CIT Battlelines

The issue of the day is obviously CIT.  It’s hard to sort out the real news from clever PR/planted stories in this situation, but it looks like the FDIC is coming out strongly against being involved in a rescue package.  Given Sheila Bair’s successful political positioning and strong popular appeal, it’s hard to see how – once dug in – the FDIC can be moved.

The lobbying frenzy has concentrated on CIT’s role in financing small and medium-sized business; “the recession will be deeper if CIT fails” is the refrain.  This is a weak argument – it would be straightforward to refinance this part of CIT’s business without bailing out CIT’s creditors, and definitely without keeping top CIT executives in place; this is the essence of “negotiated conservatorship,” which is a proven model in the US.

More plausible is the concern that given Treasury’s generous handouts to date for financial firms, if they are now tough on CIT’s creditors, this will send a new signal about how they may treat other firms – and maybe raise fears of Hank Paulson-like flipflopping.   Citigroup’s CDS spread is still at worrying levels, and Treasury/National Economic Council watches this closely – for both organizational and personal reasons.

Essentially, by trying to refloat an undercapitalized banking system, Treasury has created pervasive financial vulnerabilities to CIT-sized shocks.  These are now the basis for more bailouts and even great fiscal costs.

If CIT is determined to be “too big to fail” in today’s context, this has far reaching implications.  Instead of financial entities with assets of at least $500bn creating systemic risk, we now have to worry about anyone who has not much more than $50bn.  This is a profound change – and a point that seems to have escaped the Financial Services Roundtable, which is pushing hard for a CIT rescue.

Mr. Geithner is travelling back from the Middle East today.  Once he lands, I would guess that a bailout package will go through (on the weekend, if they can get that far) and creditors are unscathed.  But I still suspect that there will be management change at CIT.

How the CIT deal impacts current Capitol Hill discussion on system risk and regulatory reform remains to be seen.  The effects there could be more profound than expected.

By Simon Johnson

Some discussion of these issues with TNR is here.

24 responses to “CIT Battlelines

  1. Either way this goes won’t be pretty for the Treasury Department. If they get bailed out questions should fly about if they’re too big to fail how come they were not included in the stress tests? And if they let them fail there will be a bigger shock to the system than their would have been even a year ago. There’s just not as much capital in the financial markets right now.

  2. As much as I want a financial system that can absorb its own losses from the stupid risks it takes with other people’s money, I have to wonder letting CIT fail is a sign that we’ve firmly institutionalized “too-big-to-fail” into the financial system.

    To reap the benefits (and bonuses) of Goldman, you need the gargantuan size and political influence of Goldman. Smaller banks and firms without the political capital (like Lehman) get pushed of the cliff.

    Inevitably, this gravitational pull will force banks to become “too-big-to-fail” and thus big enough to take risks that will be financially propped up by the feds – or risk being considered too small for such enduring and profitable federal support.

    Kind of a double whammy – small size would leave you incapable of taking on the risk of a larger firm – and subject to going out of business when risks don’t pan out.

    Found this WSJ story to be thought-provoking on this matter:

    http://online.wsj.com/article/SB124762129423442667.html

    Curious what others think of this…

  3. anne: “Inevitably, this gravitational pull will force banks to become “too-big-to-fail” and thus big enough to take risks that will be financially propped up by the feds – or risk being considered too small for such enduring and profitable federal support.”

    Sounds like old vinegar in new bottles to me. How big is a bank capable of becoming if it has troubles? No, what will normally happen is that such banks will be bought up by too big to fail banks, which is what happens today.

    Yes, of course, the Too Big to Fail doctrine tempts banks to become too big to fail. However, the U. S. has more or less explicitly followed it for 25 years. Again, nothing new.

  4. I hope Sheila Bair sticks to her guns. And if Geithner tries to bully Sheila Bair into joining Geithner’s insane corporate welfare program for banks, Sheila Bair should go public. If Geithner tries to bully the FDIC she should write an Op-Ed piece in the New York Times or WSJ stating her position on the issue. The FDIC should take those CIT assets and sell them to a healthy medium sized bank that knows how to manage a balance sheet. Does Geithner think that by giving unlimited assets and capital to insolvent firms, our economy will become for productive???

    I want to quote from an essay/paper put out by the Federal Reserve Bank of Minneapolis titled “What Should We Learn from the Great Depressions of the 20th Century?”. The quote is as follows “If we do not consider the consequences of policy for productivity, in the long run we could all be in a great depression.”

    In other words, how can we have a productive economy by endlessly giving capital and assets to people who take billions of dollars and run their banks into insolvency??? Which economic theory does this fall under?? Because if Geither can quote me ANY economic theory which states or shows it’s good to give money to managers (CIT Group) that had billions of dollars in capital and assets and turned it into an insolvent bank, I would LOVE to hear that theory.

    SHEILA BAIR AMERICANS SUPPORT YOU!!!
    SHEILA BAIR STICK TO YOUR GUNS!!!!!!! If Geithner wants to give money to CIT Group, tell Geithner he can open his personal bank account and give HIS money to CIT Group.

    Here again is that paper I quoted from if anyone wants to read it. http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4214

  5. Ted – love the question you ask! “How can we have a productive economy by endlessly giving capital and assets to people who take billions of dollars and run their banks into insolvency???”

    Been wondering that myself…

  6. Anne, one of the last sentences in the WSJ article says it all, “But U.S. policy toward financial companies cannot avoid all hardship, or the result will be a de facto cartelization of finance, with a resulting loss of competition and dynamism that have long been an American strength.”

    I have never seen a decent, evidenced-backed, argument that ‘too-big-to-fail’ is a viable policy either for the US or the UK (my previous country of residence). As Mervyn King, Chairman of the Bank of England, recently said, “Too big to fail is too big!”

    What astounds me is that the ‘chattering classes’ can’t understand a basic principle; Western capitalism has too much debt in the system and until it is removed there is no way forward. We need political leadership that embraces this fact and explains to the electorate that there isn’t a painfree way out of this mess. Prolonging the ‘smoke and mirrors’ only prolongs greater pain.

  7. Interesting that Ted and I were saying roughly the same thing at the same time!!

  8. It would be “straightforward to refinance” CIT’s commercial lending business? Puh-leeze! How, exactly? CIT is probably the largest commercial/vendor lending company in the country, with thousands of undrawn revolvers outstanding to businesses who finance 100% with CIT, and Simon thinks it would be “straightforward” to refinance these lines at a time when banks are already ridiculously reluctant to lend to businesses? What a joke.

    Also, Simon erroneously calls stiffing creditors “the essence of a ‘negotiated conservatorship,’ which is a “proven model in the US.” We did it once, with Continental Illinois back in ’84, and the “essence” of the entire episode was that the government BAILED OUT CONTINENTAL’S CREDITORS! Those of us old enough to remember it also know that it was a complete train-wreck — Contintental wasn’t “re-privatized” for 7 years. So not only is a negotiated conservatorship NOT a “proven model in the US,” it’s also the exact opposite of stiffing creditors.

    It’s hard to imagine how Simon could be more clueless.

  9. The amazing part of the Goldman story which no one has picked up on is the effect of paying out the bonuses to Goldman executives and the failure to retain sufficient capital against future shocks. While there is a generalized rant about the size of the bonuses, the media does not seem to connect the dots. If you are going to run a highly risky venture, backed up by government guarantees and backdoor subsidies via AIG transfers at 100% of stated value, shouldn’t the quid pro quo be that Goldman must limit the size of the bonuses and retain more capital against future losses? Back in the days when Goldman was a partnership, there was requirement to plow back bonuses into the trading capital of the firm through deferred compensation mechanisms. Where is the regulatory oversight or moderating influence of the Fed, the Goldman board or the Treasury to remind the management that they just had a “near death” experience and the prudent course would be to moderate bonus payments for the good of the enterprise. I am sure there will be a hue and cry that this interferes with their need to retain such talented executives. But isn’t this the group that created the “near death” experience or have all those folks been removed?

  10. PaulH–
    I wonder what support the WSJ could provide for the idea that the cartelization of finance would result in a loss of competition and dynamism. As I recall the 1950s and 1960s, a period of considerable American strength, investment banks were clubby, commercial banks were white shoe and a drowsy, utility-ethos pervaded the entire sector. Properly regulated, a ‘cartel’ is a utility. Of course, ‘properly regulated’ is one of those terms that just may assume the conclusion. But I’m still baffled at why the business of shuffling money around should be particularly lucrative if done according to a set of proper rules.

  11. I completely agree – but the feds last fall made the very profound decision to prop up the financial sector to avoid collapse.

    My question is – since we’ve made the commitment to absolve bankers of their losses, if we absolve only the losses from the biggest companies, aren’t we creating further incentive for additional consolidation? Where’s the “competition and dynamism” in that?

    Is that what we’ve wanted all along? The best and brightest working at just a couple of really big institutions, so that no matter what they do, the feds will HAVE to spread out the TARP to catch them when they fall? Who’ll use a smaller bank if they know that it will not be supported, should it fail? But Goldman and Chase WILL get the full backing of the feds?

    It seems that instead of moving away from “too-big-to-fail” – our policies in recent months have cemented it into place forever.

    (I don’t know what it is like where you live, but I happen to think that the electorate is feeling plenty of pain right now, at least over here in the flyover zone. What we need is the leaders of the financial institutions – the people who oversaw the risky behaviors that led to the collapse – to perhaps share in some of the downsides of the catastrophe – but that’s not happening at all – and does not look like it will ever happen.)

  12. Their business would not be straightforward to refinance at all, unless by straightforward you mean the Treasury is providing the capital. Why do you think there was a rush among their clients to draw down their lines? They are doing what they can to get by.

    Also, some of their small business clients are among their creditors.

    I agree CIT should not be bailed out, but they will be because this administration makes decisions for sentimental and not economic reasons.

  13. How big a bailout are we talking about?

  14. It comes back to the point Nemo made yesterday: there is no evidence bailouts have any political cost whatsoever.

    When the markets were crumbling and AIG bonuses were being paid, it looked like there was a political tide against bailouts. But it turned out that there was a political tide against falling markets; once the markets were talked up, the pressure fell away.

    The path of least resistance is to agree to the bailout. Refusing the bailout causes (a) the nonzero risk the equity market declines; (b) complaining from affected stakeholders. Granting the bailout, well, that’s just following precedent.

  15. Any more grand government intrusion schemes into the market will only result in more fraud and market manipulation.

    In the 50′s and 60′s there were very bright lines of behavior, that people did not cross and as a result the regulatory system performed in a significantly better way. What got us into this tragic mess is the wholesale fraudulent crony capitalism practiced by our regulators, our politicians and Wall Street. Any economic system based on fraud is bound to fail sooner or later. This is our regulatory system now; it just smoke and mirrors. This crony capitalism is new and did not exist back then to anywhere near the extent of today.

    To create more government intrusion will only make matters worse. Any cartel or government intrusion into the private sector is fraught with opportunities for market manipulation, unless there are clear transparent rules that are enforced. We are a long way for transparent rules that are enforced. Those in power, particularly at the Fed and Treasury, now routinely violate the law, and are never held to account or brought to justice.

    Add the fact that today’s media, unlike the media of yesteryear are just the spin doctors for the fraud. They rarely report the vast amount of market manipulation, and regularly present a dishonest picture to hide the manipulations of those in power.

  16. H Baskerville

    That’s true there isn’t much downside political risk. But I think the stockmarket comes into play here as much. As the WSJ pointed out some months ago, the Fed and the Treasury look to the stock market as an indicator of public confidence. They place more emphasis on it than we’d like from such a questionable economic indicator. With the first bailout, it wasn’t until the market did another dip and people called their congressmen to complain about their stock funded retirement that both parties got on board. Hard to sell bailouts when the stock market is going up. When it goes down, nothing is off the table.

  17. We are not going to get banking reform unless and until people realize what a Debt-Deflationary Spiral would do, and that we have just avoided one. Short of that, this will be seen as curable by normal means.

    If you do not think that such a possibility has just narrowly been averted, then I can understand not wanting the govt to intervene. But if you agree with me, you might well believe that we’re not out of the woods yet.

    I understand that many people might not get where I’m coming from, so I’m supplying a good link about Fisher:

    http://www.economist.com/businessfinance/displaystory.cfm?story_id=13104022

  18. don — thanks for carrying the torch on this one.

    here’s another link, for the curious: http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf

  19. looks like no bailout.

    poof.

  20. “A failure of CIT would impact thousands of retailers and, consequently, the consumer spending that makes up two-thirds of our nation’s economy,” Tracy Mullin, the chief executive of the National Retail Federation, an industry group, wrote in a letter to the Treasury secretary, Timothy F. Geithner, earlier on Wednesday. “That cannot be allowed to happen at a time when retailers are already struggling to survive the national recession.”

    It seems that the govt believes that Deflation has been defeated. I hope that they’re correct.

  21. The key phrase in your interesting comment is “Properly regulated …”.
    But howsoever things are changed with respect to regulation or systemic risk the reality is that any parachute that is deployed by the ‘authorities’ will open too late to stop us hitting the ground.

  22. This is degenerating into a farce… If $50 billion is now ‘too big to fail’ then Bernie Madoff’s investors missed the cut by only a few months!

  23. bayardwaterbury

    For me, it’s not bailout fatigue. I genuinely believe that this will provide the proper occasion for sending a new message to the market. FDIC has allowed the failure of banks this large, and CIT isn’t even a bank. Nope, sorry, not this time, and hopefully not next time.

    As I have said before: a little extreme pain right now, can prevent a never ending ache. Let’s get the major surgery over, have some therapy, and get on with our lives.

  24. My previous was not meant to suggest that pain isn’t being felt already by huge numbers across the world. But I have this terrible feeling in my water that what we have been through is nothing compared to what is ahead of us. About the only upside of that would be that, this time, the banks will get their just ‘rewards’.