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 November 2009 Poster Child CIT Group's Travails Exemplify Just About Every Mistake of the Past Year
You hear a lot about the biggest companies like Citigroup, General Motors, and AIG, but they only tell part of the story. They got into trouble and the government bailed them out. They were deemed too big to fail. But they're only a small portion of the companies that have been driven to the brink in the past year. CIT was not fortunate enough to be counted among them. Although there's been a lot of finger pointing, there are some real lessons to be learned from CIT's journey. At the time of this posting, the story is not yet complete, but the ultimate outcome won't diminish what should have been learned. See what you think.
An Established Business The current structure has CIT Group as a subsidiary of CIT Bank, its holding company. Although CIT owns a bank in Utah, the New York headquartered CIT Group is the primary business.
The "dollars" side of the equation is controlled by monetary and fiscal policy. The Fed is the nation's steward of the money supply. They indirectly control it by setting short-term interest rates or changing the amount banks have to set aside on reserve. They can directly impact it by buying or selling fixed income securities in the open market. Congress controls fiscal policy which includes financing (taxing and borrowing) and spending. Depending on the amount the government needs for these activities, dollars will either be added or removed from the overall economy. CIT offered a broad range of services to customers including consulting, restructuring, and management of receivables. Lending, however, was always the primary business. Like most commercial lenders, CIT financed its intermediate to long-term loans by borrowing in short-term capital markets. The difference between its short-term liabilities and long-term assets provided the profit margin. Additional funds were periodically raised by floating bonds when interest rates were favorable. In a normal market, this is a pretty standard business model and obviously, it worked well for CIT for one hundred years. This approach was not unique, and in fact, it's the same model used by many commercial lenders. CIT was a respected firm with investment grade debt. One might say, it was a capitalist success story. Like many other financial intuitions, CIT entered the student loan and sub-prime mortgage market several years before the meltdown. These weren't the majority of the credit portfolio, but they were contributing factors to the problems that subsequently followed.
Finding Funding
Suddenly (or it least it seemed suddenly) major money center financials, those that had been considered the best capitalized, were on the brink of bankruptcy. Investors didn't know who they could rely on so shunned all credit. Everyone's books were suspect and no counterparty was trustworthy. Even short-term credit disappeared. For a company like CIT that depended on capital markets for liquidity, this posed a major problem. To its credit, CIT had been relatively well capitalized so the crisis didn't come to a head until December 2008. That's when the mistakes began to compound. Late in 2008, the Congress authorized the Troubled Asset Relief Program (TARP) initially charged with purchasing distressed assets from troubled lenders. Over time its purpose evolved into what essentially amounted to bail-outs of struggling institutions. CIT applied to the Treasury for assistance in December 2008 and received $2.3 billion. Apparently at that point, government officials believed CIT was worthy of taxpayer assistance. The government's largesse was enough to get CIT halfway through the summer. Although the stock market started to show signs of recovery in the late spring, credit markets remained frozen. In the quarter ending June 30, 2009, CIT's cost of funds was greater than its interest income. As a result, the margin was a negative $19.1 million. A year earlier, it was a positive $169.8 million. With debt coming due, CIT appealed to its bondholders for assistance. In July 2009, institutional bondholders agreed to provide an additional $3 billion in financing. In order to win the support, CIT promised to quickly offer a plan for refinancing and recapitalization -- not an unusual course for troubled companies.
The Offer In September, CIT presented its promised restructuring offer to bondholders for their approval. The offer asked bondholders of $31 billion of the $54 billion outstanding to exchange their present bonds for new debt that will be secured by assets of the restructured company. Bondholders would also receive essentially all the equity in the new entity. Current shares would be worthless and the stockholders would be left with nothing. When presented this way, there's little reason bondholders wouldn't go along with the offer. But there were some important twists. First of all, in the exchange, bondholders are asked to reduce their stake buy just under $6 billion. In other words, they'd have to take a loss to make the proposal work. Complicating matters is the fact that this haircut would not be evenly distributed over the bondholders. Those holding paper maturing this year would receive value up to 90 cents on the dollar in the exchange while those with debt maturing further in the future would receive less -- in some instances, much less. The reason for this is obvious: It's more critical to eliminate the near-term debt than obligations that won't come due for years. Secondly, not all bondholders would participate in the exchange. Those with subordinated debt -- loans lacking priority on assets -- would receive little if anything. In this case, some debt is more equal than others. Finally, as a result of the foregoing, bondholders voting on the exchange offer will essentially be voting against each other. Clearly the exchange is in the interest of those with short-term debt, but not so much for those with longer. To increase the sense of urgency in the decision, CIT prepared a pre-packaged Chapter 11 bankruptcy filing to be used in the event the exchange failed, so bondholders had to factor that into the impact of their vote as well.
Comedy of Errors Consider, for example, the government's position in all this. (Actually, it's the taxpayers' position, but unfortunately the taxpayer had no say-so.) After investing granting $2.3 billion from TARP funds, the Treasury refused any further assistance. Apparently CIT was worth saving nine months ago, but not now.
There's something to be said for not throwing good money after bad, but this is an odd situation because most of that earlier investment would be wiped out either through the exchange offer or bankruptcy. In other words, the only way the Treasury could possibly recover the initial investment was to offer further assistance, but failing to do so they tacitly forfeited 2.3 billion taxpayer dollars. Either giving CIT the money in December 2008 was a mistake or refusing further assistance now is. Either way, it's a botch job. From the looks of it, the initial infusion was probably the mistake. The FDIC which is charged with insuring bank deposits has also declined to let CIT to take on new deposits in its Utah bank. Additional deposits could have facilitated new loans (and revenues), but the FDIC wanted to see improvements in the balance sheet before putting new deposits at risk. The big difference between the FDIC's and the Treasury's stance was that the FDIC didn't already have a stake in CIT's survival. CIT's shareholders are in a bad position, too. Regardless of what was decided -- either recapitalization through the exchange offer or bankruptcy -- they're left holding worthless securities. Throughout the entire process, they've had the least say of all. But that didn't keep the stock from trading up. That's right, up. Chart 1 above shows the steep decline in CIT's share price over the past year, but Chart 2 shows the intraday trades from the five trading days ending October 1, 2009. CIT's shares spiked when the exchange offer was first released to the bondholders. Judging from Chart 2, you'd think the shareholders were just thrown a lifeline to rescue them from the crisis. What's up with that? Some attributed it to individual investors who didn't realize the true implications of the exchange. Others who were more cynical (and probably more correct) saw it as the work of short-term speculators who pushed what amounted to a penny-stock up in the hopes of selling to someone else at a higher price before the market closed. Either way, someone was bound to be left holding the bag. You'd think investors would learn, but you'd be wrong. These were just the latest in the comedy of errors that ultimately left CIT in Chapter 11. As General Motors so clearly demonstrated, it doesn't matter if you're a well-established company or not. If the government doesn't think you're too big to fail, you're just as susceptible as a poorly capitalized start-up when the credit markets are stressed. When the government does start doling out dollars, they're just as incompetent if not more so than the companies they're bailing out. It's easy to make mistakes like that when you're dealing with someone else's money, in this case the taxpayers'. Although business schools teach us that bondholders are better secured than equity holders, that's less meaningful than it sounds. Just ask the CIT bondholders who weren't fortunate enough to hold paper coming due in the next few months. And the stockholders aren't much better, they're willing to buy stocks that are already virtually worthless. All of these foibles and mistakes are clearly illustrated in CIT's debacle. No one escapes unscathed, and that's probably as it should be.
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HEN HISTORIANS LOOK BACK at the market turmoil of the past year, there will be plenty of problems to document. It's included everything typically
found in such a plot: Greed, ignorance, arrogance, and even a little bad luck. Fortunately for them, it won't be difficult to detail what happened, they'll only need to tell the story of CIT Group, Inc. This poor company, its shareholders, and lenders suffered
from just about every blunder of the crisis.
