Why CIT Group's bankruptcy doesn't matter

I would like to congratulate the Obama administration for drawing the right line in the sand. Unlike the Bush administration, Obama did not permit a $639 billion bankruptcy -- Lehman Brothers -- whose collapse nearly caused social chaos as people lost confidence in their money market funds. With today's CIT Group (CIT) bankruptcy filing, the U.S. will lose $2.3 billion in TARP money, but with $71 billion in assets, CIT will keep operating and global panic will not follow.

As I posted previously, CIT Group makes loans to about a million small businesses like Dunkin' Brands franchises. Those businesses need capital to operate and they can't get it very easily by accessing public debt and equity markets. So lenders like CIT Group really matter to them. But the company got distracted by subprime mortgages and student loans and it is likely to scale back to its core business of lending to small and medium sized business.

In the pre-packaged bankruptcy, Carl Icahn is providing $1 billion to fund operations while it reorganizes through a debtor-in-possession loan until the end of 2009 -- when Bloomberg reports -- CIT Group expects to emerge from bankruptcy. Bondholders -- 85 percent of whom voted their $30 billion in favor of the deal -- will receive about 70 cents on the dollar according to DealBook.

The U.S.'s $2.3 billion in preferred stock and common shareholders' stock will be wiped out. Those common shareholders include FMR LLC -- a Fidelity Investment company -- with a 9.9 percent stake in CIT common and Brandes Investment Partners LP with 9.7 percent, according to Business Week.

I think that investors should derive confidence from this announcement. That's because it proves that the private capital markets can function well enough without government assistance to allow a company to fail without government intervention. Unfortunately taxpayers will lose $2.3 billion (out of $700 billion in TARP money) in the process.

But the real problem is that bigger TARP recipients -- like Citigroup (C) -- could be in greater danger, according to the New York Times. However, the U.S. has decided that the cost of their failure cannot be born by free markets. So they're still too big to fail. And the U.S. taxpayer may need to throw more good money after bad to prop them up.

An interesting footnote to this deal: up until last Friday, as I posted early last month, Goldman Sachs Group (GS) was poised to pull in a cool $1 billion if CIT went bankrupt. But on October 30th, CNNMoney reports that Goldman and CIT reached an agreement in which CIT would reduce the size of its Goldman loan to $2.125 billion from $3 billion.

In exchange, CIT will pay Goldman a mere $535 million -- including a termination fee of $285 million and collateral of $250 million. That looks much better than the cool $1 billion Goldman would have gotten.

Peter Cohan is a management consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter. He owns Citi shares and has no financial interest in the other securities mentioned.

Read Full Story