Cit Grp. Pfd A (fka CIT-A)

[Stock]

Strong bank bid could squeeze CIT's CDS auction

Wed Nov 18, 2009 4:02pm EST

By Karen Brettell

NEW YORK, Nov 18 (Reuters) - An auction to settle credit
default swaps on CIT Group (CITGQ.PK) is likely to be the
largest the market has faced so far, and trading by banks with
exposures to CIT's swaps could potentially squeeze its the
prices of its bond and drive up CDS valuations.

CIT, a lender to hundreds of thousands of small and
medium-sized U.S. businesses, filed for a prepackaged
bankruptcy on Nov. 1, triggering payments on its credit default
swaps -- contracts that protect against losses from a debt
default.

The auction on Friday will determine a value for the CDSs,
which will be used to settle the contracts.

An unexpectedly high CDS valuation, in general, may favor
protection sellers while a low valuation could benefit
protection buyers. This is because the protection seller pays
the buyer the full sum insured, minus the recovery value when a
borrower defaults.

CIT's collapse is unlikely to lead to outsized losses in
the CDS market though.

"The overall impact of CIT's default should be relatively
contained given that its troubles have been well anticipated by
the market, as evidenced by its recent spread history," Atish
Kakodkar, analyst at credit research firm CreditSights, said in
a recent report.

The CIT auction is significant, however, as it will likely
involve the largest volumes the process has seen to date.

Net volumes of around $3.1 billion are outstanding in
single name protection on CIT's debt, while an additional $2.9
billion is outstanding in trades based on indexes the company
is included in.

A large amount of protection on CIT was also sold in
tranche trades based on the indexes. In addition, the company
was among the most popular credits included in other
collateralized debt obligations (CDOs) backed by CDSs.

Volumes in these deals are hard to estimate, though
analysts say they are likely large.

Standard & Poor's said in July that it rated 2,470 CDO
tranches that had exposure to CIT.

BANK BID

Banks that were counterparties to CDOs including CIT are
likely to provide a large bid to buy bonds in the auction,
which could potentially drive up the value of the CDSs,
analysts said.

"Dealers who choose to buy the bonds during the auction
could cause final recovery on the name to be higher than it
would otherwise be," analysts at Barclays said in a recent
report. Strong demand by banks for the debt could push up CIT's
final CDS price by as much as 2.5 points to 4 points, Barclays
said. The company's bonds traded on Wednesday between 66 and 70
cents on the dollar, according to MarketAxess.

CIT, which was rated investment grade until April this
year, was a popular company to include in CDOs because its CDSs
yielded an attractive premium relative to the company's rating
when the majority of the deals were issued between 2005 and
2007.

Banks that acted as counterparties to these deals hedged
their exposures by selling protection on the companies
underlying the deal in the single name market. These single
name contracts, however, are settled one to two months before
contracts in the CDOs are.

The banks are expected to buy CIT's bonds to protect
against losses they would face if CIT's debt gains in the gap
between settling each of the trades.

Potentially countering this bid are so-called basis
investors, who own CIT's debt and also own CDS protection.
These investors are expected to be large sellers of the bonds
in the auction.

If enough of these investors sell bonds in the auction they
may offset any the bank bid for the debt.

"The net open interest to buy or sell bonds in the auction
should, therefore, depend primarily on the buying demand from
correlation desks versus the selling interest from basis
traders," said CreditSights' Kakodkar.

http://www.reuters.com/article/marketsNews/idCNN1857745420091118?rpc=44