Federal Regulators and CIT Play Chicken

A remarkable game of chicken is being played in Washington that has the potential to set a new precedent for banks pushed to the brink in this year old financial crisis. It may also cause some serious headaches for nearly a million small businesses.

On one side are federal regulators - specifically FDIC chairwoman Sheila Bair. On the other, CIT Group - the country's largest lender to small business.

CIT may declare bankruptcy as soon as tomorrow unless federal regulators allow it to shift around $9 billion of its own assets it needs to reassure the credit markets it has the money it needs to meet its obligations.

CIT specialty is providing cash to businesses waiting to get paid by customers. One way CIT does this is by basically buying pending invoices. In the trade this is called "factoring" and it is popular solution to a business owner's cash flow problems.

For example - a dress maker will sell its invoices to CIT for the cash it needs to buy fabric to make new garments. Factoring is a service largely avoided by the country's biggest banks because of the relatively small size and great frequency of these transactions. Factoring is also less expensive and less restrictive for small business owners than a conventional loan - 960,000 businesses get quick cash loans from CIT Group, including about 60 percent of the retail trade.

But over the last few years CIT, like nearly everyone else in the financial industry, didn't stick to its knitting. They too made bad bets on risky loans and debt instruments. Despite receiving $2 billion in TARP money last year, investor confidence in the firm has steadily eroded. It's lost $3.4 billion over the last two years, does not foresee a profit until 2012 and is having a very difficult time getting loans to pay its own bills.

Is CIT too big to fail? For now, it seems the answer from Washington is "no."

The FDIC is sticking to its determination that CIT has little chance of ever being successful. Other regulators have determined that the systemic risk of CIT's failure does not merit the kind of government help extended to Citigroup, AIG and others. Some in the banking industry, like JP Morgan Chase also believe the failure of CIT would not threaten the financial system.

But the impact of CIT's demise on small and medium size businesses is an unknown. MIT economist Simon Johnson is among those who wonder if throwing CIT to the wolves may be too risky. This Great Recession has been brutal on small businesses. CIT's failure could be a major obstacle on their road to recovery.

As of Thursday afternoon sources deeply involved in the negotiations between the government and CIT say there is still a glimmer of hope for the firm. But given the degree of "bailout fatigue", it seems increasingly possible that CIT will be forced to blink first and seek the safe harbor of Chapter 11. The immediate cost to the US taxpayers would be the $2 billion in TARP money it loaned to CIT. The long term cost to the economy is anybody's guess.

Guy Campanile is a CBS Evening News Business Producer.