Taxpayers on hook as some bailed-out firms prove frail
With CIT in bankruptcy, U.S. is faulted for investing in weakened companies

By Tomoeh Murakami Tse
Washington Post Staff Writer
Monday, November 16, 2009

NEW YORK -- A year ago, the financial system was tottering and government officials arranged a $2.3 billion emergency cash infusion into CIT Group, a troubled lender to small businesses.

Today, CIT is in bankruptcy court, and the taxpayers' investment is on the brink of being wiped out. It would be the largest loss so far from the government's massive rescue of the financial system, but it isn't likely to be the last.

Officials poured about $700 billion into investments in scores of companies, from giants such as the automaker General Motors and the insurer American International Group to smaller regional banks. Of them, 46 had missed required dividend payments to the government as of the end of September, according to the inspector general overseeing the program.

On Nov. 6, United Commercial Bank of San Francisco failed, becoming the first recipient of the Troubled Assets Relief Program, or TARP, to collapse. The cost to taxpayers: $299 million.

Analysts expect more bailed-out firms to fail in the months ahead. Others may survive but will struggle to repay the government. Steven Rattner, the former head of the government's efforts to bail out the auto industry, said recently that the full public investment in GM is unlikely to be repaid. Meanwhile, AIG is dismantling itself, selling healthy subsidiaries at what critics say are bargain prices in an all-out effort to get cash to repay the government.

About $400 billion of federal investments remain in the corporate sector, much of it channeled through TARP. Critics of the program say losses were inevitable, in many cases.

Bankers, lawmakers, state banking regulators and oversight committees have faulted federal officials for providing funds to firms that were so sick that they couldn't recover and for failing to be open about how recipients were chosen. Some critics have also attacked the government for the types of investments they made.

Many investments were in the form of preferred shares, which pay a high dividend but get wiped out in bankruptcy, even reorganizations in which the firms survive. That's what's happening with CIT.

The government provided assistance to CIT only after the Fed determined that the company would be "well capitalized" by regulatory standards by the time it became a bank holding company. But that didn't mean that it had enough money to ride out its snowballing losses, even with federal help. And while the Treasury Department's stated goal was to help CIT keep making loans, in practice lending all but evaporated afterwards.

"It was very obvious as of a year and a half ago that it was in dire need of a substantial amount of more capital," said Sean Egan, co-founder of the independent credit rating firm Egan-Jones, who had questioned the move at the time. "The $2.3 billion was wasted. They didn't save CIT, and they didn't save the taxpayers' money."

Bert Ely, an Alexandria banking analyst, said CIT should have been reorganized under bankruptcy in December because its business model -- borrowing money cheaply and lending it out again to others -- was "basically broken." With the company's credit ratings tumbling, its cost of borrowing had reached a point where CIT could no longer be profitable, he said.

"The problems of CIT would have been confronted earlier," Ely said. "There wouldn't have been a lot of the turmoil in CIT and among CIT customers that we've seen. But in the meantime, it's kind of rotted on the vine. . . . CIT is one particular TARP investment for which there ought to be a lot of questions asked."

Signs of trouble at CIT Group were apparent early in the financial crisis, after the subprime mortgage market began teetering. Anxious investors retreated from the credit markets, cutting off CIT. The company had depended almost solely on these investors to raise money. Borrowing costs rose, loans soured, and CIT, which had expanded into subprime mortgages and student lending, began reporting losses in mid-2007. At the end of that year, the company had $477 million in problem loans.

By early 2008, the company was drawing on $7.3 billion of emergency bank credit. CIT quickly blew through those funds. Analysts questioned the 101-year-old firm's ability to remain solvent. It sold off assets to stay afloat. The volume of problem loans spiked to $1.4 billion by the end of last year.

In December, federal regulators came to the rescue. In making CIT eligible for bailout funds by approving its application to become a bank holding company, the Federal Reserve's board of governors noted that CIT was a leading lender to start-up and existing small businesses, as well as a leading provider of factoring services, which allow retailers and other companies to finance their ongoing business by selling debt for immediate cash. Approving the CIT application would "benefit the public by strengthening CIT Group's ability to offer its nonbanking products and services to customers nationwide," the Fed said. Those benefits, the Fed said, "outweigh possible adverse effects."

"Emergency conditions" arising from turmoil in the financial markets justified "expeditious action on this proposal," the Fed board explained. It determined that CIT was "adequately capitalized" by regulatory standards and projected that the firm would soon be "well capitalized" as a result of its recent efforts to raise additional capital in private markets.

The Feb board unanimously endorsed CIT's application to become a bank holding company, making it one of several firms -- including Goldman Sachs and American Express -- that underwent such a conversion to gain access to government support.

One day later, in the final weeks of the Bush administration, Treasury gave preliminary approval for the emergency infusion of cash into CIT.

Yet despite officials' hopes, CIT made few new loans. The firm made only 142 loans backed by the Small Business Administration in the 12-month period that ended Sept. 30, down from 1,195 loans in the previous year.

Meanwhile, problem loans reached $2.3 billion six months after the Treasury rescue. The firm's ability to absorb losses had diminished substantially, according to an analysis by SNL Financial.

In July, CIT requested more federal funding but was denied as administration officials decided that a failure would not pose a threat to the recovering economy.

CIT is now hoping to emerge next month as a newly restructured company through what is known as a prepackaged bankruptcy, with minimal harm to its customers and bondholders. The taxpayer investment, however, does not receive the same protection.

"We all hoped that all of the TARP investments would be good, and the taxpayers certainly have gotten a very strong return on many of those investments, but it's inevitable when you invest in hundreds of institutions, that some of them are going to go bad," said Phillip Swagel, who served as assistant Treasury secretary for economic policy until January

Swagel, who was a member of the five-person committee that vetted each application for bailout funding, said CIT had been approved on the merits of its application and not because it was deemed vital to the health of the financial system.

But Alan S. Blinder, a Fed vice chairman during the Clinton administration, said the case for CIT was hardly clear-cut.

"Of all the financial companies that were rescued or semi-rescued, CIT was always the thinnest case, the toughest to defend," he said. "My attitude was: Hold your nose and go for it. It's something that I would rather not have seen the government do. . . . But the Fed and the Treasury and the others were in the unenviable position of being like the Dutch boy with the finger in the dike. And we definitely didn't want the dike to burst."

© 2009 The Washington Post Company