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Tuesday, July 14, 2009

CIT and the Corrosive Power of Moral Hazards

Most folks have never heard of the CIT Group. It's like that even now you haven't heard of the commercial lending and financial services firm. It's likely that over the next couple weeks you will hear a lot about this company. CIT Group is now struggling just to survive. They have about a billion dollars worth of bonds due, and they simply don't have enough capital available to cover the due date.

CIT has a $1 billion payment due in mid-August and it is unclear the company "will be able to handle that," said this person. The company will give more guidance when it discusses second quarter earnings in two weeks.

CIT declined to comment on whether it was preparing a filing or why it had retained Skadden Arps. But if CIT did file, the consequences could be considerable, because the 101-year-old company, as of March 31, had $68 billion of liabilities.

So, with a month to go before the due date, CIT appears to be doing whatever company and government is doing these days. They are coming hat in hand in begging the government for help.

CIT Group Inc. rose in New York trading and the cost to protect its debt against default fell after the lender said it’s in talks with regulators about a rescue.

The lender’s stock jumped 36 cents, or 27 percent, to $1.71 at 9:42 a.m. in
New York Stock Exchange composite trading, boosted by CIT’s statement that it was in “active
discussions” with regulators about federal aid. CIT has $1 billion of bonds maturing next month, and the firm so far has been unable to persuade the U.S. to back its debt sales. Those talks continued yesterday, said
Curt Ritter, a CIT spokesman.

Furthermore, CIT is framing their need in the context that their failure would send ripples through not only the financial system but our economy as a whole.

The collapse of the company, run by Chairman and Chief Executive Officer Jeffrey Peek, would put 760 manufacturing clients at risk of failure and “precipitate a crisis” for as many as 300,000 retailers, CIT said in internal documents obtained by Bloomberg News.

It would also be the biggest bank failure measured by assets since regulators seized Washington Mutual Inc. in September. CIT reported $75.7 billion in assets and $68.2 billion in liabilities, including $3 billion in deposits, at the end of the first quarter

Does this sound familiar? It should. It's what we heard from an entire banking system back in October before we passed TARP. It's what we heard at the end of the year from GM and Chrysler when they were also on the verge of collapse. Do you remember CEO's of GM and Chrysler proclaiming that their failure would lead to the failure of thousands of suppliers? Doesn't that sound an awful lot like the argument made by CIT? In effect, like other banks, GM, Chrysler, and California, CIT is essentially arguing that they are too big to fail. It's roughly the same sob story that California is still using in hopes that the Federal government will back their debt. (so far they're the only ones that have been unsuccessful) Every industry from manufacturing, news, and small businesses have been mentioned as those deserving bailouts because their survival is necessary to the economy.

I have spoken often of the concept of moral hazard.

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. In insurance, moral hazard that occurs without conscious or malicious action is called morale hazard.

Now, we'll never know why CIT, just a month before doom, now suddenly is begging the government for a bailout. In fact, I posed that very question to the author of the Bloomberg piece, Pierre Paulden, and he correctly pointed out that this would require that he speculate about someone else's thought process.

Yet, it's without a doubt that CIT continues a very troubling patter. Companies and even governments take on too much risk, too much debt, and then wait until the last minute to figure out what to do. Then, immediately come to the federal government for bailout. Furthermore, company and other entities continue another pattern. They frame their bailout as necessary because their failure, CIT, GM, California, would send a ripple effect throughout the economy. If large corporations and states get the idea that their scope can strong arm and extort the federal government into bailouts because they are deemed "vital to the economy", that's the very definition of a "moral hazard". We'll never know if that's what happened in the case of CIT. We can only say that this case has all the characteristics of moral hazard. We can, further, say that critics of TARP and bailouts predicted just such scenarios in opposing them.

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