No Bailout of CIT Group; At Least For Now

Yesterday, CNN reported:

Cash-starved small business lender CIT Group said Wednesday evening that it has been told it won't be getting a government bailout anytime soon.

There is "no appreciable likelihood of additional government support being provided over the near term," the company said in statement. The CIT board and executives are evaluating alternatives.

In the preceding days, there had been discussions between the federal government and CIT concerning a fresh round of federal assistance for the troubled small business lender. Had assistance been rendered, it would have stretched the federal government’s “too big to fail” doctrine beyond its implied purpose of preventing events for which the fallout could lead to the failure of the nation’s financial system. Instead, such a decision would have indicated that the “too big to fail” doctrine, already laden with moral hazard, had evolved into one in which it is politically unpalatable to allow even smaller entities to fail. Then, political connections, not the size of the firm or the risk it posed, would become the arbiter of whether a firm’s survival would essentially be guaranteed by the federal government. Such an outcome would further erode market discipline.

CIT Group is much smaller than the financial firms that were propped up by massive federal assistance. In its March 31, 2009 quarterly balance sheet, CIT reported $75.7 billion in assets. In contrast, assets held by Citigroup amounted to $1.9 trillion at the end of last year. Bank of America had assets of $1.8 trillion, and AIG’s assets amounted to $860.4 billion. Simply put CIT Group was nowhere near the class of firms that posed systemic risk.

Furthermore, were CIT’s to fail, it would not become the largest failed financial institution. When Washington Mutual Bank was shut down by the FDIC, it held assets of $307 billion. Additional banks with assets of $10 billion or more that were closed down were IndyMac, Downey Savings & Loan, and BankUnited Federal Savings Bank.

Rather than stretching the “too big to fail doctrine” into a de facto policy that exacerbates moral hazard, two viable alternatives exist:

• The FDIC could close down CIT Group and use its normal resolution process to dispense of CIT’s assets. CIT had previously registered as a bank holding company.

• The federal government could leave CIT to find such financing that it needs from private sources. Failing that, it could leave CIT to file for bankruptcy. Considering the FDIC’s need to conserve cash for the additional bank failures that are likely in coming months, the second option of leaving CIT to file for bankruptcy is probably the more attractive choice.

Either course would indicate to wary taxpayers that the federal government will not provide assistance to firms that are not too large to fail. Instead, extraordinary federal assistance would be confined to those entities that pose systemic risk. That, in turn, would limit the probability of the development of more widespread excessive risktaking in the future based on expected federal bailouts to preclude firm failure. Currently, moral hazard elevates the risk of such practices on account of a de facto federal guarantee that has been affirmed and reaffirmed for firms that pose systemic risk since the 1970s.

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