Does Liquidating Bad Debt Start with CIT Group?

One prominent argument used by critics of the government’s actions since September 2008 has been that various programs – TARP, TLGP, etc. – have been used to avoid the reckoning needed to clear bad debts out of the system.

For a time, any new risks that emerged were dealt with through creative application of the rules (as with many “bank holding companies”) or, when that failed, by simply creating a new lending facility.

The government’s blessing likely saved many marginal institutions, and several larger ones as well.

The policy of saving everything that’s not Lehman looks ready to be put to the test, as CIT Group (CIT) is said to be unable to obtain help from the government. The stock now trades under $2/share, and the credit default swaps are flirting with a 40% up-front premium. For its part, CIT has argued that they provide key financing to small businesses, and should be supported while they work out things on their balance sheet. Without CIT, it continues, these companies might have their credit lines dry up, creating economic ripple effects.

I’m not going to speak in particular about CIT, but about the precedent – one way or another – that it could create. Why should you allow for failure?

• Clears competitive playing field for survivors
• Forces reconciliation of bad debts
• Rationalizes return expectations
• Promotes economic economic activity (double word intended)

The main theme is that profitability moves in cycles. The more competitors in a space, such as lending, the narrower the earnings spreads will be. Want to achieve ROE targets from a quieter era? Add more leverage to your declining ROA. That will do the trick, until the cycle turns and the quality of your loan book starts to raise eyebrows from those who lend to you.

The seemingly free lunch from borrow short, lend long has to have periodic shakeouts; it’s what keeps spreads healthy and allows some banks to make profits long-term.

Does government help certain businesses in many ways? Yes, point granted. But should government be responsible for making decisions about one-off bailouts every time a company gets in trouble? Letting a debt-laden company linger when the underlying equity is close to zero, especially by using taxpayer money, is implicitly transferring money to debtholders, as well as granting equity holders increased option value.

In other words, private capital wins all around, at the expense of public money. How this is good public policy eludes me.

“Rationalize” is often management-speak for “cut” – but that’s exactly what should happen in a recession. Letting failure happen shows that equity ownership, and debt lending, carries risks. It forces investors to think more carefully about allocating capital, and discourages reaching for high returns. If a company can execute a debt-for-equity swap to recapitalize, that’s great – but it stresses the point that a combination of high returns and safety can’t always be achieved through a full cycle, even at a senior position in the capital structure.

When firms disappear from the competitive landscape, it helps those with strong hands. Taking it a step further, it also impacts those who did business with the failed company. If you happen to be a smaller business, and your lender goes under, what happens to you? If you are a good credit, it shouldn’t be impossible to find another source of credit. Will it be more expensive?

Perhaps. But under-pricing risk on the part of your original lender led to their insolvency. The solution to that is to raise the associated costs, so that the lending activity is economic (i.e. value-creating) over a full cycle after appropriately provisioning for credit losses. This might be painful for some marginal borrowers, but it is ultimately what helps the system clear out and reset to one that allows for healthy growth.

Recessions cause pain. Often times it seems unfairly applied, but no good solution has been found. Losses have to be taken at some point, by someone – postponing the process simply leads to silent losses (decreased profits) through the opportunity costs associated with the unreasonably high competition that comes with subsidized businesses.

Up to this point, it has seemed that politicians have preferred the delay-and-pray, but a chance to change course has arisen. Hopefully, policymakers will start evaluating the viability of allowing failure to happen naturally across all industries, recognizing the immediately unintuitive outcomes may be in the best long-term interest of the country as a whole.

Disclosure: None.

Comments

[nyc female...:]

The author of this article obviously does not own any stock or bonds in CIT and therfore is not well infomed.Therefore,he has not been folowing some of the positive moves in CIT. CIT has paid the bonholders a steady 7% and has provided retirement income to millions of widows. CIT has done an excellent job at providing financing to milions of small business owners.
Also, several small business owners are depedent on their financing to run their daily operations as an alternative to bank loans.
CIT's collapse would have the same negative effect that the Lehman collapse had in the bond and stock market.
Also, a credit crisis with the collapse of CIT would adversely effect small business owners and this would be a disaster.
To bailout Goldman, Citibank, AIG and leave CIT out would be unethical and show favoritism and poor judgment from Washington.

Jul 15 08:05 AM

[Help Wanted:]

When firms disappear from the competitive landscape, it helps those with strong hands. Is that what you said? Why do those firms now have strong hands? In large part, it was because of the aid the government gave them, but refused to give CIT. Let's look at Citigroup (last issued TLGP debt on 6/25/09) and GE Capital (last issued TLGP debt on 6/19/09). These are examples of the "strong hands" you are talking about, which are still issuing FDIC-backed debt. Sheila Bair is a joke. She has balked at providing CIT with access to the TLGP because the move would expand it beyond its original purpose of unfreezing credit markets last fall. Yet, here are 2 companies that have issued such debt within the last few weeks. I also firmly believe that CIT's ratings would be nowhere near where they are today had the FDIC given CIT access to TLGP before now. This is yet another misstep for the agency. GE Capital certainly would not be a double-A credit had it not been allowed to issue ~$45 - $50 billion in FDIC-backed debt. CIT became a bank holding company so that it could move its lending operations into its bank and issue at attractive rates. This is a long-term profitable solution for a company with strong historical performance. Unfortunately, the FDIC is standing in the way of implementing this solution in spite of the fact that it approved its holding company status 9 months ago (when it was an investment grade-rated credit by all 3 agencies).

Jul 15 08:43 AM

[john s. gordon:]

author assumes that CIT failure would permit other entities (e.g., GE capital) to take up the slack & provide necessary loans to small & medium size businesses.
said assumption is false.
GE capital is in no shape to perform this function, and the effect on small & medium businesses will be devastating.
> jack

Jul 15 08:57 AM

[James Cullen:]

We shouldn't judge a company's societal value by its ability to make payments to bondholders... millions of widows? Is this Seeking Alpha or Miss America?

Favoritism and poor judgment from Washington? Sounds like par for the course. Yes, it is unfair to let CIT fail after savings others. Most of us were told life is unfair in kindergarten. Every company on the brink will come up with important functions it fulfills, so where, if ever, do you draw the dividing line between companies that get saved and those that don't?

As for providing financing... there are plenty of companies that worked to achieve the noble goal of helping people afford homes that are no longer in business - we call them subprime lenders, and actually look down on them quite a bit. Again, the entire idea is to reward those who took smart risks, and not save those who were overleveraged or overplayed borrowing short. Just because we can't go back in time and undo prior bailouts doesn't mean we're obligated to save everyone.

On Jul 15 08:05 AM nyc female lawyer- bondholder wrote:

> The author of this article obviously does not own any stock or bonds
> in CIT and therfore is not well infomed.Therefore,he has not been
> folowing some of the positive moves in CIT. CIT has paid the bonholders
> a steady 7% and has provided retirement income to millions of widows.
> CIT has done an excellent job at providing financing to milions of
> small business owners.
> Also, several small business owners are depedent on their financing
> to run their daily operations as an alternative to bank loans.<br/>CIT's
> collapse would have the same negative effect that the Lehman collapse
> had in the bond and stock market.
> Also, a credit crisis with the collapse of CIT would adversely effect
> small business owners and this would be a disaster.
> To bailout Goldman, Citibank, AIG and leave CIT out would be unethical
> and show favoritism and poor judgment from Washington.

Jul 15 09:46 AM

[helplessobs...:]

For readers who want a real recovery from this crisis pure and simple we have to have debt liquidation as the author suggests. So far there has been little liquidation with sour debts being offloaded to the taxpayer. This cannot go on. Gift giving to the likes of AIG and the $12B handed to GS via the AIG bailout are festering with the taxpaying public. Real trouble is brewing. Get ready.

Jul 15 11:24 AM

[spope33:]

Back of envelope calculation:

Assume CIT assets of $75 are worth 50 cents on the dollar, or 38B. CIT has factoring liabilities of 9B, 3.5B of deposits in the banking company, 2.5B TARP, and owes 3B to Goldman, all of which get paid before the rest of the bondholders, so that leaves 20B for 50B of debt, so a recovery rate of 40% if done fairly. If there are parallels to previous deals they will get less than that from the administration say 30% - 35%. That could trigger a backrupcy filing from bondholders disappointed with the cramdown.

Of course the assets could be worth more than I assumed above.

Jul 15 04:18 PM