Rolfe Winkler

Goldman Sachs has done it again, deftly navigating markets to maximize its own returns and leave others nursing losses.

The deal in question is a loan Goldman made to the troubled lender CIT. The loan was dressed up as a derivative, which means Goldman can extract payments it is owed outside of the normal bankruptcy process.

Nothing wrong with that; Goldman has made another great trade. But is the exemption it exploited worth closing?

At issue is the integrity of the bankruptcy process.

By calling a time-out on creditors, bankruptcy offers the opportunity to reorganize and rehabilitate troubled companies, which is often in creditors’ best interest. A debtor’s assets often have more value if they keep generating cash flow, if the company in question continues as a going concern.

But if certain creditors get to pick off assets when a time-out is called, bankruptcy itself may be undermined. Such is the luxury of holding derivatives, which thanks to a 2005 bankruptcy reform, are exempt from the automatic stay that prevents creditors fleeing with their cash. Derivative holders also enjoy netting and close-out privileges that aren’t available to other creditors. And as we learned in the Lehman bankruptcy, derivative traders may make off with cash that isn’t rightfully theirs, forcing other creditors to chase them down.

Because Goldman’s loan to CIT was structured as a derivative — specifically, a “total return swap” — Goldman’s claim won’t be stayed along with others’ if CIT files for Chapter 11. The filing would trigger a $1 billion payment to Goldman.

Spying an opportunity to arbitrage regulation, smart lenders are doing the same as Goldman, structuring loans as “swaps, currency exchanges or securities deals,” according to bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges. Many are doing whatever they can to “put transactions beyond the control of bankruptcy courts.”

Why exempt derivatives from bankruptcy rules? A chief reason, according to proponents, is systemic risk. Derivative markets are just too volatile. You can’t force traders to sit on their positions through a lengthy bankruptcy process without breaking the daisy chain that connects counterparties.

First off, according to a paper by Robert Bliss and George Kaufman, it’s possible that the protections afforded derivatives actually increase systemic risk.

But for the sake of argument, let’s assume they’re necessary. Then we have another case of the tail wagging the dog, of reorganizing our financial markets around the needs of derivatives traders.

For what? The increased “liquidity” that derivative traders are so fond of reminding us they provide? CIT might not have been able to secure extra financing a year ago had Goldman not been able to structure its deal as a derivative. But maybe that would have been a good thing. If a company can’t secure financing via conventional lending sources, that’s probably a great sign the balance sheet needs to be restructured.

And I wonder: has total liquidity, in fact, increased? If conventional lenders see that their claims are increasingly superseded by derivative deals, will they be less inclined to offer financing?

In the end we could end up with another race to the bottom as bad financing options chase away good ones. Borrowers may sacrifice the protection of bankruptcy tomorrow for cash needed to survive today.

The CIT loan illustrates the need for change. To be sure it would be too disruptive to roll back the bankruptcy exemption for derivatives all at once. Still, it’s yet another reason we must shrink the derivatives market dramatically. Increasing capital requirements and migrating trades to exchanges would be a good place to start.

NEW YORK, July 20 (Reuters) – Why did shares of CIT rally as much as 100 percent today? Presumably investors saw headlines with the word “rescue” and thought it made sense to take a flyer. This is foolish.

CIT is highly leveraged and its assets are deeply troubled. Even if CIT is “saved” through a restructuring, there’s no prospect that the equity will have any value. The only hope is a backdoor bailout, and that’s highly unlikely.

To understand why CIT’s stock is essentially worthless, all you need to know is one equation: Assets = Liabilities + Equity. For a financial company like CIT, assets are the loans it makes to borrowers. Its liabilities are the dollars it borrows from lenders and depositors to fund those loans. Shareholder equity is what’s left over.

As the economy has deteriorated, so has the value of CIT’s assets. But the value of its liabilities remains fixed. Equity acts like a buffer to protect the value of liabilities as asset values fall. In other words, stock investors eat losses so that lenders and depositors don’t have to.

Lenders see the value of CIT’s assets has declined and, consequently, aren’t interested in lending anymore. This leaves CIT facing the same type of liquidity emergency that led to the failures of Bear Stearns and Lehman Brothers. And any lender-sponsored “rescue” would divvy up what remains of CIT’s assets amongst themselves, leaving equity holders with nothing.

Under its “base case” stress test scenario, ratings firm CreditSights estimates that CIT may face as much as a $4.6 billion capital shortfall. A more severe economic environment could leave CIT facing a $7.6 billion shortfall. Unsecured senior and subordinated debt holders face “a significant haircut” and preferred shareholders are likely to see “diminutive returns.” There isn’t enough pie for creditors to split, so shareholders shouldn’t expect anything left over for them.

So why take a a gamble on the stock? Maybe investors think Ben Bernanke will successfully reflate the economy, or perhaps CIT will find a buyer. As long as the company can kick the can down the road, there’s always hope, right? Actually no. With unemployment headed towards 10 percent, the underlying default rate on CIT’s assets will get worse before it gets better.

The other possibility is a bailout. True, FDIC has denied CIT’s request to access its debt guarantee program and yes, Treasury is unwilling to extend additional credit after losing the $2.3 billion of TARP money it already invested in CIT.

But an implicit bailout may still be available: FDIC-insured deposits. CIT Group has an FDIC-member subsidiary, CIT Bank. If CIT can’t convince the Feds to back its debt directly, maybe it can persuade them to allow an asset transfer from the holding company to the bank subsidiary in order to access more FDIC-insured deposits. Compare the 13 percent interest rate CIT is likely to pay bondholders to “rescue” its business with the two percent interest rate it would likely pay on one-year CDs guaranteed by FDIC and you understand why deposits are a preferable funding mechanism.

But it will take much regulatory forbearance to make that happen. Both the Federal Reserve and FDIC would have to sign off. We already know that Sheila Bair isn’t a fan of CIT’s business model. She didn’t grant them access to the ebt guarantee program because she clearly does not want to expose her agency to more losses. Thankfully for taxpayers, who ultimately stand behind insured deposits, it’s a safe bet she won’t let CIT raise any more.

With no bailout on the horizon, CIT’s balance sheet will continue to deteriorate, which means its shares are worthless. Investors should stay away.

I noticed an odd paragraph in this morning’s WSJ story on bondholder plans to rescue CIT:

CIT and its bondholders hope that their effort to stabilize the company will cause bank regulators to look more favorably on a CIT plan to transfer more of the company’s loans from the holding company to its bank in Utah. CIT has trouble borrowing money, but its bank can finance itself by taking in deposits. To transfer more assets to the bank, however, CIT needs an exemption from the Federal Reserve and a nod from the Federal Deposit Insurance Corp.

I understand why CIT would want to transfer assets to the bank, sort of.  Deposit funding is clearly much cheaper than other options they have.  Backed by FDIC insurance, deposits can be had at interest rates far below CIT could get in the bond market.

But as everyone points out, you can’t build a deposit base overnight.  Not unless you’re offering a high interest rate on brokered deposits, I suppose.  And FDIC will most certainly NOT let them do that.

But why would bondholders be in favor of a plan to transfer assets out of the holding company?  If those assets go to the bank, then they would back deposit liabilities.  Bondholders need those assets to back their debt.

Hmmm…..

CIT’s press release this evening:

CIT Group Inc….has been advised that there is no appreciable likelihood of additional government support being provided over the near term.

The Company’s Board of Directors and management, in consultation with its advisors, are evaluating alternatives.

The company likely has only one alternative….bankruptcy.

With the fall in CIT’s preferred stock, taxpayers’ money is already lost.  WSJ:

U.S. Treasury Department officials believe they will lose their entire $2.3 billion investment in CIT Group Inc., a spokeswoman said, which could mark the first loss of public money injected in banks through the Troubled Asset Relief Program.

Big kudos to Sheila Bair.  Everyone wanted her to open up the debt guarantee program and she said no.  This is progress, folks.  Bankruptcies, not bailouts, are the proper way to work out bad debts.  Extending a bigger lifeline would only compound taxpayer losses.

As CIT hangs by a thread, some news outlets are reporting that it would be the biggest bank to fail since WaMu.  Measured by total firm assets this is true, but measured in terms of deposits, CIT is a fraction of WaMu’s size.  That’s why Sheila Bair is willing to let CIT go under.  And she’s right.

CIT Group’s balance sheet is plenty big ($76 billion of assets as of 3/31/09), but it’s funded primarily with debt, not deposits.  If the firm goes boom, investors will lose, not FDIC’s deposit insurance fund.

So from FDIC’s perspective, CIT clearly isn’t too big to fail, which is likely why it doesn’t want to give the company access to TLGP.  The debt guarantee program is a bit of a scam to rescue the deposit insurance fund, which would buckle if most of the big banks it protects went under.  The ones FDIC can’t handle closing, those that are “too big to fail” it offers an implicit guarantee against failure.  CIT Bank isn’t in that category.

The argument that CIT needs to be rescued because small businesses rely on its lines of credit is a bad one.  Similar arguments are made in favor of prospective homebuyers who are judged good risks, but who can’t get credit to buy a house.

The issue isn’t creditors, it’s lenders.  Lenders like CIT simply don’t have sufficient capital to make new loans.  Creditors that complain they can’t get other people’s money to fund their operations are missing the point:  Other people don’t have money to lend.

If businesses actually are good credit risks, then they shouldn’t have a problem securing a line of credit from another, stronger lender.  If they can’t get another line of credit despite being a “good” risk, it’s because the system doesn’t have enough capital to support the creation of new loanable funds.

Business models that rely totally on borrowing in order to fund working capital aren’t as robust as those that can fund themselves with cash from earnings.  Many will, and should, fail.

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*For more details, do a quick search for “CIT Bank” in FDIC’s bank find tool.  You’ll find CIT Bank on page 2 of the search results.