Tuesday, July 21, 2009

More CIT Musings.

I am continually amazed of what I see everyday watching the markets.

Anyone who believes the Efficient Market Hypothesis is tangible has to explain to me whats going on in CIT.

I am still trying to figure out why CIT rallied over 100% yesterday. On the surface it would look like the company got a lifeline from its bond holders, but the common equity has little or no value. Investors saw the word "rescue" and thought it made sense to take a flyer.

But in actuality.

CIT is highly leveraged and its assets are deeply troubled. Even if CIT is "rescued" 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 at this moment.

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.

Ratings firm CreditSights estimates that CIT may face as much as a US$4.6 billion capital shortfall. A more severe economic environment could leave CIT facing a US$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 US$2.3 billion of TARP money it already invested in CIT.

But is an implicit bailout still available:

Maybe, but unlikely.


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 10.5 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 debt 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.

In the final analysis, shorts had to cover their bets as a likely bankruptcy didn't happen.

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