The survival of CIT Group Inc , a key source of financing for thousands of small and medium-sized companies, became ensnared in disagreements between regulators in Washington on Monday.

The Federal Deposit Insurance Corp, which insures deposits at U.S. banks, opposed an attempt by the Treasury Department and Federal Reserve to rescue the lender by granting it access to a government debt-guarantee program, according to a source familiar with the matter.

The prices of CIT shares and bonds tumbled as investors worried the commercial lender would not be able to meet its obligations to bondholders, perhaps pushing the company into bankruptcy and disrupting the financing on which its corporate customers depend.

CIT's difficulties are going to make funding more expensive all around, said Dan Brown, chief economist for Euler Hermes, a unit of insurer Allianz SE .

The lender's failure would be the biggest collapse of a financial firm since regulators seized Washington Mutual Inc in September.

It is not the first time in recent months that there has been a disagreement between the FDIC and the Treasury and Federal Reserve. FDIC Chairman Sheila Bair, who is well-liked by key congressional leaders, and Treasury Secretary Timothy Geithner have battled over policy and turf, according to numerous reports.

FDIC is wary of granting CIT access to its debt program partly because it is not satisfied with the lender's collateral, the source said.

Unlike other government aid programs, the debt guarantee facility does not rely on taxpayer money. The FDIC would have to absorb any losses that result from the facility, and would have to recoup the funds by taxing the bank industry.

As a result, the Treasury and Fed are exploring other ways to provide relief to CIT, the source said, speaking anonymously because the government discussions have been private.

Speaking on a trip to Britain, Geithner said he was confident the government would be able to deal with CIT.

But the possibility of government aid for CIT -- which became a bank holding company last year to qualify for $2.33 billion of bailout funds -- would also raise questions for lawmakers and taxpayers wondering just how far the government should go to save struggling companies. Much of CIT's business could be taken on by other lenders such as JPMorgan Chase & Co and Deutsche Bank AG .

CIT has hired top law firm Skadden, Arps, Slate, Meagher & Flom LLP to explore a possible bankruptcy filing [nBNG465972], The Wall Street Journal reported on Monday. A CIT spokesman confirmed that Skadden, Arps had been retained but declined to elaborate.

RATING DOWNGRADES

A delay in getting approval for the debt-guarantee program -- which CIT applied for in January -- and tight credit markets have caused a liquidity crunch for the company. It has lost close to $3.3 billion since the end of 2007 and says it faces a $10 billion funding gap in the year to March 31, 2010.

Moody's cut CIT's senior unsecured credit rating four notches on Monday, to B3 from Ba2, citing growing concerns with CIT's liquidity position and prospects for survival of the franchise.

Later on Monday, Standard & Poor's downgraded CIT by one notch to CCC-plus from BB-minus, noting in a statement that if the company does not get access to the FDIC's debt program or is unable to obtain liquidity elsewhere, We believe that it might attempt to restructure its debt, perhaps in bankruptcy or through an exchange offer we would view as distressed.

Shares of CIT, which lately has provided debtor-in-possession financing for Eddie Bauer Holdings and newspaper publisher Philadelphia Newspapers, fell nearly 12 percent to close at $1.35, after dropping to a low of $1.08 earlier in the day. Its 5 percent notes due in 2014 fell to 48 cents on the dollar from 57 cents on Friday.

Analysts warned that the company could face a rush from borrowers to draw down credit lines.

The likelihood of borrowers drawing down on their lines has definitely increased, said David Chiaverini, analyst with BMO Capital Markets in New York.

CAPITAL RAISING

To boost liquidity, CIT said it was discussing a transfer of assets such as its vendor finance and trade finance businesses into its CIT Bank unit by obtaining a waiver of a Federal Reserve rule that limits such transactions. This is one of the possibilities the Treasury and Fed are exploring, according to the source.

The lender could also step up attempts to sell assets, such as its $4.5 billion railcar leasing unit, analysts said. CIT shopped the railcar unit last year for several months before shelving the plan after its capital position improved and commercial lender GATX Corp , which had been seen as a potential buyer, offered more than $3 billion for a similar business owned by General Electric Co .

Quick asset sales now, however, are unlikely to fetch top prices without government support in the form of either access to the FDIC's program or a waiver to transfer assets to its bank. Asset sales, even at unattractive prices, are CIT's best hope for improving its capital position, analysts said.

It's virtually impossible for them to attract outside capital in either equity or debt form at this juncture, said David Havens, a managing director in credit trading at Hexagon Securities in New York.

(Additional reporting by Chelsea Emery in New York and Ajay Kamalakaran in Bangalore; Editing by Muralikumar Anantharaman, John Wallace and Steve Orlofsky)

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