may not be able to refinance the debt that is coming due. In such cases, these firms will either be forced into the first way of reducing debt, selling assets and perhaps taking a loss on the sale of the assets, or they will have to renounce the debt by declaring bankruptcy.

One sees CIT examining its resources to decide what is its best option. The second option does not seem to be a viable option because CIT doesn’t have sufficient time to generate enough revenues so that it can pay down its debt. So, it is looking at a situation where it has a substantial amount of debt maturing in the next six months or so. Refinancing is an option, but with its bond ratings reduced to the ‘junk’ category, this could be quite expensive and could produce negative cash flows so that earnings could not provide revenues to pay down debt. Thus, CIT could sell off assets to generate cash to pay off the maturing debt. But, how much does CIT stand to lose if it sells off assets?

If these are the scenarios, then it is good that CIT is getting advice on declaring bankruptcy. This still presents a problem. As people see this possibility facing the company, why should short term lenders continue to help finance the company and why should borrowers continue to borrow from CIT, a company that may not be there tomorrow? Also, on Monday morning investors dumped the company’s stock.

The fact of the matter is that there are many companies, governments, and individuals (and their families) that face this situation right now. And it is very, very scary.

The question is, given these problems, why should these economic units spend? They have a debt problem. And, with rising unemployment and more and more debt coming due in various sectors of the economy, like commercial real estate, why should we expect people to pick up their spending in the near term? There are other, more pressing issues to deal with. This is why the economy is not going to start to pick up much speed soon.

Almost every week there is a new “CIT” that we read about. These companies are too big to ignore. And, that is what is so worrisome. How many more of them are there?

Something else that is worrisome as well. When banks are closed by the FDIC, the general operating procedure is to place the deposits and good assets of the closed bank with a healthy bank. Word is that there are not that many healthy banks around. Thus, the deposits and good assets of banks that are closed are not being placed with healthy banks (See “FDIC’s Challenge with Busted Banks”). So, we now have more banks that have been focused on their own problems taking on the problem of integrating the deposits and good assets of closed banks which can’t help but divert their attention from their own problems. As of last Friday, 53 banks have been closed this year and the expected total of bank closings for the year is over 100. If we don’t have a lot of healthy banks around now to take care of the current crop of banks that are closing, what are we going to do for the rest of the year?

Comments

[DannyBoy29:]

What about a fourth alternative, converting debt to equity? Granted it would be dilutive to current equity holders and may not be an option in all cases, I doubt CIT’s bond holders want a potentially worthless stock, but in many cases it is a viable alternative.

Jul 14 02:16 PM

[Mase:]

To me, this would come under the third option, "renouncing the debt". Nassim Nicholas Taleb and Mark Spitznagel suggest this in their Financial Times article this morning (www.ft.com/cms/s/0/4e0...). The existing shareholders have already given up their rights by not paying attention and letting the company go "down the tubes" so diluting the current equity holders is not the issue. The question then is what does providing the equity exchange do? Taleb and Spitznagel argue that the world has changed and is more volatile, therefore, debt is riskier than it was before. Because of this more equity should be involved in any financing decision.
Who disagrees with this? But, what is getting equity for your bonds? It is basically renouncing the debt of the company on a gamble that the company will get its act together. This can also be done through bankruptcy.


On Jul 14 02:16 PM DannyBoy29 wrote:

> What about a fourth alternative, converting debt to equity? Granted
> it would be dilutive to current equity holders and may not be an
> option in all cases, I doubt CIT’s bond holders want a potentially
> worthless stock, but in many cases it is a viable alternative.

Jul 14 02:53 PM

[conceptwizard:]

This has to end...we have to stop backstopping, bailing and everything else. We have to allow the free market to aborb the weak and let the strong prevail. Government intervention at the expense of the taxpayer is not what we voted into office. We voted change, complete and utter , groundbreaking change. What we got was more of the same times infinity.
The Government is just delaying the deleveraging process by selling us out. We will deleverage anyway, we have to to be able to start over from the bottom wherever that is. The bottom has been made cloudy by Obamanomics.
Do not bail out CIT or anyone else, and their will be a too big to fail yet to come believe me.
The Government must start deleveraging as well, debt reduction has to be the name of the game from here on in. We can not afford anymore period.

Jul 14 05:06 PM

[j_remington:]

This week Goldman has options positions to unwind for July. Next week we will see the bad news.


On Jul 14 05:06 PM conceptwizard wrote:

> This has to end...we have to stop backstopping, bailing and everything
> else. We have to allow the free market to aborb the weak and let
> the strong prevail. Government intervention at the expense of the
> taxpayer is not what we voted into office. We voted change, complete
> and utter , groundbreaking change. What we got was more of the same
> times infinity.
> The Government is just delaying the deleveraging process by selling
> us out. We will deleverage anyway, we have to to be able to start
> over from the bottom wherever that is. The bottom has been made cloudy
> by Obamanomics.
> Do not bail out CIT or anyone else, and their will be a too big to
> fail yet to come believe me.
> The Government must start deleveraging as well, debt reduction has
> to be the name of the game from here on in. We can not afford anymore
> period.

Jul 14 06:57 PM

[BPYHO:]

CIT is a bank that actually HELPS small businesses..... I HATE the bailouts However, of all the banks that have already been bailed out, CIT definitely more worth!

Jul 14 07:11 PM

[User 422955:]

I never saw the phrase "credit inflation" before. When I searched it on Google, most of the results came back with a punctuation mark in between the two words. Punctuation changes the meaning, since the two words no longer form a single phrase.

Here on SA, some time ago, I read excellent material on financial panics. The authors argued that we are in a financial panic, not a recession or depression. I hadn't seen the phrase, "financial panic", before, either. However, there is lots of material available on financial panics. They are caused by the explosion of credit bubbles.

The author, John Mason, says that "credit inflation" was caused by the US government. On the contrary, the credit expansion was caused by the Chinese government, which extended too much credit to the US government. Banks and other financial intermediaries created too much credit by employing too much leverage. &c., &c.

Jul 14 07:39 PM

[Tack:]

Although it may surprise some, CIT has shown positive cash flow continuously for the last five years. The company does not have unmanageable financial problems; it suffers from a worse enemy: manfactured fear.

CIT's problem is the classic liquidity trap, aided and abetted by well-timed, fear-inducing media reports and the actions of short sellers and CDS holders, who wish to see CIT's lender's scared away from renewing credit lines, thereby causing the company to fail. If CIT's credit lines are rolled over, as would routinely occur in normal times, then they have no problems that can't be internally managed through the recession and recovery cycle.

The failure of the Feds to confirm guarantees to CIT, after specifically allowing them to qualify for funding, smacks more of politics or scheming than any sound business judgment. First, the public squawks about "bailouts" when they have little or no understanding of the mechanics or what is at stake. Second, because classic lending models are seen to be more in favor for the future of the post-crisis financial world, rather than the exotic instruments of the recent past, CIT's borrowers are likely coveted by some behind-the-scenes forces (i.e., big banks) that previously would have had little interest in the firm's business sectors. No doubt, some would welcome buying CIT's business units out of bankruptcy and/or FDIC seizure for pennies on the dollar.

It will be interesting to see which forces win the current tug of war.

Jul 14 07:40 PM

[Biobob:]

The knee-jerk reactions followed by after-the-fact reasoning and explanations of why these extroardinary actions had to be taken, starting back in the fall of 2008 smack of cronyism and an all too close relationship between the Treasury, the Fed regulators, and the regulated banks. The revolving doors between the Gov't. and the handfull of "too-big-to-fail" banks are obvious, and have been noted for some time. Because of these connections, oversight has been clouded by opportunistic greed, and even the sanest of actions (like insuring leveraged risk was covered by adequate capital reserves) were ignored.

The answer I believe, is to force a moritorium of one year on anyone leaving a top spot in Treasury or the Fed, from taking a position in any of the banks that are subject to regulation by those bodies. People like Paulsen, Bernanke, and Geitner should take positions in academia for a year, or another closely related field, to make a clean break, and leave no indications of conflict of interest between their jobs as regulators, and as highly paid executives of the very companies they regulated. My employment contracts with all of the high tech computer companies I've worked for during my career had such clauses incorporated, which I had to sign. I find it almost offensive that these public-minded people will work so hard to get into these government positions, and at the end of their tenure, argue that "It's unfair to prevent me from working in my chosen field, because I sacrificed a lucrative private job so I could serve my country as a public servant." They want their public-mindedness to be one-way only - for their advantage.

I think if they knew they weren't going to immediately reap monetary rewards for their "public-minded zeal", we might get people who are more willing to take on the necessary regulatory steps to keep the economy on track, without the conflict of worrying about how their future employers viewed their public office performance.

Jul 15 12:07 AM

[Ryu Mei Co:]

The recent rally of CIT share price, in my opinion, indicates the Market is betting on the US government bailing out CIT. Frankly, I do not want to play this US government is bailing or is not bailing out company game anymore. It is not worth a few sleepless night over it. If US government did not want to help CIT, then let CIT take the poison pill quickly rather than delaying the inevitable.

Jul 15 01:20 AM

[whidbey:]

It is China's fault, they should never have screwed up and trusted us! Makes one wonder if it was not entrapment. Disgusting to one's weaknesses exploited in this way.

Bankruptcy is the answer and it might start something when on the zombies see how well it can go with a good judge. We could clear up GM, C, and god knows many more and return the assets to work.

Jul 15 01:36 AM

[Ryan Barnes:]

Is anyone else curious as to the incessant use of the term "credit inflation"? It's really not a legitimate phrasing, as it confuses what I imagine to be the author's intent with inflation's proper etymology, which to describe a rise in price level.

So unless the author is making a broad statement about interest rates, how about we just use what the other 99.9% of folks use. Credit expansion, credit growth, there's plenty of other options folks.

Jul 15 10:18 AM

[Steven Reed:]

What about us national debt just hitting 1 trillion?

The economy is in the tank and what is really being done as we sink into quick sand. Since around 1998 I have promoted developing technology parks in Missouri and this spring around 15 state representatives were on board. I even pushed for a bill that would allow all industrial parks to be changed in name and concept to technology parks. Indiana passed similar law a few years ago that allows cities to apply to establish as Tech Parks. technologypark2006.org and nonewtaxes.4t.com are websites with information on the issue.

We have the problem of not having a national economic plan, or transportation like rail, and environmental plans. Does global economy (our wages lowering while theirs rise), and service industry (we do not make things they come form overseas), ring a bell? We need new innovations to start making products of the future now. Can our government say emergency? It is going to take more than a few road projects and giving money to banks (like Bank of America that is so bloated they do not know how to help save people in trouble). Hello, we have problems of the magnitude that I think we may end up seeing 50 separate states if we do not wake up. Companies are saying hire no more get by with what we can. VP Joe Biden does get it! And then the report China’s GDP is going to grow 8% this year!

Sincerely,

Steven L. Reed
stevenlloydreed@hotmai...
1441 South Estate Ave.
Springfield, MO 65804
417-882-2942

Jul 15 10:45 AM

[CLH:]

John the market says you are wrong. The market has been soaring since March. The market predicts the economy by 6 to 12 months. I believe the market and not you.

Jul 15 11:19 AM

[helplessobs...:]

WOW, this is a great post and comments are outstanding. Hats off to all.

Jul 15 11:55 AM

[Gregman2:]

"The third way to reduce debt is to renounce the debt: that is, declare bankruptcy." It's a catchy title for your new book: "The Third Way.";-) By the way, excellent post, thank you. The third way is the only way to efficiently and rapidly get on with things...consider the GM bankruptcy.

Jul 15 12:40 PM

[c smith:]

...and why should borrowers continue to borrow from CIT, a company that may not be there tomorrow?

Dumb question. If I'm a CIT creditor, not only do I want to continue to borrow from CIT, I want to DRAW DOWN whatever lines I have w/CIT immediately. This is what is, in fact, occurring.

Jul 15 01:48 PM

[Andy Romanoski:]

Appears as if CIT was a great example for this article as it finally madie its declaration on Sunday....

Nov 03 02:33 PM