Another Crack Opening Up?

You see plenty of reports nowadays suggesting that financial Armageddon has been avoided. Meanwhile, "experts" in Washington and on Wall Street congratulate each other on their apparent success in preventing the crisis flood waters from breaching the financial system's levee walls.

In reality, all they've really done is plugged some of the initial gaps with funny money-filled sandbags -- just as a raft of other holes are beginning to open up. That's the thing about bursting credit bubbles: every time you think you've turned back the tide, more red ink suddenly starts flowing through the cracks.

What's more, these bubbling breaches aren't necessarily seen by those in charge as the spearheads of deadly surges to come. In many respects, in fact, that describes the miscalculation that occurred with Lehman Brothers.

Now, according to Dow Jones Newswires columnists Donna Childs and Sameer Bhatia, writing in CIT Poses Lehman-Like Risk," we may be poised to see it happen once again.

The implications of the capital crisis of CIT Group Inc. fill 24-hour news coverage and yet credit default swaps are near record lows and the markets appear calm, a peculiar disconnect given the events that followed Lehman Brothers' bankruptcy. What gives?

The century-old lender narrowly avoided a bankruptcy filing this week when it obtained $3 billion in loan commitments from its bondholders. Tuesday, documents filed with the Securities and Exchange Commission laid out steps that it will take to avoid bankruptcy, though it warned that any misstep likely would lead to a Chapter 11 filing. Who has correctly gauged the risk CIT poses to institutions, markets and the economy - the media, the markets or the government?

The market judged Lehman a serious matter. In the days preceding Lehman's bankruptcy, credit default spreads spiked. The Markit iTraxx Europe Senior Financials Credit Default Swap Index spread rose from 94 on Sept. 12 last year to 147 three days later, the date Lehman filed bankruptcy. The index spread peaked on March 6 this year, reaching 199, but it has since retreated to 114.

It appears anomalous that CDS spreads are near historic lows, despite a possible imminent collapse of an important commercial lender. So why haven't spreads moved significantly despite the media's scrutiny of CIT's crisis?

The likely reason is that markets clearly understood the systemic financial risk posed by Lehman's more than $350 billion counterparty exposure yet don't grasp the risks posed by CIT's exposure to the manufacturing, retail and commercial real estate sectors.

This may also explain why the U.S. government bailed out American International Group Inc., an entity it deemed too connected to fail given the significant counterparty exposure to other financial institutions, and yet appears unfazed by the risks posed by CIT.

Such a view is shortsighted. CIT factors the accounts of some 1 million small businesses, by which process it purchases their accounts receivable. In some cases, it advances cash against those purchases; in other cases, particularly with many Chinese institutions, it doesn't. Should CIT default, small businesses that believed they were borrowing from CIT would become unsecured creditors of CIT.

Many of those small businesses operate in the manufacturing, textile and garment industries. This appears to be a different type of risk exposure than that represented by Lehman or AIG yet it is nonetheless a real risk to the economy and by extension the global financial system.

The failure of Lehman precipitated a seizure in the credit markets from which the world has not yet recovered. The failure of CIT will likely precipitate similar seizures in both trade finance and commercial real estate markets. The attendant consequences will inevitably come back to haunt the larger financial institutions with exposure to these sensitive sectors.

The business news media correctly report that CIT has a 1% share of market for loans to U.S. small and mid-size businesses. Friday, The Wall Street Journal reported a pertinent fact: CIT services roughly 300,000 retailers and 1,900 manufacturers and importers, representing as much as $40 billion in receivables.

The CIT story is complex, mid-chapter and sometimes hard to read but it can't be ignored by the government, markets and financial institutions.

Comments

[roger]

Its not just the economy anymore. There is in the country a very ugly mood, despair, disunity, hate and fear plus intense corruption in the highest places of finance & government , to top it off politicians on the right are playing the race card to the hilt . Unless the economy turns around (and I would bet my life it won’t) Obama may not finish his first term. nothing good will come out of all this. its more than a crack, it's a tectonic shift

[W.C. Varones]

Roger,

You had me until "politicians on the right are playing the race card to the hilt."

Whatchoo talkin' 'bout, Willis?

[patrick]

"Should CIT default, small businesses that believed they were borrowing from CIT would become unsecured creditors of CIT."

I don't get this statement. A small business borrows from CIT. CIT goes bankrupt. How is the small business which owes money to CIT in any kind of trouble? I can see how a small business that loans money to CIT would be hit if CIT goes belly-up, but not if they borrow.

[Michael Panzner]

I am not the expert by any means, but it is my understanding that many of those loans are overcollateralized by accounts receivable, so if the excess funds (over and above the credit obligation) were received by CIT and not yet forwarded to the borrower/client, then the latter could be exposed in a bankruptcy. If anyone has a better handle on this than me, feel free to comment.

[chris]

The author of the above column is incorrect. CIT does not post a broader economic risk for the particular reasons listed above (small business finance). Do these people not know anything about factoring or ABL? There are a hundred factoring companies that can step in at (literally) a day or two's notice and pick right back up financing these retail and manufacturing receivables the second CIT goes away. I know for a certainty that three or four big ABL guys have been running reverse ucc searches to find out who CIT's clients are and get lined up to step in as soon as possible, if not already. These lines are very easy to pay off and convert, and there is NO shortage of well capitalized, aggressive ABL lenders out there right now who will fund these credit facilities. The ONLY real credit risk the small business' have to CIT (if it goes bankrupt) is the typical 10% reserve or holdback of any current or outstanding receivables factored at the time of a bankruptcy. Losing that will be a painful, but very temporary event for the small business borrowers.

I'd imagine that most of the 300,000 small businesses mentioned above are in the process of switching factors as we speak. And this process is a day or two long event typically...

No issue here.

[green shot]

Check this list of top 50 US banks:

http://www.ffiec.gov/nicpubweb/nicweb/Top50form.aspx

Now, read this news:

http://www.bizjournals.com/nashville/stories/2009/07/20/daily22.html
(SunTrust)

http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSN2123992520090721
(State Street)

http://www.bizjournals.com/dayton/stories/2009/07/20/daily80.html
(Capital One)

http://www.forbes.com/feeds/ap/2009/07/21/ap6679264.html
(Regions)

http://www.bizjournals.com/cincinnati/stories/2009/07/20/daily30.html
(KeyCorp)

http://www.forbes.com/feeds/ap/2009/07/21/ap6679108.html
(Comerica)

http://www.reuters.com/article/rbssBanks/idUSN1740567220090717
(Marshall & Ilsley)

http://www.forbes.com/feeds/ap/2009/07/23/ap6691561.html
(Huntington Bancshares)

http://www.reuters.com/article/bondsNews/idUSBNG54554120090723
(Synovus)

http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSN1350913920090717
(First Horizon)

Profits? Recovery? Try looking beyond Bank of America, JPMorgan, Citigroup, Wells Fargo and Goldman Sachs.

[Don]

This bubble is continuing to deflate, and will not stop until it is completely on the ground. There's not enough money in the world to stop it. I promise you that.

Commercial real estate is the next big shoe to drop. Heck, it's already dropping. The only real revenue the big banks are making, are investments in market volatility.