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) -- The U.S. Treasury Department is lined up to lose nearly all of its $2.33 billion preferred equity investment in

CIT Group

(CIT) - Get CIT Group Inc. Report

, regardless of whether the lender ends up filing for bankruptcy, in what would be its largest realized loss so far in the $700 billion TARP program.

Treasury Department spokeswoman Meg Reilly told

via e-mail that: "Treasury is in discussions with the lender group with aim of protecting the interests of taxpayers," but without being accorded some sort of special dispensation, it's difficult to run the numbers and come up with a scenario where the government is lined up for anything but a severe haircut.

Reilly went on to write Treasury is "encouraged that the Company's interim liquidity needs are being met by private lenders and that a necessary restructuring is now being contemplated by the Company's existing creditors, " but declined to comment any further.

Still, even Reilly appears to be preparing the public to lose some money here.

"It's important to remember that Treasury has made investments through the Capital Purchase Program in 685 institutions. Through warrant dispositions and dividend income, Treasury has already realized $9.7 billion of gains from this program and had $70.7 billion of preferred stock repaid at face value," she writes.

CIT made an offer to its debt holders last week in which they would exchange existing obligations for equity and new debt maturing at a later date. If CIT can't get enough bondholders to accept the offer, it will file for bankruptcy and the Treasury will lose all its investment under the TARP's Capital Purchase Program, according to a public filing CIT made last week.

If all bondholders accept CIT's proposal, Treasury and other preferred shareholders would lose their preferred status and receive 3.5% of the common equity in a restructured company. If the minimum number of bondholders required to complete the restructuring agree to the deal, the preferred shareholders would get a total of 5% of the equity in the new company. The Treasury, which makes up the bulk of that 5%, would get 3.5% of the new company.

Assuming a restructured CIT has a $5 billion market cap, that would leave Treasury with $175 million worth of common shares (3.5% of $5 billion). Why $5 billion? CIT's market cap at the end of the third quarter 2007, when it was already well off its peak but still regarded as a viable company, was slightly more than $6 billion.


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's market cap is $6 billion. Taking those two factors into account, it seems hard to imagine a $10 billion market cap, but even that would only leave Treasury with $350 million--so still a nearly $2 billion loss.

Despite the fact that the Treasury's preferred shares would usually give it less negotiating power than debt holders, the Treasury is, of course, the Treasury, and appears to be able to do pretty much whatever it wants. The CIT filing describing the terms of its offer notes that the reclassification of the Treasury's preferred stock into common stock is "subject to the approval" of the Treasury, "of which there can be no assurance."

Linus Wilson, a professor at the University of Louisiana's business school, has been a vocal critic of the TARP's Capital Purchase Program, and has taken issue with some of the


's calculations relating to companies that have repaid it, like

Goldman Sachs

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American Express

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Morgan Stanley

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US Bancorp

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Wilson further argues the Treasury originally


for its stake in CIT. Considering the likely outcome, whether or not the government got the best deal possible on the front end is fast becoming a moot point.

CIT's offer to bondholders expires Oct. 29, a minute before midnight.


Written by Dan Freed in New York