Monday, July 13, 2009

Lehman, Redux

The looming failure of CIT offers the real possibility of a repeat of the Lehman Brothers shock.

The reasons that Lehman Brothers was permitted to fail in a disorderly fashion aren't worth visiting in any detail, mostly because of the storm of post-hoc CYA bullshit that cascades forth from otherwise decent people at the first inquiry into those reasons. Suffice to say that no one adequately appreciated the consequences of the Lehman bankruptcy, and everyone immediately (okay, it took the House two tries) sprang into action when those consequences were understood.

Does the CIT failure have the same potential for systemic risk that Lehman did.

The answer is simple. No, if you are concerned only with the stability of the financial services sector. Within the financial services sector, Lehman was more systemically important.

Unfortunately, if you are concerned with the general economy and not the casino, the answer is also simple. The answer is, Yes. CIT is systemically more important to the flow of credit in the general economy than was Lehman, which was, after all, merely a capital markets player.

CIT provides financing to businesses that operate in the general economy. You can call that financing liquidity, working capital, floor planning, receivables factoring, whatever. It makes no difference how you describe it, the financing provided by CIT and its competitors is critical to the continued operation of a huge swath of the economy.

It is easy from a certain perspective to dismiss this swath as a bunch of Dunkin' Donut franchises. After all, we could all do with a few less donuts, right?

It is more accurate to describe this swath as the Main Street mom-and-pop merchants who have survived the onslaught on the Walmarts and Targets and Costcos. The businesses who are CIT's customers are hardware stores, furniture outlets, franchised tire dealerships, music stores, boat dealerships, etc. Anybody who has to finance inventory or receivables.

And times are tough for these businesses. The consumer has retrenched. Not so many big ticket consumer durables are being bought (the auto industry may be the poster child for this observation, but it extends to clarinets and baby furniture, too). Many, many of these businesses are operating on the forebearance of their lenders, they aren't making the inventory turns the floor planning arrangements contemplate, the receivables are a little hairy. Some of them have waiver letters, others are simply letting it ride. And lenders, like landlords, are working with their good tenant/borrowers.

Only a mandarin safely entrenched from the realities of the marketplace and the credit markets would blithely assume that following the failure of CIT, companies like GE Credit, Litton and Wells Fargo will step into the void and meet the credit needs of former CIT borrowers. Two reasons they won't. First, they are too busy rebuilding their own balance sheets to do much more than give lip service to meeting the broader social needs that provide the only conceivable justification for the special privileges the government has accorded them. Second, the reason CIT is teetering is that its customers are teetering. Those customers aren't very attractive credits. As new business, they are non-starters.

So, this is likely to be a learning experience. While Vikram Pandit wanders across the landscape proclaiming that the future of Citi lies in global adventures, the credit needs of Main Street will be unmet. Small and medium size businesses will fail at an accelerated rate. Unemployment will rise, the economic 'recovery' will stall. In some ways it will be like last Fall's commercial paper adventure, except that the administrative challenge of providing credit to thousands of small to medium sized business will probably prove insurmountable.

Clearly, the economy will not tank on the failure of CIT. From a cool and dispassionate perspective, it almost seems like an experiment worth running. But that perspective may be hard to maintain if bankrupt small businessmen start dousing themselves in gasoline and setting themselves on fire on the Washington Mall.

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