CIT Group Failure Threatens Halt To This Year's Financial Sector Recovery

(MoneyWatch)  Just as the financial services industry seems to have made it past the worst of the economic meltdown, one small lender now threatens to reverse that trend. CIT Group, a lender to small and medium sized businesses, appears to be on the brink of collapse for the second time this year.

CIT Group averted bankruptcy over the summer, when it secured a $3 billion loan with its bondholders, and managed to tweak a giant tender offer for debt maturing shortly thereafter. The move served as a mere stopgap however, since the lender had a $2.9 billion negative cashflow position at the end of June this year.

With the moment of truth at hand once again, insiders say that CIT is attempting to prioritize nearer-term debt holders, a move which would dilute common stock holders by around 95 percent, leaving them almost wiped out.

Wednesday, traders pushed up the cost of CIT's credit default swaps by 4 percent, to 26 percent; the implication is that the lender has a 45 percent chance of defaulting on its debt within three months, and an 85 percent chance of defaulting on its debt by 2014.

Meanwhile, CIT is also rumored to be recommending that bondholders approve a pre-packaged bankruptcy plan in case the new debt-exchange doesn't go through.

Whatever the outcome, it's clear that CIT doesn't have the financial muscle to protect all parties involved.

For equity holders, any further financing efforts are likely to leave them holding the bag, since they are at the bottom of the heap in terms of having any claims on the firm's assets. Holders of debt maturing later than next year look likely to experience some sort of default.

Most worryingly of all, for small businesses there really aren't many other places they can go to get the kind of financing that CIT provides them with right now:

"Large banks, who have been able to find their way back from the abyss, are not making these loans, and the regulators on the ground are telling them not to make these kinds of loans. It is not the best use of their capital. They are high risk. They are small. It takes a lot of energy. And our smaller regional and community banks are on the cusp of failure," said Lynn Tilton, chief executive of distressed investment firm Patriarch Partners said on Tuesday at the Reuters Restructuring Summit.

Tilton wants the firm to use the potential consequences of its own bankruptcy as a way for government officials to sit up and listen, and potentially step in to save the day. In that case, the result would be an additional fresh bailout package, just as it was thought that many financial services firms were weaning off their own and starting to raise money in the capital markets.

That in turn will make many of the recent bank share offerings much less attractive, as stock prices of small banks decline on fears of further CIT-style fallouts.

Followers of financials will be watching CIT like a hawk over the coming days, and so they should be. It genuinely appears now that the lender threatens to put a spanner in the works of much of this year's momentum among financial services firms.