CIT Group Inc, a lender to hundreds of thousands of small and medium-sized businesses, filed for bankruptcy on Sunday, as the global financial crisis left it unable to fund itself and the recession clobbered its loans.

The bankruptcy, one of the largest in U.S. corporate history, has been widely expected for months and is unlikely to provide a massive near-term shock to the financial system. But CIT's trouble could further weigh on the fragile U.S. economy.

The bankruptcy is also a blow for the U.S. government, which invested $2.33 billion in CIT in December through the Troubled Asset Relief Program and will likely lose most of it.

Taxpayers will receive money only after bank debt and bond investors are repaid. The bankruptcy would translate to the first realized loss for the government from TARP, although it may recover some funds over time.

CIT had fought activist investor Carl Icahn, who said he was CIT's largest bondholder, over its future plans. But late last week the two resolved their differences. Most of CIT's creditors have already approved its reorganization plan, and the company said it hopes to emerge from bankruptcy by the end of the year, around when Chief Executive Jeff Peek is slated to resign.

Getting through bankruptcy quickly is crucial for CIT if it wishes to keep its customers, which include Dunkin' Donuts franchisees and film producer Dark Castle Entertainment.

The longer a financial institution stays in bankruptcy, the more the value of the business dissipates. It's faith and trust and perception that are so important for a financial institution, said Jack Williams, a bankruptcy law professor at Georgia State University College of Law.

CIT does intend to stay in business, and its operating subsidiaries were not part of the New York bankruptcy court filing. CIT is still making new loans and honoring commitments to fund customers, people familiar with the matter said.

Once CIT emerges from bankruptcy, it hopes to move businesses including vendor finance, which companies use to offer financing to their customers, and factoring, which helps companies finance their unpaid bills to customers, into its bank subsidiary.

If regulators approve the move, CIT hopes to fund new loans and leases for those businesses with bank deposits.

S&P 500 stock index futures opened slightly lower on Sunday and the U.S. dollar edged higher as news of the bankruptcy spurred traders to reduce risk-taking.

The bankruptcy filing is unlikely to crater financial markets, said Chip Hanlon, president of Delta Global Advisors in Huntington Beach, California, but he noted it's not a positive.

If anything it may be psychological and weigh on people's mind about how things are overall. It adds to peoples' question marks about how healthy the economy is, Hanlon said.

THE PLAN

CIT, which filed for protection under Chapter 11 in the Southern District of New York, plans to reduce its total debt by about $10 billion in bankruptcy.

As of the middle of this year, CIT and its operating units had $71 billion of assets and $64.9 billion of debt. That would make CIT's bankruptcy one of the largest in U.S. history, although most of the assets are not at the holding company that filed for protection from creditors.

Under the bankruptcy plan approved by CIT's lenders, creditors will end up owning the company. Most bondholders will also end up with new CIT debt whose face value is about 70 percent of the face value of their old debt. Preferred shareholders, including the U.S. government, will get money only after lenders are paid back. The U.S. Treasury acknowledged it will likely end up with little.

We will be following developments very closely with an eye toward protecting taxpayers ... but as the company's disclosure on the prepackaged bankruptcy makes clear ... recovery to preferred and common equity holders will be minimal, Treasury spokesman Andrew Williams said.

CIT's shares peaked above $60 apiece in 2007, but closed on Friday at 72 cents.

The new CIT debt is secured by about $30 billion of assets. Those same assets secured about $7.5 billion of financing that CIT has received in recent weeks. To the extent CIT has further difficulty repaying debt, the lenders of the $7.5 billion facilities are first in line to be paid back from the roughly $30 billion pool.

THE STORY

CIT CEO Peek joined the company in 2003, and aimed to make the small lender much bigger and more profitable. He built up consumer lending businesses, including subprime mortgages and student loans, and boosted its investment banking and securitization efforts.

The company financed itself mainly by borrowing from bond markets. But as the credit crunch intensified and the company lost its investment-grade credit ratings, funding became prohibitively expensive for CIT.

Numerous other financial companies that relied heavily on bond markets to fund themselves -- including Fannie Mae, Freddie Mac, and Lehman Brothers -- have failed.

The recession also left CIT with piles of bad loans. As of mid-year, nearly 10 percent of loans in its corporate finance unit were bad.

CIT, founded in 1908, has historically been one of the biggest lenders to small and mid-sized businesses, a sector that is starved for credit now. U.S. President Barack Obama is offering taxpayer money to community banks in an effort to kickstart lending to these companies, which employ about half of the U.S. work force.

CIT had hoped that its status as a major lender to small businesses would help it win more political support as it tried to right itself earlier this year.

But in July, the Federal Deposit Insurance Corp refused to guarantee CIT debt issuances, and the company scrambled to find other ways to fund itself.

A group of CIT bondholders lent it $3 billion in July, on a secured basis, and the company found bond holders willing to exchange $1 billion of old debt for new securities.

Those moves bought CIT some time, but it still had about $800 million of unsecured debt maturing in the beginning of November, and more than $3 billion of unsecured debt maturing by the end of March.

Last week, CIT secured an additional $4.5 billion of financing from investors, which will help carry it through bankruptcy. Icahn on Friday said he has agreed to provide a $1 billion credit facility to CIT as well. That agreement followed weeks of tussling with management.

Icahn had pushed CIT to wind itself down and use maturing assets to pay off debt, instead of trying to fund new business out of its bank.

(Reporting by Dan Wilchins and Elinor Comlay; Additional reporting by Caroline Humer and Chris Sanders in New York, Timothy Ahmann in Washington, and Anirban Nag in Sydney; Editing Bernard Orr)

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