NEW YORK - The star-crossed $7.4 billion Chrysler buyout is not just a headache for private equity firm Cerberus Capital Management, but some of the biggest banks on Wall Street as well.

Chrysler is operating thanks to $4 billion of government loans and seeking more. A possible bankruptcy could be a solution for the company, which is racing to complete a tie-up with Italy's Fiat SpA.

With a worst-case scenario being liquidation and the best case a deal with Fiat, the way the auto company's future plays out will impact the recovery lenders can expect. Chrysler reached an agreement with Fiat in March on the framework for an alliance.

Five Wall Street banks -- J.P. Morgan Chase & Co, Bear Stearns, Goldman Sachs Group Inc, Citigroup Inc and Morgan Stanley -- underwrote the financing when the deal was agreed in the summer of 2007. They provided a $7 billion term loan that provided working capital for the automaker.

Portions of that senior secured debt were sold to roughly 50 other institutions, a source familiar with the credit group said. Banks typically look to reduce exposure by selling part or all of their debt, although the syndication hit the markets in the wake of the subprime mortgage meltdown, making it harder to sell this debt on. Some exposure still remains on some of their books.

JPMorgan's purchase of Bear Stearns meant its exposure increased. Two sources familiar with the credit group said JPMorgan has about $2.5 billion in total exposure to Chrysler's auto business, but it is unclear how much of that has been hedged or at what value it is being held on the bank's books. Citi has under $1 billion, one of the sources said.

Goldman Sachs sold some of its loans last year, sources previously told Reuters LPC.

All the banks declined comment.

The banks are now in talks with the government about reducing Chrysler's debt by swapping some of it out for equity, new debt or a lesser amount in cash, sources familiar with the talks said on Friday.

The banks have the highest priority debt -- senior secured. That would normally take priority over other debt in a bankruptcy, although one source familiar with the situation said that, given the complexity on the situation, it is unlikely to be a normal bankruptcy.

The other debt is a second lien loan of $2 billion held by Daimler and Cerberus, a third lien loan of $4 billion held by the U.S. Treasury and an obligation to fund the employee retirement plan. In part, how much the banks get depends on how negotiations with Fiat progress, said a source familiar with the process.

The bank debt is worth far less than $7 billion on the open market. The average bid for Chrysler's automotive operations bank loan is around 15.2 cents on the dollar.

The best case for the senior secured is a deal with Fiat: They cut the deal, Chrysler survives as a going concern and it turns out that the value of the going concern is enough to pay them off in full, said Douglas Baird, professor of law at the University of Chicago.

INVESTOR PAIN?

It is unclear how much Cerberus, which has both debt and equity holdings, would lose.

Cerberus, along with a consortium of co-investors, bought its 80.1 percent stake in Chrysler and the auto company's financing arm Chrysler Financial in May 2007 for $7.4 billion, investing $5 billion to improve the automotive group, pumping $1.05 billion into its financing unit and paying $1.35 billion to the seller, DaimlerChrysler.

That followed its acquisition the previous year of a 51 percent stake in General Motors financing arm GMAC.

The Chrysler and GMAC investments combined make up less than 7 percent of Cerberus' total investments, a source previously told Reuters. The Chrysler investment makes up less than 5 percent of any one of Cerberus's several funds, a source familiar with the situation said on Friday.

Cerberus has long been prepared for a loss on the equity side. It said last year it would agree to forgo any profits that could be earned relative to Chrysler as a result of any financing the government may choose to provide.

To assist the administration in the restructuring of Chrysler, we agreed to give up our equity stake in Chrysler Automotive, convert debt to equity and subordinate $2 billion of other interests to the government's financing, Mark Neporent, Cerberus' Chief Operating Officer and General Counsel, said in a letter to the New York Times in February.

If Cerberus' debt is swapped for equity, Cerberus could end up with a small equity position in the new car company, a source familiar with the situation said, although that would be determined by the Government.

One investor in Cerberus' funds who talked to Reuters on condition of anonymity, said limited partners -- the pension and endowment funds that put money in private equity funds -- had themselves written off the Chrysler investment when Cerberus said it would give up its equity stake.

Once that happened for the LPs, its already worth nothing, said the investor.

The investor said Cerberus has a hole to dig out of, but the firm has done a lot of other lower-profile deals that are performing well.

Cerberus has written down the value of the investment stake, according to a source. But it was unclear what value the private equity firm has put on the company.

German automaker Daimler AG -- Chrysler's former owner -- controls the remainder of Chrysler. Daimler has written its stake down to zero.

(Additional reporting by Caroline Humer, Jui Chakravorty and Dan Wilchins in New York and Faris Khan at Reuters LPC; Editing by Andre Grenon)

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