Capital Markets

The Bust that Worked

CIT's bankruptcy fuels the debate about resolving financial failures.
Economist StaffNovember 6, 2009

CIT might just be that rarest of things: a financial-services firm that emerges from bankruptcy largely intact. The small-business lender filed for Chapter 11 protection on November 1st with the backing of most bondholders in a so-called “prepackaged” filing. A judge this week agreed to rule on its reorganisation plan on December 8th. If all goes well, a new, creditor-owned company, shorn of $10 billion of debt, could be up and running by the beginning of next year.

If CIT can persuade the judge to approve its plan, its fate will then rest with its regulators, including the Federal Deposit Insurance Corporation (FDIC). Badly burned when bond markets seized up, the company wants to move some important businesses to its Utah-based bank, where they can be funded by cheaper deposits. At the moment it is paying much more to borrow than it can charge for its loans.

But the bank remains hobbled by a “cease and desist” order from the FDIC that limits its deposit-gathering. CIT’s advisers hope this will be lifted but, as one admits, regulators are “in no mood to do favours”. It is not alone in its predicament. GMAC, which was also tripped up by a combination of wholesale funding and risky loans, has been forced to reduce its deposit rates, which it had hiked in a desperate bid to attract savers. The former financing arm of General Motors (GM) is in talks over a third injection of public capital.

CIT’s plight is meanwhile being used as ammunition in a rancorous debate over how to handle failed financial firms. The Obama administration wants Congress to hand regulators power to circumvent the bankruptcy process and take over troubled lenders large enough to threaten overall stability. But critics say CIT’s reasonably orderly filing shows that bankruptcy works, even for financial firms.

It should be the first choice wherever possible, they argue, because it provides creditors with predictability that is sorely lacking in the government’s proposed resolution regime. The Obama plan is vague about which creditors would take losses, and when. And it would invite meddling of the sort already seen in the bail-outs of GM and Chrysler, as lawmakers press regulators to treat their constituents favourably, says Peter Wallison of the American Enterprise Institute, a think-tank.

Worse, officials with resolution authority might be tempted to follow a “better safe than sorry” policy, rushing to take over firms whose failure would cause disruption but not systemic breakdown. The Treasury came close to doing just this with CIT, at first urging the FDIC to provide the firm with debt guarantees after concluding, incorrectly, that its collapse would send shock waves through the economy.

Nevertheless, the path trodden by CIT is not a template for the whole industry. It may be America’s fifth-largest bankruptcy but it is relatively modest in size for a financial firm. And its decline was gentle enough to allow it to get creditors behind its reorganisation. Lehman’s failure showed that straightforward bankruptcy is not ideal as a tool for resolving the biggest, most connected firms. Joseph Smolinsky of Weil, Gotshal & Manges, a law firm, thinks it is worth considering an adapted form of bankruptcy that gives the government the power to, say, sell assets or make management changes while leaving most creditors’ rights intact.