Description

Long - CIT Group Unsecured Bonds

7/27/09

Current Price: (5.6% April 2011 Bonds): 59

Recovery Value: 80-100

Total Unsecured Bonds: $34 b

Thesis:

CIT bonds are a long because recovery value in liquidation is 80-100 vs. current pricing of 59. To get to a recovery value of 60 would require cumulative losses on CIT's loan portfolio of 40% which is beyond draconian. There is a decent probability that CIT restructures in a pre-pack that gives the unsecured creditors new equity which could result in ultimate recovery value above par should loss realization be less than current pessimistic assumptions. Annualized return in a 2.5-year liquidation is 13%-24% with minimal downside risk. Returns could be much higher if the company is reorganized or survives.

(note: for smaller investors there are retail notes traded that can be purchased 10-15 points back from the more liquid global bonds. The risk/reward is even more compelling at 45 vs. 60).

Background:

CIT is a century-old diversified financial lender to small and medium sized business. Loan segments include asset-backed and cash flow lending (32%), aircraft and railcar leasing (22%), small-ticket equipment leasing through vendor programs (19%), student loans (19%), and factoring for the retail industry (8%).

Before new CEO Jeff Peek joined the company in 2004, CIT was respected for being highly competent in their core business units of asset-based lending, factoring, vendor finance, and equipment leasing. Concurrent with Peek's arrival and the loosening credit standards of recent years, CIT expanding into cash flow lending, sub-prime mortgages, student lending, and other marginal areas of business. Industry calls indicate that CIT was originating paper of such low quality that they could not even syndicate some during the great credit bubble.

CIT funded itself predominantly through the short term unsecured market for much of its history. Beginning in late 2007, the company began to experience more difficulty in accessing this funding as we entered the credit crisis. Financing concerns forced CIT to apply for bank-holding company status (BHC) in December 2008 to receive $2.3 b of TARP preferred equity from the government.

The TARP injection along with additional common and preferred equity offerings was not enough to stem a loss of confidence in the market of CIT's loan portfolio and liquidity which came to a head in June/July. Faced with a liquidity crunch the company has resorted to a punitive $3 b secured financing with large owners of unsecured bonds in an effort to keep the company from filing chapter 11 imminently.

CIT is currently tendering at a discount for its upcoming maturity of $1 b of bonds due on 8/17/09. Should the tender be unsuccessful, the company will likely file BK and a slow liquidation is possible. If the tender is successful, CIT will have bought itself time to try and arrange an orderly pre-packaged bankruptcy out of court which will serve retain enterprise value as there will be a better chance for a going concern rather than liquidation. 

Present Situation:

Purchasing the bonds of troubled financial companies at distressed prices can sometimes be an attractive situation because there is a large portfolio of loans that are worth something. Maybe they aren't worth the par value equity holders believed, but you can create a purchase price of the portfolio at an absurdly low level if the bonds can be purchased at a low dollar value. Recent examples of this type of situation include GMAC, FMCC, and Sallie Mae. CIT Group appears to be another analogy.

Using conservative assumptions, recovery value on the CIT portfolio today is 97 in our base case and 80 in the low case. This assumes that CIT bank is seized by the FDIC even though it is well capitalized, the GS financing facility's over-collateralization is seized and sold, and applies aggressive loss rates to the different loan segments of CIT's portfolio. This also ignores ~$3 b or ~10 bond points of cash flow net of bankruptcy costs generated over 2-3 years due to ceased bond interest payments. Analysis & explanation of base case recoveries is below, apologies if the formatting does not come out great:

Commercial real estate - $850 mm portfolio of which half is 1^st lien loans and half is 2^nd lien loans or junior. Assume 100% of the 2^nd liens default with 10% recovery and 30% of the 1^st liens default with 60% recovery.

Asset-backed loans - $6.5 b portfolio net of GS facility. This assumes that all of GS's collateral was from the ABL portfolio rather than the cash flow portfolio within corporate finance. Assume 20% of CIT's customers default with 60% recovery.

Cash flow loans - $10.5 b portfolio. This is a marginal portfolio that was created in the last 5 years using loose underwriting standards. Assume 30% of the portfolio defaults with 20% recovery values given little asset protection.

Transportation finance - $8 b of aircraft (average 5 year old, mostly narrow body) fully leased to customers. Using current secondary market values by plane type yields a value greater than book. Assume a 10% liquidation discount and recovery is over ~90%. There is also $4.8 b of railcars that is 93% utilized which I assume a 10% discount to book in a sale which implies ~$60k/railcar, in-line with replacement cost and private market valuations according to people looking at the portfolio which is currently being shopped. Note that of all of CIT's businesses, the railcars and aircraft are the most salable given the strength of the portfolio's performance and underlying value of the assets.

Trade finance (factoring) - $6 b portfolio. Assume 30% of receivables do not pay with 30% recovery. This would mean that 30% of companies within the retail industry file for bankruptcy and do not pay critical vendors (i.e. they liquidate).

Vendor finance - $13 b portfolio. Assume 30% of small businesses default on their leases of mission critical equipment (computer servers, telephone systems, etc.) and the assets are liquidated for 30% of depreciated cost.

Student loan portfolio - $11.4 b is US government guaranteed. Private student loans of $740 mm are toxic as most are from non-traditional schools including $200 mm tied to a flight school that has since declared bankruptcy and stopped classes. Assume the $200 mm is a zero, and the rest default at 30% with 20% recovery.

Why This Opportunity Exist:

• Threat of bankruptcy - large supply of bonds ($38 b) need to change hands from those who are not allowed to or those that do not wish to own bonds through a restructuring or liquidation.
• Many market participants look at a complex non-transparent loan portfolio and do not want to try and make a bet on what loss rates will be realized. Estimates from those who get lower recovery values are being exceedingly pessimistic - hopefully you will agree based on our default/severity assumptions listed above. Regardless, the key to the margin of safety is to get to a recovery where you actually lose money from here takes worse than draconian scenarios.

Risks / What Would Make Us Wrong:

• Subordination through debt exchanges - CIT could try coercive debt exchanges that subordinate non-participants. You could end up in a situation where you do not participate in the exchange, new bonds are issued above you, and then the company files before your bonds come due. In that scenario your recovery value will have been reduced due to new bonds ahead of you. This risk is mitigated by staying close to the front-end of the curve so that you have the ability to hold-out from a tender, and the company has less opportunity to try and subordinate you.
• Fire-sale of assets in bankruptcy - If CIT ends up in liquidation, the secured lenders could try and force a fire-sale of assets to get themselves repaid more quickly than a slow wind-down. The unsecured creditors will argue for equitable treatment, that recovery to the estate will be maximized through a run-off of the majority of the assets. Factoring and most of corporate finance, trade finance, and vendor finance can be run off in less than 3 years. Transportation and government guaranteed student loans will have a decent bid in a sale process.

Catalyst

 Potential Event Timeline / Catalysts

• Tender for August 2009 bonds succeeds or fails. If fails then a filing is likely.
• If tender succeeds, look for an attempt at a debt exchange or a pre-pack deal in the next 3 months.