Warren Buffett on CIT Group's failing business model

CIT Group (CIT), the lender to small and mid-size businesses, has seen plenty of trouble lately -- something that puts it in good company with other financial institutions. But CIT Group is unique in one sense, and that is the company's lack of a deposit base. That financing strategy is killing the company, Warren Buffett said on Fox Business News. "[T]he problem with CIT is that their raw materials, which is money, costs them far, far, far more than their competitors. So the banks have access to money at average rates that are really very tiny now. And CIT's money cost them way more."

Instead of mainly taking in deposits and loaning that money out, CIT Group borrows on the debt markets and uses the capital it receives to finance its customers. That strategy collapsed in the wake of Lehman's failure, as the cost of borrowing for companies like CIT soared enough to make spreads, or the difference between borrowing cost and lending revenue, unprofitable. The company has struggled to access the liquidity it needs to pay off near-term debt maturites, and the market's confidence in the company has been shaken.

Earlier this week, CIT agreed to take distressed debt financing from several lenders, paying a minimum of 13 percent for $3 billion in funds. While this will postpone a potential bankruptcy filing by the company, Buffett was clear that such measures were little more than a patchwork solution. "[I]f you are the high-cost producer in a business, you know, eventually it catches up with you and basically that business has to be transferred to somebody who has low funding costs... You can't compete in the money business paying 13 percent for money today," he added.

Left unsaid is the dual role the government has had in pushing CIT Group to the brink: it both lowered interest rates and refused to guarantee debt issuances by the company. The FDIC has not allowed CIT Group to access the Temporary Liquidity Guarantee Program (TLGP), fearing that the company will default and the agency will be forced to make up the losses. TLGP makes it much easier for companies to raise debt, because the implicit backing of the U.S. government grants a AAA-rating.

DailyFinance has documented the impact falling interest rates have had on the profitability of deposit-taking banks, noting that the savings amount to billions of dollars per quarter for major retail operations like Wells Fargo (WFC). Short-term interest rates are one lever the Federal Reserve attempts to use to manage the economy; rates are at an all-time low in an established range of zero to 0.25 percent.

This does not excuse CIT Group's management for failing to recognize the risks to its funding model, nor for the well-documented push to expand into student loans and subprime mortgages. It is, however, an example of the unintended consequences that occur when government promotes favoritism through intervention in markets -- something you likely won't hear your Congressperson talk about in his next rant about bailouts.

James Cullen edits and writes at CollegeAnalysts.com. He has no personal position in the stocks mentioned above.

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