Does Liquidating Bad Debts Start with CIT Group (CIT)?

July 15th, 2009 by

James Cullen

One prominent argument used by critics of the government’s actions since September 2008 has been that various programs – TARP, TLGP, etc. – have been used to avoid the reckoning needed to clear bad debts out of the system. For a time, any new risks that emerged were dealt with through creative application of the rules (as with many “bank holding companies”) or, when that failed, by simply creating a new lending facility. The government’s blessing likely saved many marginal institutions, and several larger ones as well.

The policy of saving everything that’s not Lehman looks ready to be put to the test, as CIT Group (CIT) is said to be unable to obtain help from the government. The stock now trades under $2/share, and the credit default swaps are flirting with a 40% up-front premium. For its part, CIT has argued that they provide key financing to small businesses, and should be supported while they work out things on their balance sheet. Without CIT, it continues, these companies might have their credit lines dry up, creating economic ripple effects.

I’m not going to speak in particular about CIT, but about the precedent – one way or another – that it could create. Why should you allow for failure?

Clears competitive playing field for survivors

Forces reconciliation of bad debts

Rationalizes return expectations

Promotes economic economic activity (double word intended)

The main theme is that profitability moves in cycles. The more competitors in a space, such as lending, the narrower the earnings spreads will be. Want to achieve ROE targets from a quieter era? Add more leverage to your declining ROA. That will do the trick, until the cycle turns and the quality of your loan book starts to raise eyebrows from those who lend to you. The seemingly free lunch from borrow short, lend long has to have periodic shakeouts; it’s what keeps spreads healthy and allows some banks to make profits long-term.

Does government help certain businesses in many ways? Yes, point granted. But should government be responsible for making decisions about one-off bailouts every time a company gets in trouble? Letting a debt-laden company linger when the underlying equity is close to zero, especially by using taxpayer money, is implicitly transferring money to debtholders, as well as granting equity holders increased option value. In other words, private capital wins all around, at the expense of public money. How this is good public policy eludes me.

“Rationalize” is often management-speak for “cut” – but that’s exactly what should happen in a recession. Letting failure happen shows that equity ownership, and debt lending, carries risks. It forces investors to think more carefully about allocating capital, and discourages reaching for high returns. If a company can execute a debt-for-equity swap to recapitalize, that’s great – but it stresses the point that a combination of high returns and safety can’t always be achieved through a full cycle, even at a senior position in the capital structure.

When firms disappear from the competitive landscape, it helps those with strong hands. Taking it a step further, it also impacts those who did business with the failed company. If you happen to be a smaller business, and your lender goes under, what happens to you? If you are a good credit, it shouldn’t be impossible to find another source of credit. Will it be more expensive? Perhaps. But under-pricing risk on the part of your original lender led to their insolvency. The solution to that is to raise the associated costs, so that the lending activity is economic (i.e. value-creating) over a full cycle after appropriately provisioning for credit losses. This might be painful for some marginal borrowers, but it is ultimately what helps the system clear out and reset to one that allows for healthy growth.

Recessions cause pain. Oftentimes it seems unfairly applied, but no good solution has been found. Losses have to be taken at some point, by someone – postponing the process simply leads to silent losses (decreased profits) through the opportunity costs associated with the unreasonably high competition that comes with subsidized businesses. Up to this point, it has seemed that politicians have preferred the delay-and-pray, but a chance to change course has arisen. Hopefully, policymakers will start evaluating the viability of allowing failure to happen naturally across all industries, recognizing the immediately unintuitive outcomes may be in the best long-term interest of the country as a whole.