A turning point in the financial crisis

By Felix Salmon
July 19, 2009

If CIT really has dodged a bullet here and avoided bankruptcy, that’s spectacularly good news. I’m assuming here that a deal has done, based on nothing but a single one-line headline on WSJ.com; these things tend to be fraught and fractious, however, so I’m not counting my chickens just yet. But if CIT has really avoided bankruptcy, that’s a major turning point in the history of the financial crisis.

It’s good news for various individual constituencies, of course, especially all the small and medium-sized businesses which will now find it easier to roll over their loans. It’s good for CIT’s shareholders, who might be left with something more than $0. It’s good for CIT CEO Jeffrey Peek, who did his best Dick Fuld impression over the past few months, refusing to raise capital even as everybody else was taking any capital they could get, and as a result almost sent his company the way of Lehman. And it’s spectacularly good news for CIT’s bondholders, who could well see the value of their holdings rise from the single digits into the high double digits as soon as the markets open.

Most of all, however, it’s good news for the system as a whole, which seems to have demonstrated that it’s possible, if not easy, for a private-sector alternative to bankruptcy to be worked out without government interference or guarantees.

I have to say that on Friday, I didn’t think such a thing possible. But with CIT’s unsecured bonds reportedly trading at less than 10 cents apiece on Friday, it was clearly in the large bondholders’ best interests to do some kind of deal, even if doing so meant other bondholders would get a free ride.

The point here is that there is almost nothing which can destroy as much value overnight as the bankruptcy of a financial institution. There were questions over CIT’s solvency, of course. But we’re talking a few billion dollars of shortfall on an $80 billion balance sheet: if capitalism worked the way it’s meant to, then maybe shareholders would be wiped out, but bondholders’ recovery would be high.

But financial-company bankruptcies don’t work that way, as we saw with Lehman Brothers, liquidating a bank is a sure-fire way of getting such low prices for your assets that even secured bondholders start worrying; unsecured bondholders are liable to walk away with little if anything.

It makes sense, then, that those unsecured bondholders would have every incentive to come to some kind of deal with CIT. The problem with any deal done outside bankruptcy court is that any creditors not taking part in the negotiations are going to have to be paid off in full. In turn, that means that the bondholders who are in negotiations are going to have to provide new money, so that CIT has the cash to service its debts. And no one likes throwing good money after bad, especially when that new money doesn’t have the protections afforded to DIP financing in a bankruptcy situation.

If bondholders managed to overcome all those obstacles over the course of the weekend and come to a deal which saves CIT, then maybe the market is starting to be able to work things out on its own, without the need for government involvement. And maybe spreads on bank debt in general will continue to tighten in, as the expected recovery in case of distress rises from the single digits to something much higher. I do hope this deal happens.

Update: The WSJ article is now up:

The deal, which was being considered by CIT’s board Sunday night, charges CIT very high interest rates, and it doesn’t permanently fix the company’s long-term financing needs, say people involved in the transaction. But it buys time for the lender to restructure itself, and minimizes bondholders’ losses. Bondholders calculated they would lose more if CIT filed for bankruptcy and sold assets at fire-sale prices than if they offered the rescue.

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