If it's not a risk to the financial system, let it fail.

That's the message from the government's reluctance to swoop in and bail out one of the nation's biggest commercial lenders, CIT Group Inc, as it struggles to stay afloat. But even though CIT doesn't have the firepower to take down the global financial system, its failure would certainly be felt by some of the struggling small businesses that rely on its financing.

CIT is negotiating with its regulators to find a solution to its near-term liquidity problems, but speculation that it will file for bankruptcy has intensified after the Wall Street Journal reported that it was preparing for a possible filing.

Not that you can blame the Federal Deposit Insurance Corp and the tough-minded Sheila Bair for thinking twice about supporting a junk-rated lender that has already sucked in more than $2 billion of government funds.

A failure, however, could still hurt Main Street since it's sure to make already tight credit conditions even more restrictive for businesses already on the ropes. This is important for regulators as well as investors to keep in mind.

For the last two years, dangers in the esoteric corners of the opaque credit markets were the ones that needed minding. Problems with complicated and difficult-to-understand structured credit products helped fell financial giants like

Lehman Brothers and AIG who were supposed to know best how to manage risk.
Regulators have responded in kind with a blueprint for overhauling the system and a commitment to supporting firms that are too big to fail.

But the dangers are shifting. Though credit is flowing to large companies seeking to drum up funds through the debt markets, smaller ones are still finding it difficult to access funds. The National Federation of Independent Business reported that 16 percent of small-business owners reported loans were harder to get in May -- the highest reading since the recession of 1980-82.

A potential CIT failure could make matters worse. Though it may not be a household name, it is a major middle-market lender. Among its many business lines, the company is an important source of financing for thousands of small- and medium-sized businesses that don't have the heft to raise funds in the capital markets.

The lender's best business bits would certainly be picked up by larger banks, but that would most likely only take care of the most credit-worthy clients. There's sure to be some that would fall through the cracks into a world where access to credit is still challenging.

Even credit cards are harder to come by. Advanta, which specialized in small business credit cards, shut down its credit card accounts for future use after it ran into trouble.

This isn't to say the government needs to come to the rescue every time a financial institution gets in trouble. It doesn't. But CIT's potential failure should be a warning sign that while systemic risk has been cured, the credit crisis has not.

That means more pain is yet to come and the much-desired economic recovery could prove elusive for some time.

Update: See what my colleague Matthew Goldstein has to say on CIT here. And Rolf Winkler argues here why CIT shouldn't be bailed out.

– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

Let the trading begin.

California will be mailing out its first batch of IOUs today after the state’s stalemate over how to close the more than $24 billion hole in the budget leaves it with insufficient funds.

The IOU market could swell to $3.36 billion by the end of the month if lawmakers and the governor still can’t find a middle ground.

Big banks, which stepped into the breach 17 years ago when the state last issued IOUs, appear to be reluctant to do the same this time around. Wells Fargo & Co, Chase and Bank of America have so far said they will accept the IOUs from their customers as they would any other check, but only for a very limited period of time. All three banks say they’ll stop accepting them after a week.

For the more entrepreneurial investor, California’s newly introduced debt could be the opportunity of a lifetime, or at least of the summer.

The IOUs are registered warrants with an interest rate of 3.75 percent and a maturity date of October 2. But for the purposes of marketing, let’s just call them Terminators.

They have the potential to become what Wall Street likes to call a liquid market — a large amount of securities with similar characteristics that investors can buy or sell quickly. And given the uncertain legislative landscape, there would be an opportunity to make a buck or two.

First, the Terminators are slated to go out in batches rather than all at once, meaning that those sold in the beginning are likely to be worth more since the interest will be paid over a longer period of time. All the warrants will carry a maturity date of October 2 no matter when they’re sent out. Arbitrage anyone?

Second, the more liquid the market, the easier it is to trade. The longer the budget stalemate endures, the more Terminators will be issued. If you thought the deficit projections for July were big, take a look at August and September.

The controller projects cash shortfalls of $3.7 billion and $6.5 billion in those respective months and “double-digit freefall” after that. That means traders could swap Terminators on a daily basis, with prices fluctuating according to prevailing views on how long the crisis goes on.

That may just mean days. Or it could be for substantially longer. For the October 2 maturity date comes with a big caveat: California will redeem the securities only if it has the cash. If it doesn’t, presumably it will have to issue even more Terminators.

If the crisis does go on and there is a great big pool of these IOUs sloshing around California, what’s to stop someone from collecting, say, $500 million worth and slicing and dicing them into an asset-backed security?

Add general obligation bonds (which the state is required to service with cash) to the mix, and the bond’s triple-A slice should be adequately protected in case the cash doesn’t start flowing on October 2. On a fixed-income desk somewhere on Wall Street, someone is most likely crunching the numbers.

There is also an opportunity to claim altruistic motives. Some of the state’s most vulnerable people are at risk of having key services cut if the IOUs can’t be sold for cash.

The controller estimates that the Department of Social Services is slated to receive roughly $1.2 billion in Terminators during July alone if the impasse continues, while other social service agencies that help people with developmental disabilities and mental health issues will receive more than $400 million in warrants. By buying up these notes, investors can ensure cash will continue to flow to the underserved.

Of course, this market wouldn’t be for the faint-hearted. After all California could emerge quickly from the budget crisis, as the IOUs promise to shame lawmakers to hammer out the compromise. Then investors would most likely be stuck with the notes until October 2, and who would want that?  Certainly not Californians.

(Editing by Martin Langfield)

– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

Don’t underestimate the power of California, and its ability to suck in a reluctant federal government to bail it out of a fiscal mess of its own making.

But the Obama administration and Congress should resist. Not only is the federal government shouldering the already heavy burden of sorting out the auto and banking industries, the housing giants Fannie Mae and Freddie Mac and the hard-to-get-rid-of American International Group (AIG.N), but such action would undermine the state’s need to revamp what has become an ungovernable system built on gerrymandering, ill-conceived tax schemes like Proposition 13 and unrealistic restraints like needing a two-thirds majority to pass a budget.

Intervention in California would open another too-big-to-fail Pandora’s box, but one that is much more difficult to navigate politically since the federal government would be dictating which state, and by extension which voters, are worth saving.

California, though the most extreme case, isn’t the only state suffering. In fiscal year 2009, 38 states are experiencing revenue shortfalls, according to a joint survey by the National Governors Association and the National Association of State Budget Officers.

Over three quarters of the states have already slashed their budgets by $31.6 billion, but that won’t solve the more than $180 billion gap still projected between 2009 and 2011. It would also further encourage complacency in the $2.7 trillion municipal bond market, where the assumption persists that no matter how disastrous a state’s finances, investors need not worry about default.

That California has itself to blame as much as the slump in revenues should also make it a hard sell for a bailout. The embarrassing budget impasse has left the Golden State with a $24 billion gaping hole in its state finances and a cash crunch that will force the state controller to send out IOUs for the second time this year later this week.

So far the cash crunch is limited to a $2.8 billion shortfall in July that can be plugged by handing out IOUs to local governments, state vendors and recipients of income tax refunds. But by September that shortfall will swell to $6.5 billion, according to the state controller, and by October, California will need to pay off the IOUs issued this month.

Of course this could be remedied by the governor and state legislators if they could agree on a budget and painful measures to address the cash shortage, but even the June 30 deadline hasn’t been enough to force them to overcome the entrenched dysfunction in the state government.

It should be said that the prospect of defaulting on the state’s roughly $70 billion of bonds outstanding — that includes its general obligation bonds and its Economic Recovery Bonds — is likely some months away, but the rapid deterioration of the state’s finances, the size of the budget gap and the governor’s insistence that short-term borrowing in the credit markets is off the table as a solution, brings the possibility into much sharper focus.

The scope of the mess and state government’s inability to tackle it has caused those with an aversion to drama to sell California municipal debt, pushing up 30-year yields to a lofty 6.2 percent this week, up from the 5.3 percent to 5.4 percent seen in the beginning of May, according to Municipal Market Advisors. The cost of protecting the bonds has also been rising.

Given the unprecedented nature of a California default — you have to go back to The Depression to find a state, Arkansas, failing to meet its debt obligations — there’s an expectation that the federal government would intervene to ensure bond holders are protected, at least partially.

That’s because a state the size of California — it would be the world’s eighth largest economy if it stood alone — would have an extremely difficult time managing its finances without access to the capital markets. It also promises to darken the United States’ black eye from the credit crisis since it would show how weak such big states, which contribute to federal coffers, are.

That could pressure its own cost of borrowing higher as international investors become even less enamored with government debt. California has already asked the U.S. Treasury for a healthy heaping of funds from what has become the catch-all Troubled Asset Relief Program, which was initially created to buy toxic assets from financial institutions, but Timothy Geithner has kept his distance, signaling back in May that any decision to lend a helping hand to the state should come from Congress.

The pressure is likely to mount in the days, weeks and months ahead, however, if there’s no resolution from the state on how to right its finances. Fitch Ratings has already downgraded California’s ratings, and Moody’s Investors Service and Standard & Poor’s have warned that they could do the same if nothing is done.

Negative press surrounding hardships from those receiving IOUs in lieu of cash will also turn up the political heat to do something. The federal government, however, should stay out of the mess and signal more strongly to state politicians and investors alike that they’re on their own.

The California budget impasse comes to a head one way or the other this week, with state lawmakers needing to make nice by June 30 to close a $24 billion budget gap. If they don't, rating agencies have threatened to downgrade the state's credit ratings.

California's Comptroller said he would begin handing out IOUs on July 2 and the Treasurer said the state will draw on reserves to service the debt of all economic recovery bonds on July 1. (These bonds were created in 2004, when voters gave the state government the authority to raise $15 billion through bond issuance to plug another budget deficit.)

While a slump in real estate and tax revenue are very real factors behind California's disastrous finances, the San Francisco Chronicle also bullet-points more entrenched problems that have made it difficult if not impossible for the state to surmount extreme dysfunction.

-- Partisanship: California's gerrymandered legislative districts tend to protect incumbents and encourage more political extremes - Republicans on the right and Democrats on the left with less incentive to reach out to the political middle, much less compromise at the Capitol.

-- Term limits: Proposition 140, passed in 1990, limits legislators terms to six years in the Assembly and eight in the state Senate.

-- Ballot-box budgeting: Initiative-loving Californians mandated set-aside funding for all kinds of single-interest issues, from education to stem cell research.

-- Prop. 13: The 1978 landmark law slashed commercial and residential property tax rates, shifting state reliance to other more volatile sources.

-- The two-thirds majority rule: The Golden State is one of just three states that require a two-thirds majority vote from each legislative house to pass budgets.

Fitch Ratings cut California's ratings to A-minus last week from A, and warned that further action could be forthcoming if there's not a budget agreement beyond June 30.

California general obligation bonds have been getting hit as a result of all the uncertainty. In May, the bonds were trading roughly 37 basis points above AAA-rated munis, according to Municipal Market Advisors. Now they stand at 105 basis points. It's also helping to drag down the overall market, though returns for the year are still in the black at 5.2%.

The big fear of course is default, but there are many gradations about what they could mean for bondholders.  The worst case scenario would be repudiation, or simply walking away from its debt obligations, though this seems extremely unlikely given the size of the California economy (eighth in the world if it stood alone) and its dependence on future credit market financing. Then there's defaulting on the debt servicing or paying only part of it.

There's still some hope that the federal government would step in if it came to default, but the Obama Administration has been reluctant to prop up state and local governments, especially when it has its hands full with the auto industry and the financial system. It also would open up the federal government to petitions from a long line of states and municipalities also getting squeezed.

– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

Reasons people give to explain the quick switch-back movements in stocks and other risky assets are becoming, well, just bizarre.

On Monday, it was the World Bank’s dire outlook for the global economy — no matter that the organization’s president already said output was likely to decline by close to three percent earlier this month.

On Tuesday, it was Moody’s Investors Service reaffirming the Aaa rating of the United States that gave stocks a brief lift, even though few expected any rating agency to make a move on its credit standing any time soon.

Investors should take these kinds of explanation and moves with a grain of salt, especially during the summer months when trading volumes are light and conviction easily undermined.

Those taking the long view shouldn’t let the noise, whether it be a World Bank report on the economic outlook or a perceived change in a data point, distract them from the fact that the financial system is still on life support and therefore susceptible in a very real way to a downturn once governments start to pull the plug.

The Federal Reserve is well on its way to purchasing $1.45 billion of mortgage-related assets in addition to $300 billion of Treasuries, which it could expand if central bankers decide they need more power to drive down interest rates.

This week, in an attempt to drive down rates even further, the European Central Bank is offering funds at a bargain basement rate of one percent for one year. The Bank of England, meanwhile, is keeping rates in that country at a record low while earmarking 125 billion pounds to buy up debt as part of its quantitative easing policy. And the list goes on.

The trillions of dollars injected into the global financial system have helped bolster short-term lending markets to such an extent that few are even talking about such hot-spot gauges as Libor/OIS that flashed beet red last year when banks balked at lending to one another.

By driving down short-term borrowing costs, this money, among other things, encourages banks and investors to invest in higher-yielding, riskier assets that had been beaten down by the crisis.

The return of risk appetite has in turn bred comfort that things are returning to normal. But they’re not, yet.

That’s why the timing of when governments begin to mop up this excess liquidity will be key to where markets go from here. There will be plenty of trading opportunities between now and then, to be sure, but it will be some time before we’ll see anything that we can call normal. Yet, normalcy is what many crave.

Many had hoped that the run-up in stocks and other risky assets since March was the real deal — a sustained rebound, in the manner of 2003.

Real money had been moving into stocks and risky corporate debt not because of isolated headlines but a growing, and I would argue misplaced, belief that the stabilization of financial markets held out the possibility of a rapid rebound, and the opportunity to rebuild 401(k) accounts and other investments pancaked by last year’s crisis.

After taking out $31.5 billion in March, investors rechanneled funds back into equities, adding approximately $36 billion to stock funds since then, according to AMG Data Services, which tracks mutual fund activity.

This isn’t surprising, as it’s hard to turn your nose up at 32 percent gains in the S&P 500 since it hit rock bottom in early March or the even more impressive 36 percent returns seen in the Merrill Lynch Master II high-yield corporate bond index.

But these returns are being juiced by easy money, which means the picture could look much different when cheap funding is harder to find.

– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

Call it a battle for beginnings and endings, and the Federal Reserve is smack in the middle.

As Fed policymakers convene for a two-day meeting starting on Tuesday, the lines are growing more defined between those who want the Fed to do more to stimulate a still fragile economy, and those who are calling for a defined exit strategy to prevent the global economy from going into an inflation-inducing overdrive.

There’s a way to placate both camps, at least in the near-term, and that’s for Ben Bernanke and his colleagues to retire some of the temporary short-term lending facilities put in place at the height of the financial meltdown last year.

It would show good faith that the U.S. is serious about exiting some of those emergency facilities, and it would give the central bank breathing room to keep its ultra-easy monetary policy in place until it’s ready to call the all clear.

Bernanke, as a scholar of the Depression, is all too aware of what can happen should the central bank move too quickly and forcefully in removing stimulus.

One program in particular is a ripe candidate - the Commercial Paper Funding Facility.

Introduced last year, the CPFF made sure that highly-rated companies could get access to short-term funding at a time when traditional commercial paper lenders like money market funds, spooked by losses caused by the Lehman Brothers bankruptcy, shunned such borrowing. By the end of 2008, the Fed’s commercial paper lending added $334.1 billion to its balance sheet.

Since then, the demand for short-term government financing has waned. For one, the program bought companies precious time to cut their dependence on short-term markets as they found financing elsewhere, such as the longer-term corporate bond market. The sharp slowdown in the economy also curbed companies’ need for short-term borrowing, which was often used to cover payrolls, rent or other basic expenditures.

In the latest week, the Fed reported that its facility had shrunk by $6 billion to $132.1 billion in a sign that companies were choosing to pay down their debt before next July when a good portion of the loans begin to mature.

Barclays Capital money-market strategist Joseph Abate expects the commercial paper facility, along with another facility that gives loans to banks so they’ll buy certain types of commercial paper from money market mutual funds, could fall below $50 billion by the time the programs are due to expire in October.

These programs have already been extended once, so they are still in play despite the stated end date.

While practically speaking there would be no harm in keeping facilities like the CPFF open indefinitely just in case financial markets should swoon again, there are pragmatic considerations that should be taken into account.

It’s better to show a commitment to exit strategies with a program that has largely run its course than to start tinkering with interest rates and quantitative easing that can have an outsized impact on the U.S. and global economy, which are still by no means out of the woods.

The World Bank reiterated on Monday its forecast for world economic slump this year, with output contracting by 2.9 percent rather than the 1.7 percent decline predicted in March.

The rise in Treasury yields earlier this month and the quashing effect they had on mortgage lending activity also should be a reminder that the Fed needs to stay flexible when it comes to its unorthodox policies. But it’s time to show the world that it’s also ready to put aside some weapons in its arsenal when the time is right.