CIT Collapse Would Hit Hard European CDOs

CIT Group tops the list of names in portfolios of European synthetic CDOs rated by Standard & Poor's, which would mean widespread default losses in the nearly $600 billion market if it files for bankruptcy.

S&P said in late 2008 that 1,053 European synthetic collateralized debt obligations (CDOs) -- 66 percent -- included CIT, a New York-based lender to small and mid-sized businesses, in their portfolios of credit default swaps (CDS).

CIT stock and bonds have fallen this week on fears of a bankruptcy filing, while a source familiar with the matter said the U.S. Federal Deposit Insurance Corp was opposed to a rescue favored by the Treasury Department and Federal Reserve.

Since mid-2008, five-year CDS spreads on senior CIT debt have widened in volatile trade, signaling its financial plight, reaching a record closing wide of around 2,744 basis points on Oct. 20, according to Markit data.

"This is a telegraphed punch. People will have seen it coming," said Citigroup credit strategist Michael Hampden-Turner. "Lots of people will have marked it down already."

Even so, people in the market had become more sanguine about systemic risk since the fourth quarter of 2008, he said.

"This brings back a reminder that we are not out of the woods yet -- that there is still fallout from the credit crunch to come," he said.

S&P officials could not immediately provide updated information, saying that the timing of an updated list was not yet decided.

But credit strategists said limited trading in the synthetic CDO market meant that rankings would probably have changed little since then.

CIT also ranked third among CDO portfolio names in a similar 2008 list by Fitch Ratings, which rates fewer deals than S&P.

"CIT is quite large with $80 billion in assets and $39 billion in debt, and a bankruptcy will have some impact on the market (overall)," BNP Paribas credit strategists wrote.

Moody's cut the company's rating by four notches to B3 on Monday, while S&P cut its counterparty credit ratings to CCC+/C from BB-/B.

Five-year CDS on the company were around 2,521 basis points, or 41 percent upfront, early on Tuesday.

That means an investor must shell out $4.1 million initially plus $500,000 per year to buy protection against the default of $10 million of CIT debt.

Boom-Era Deals

In October and November, seven high-profile corporate failures, including Lehman Brothers and Washington Mutual, led to $23 billion in synthetic CDO default losses, out of a total net notional value in the market of $584 billion, Citigroup credit strategists calculated in late 2008.

Synthetic CDOs are bundles of 100 to 150 investment-grade CDS -- bets that companies will honor their debts -- that are sliced up by degrees of risk.

The riskiest tranche at the bottom takes the first few percent of default losses from any name in the portfolio, before losses move to the next tranche up. Most deals were sold in the boom years of 2005 to mid-2007 and still have five to 10 years to run.

Investors typically had CDOs tailored to produce a single tranche with a high yield for a top rating. Slices typically started between 5 and 9 percent and would be wiped out between 7 and 10 percent.

The dealer would neutralize the risks of other slices of the deal using hedges in the CDS market. Depending on the portfolio, a tranche that kicked in as low as 5 or 6 percent could have got an initial triple-A rating.

Citigroup calculated in late 2008 that a portfolio of 100 names that included all seven of last year's failures would have lost up to 4.38 of notional value.

This year, carmaker General Motors and auto parts maker Lear Corp have also filed for bankruptcy, but these were popular names only for CDOs structured before mid-2005, Hampden-Turner said.

Neither of them features in either S&P's or Fitch's rankings of the 50 more popular names in CDO portfolios.

Meanwhile, in the underlying CDS market, net notional exposure to CIT amounted to $3.465 billion in the week ended July 3, according to data from the Depository Trust and Clearing Corp (DTCC).

Given that CIT is a member of the CDX IG, which is the main U.S. investment-grade CDS index, "further developments are likely to be a focus for the market in the near term," Deutsche Bank credit strategists wrote.

Out of the 1,000 top reference entities in the CDS market listed by the DTCC, CIT ranked 34th in net notional exposure.

Excluding sovereign CDS, it ranked 19th among corporate names after General Electric Capital and mostly banks including Deutsche Bank, Morgan Stanley and Goldman Sachs . (GE is the parent of CNBC).

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