Financial Distress of CIT Group: Causes and Consequences | Assignments Investment Theory

Oaktree-CIT Case Assignment

Question 1:

Why is CIT in financial distress? What are the main factors that contributed to CIT’s poor financial performance in 2007-

2009?

CIT Group faced financial distress during the 2007-2009 period. Following are the chronological CIT Group’s deteriorating

conditions during that period based on the case:

• June 2007 – CIT had a loss of $127 million quarterly loss;

• By the end of 2007 – Approximately 30% of CIT assets were encumbered by secured borrowing;

• In the first quarter of 2008 – CIT drew down $7.3 billion, the full amount available under four separate senior unsecured

revolving lines to fund daily operations, and its shares plunge 17.3% to around $9 (refer to Exhibit 1);

• June 2008 – It secured $3 billion of financing from Goldman Sachs. Also, CIT lost its ability to use the commercial paper

market to raise short-term liquidity for ongoing operations as it lost its top-tier A1/P1 ratings;

• July 2008 – CIT was exiting the mortgage lending business, and it sold the business for $1.8 billion and the assumption

of $4.4 billion in debt to Lone Star Funds;

• December 2008 – CIT got approval for $2.3 billion capital infusion by the US government's financial aid program;

• June 2009 – Credit rating agency cut its rating on CIT Group into junk territory; and

• July 2009 – CIT had been running at a net loss for 9 straight quarters and had been unable to sell its corporate bonds as

its primary source of funding. By the end of 2009, CIT had more than $2 billion of debt due and over $4 billion due in the

first half of 2010. Ultimately, CIT reached out to its largest creditors and tried to work out a financing plan in hope of its

way out of a deepening liquidity crunch by obtaining $3 billion.

Based on the timeline mentioned above, the global financial crisis severely impacted the CIT Group. Main factors, both

systemic and company-specific had caused CIT into a state of financial distress are as follow:

• Exposure into higher risks

CIT’s troubles began after the newly appointed CEO Jeffrey M. Peek strived to expand CIT by venturing into higher-risk

areas like subprime mortgages and student loans in 2003, without putting proper credit controls in place. While the

strategy temporarily boosted profits and share prices, CIT failed to accurately price the risk of these loans, leading to

significant losses.

• Heavily reliance on capital market to raise funds

Unlike banks with steady savings deposits, CIT relied heavily on issuing bonds and short-term debt, like commercial paper

to fund the operations. Nearly 80% of CIT’s debt financing was medium- to long-term unsecured debt, with commercial

paper issuance and secured non-recourse borrowing accounting for another 15%. This worked when things were good,

but when the crisis hit and people stopped lending, CIT struggled to access liquidity.

• Spill-over effect by the customers

Many of CIT's business customers were also impacted by the crisis (e.g. small businesses, retailers). This led CIT, as a

lender, faced challenges as the credit quality of the loan portfolio decreasing, impacting its financial performance.

• Credit rating downgrades

As CIT's financial performance deteriorated, credit rating agencies downgraded its debt, causing it more expensive for

CIT to access funding by issuing bonds and commercial paper, to finance its operations.

• Denial of access to the US government’s financial aid programs

Ironically, CIT couldn’t secure the access to the US government assistance programs like TARP and TLGP. In order to

qualify for TLGP, the regulatory body had to determine that CIT was solvent and that its failure would pose a systemic

risk to the financial sector. It was considered not systemic enough given its key role as a lender to small businesses across

the US. This left CIT without a significant source of funding.

In summary, risky lending, cheaper but riskier funding sources, recessionary pressures on loan performance, rating

downgrades, and inability to access government assistance programs combined to severely damage CIT's financial

performance during the financial crisis.

Question 2:

How did CIT fund its operations leading up to the financial crisis? How did it change during the financial crisis? Why is CIT

struggling to refinance its debt now?

Pre-crisis funding:

In the period leading up to the financial crisis, CIT primarily generated its funds by utilizing medium-term to long-term

unsecured debt and short-term commercial paper markets. The commercial paper facilitated an inflow of funds, with

rollovers occurring every few months to provide cash for CIT's lending activities. Simultaneously, the issuance of medium-

term to long-term unsecured debt remained consistent as investors sought a share in CIT's great profits.

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Question 1: Why is CIT in financial distress? What are the main factors that contributed to CIT’s poor financial performance in 2007- 2009? CIT Group faced financial distress during the 2007-2009 period. Following are the chronological CIT Group’s deteriorating conditions during that period based on the case:

June 2007 – CIT had a loss of $127 million quarterly loss;
By the end of 2007 – Approximately 30% of CIT assets were encumbered by secured borrowing;
In the first quarter of 2008 – CIT drew down $7.3 billion, the full amount available under four separate senior unsecured revolving lines to fund daily operations, and its shares plunge 17.3% to around $9 (refer to Exhibit 1);
June 2008 – It secured $3 billion of financing from Goldman Sachs. Also, CIT lost its ability to use the commercial paper market to raise short-term liquidity for ongoing operations as it lost its top-tier A1/P1 ratings;
July 2008 – CIT was exiting the mortgage lending business, and it sold the business for $1.8 billion and the assumption of $4.4 billion in debt to Lone Star Funds;
December 2008 – CIT got approval for $2.3 billion capital infusion by the US government's financial aid program;
June 2009 – Credit rating agency cut its rating on CIT Group into junk territory; and
July 2009 – CIT had been running at a net loss for 9 straight quarters and had been unable to sell its corporate bonds as its primary source of funding. By the end of 2009, CIT had more than $2 billion of debt due and over $4 billion due in the first half of 2010. Ultimately, CIT reached out to its largest creditors and tried to work out a financing plan in hope of its way out of a deepening liquidity crunch by obtaining $3 billion. Based on the timeline mentioned above, the global financial crisis severely impacted the CIT Group. Main factors, both systemic and company-specific had caused CIT into a state of financial distress are as follow:
Exposure into higher risks CIT’s troubles began after the newly appointed CEO Jeffrey M. Peek strived to expand CIT by venturing into higher-risk areas like subprime mortgages and student loans in 2003, without putting proper credit controls in place. While the strategy temporarily boosted profits and share prices, CIT failed to accurately price the risk of these loans, leading to significant losses.
Heavily reliance on capital market to raise funds Unlike banks with steady savings deposits, CIT relied heavily on issuing bonds and short-term debt, like commercial paper to fund the operations. Nearly 80% of CIT’s debt financing was medium- to long-term unsecured debt, with commercial paper issuance and secured non-recourse borrowing accounting for another 15%. This worked when things were good, but when the crisis hit and people stopped lending, CIT struggled to access liquidity.
Spill-over effect by the customers Many of CIT's business customers were also impacted by the crisis (e.g. small businesses, retailers). This led CIT, as a lender, faced challenges as the credit quality of the loan portfolio decreasing, impacting its financial performance.
Credit rating downgrades As CIT's financial performance deteriorated, credit rating agencies downgraded its debt, causing it more expensive for CIT to access funding by issuing bonds and commercial paper, to finance its operations.
Denial of access to the US government’s financial aid programs Ironically, CIT couldn’t secure the access to the US government assistance programs like TARP and TLGP. In order to qualify for TLGP, the regulatory body had to determine that CIT was solvent and that its failure would pose a systemic risk to the financial sector. It was considered not systemic enough given its key role as a lender to small businesses across the US. This left CIT without a significant source of funding. In summary, risky lending, cheaper but riskier funding sources, recessionary pressures on loan performance, rating downgrades, and inability to access government assistance programs combined to severely damage CIT's financial performance during the financial crisis. Question 2: How did CIT fund its operations leading up to the financial crisis? How did it change during the financial crisis? Why is CIT struggling to refinance its debt now? Pre-crisis funding: In the period leading up to the financial crisis, CIT primarily generated its funds by utilizing medium-term to long-term unsecured debt and short-term commercial paper markets. The commercial paper facilitated an inflow of funds, with rollovers occurring every few months to provide cash for CIT's lending activities. Simultaneously, the issuance of medium- term to long-term unsecured debt remained consistent as investors sought a share in CIT's great profits.

Graph 1: Debt Structure Details, December 2006 (pre-crisis) Source: CIT Group Balance Sheet (2006) Referring to the CIT Group balance sheet on December 2006 (refer to Graph 1), CIT relied heavily on issuing medium-term to long-term unsecured debt amounting to 79.6% of its total debt, commercial paper amounting to 8.8%, some secured borrowings (7.2%), and very little deposit funding (<5%). Funding changes in crisis: CIT raised most funds by issuing medium-term to long-term unsecured debt. Being unsecured, these debts offered had no specific collateral for investors to fall back on if CIT defaulted. Thus, investors demanded higher interest rates on these debts. The high risk associated with unsecured debt, combined with the global economic challenges during the financial crisis, contributed to the financial difficulties that CIT faced during that time. Due to the crisis, CIT’s credit ratings experienced a downgrade. For CIT which mostly relied on capital markets rather than deposits to fund itself, this meant if sentiments turned negative, CIT would be unable to issue fresh bonds to repay maturing ones. Also, for the case of commercial paper, investors could refuse to roll over leaving CIT cash crunched. And that is exactly what emerged when the financial crisis set in. Investors lost their appetite for commercial paper and bonds issued by CIT, making CIT lost access to commercial paper and unsecured bonds. This created challenges for CIT in securing funds for its operations. In the third quarter of 2007, CIT began relying more on secured borrowing, and approximately 30% of its assets were encumbered by secured borrowing. Furthermore, it drew on $7.3 billion in backup bank lines of credit in 2008. Additionally, as its commercial paper lost its A1/P1 credit rating, CIT arranged a $3 billion secured loan from Goldman Sachs. Graph 2-4: Debt Structure Details, December 2007, December 2008, and June 2009 (from left to right) Source: CIT Group Balance Sheet (2007-2009) Referring to the CIT Group balance sheet during crisis from December 2007 to June 2009 (as shown in Graph 2-4) and compared them with the debt structure in 2006, CIT still relied heavily on the unsecured debt, but they were decreased at significant level from pre-crisis at around 80% to 53% of its total funding in 2009. Compared with 2006, commercial paper’s share decreased from 9% to 0% in 2009, some secured borrowings’ share increased from 7% to almost 30%, and deposit funding increased from less than 5% to 9%. Current refinancing difficulties: In 2009, as lending losses mounted and a substantial amount of bond debt needed refinancing, CIT was under financial distress. With more than $2 billion of debt due at the end of 2009 and over $4 billion due in the first half of 2010, CIT urgently needed to refinance its near-term maturities. Adding to the challenges, regulators denied CIT access to government aid programs (TLGP) that could have helped. This led to further credit downgrades, and its annual CDS spread jumped to 6, basis points. Investors were unwilling to lend to CIT given its poor financial performance. Due to these reasons, CIT was unable to refinance its debt. Ultimately, CIT had to resort to a last-resort $3 billion rescue loan from its largest creditors to prevent into bankruptcy. The company's longstanding reliance on considerably “easy” funding for its operations proved unsustainable. Question 3: What are the unique characteristics of CIT that will influence the outcome of the restructuring? What are the important elements of a restructuring that we need to keep in mind for the case? Based on the case, a few key unique characteristics of CIT Group that would influence the outcome of its restructuring:

As a bank holding company, CIT falls under stricter supervision on capital, liquidity, risk management by the Federal Reserve. CIT may likely to face regulatory restrictions on share buybacks, dividends, and bonus pay-outs to preserve capital during restructuring. Management needs to oblige to the regulations and move past them to succeed.

Timing Pre-packaged plan of reorganization with negotiated terms upfront would substantially speed process and reduce risks. Question 4: What was Oaktree’s strategy for investing in CIT’s publicly traded debt? Compute the return on investment for Oaktree if CIT files for bankruptcy now. (Historical recovery rates for senior secured and senior unsecured debt are 80 cents and 45 cents on the dollar, respectively. The five-year default rate for senior secured debt is approximately 3%. The average purchase price for notes held by Oaktree is 65 cents on the dollar). What were the risks for this strategy? Oaktree's investment strategy:
In late 2008, Rajath Shourie and his team at Oaktree viewed that t he market was undervaluing the recovery that CIT ’s unsecured creditors would realize in the case of bankruptcy.
As all CIT notes were trading at a discount , Oaktree found that there was a significant dispersion in price across the different maturities of CIT unsecured notes.
The near-term notes were more expensive than longer-term notes because they were more likely to be repaid at par or bought out in a restructuring. Additionally, in the case of bankruptcy, only notes with longer maturities that were purchased at a significant discount were likely to have a positive return. Thus, Oaktree decided to buy CIT unsecured notes with mid-term maturities. Return on Investment:
Purchase price: $0.65 per $1 face value
Historical recovery rate for unsecured debt: $0.45 per $1 face value
Gain (loss) per $1 face value purchased: $0.45 - $0.65 = ($0.20)
Gross return = ($0.45/$0.65) - 1 = ( 3 0.8%) Risks of the strategy:
Deviation from historical averages of actual recovery rates The actual recovery rates in a bankruptcy could differ from historical averages, leading to larger losses. Unforeseen factors like legal and regulatory complexities, or changes in market sentiment could result in larger losses.
Avoidance of bankruptcy CIT might avoid bankruptcy and pay bonds at par, and it could either limit the potential upside or downside of Oaktree’s investment strategy. But in this case, the success of Oaktree's strategy was dependent on CIT experiencing financial distress leading to bankruptcy. If CIT successfully implements an alternative solution or recovers without entering bankruptcy, Oaktree's expected returns may not go as expected.
Timing of bankruptcy filing The timing of CIT's bankruptcy filing can impact the returns. If the bankruptcy process is longer than expected, it may affect the recovery rates and overall returns.
Out-of-court restructuring If CIT were to undergo a restructuring outside of bankruptcy court, Oaktree's expected recovery scenario might not go as planned. Out-of-court negotiations could result in terms less favourable to debt investors.
Information and execution Oaktree believed that to realize the investment opportunity, Oaktree tried to accumulate a position in CIT’s unsecured debt, without leaking this information to the market. Gathering accurate and timely information, especially about CIT's financial prospects and potential restructuring is crucial. However, executing trades for accumulating the position in the bonds also requires careful consideration of market conditions, liquidity, and the potential impact on prices.
Limited control As a passive debt investor, Oaktree has limited control in CIT's restructuring. Unlike active creditors with substantial control, Oaktree may lack the ability to shape key decisions, such as restructuring terms and recovery options. Appendix and Supporting Materials Exhibit 1: CIT Group, Daily Stock Prices, July 2007–July 2009 (in $)

Source: HBS Case Study, Reuters shares plunge 17.3% to $9.

Financial Distress of CIT Group: Causes and Consequences, Assignments of Investment Theory

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