CIT, U.S. Treasury: Collateral Damage

NEW YORK ( TheStreet) -- The U.S. Treasury's $2.33 billion preferred stock investment in CIT Group ( CIT) stands a good chance of being wiped out entirely in what would be the biggest loss to date for the Capital Purchase Program (CPP) launched in October under the Bush administration and largely defended by the Obama administration.

The loss would highlight the risk inherent in the investment of such a large sum in a teetering company, a risk for which the government did not demand appropriate compensation, according to Linus Wilson, finance professor at the University of Louisiana and an outspoken critic of the bailout.

Wilson notes that CIT's preferred stock offered a yield of nearly 20% a day ahead of the Treasury's Dec. 31 investment. As the value of the underlying stock rallied in the wake of the news, the yield declined to 14.2%.

"That, of course, is much higher than the measly 5 percent dividends taxpayers were offered for taking on that risk," Wilson wrote in an email message to TheStreet. He reckons the Treasury subsidized existing CIT investors by 65.4%, paying $2.33 billion for securities worth $805 million. A Treasury spokeswoman did not respond to a phone call or e-mail messages requesting comment.

As of late Wednesday, media reports said the most likely resolutions expected to come of Thursday's deadline for CIT to restructure more than $30 billion in debt were a swap to eliminate at least 30% of that debt load by giving bondholders new equity, or else seeking bankruptcy protection, either through a prepackaged plan, which the company has reportedly already put in place, or a conventional filing that would put the reorganization in the hands of the courts.

A bankruptcy filing would presumably wipe out the Treasury's investment, according to Douglas Elliott, a fellow at the Brookings Institution and a longtime investment banker who focused on advising financial institutions.

"If this actually goes into bankruptcy, and if they go by the strict order of bankruptcy priority, preferred shareholders would be below the debt holders, and there's more than enough debt holders to absorb the total value," Elliott says.

If debt holders agree to keep CIT out of bankruptcy, the government might be able to recoup its entire investment, Elliott says, but he thinks debt holders would likely exact a price in return.

"I suspect If I were the debt holder making that switch I would push for the government to make some concession as well," Elliott says.

Elliott stresses he has no knowledge of the talks, but says he sees why the government might be willing to bend.

"The government in representing the taxpayers would rather have a smaller loss than a bigger one. If making some concessions preserves significant value for the preferred stock it would be the right thing to do," he says.

CIT has always been a controversial case for a bailout. Though it may be the nation's largest commercial lender to small and mid-sized companies, it is tough to argue it falls into the "too big to fail" category. The Capital Purchase Program, however, was not about propping up systemically important institutions, but rather "a means to directly infuse capital into healthy, viable banks with the goal of increasing the flow of financing available to small businesses and consumers," according to a February press release from the Treasury Department.

Commentators including not-profit news organization ProPublica have rightly questioned those statements, pointing out that many small banks that have stopped paying dividends on the Treasury's preferred equity investments, not to mention Citigroup ( C), fit few people's definition of healthy.

"CIT group should not have qualified as a healthy bank. Thus, it should not have been eligible to receive Capital Purchase Program funds," writes Wilson, the University of Louisiana professor.

CIT might have been restored to health if the FDIC had guaranteed its debt under the Temporary Liquidity Guarantee Program, as it did for large banks including Bank of America ( BAC), Wells Fargo ( WFC) and JPMorgan Chase ( JPM) as well as one very large non-bank, General Electric ( GE).

However, the FDIC rejected CIT's efforts to participate in the program, ensuring a liquidity crisis for the lender.

Not surprisingly, Wilson thinks the FDIC made the right call.

"FDIC was right to refuse to guarantee its debt earlier this year," Wilson writes. "Doing so would have been throwing good money after bad."

At least one CIT bondholder is undeterred by the gloomy predictions, telling TheStreet he still thinks CIT will be acquired. Dwayne Moyers, CIO of SMH Capital Advisors, says he bought $2 million in CIT bonds Wednesday, adding to his $100 million position. The bonds he owns mature next year, and Moyers says they were trading at 69.5 cents on the dollar recently. He believes they will be repaid in full.

"I'd add more if I could, but we have position limits," he says.

Moyers believes potential buyers of CIT are waiting to see the terms of the exchange offer before naming a price.

"If the offer values the equity at near zero, that lowers the effective cost that you have to pay for this company," he says, acknowledging he has no direct knowledge of any buyers that are eyeing the company.

CIT shares rallied mightily Tuesday as the New York Post reported hedge fund manager John Paulson was considering a merging CIT with IndyMac Federal Bank. They continued their rally even as subsequent reports by Reuters and Dow Jones disputed the IndyMac idea, but plummeted Thursday on reports in The Wall Street Journal and Bloomberg News that the options on the table, including bankruptcy and a restructuring, left little hope for common equity holders.

The stock closed Thursday at $1.21, down more than 40%, and it was edging slightly higher in premarket action.

-- Written by Dan Freed in New York.

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