Sunday, August 30, 2009

Death of a Model?

While the Chicken Littles of the financial world have been relatively quiet in the past few months, there continue to be pockets of anxiety. Perhaps the name most mentioned in the past few weeks is CIT.

This relatively obscure financing company deals in what they call “middle market business and commercial loans, financial services and solutions”. So we’re talking about Small Business Administration Loans, Factoring (lending with receivables as collateral), leasing, etc. Middle sized companies, like retail chains, service providers and specialty manufacturers turn to these guys for money. On the consumer side, they finance student loans.

So basically no “mortgage meltdown” here, although the recession has affected their loan and lease portfolio and write-downs put the company’s results into the red for the last few quarters (not unlike most financial institutions). CIT received TARP money last year (again…like everyone else).

The balance sheet appears to be solvent, with $64 billion in liabilities to $6.1 billion of equity. Hardly levered compared to most, you could say. Cash flow is quite positive.

Nonetheless, CIT tethers on the edge of bankruptcy. Why?

The problem is funding. For years, CIT has financed its operations by issuing notes and commercial paper to the “market” and then using those proceeds to lend out. They call it the “wholesale model”. Get money in the market at 4, 5, or 7%, lend it out at 9-12% effective rate. Live happy ever after.

Of course, something happened on the way to the bank (or middle market finance company). The credit freeze happened. All of a sudden the “market” for CIT’s paper was no longer there. CIT did a few things, like issuing commercial paper with a government guarantee (for a while) and converting to a bank holding company, which allows it to get FDIC-insured deposits. Additionally, CIT reduced its portfolio (essentially lending out less than it was collecting).

But it hasn’t been enough. Notes issued in previous years are coming due at a quick pace ($13 billion for the next 12 months). Funding has not been forthcoming quickly enough (deposits at the CIT bank are only $5 billion). At least not CHEAP funding.

There is a price for everything and CIT recently got a SECURED $3 billion credit line from Barclays and a syndicate of banks. But at a price: LIBOR plus 10%, with a 3% LIBOR floor. (That’s a 13% floor and there are other fees associated,too). They got some of the cost back buying back some notes at a discount, but it doesn’t offset that much.

This is obviously not a permanent solution. CIT can’t operate funding at over 13%. And of course, while its liquidity problems remain, it can’t fund cheaply. S&P already has them at CC.

It’s a catch-22. CIT can’t get the money it needs because it has no money. Rinse, lather, and repeat. Can the “wholesale model” escape this circle?

Of course, CIT itself is lobbying quite clearly for a bailout. Just check out its website. HERE. They have a point. How is CIT that much different from another banking holding company (Citi? Morgan Stanley?) or GE Capital for that matter (GE continues to get TALF support). On the other hand, shouldn’t the “market” have a market-based solution for this?

If CIT is indeed solvent as it’s balance sheet indicates (you can never be sure), shouldn’t there be a buyer for it? And also if so, shouldn’t CIT be able to return to its original business model (selling notes at “normal” yields).

Of course, there is an investment opportunity here. These “survival” plays tend to carry a very interesting risk/reward ratio. CIT’s stock has been volatile for sure. But a bailout could carry a hefty price in terms of dilution, so no simple solution there. Potentially large payout, however, CIT trades at a market cap of only $600 million (excluding the TARP money…which could convert).

And there are bonds, of course. Bets on “survival” generally have worked well since Lehman collapsed last year. Solvent companies with liquidity problems can find buyers (as was the case with Nova Chemicals) or a government hand if they are “too big to fail” (Banks, AIG and subsidiaries) or something in between (Ford Credit. GMAC).

In any case, CIT paper maturing in the next 2-4 months is trading at 60-70% of par. Putting down 60 with an upside of 100 in a few months, with only one major outcome in play (survival), is a tempting bet. In the case of bankruptcy, CIT’s long-term notes, trading at around 45-47%, would seem to indicate that the expectation of recovery is relatively high.
So overall, I kind of like those “pot odds”.

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