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What Hath The Stress Tests Wrought?

The issue of the day is obviously CIT. It's hard to sort out the real news from clever PR/planted stories in this situation, but it looks like the FDIC is coming out strongly against being involved in a rescue package. Given Sheila Bair's successful political positioning and strong popular appeal, it's hard to see how--once dug in--the FDIC can be moved.

The lobbying frenzy has concentrated on CIT's role in financing small and medium-sized business; "the recession will be deeper if CIT fails" is the refrain. This is a weak argument--it would be straightforward to refinance this part of CIT's business without bailing out CIT's creditors, and definitely without keeping top CIT executives in place; this is the essence of "negotiated conservatorship," which is a proven model in the U.S.

More plausible is the concern that given Treasury's generous handouts to date for financial firms, if they are now tough on CIT's creditors, this will send a new signal about how they may treat other firms--and maybe raise fears of Hank Paulson-like flipflopping. Citigroup's CDS spread is still at worrying levels, and Treasury/National Economic Council watches this closely--for both organizational and personal reasons.

Essentially, by trying to refloat an undercapitalized banking system, Treasury has created pervasive financial vulnerabilities to CIT-sized shocks. These are now the basis for more bailouts and even great fiscal costs.

If CIT is determined to be "too big to fail" in today's context, this has far reaching implications. Instead of financial entities with assets of at least $500bn creating systemic risk, we now have to worry about anyone who has not much more than $50bn. This is a profound change--and a point that seems to have escaped the Financial Services Roundtable, which is pushing hard for a CIT rescue.

Mr. Geithner is travelling back from the Middle East today. Once he lands, I would guess that a bailout package will go through (on the weekend, if they can get that far) and creditors are unscathed. But I still suspect that there will be management change at CIT.

How the CIT deal impacts current Capitol Hill discussion on system risk and regulatory reform remains to be seen. The effects there could be more profound than expected.

[Cross-posted at The Baseline Scenario.]