Aug. 21 (Bloomberg) -- As the world’s biggest bond investors cut off funding to CIT Group Inc., the commercial lender turned to retirees for debt financing.
CIT sold $827 million of debentures designed specifically for individuals between December 2007 and March 2008. At the time, “disruptions” in credit markets led to “the loss of access” to unsecured debt markets, “historically significant sources of liquidity for the company,” the New York-based company said in a July 21 regulatory filing.
It turns out the professionals were right to stay away. The 101-year-old lender said last month it may go bankrupt after $5 billion of losses in the past nine quarters. Retired salesman Sam Pons of Metairie, Louisiana, said he bought $220,000 of the notes through a broker in February 2008 at 100 cents on the dollar. The securities have since tumbled to as low as 44 cents.
“I was kind of naïve,” said Pons, 63. A month after buying, “the whole news came alive with CIT Group’s problems. I’ve sat on this for a year and a half now with my heart in my throat hoping they survive.”
CIT joined GMAC Inc., Prudential Financial Inc. and more than a dozen other companies that tapped individuals as credit markets closed to them through underwriters led by Chicago-based Incapital LLC. The Financial Industry Regulatory Authority now says it’s investigating whether the risks associated with the securities were adequately disclosed.
‘Pump-and-Dump’
“It’s sort of a pump-and-dump scheme in a bear market,” said David Hendler, an analyst at fixed-income research firm CreditSights Inc. in New York. “CIT had a limited funding channel in the sophisticated wholesale market. They went to where they could offload risk without too many questions.”
Finra is “aware of the product and the problems,” said Herb Perone, a spokesman for the group, which is responsible for protecting investors.
CIT sold InterNotes from 2002 until March 2008, when the company still had investment-grade ratings, CIT spokesman Curt Ritter said in an e-mail.
Mark Porterfield, a spokesman for Newport Beach, California-based Pacific Investment Management Co., manager of the world’s biggest bond fund and the largest owner of CIT debt among those investors that report holdings, didn’t return phone calls seeking comment.
The retail bond market typically lets companies sell debt at lower yields than institutional investors would demand. Yet when a company’s fortunes deteriorate, the notes may trade at higher relative yields because it’s difficult to sell them.
‘Gimmicky Devices’
“We’ve had several situations now where we’ve seen if a company gets into trouble, the liquidity tends not to be there,” said Kathleen Shanley, an analyst at research firm Gimme Credit LLC in Chicago. “Because it’s smaller issues, it makes it very hard to get out of it. If Grandma’s got her whole retirement in CIT bonds, that’s a problem.”
CIT’s $7.69 million of 6.75 percent of so-called InterNotes due March 2011 trade at 48 cents on the dollar to yield 64 percent, according to Trace, Finra’s bond-price reporting system. That yield is 26 percentage points more than the company’s $750 million of 5.6 percent securities that mature one month later, which were targeted to institutions. Those securities trade at 62 cents to yield 38 percent.
Targeting bonds to individuals “was part of a proliferation of gimmicky devices which on the surface looked attractive but was nothing more than high-pressure marketing tools,” said Arthur Levitt, a former chairman of the U.S. Securities and Exchange Commission who serves on the board of directors of Bloomberg LP, the parent company of Bloomberg News.
Incapital is the largest underwriter of retail bond offerings, with more than a 75 percent share of the market, said Tom Ricketts, who heads the firm.
‘Line in the Sand’
Ricketts has underwritten $70 billion of InterNotes, and more than $46 billion remains outstanding, he said. Incapital says InterNotes, managed by a joint venture with Banc of America Securities, are sold through 600 broker-dealers, including Fidelity Investments and Edward Jones & Co.
“We’ve always stuck to investment-grade and we’ve always put our faith that that was a good line in the sand,” Ricketts said. “To the extent that we have investors that may not get their money back, that doesn’t make me happy. CIT is in distress. We would never have put something up on our screens if we had a thought that they would ever end up in a situation like this.”
Lehman Brothers
Danielle Robinson, a spokeswoman for Bank of America Merrill Lynch, declined to comment.
Incapital underwrote debt offerings for New York-based investment bank Lehman Brothers Holdings Inc. until June 2008, three months before it went bankrupt. Units of insurer American International Group Inc. of New York and mortgage lender Freddie Mac in McLean, Virginia -- both of which became wards of the U.S. government last year -- also sold bonds through Incapital.
“You make a rational decision and sometimes the assumptions were wrong,” Ricketts said. “Not just for retail bonds but, for God’s sakes, people do all sorts of worse investments. It’s just about the safest thing you can do. Until very recently the default rates for investment-grade bonds were de minimis.”
Ricketts, 43, co-founded Incapital in 1999 after working at the Chicago Board Options Exchange, Mesirow Financial Inc. and then ABN Amro Bank NV, where he helped pioneer bond sales to individuals in the 1990s. In 1975, his father, Joseph Ricketts, founded what’s now Omaha, Nebraska-based TD Ameritrade Holding Corp., the third-largest retail brokerage by client assets.
The Ricketts family agreed to buy 95 percent of Major League Baseball’s Chicago Cubs, Wrigley Field and Tribune Co.’s 25 percent interest in Comcast SportsNet for $845 million, the Chicago-based media company said today in a statement.
‘Survivor’s Option’
The senior unsecured notes underwitten by Incapital contain a “survivor’s option” that allows them to be sold back to the issuer at par when their owner dies. InterNotes issuers typically have “a discretionary right to limit” the amount that can be exercised per year through the survivor’s option to the greater of $2 million or 2 percent of outstanding principal amount, according to Ricketts.
“It’s almost an affinity type of financing geared to elderly people,” said Levitt.
Incapital’s Web site lets visitors enlarge the font if they’re having trouble reading its contents.
John Brubaker, a retired commercial banker based in Park City, Utah, said he bought InterNotes in 2005 when Wachovia Securities pitched them for his mother-in law’s account. Brubaker said his 91-year-old mother-in-law lives in a nursing home in Salt Lake City, suffers from Alzheimer’s disease and is a widow following the death of her husband in 2003. Brubaker requested Bloomberg News not use her name.
Finra Probe
Brubaker and his mother-in-law purchased $10,000 of CIT’s 5.125 percent notes due 2014, which have tumbled to 46 cents on the dollar, according to Trace.
“We bought them in the days when interest rates were low and we were trying to enhance income,” Brubaker, 68, said. “Nursing expenses were enormous. The salesman indicated there was no market risk and in the event of death they would revert back to par.”
Teresa Dougherty, a spokeswoman for Wells Fargo Advisors, a unit of San Francisco-based Wells Fargo & Co., which took over Wachovia at the end of 2008, declined to comment.
Finra is examining sales practices at brokers that sell InterNotes, trying to determine whether they’re reporting trades to Trace within the required 15-minute time frame, and following up on “concerns about prospectus matters,” Perone said from his Washington office.
“This is something that is on our radar screen and we are looking into it and are conducting examinations and some investigations,” Perone said.
Ignore Ratings
Individuals shouldn’t just rely on brokers’ pitches and credit ratings, said CreditSights’ Hendler. Lehman was rated investment grade by Moody’s Investors Service and Standard & Poor’s until Sept. 15, the day it filed for bankruptcy.
“The investors want the income but fail to do the required research and due diligence,” Hendler said. “The companies selling don’t talk about the negative case, otherwise they wouldn’t sell as much. The brokers meanwhile are just moving the paper for commissions. The SEC has not done their job well protecting individual investors from changing circumstances.”
John Heine, spokesman for the SEC, declined to comment.
The biggest seizure in debt markets since the Great Depression has shown that credit ratings are a “lagging indicator,” Ricketts said.
“Individual investors weren’t the only people that put more faith in credit rating agencies than was probably warranted,” Ricketts said.
Difficult to Sell
A 2006 prospectus for CIT InterNotes said there can be “no assurance” an investor could resell the notes as there is no secondary market for the securities.
“There’s not a question in distress, it’s difficult to find bids for individual notes,” Ricketts said. “Individuals are typically selling in smaller sizes. The second reason is that individual investors would rather just sell and not worry about it than subject themselves to any volatility in the credit or the vagaries of the bankruptcy process.”
CIT’s only unsecured bond offerings in the first quarter of 2008 were for $600 million of retail debt, the most it sold in any quarter since the period ended March 31, 2003, regulatory filings show.
In March 2008, a month after Pons purchased his bonds, CIT borrowed the full $7.3 billion available on its credit lines. The company said in the July 21 regulatory filing that it drew down the facilities because “disruptions in the credit markets that began in 2007” prevented it from issuing unsecured debt.
Distressed Levels
Credit-default swaps on CIT were trading at distressed levels on March 10, 2008, when the company sold a retail note with a 7.25 percent coupon, according to Bloomberg data. Sellers of the contracts demanded $1.75 million upfront and $500,000 a year to protect $10 million of the company bonds from default for five years, according to Phoenix Partners Group in New York.
“InterNote securities were a small component of our funding sources, which largely relied on institutional bond offerings, commercial paper and bank financing,” CIT’s Ritter said in the statement. “At the time we ended issuances under the program on March 13, 2008, we were still a solid investment grade credit with single-A ratings.”
CIT raised $3.2 billion in bonds backed by assets including student loans and trade receivables in the first quarter of 2008, according to regulatory filings.
‘Selective Default’
The company has since been cut to Ca by Moody’s, two levels above default, and “selective default” by S&P, after failing to win a second government bailout last month and saying it may go bankrupt if its restructuring efforts are unsuccessful. CIT Chief Executive Officer Jeffrey Peek, 62, is negotiating with bondholders and considering asset sales.
Pons said he bought his CIT InterNotes after a Fidelity broker wouldn’t sell him bonds of Freeport-McMoRan Copper & Gold Inc. because those were rated below investment grade. Instead, the broker showed him the “Corporate Notes” page on the Boston-based firm’s Web site that was “full of” CIT securities, Pons said.
“He says, ‘These are new issues we’ve pre-screened,’” Pons said. “They all have A credit ratings and they’re all paying 6.5 percent, 7 percent dividends. I thought, gosh, I could live the rest of my life on making that.”
GMAC SmartNotes
Adam Banker, a spokesman for Fidelity said in an e-mailed statement the firm provides “information to investors about the benefits and risks associated with various fixed income investments, such as corporate notes. In addition, customers can monitor their investments daily through our Web site.” He declined to comment on individual customers.
Phoenix-based Freeport-McMoRan, which operates the world’s biggest gold mine, was raised to investment-grade by S&P in April 2008.
As Detroit-based GMAC teetered on the brink of losing its investment-grade ratings in March 2005, the lender was “expanding its relatively less-credit-sensitive retail debt issuance programs” to make up for its funding shortfall, S&P said in a March 21, 2005 report. A month-and-a-half later, S&P cut GMAC to BB, or two steps below investment grade, from BBB-.
GMAC issued retail debt called “SmartNotes” and underwritten by LaSalle Broker Dealer Services, a former division of ABN Amro that was acquired by Incapital last year. Ricketts said GMAC’s offerings are “the least defensible by far.”
Prudential
GMAC, which sold more than $25 billion in SmartNotes since the program was started in 1996, “issued retail debt from time- to-time when it felt the market conditions were appropriate,” said Gina Proia, spokeswoman for the company. “We have not used the retail program in lieu of institutional debt but rather as a supplement.”
Newark, New Jersey-based Prudential reported a loss of $1.07 billion in 2008, its first since 2001 and its worst year since 1994. The insurer was slashed two levels to BBB by Fitch Ratings in February and to Baa2 by Moody’s in March.
Prudential, the second-biggest U.S. life insurer, didn’t sell any unsecured corporate bonds between June 12, 2008 and June 2, 2009, in the institutional market, according to Bloomberg data. From June 12, 2008 through September of that year, it raised $146 million from retail bondholders, the data show.
The company’s $704,000 of 5.5 percent of InterNotes due in 2013, issued in September 2008, fell as low as 72.5 cents on the dollar within seven months, Bloomberg data show. The securities have since risen to 101.8 cents after the insurer raised $2.4 billion in capital in the second quarter.
Lost Money
“As with all bonds, investors choosing to sell the notes before maturity may sell them at market value to other investors and face certain risks, which are fully disclosed at the time of issue,” said Theresa Miller, a spokeswoman for Prudential.
Companies can issue the bonds to individuals in times of strife because the higher yields make them “attractive,” according to Ricketts.
“It’s not unique to CIT,” he said. “Other issuers sold more at the same time, ones that ultimately didn’t fall into distress.”
Bruce Frankland, an electrician who said he’s been thinking about retiring, said he lost money on retail notes issued by CIT and American General Finance, the consumer lending unit of AIG, and GMAC.
“If I lose my rear on this CIT deal,” retirement may no longer be “on the table,” said Frankland, 57, who lives in Mt. Carmel, Illinois, and owns $50,000 of CIT InterNotes. “I won’t be buying any bonds anymore.”
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