UPDATE 2-U.S. regulators at odds over aid for CIT Group

* FDIC clashing with other regulators over aid for CIT

* FDIC fears CIT aid involves too much risk exposure

* Treasury, Fed exploring other aid options for CIT (Recasts, adds comments from Ireland, details on bailouts)

By Karey Wutkowski

WASHINGTON, July 13 (Reuters) - The U.S. government is divided over how to handle the deteriorating condition of lender CIT Group, with the Federal Deposit Insurance Corp insisting that the lender poses too much of a risk for it to qualify for a government debt guarantee program.

The FDIC has been "very reluctant" to provide relief to lender CIT Group (CIT.N) through its debt guarantee program designed to provide liquidity to healthy financial firms, partly because the regulator is not satisfied with the lender's collateral, a source familiar with the matter said on Monday.

The Treasury Department and Federal Reserve have been supportive of CIT getting access to the facility, and are now exploring other aid options for the lender, the source said.

One option being considered is granting CIT's request to transfer assets to its CIT Bank unit, the source said, adding that such a move would take a lot of pressure off CIT's financial situation.

The source spoke anonymously because the government discussions have been private. An FDIC spokesman said the agency does not comment on pending applications. Spokeswomen from the Treasury and the Fed declined to comment.

CIT, which provides financing to many small and medium-sized businesses, has said it is in talks with regulators about how to improve liquidity after billions of dollars in losses have resulted in a credit crunch. [ID:nN13184030]

CIT's liquidity crunch comes at a critical time for regulators, and could send a message about the government's approach to ailing financial firms whose failure may cause pain but not bring markets to a halt.

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

Oliver Ireland, an attorney at Morrison & Foerster and a former Federal Reserve Board lawyer, said CIT's troubles could derail a positive, but fragile, sentiment about the U.S. economic recovery. "If you start to see some signs of significant failures along the way, it may reverse that sentiment," he said.

A head of a large hedge fund said he was concerned that if CIT is allowed to fail, it could cause credit spreads to significantly widen again.

"Letting CIT go away does a lot to the confidence in the system," the hedge fund executive said, speaking anonymously because he was not authorized to speak publicly. "The government should act soon because you don't want a run on the bank."

But Ireland said the government must weigh numerous factors, including the impact on CIT's counterparties, the overall effect on the perception of the economic recovery, and potential political fall out among lawmakers opposed to bailouts.

A SECOND VISIT TO THE TROUGH

CIT previously received government aid in December when it became a bank holding company and obtained a $2.33 billion capital injection from the government's Troubled Asset Relief Program (TARP).

The lender is asking to access the debt guarantee program as the FDIC tries to wind it down. The program was put into place in October in a bid to boost confidence in the banking sector and unfreeze credit markets.

Many of the largest banks that previously participated in the program have been issuing large amounts of debt not guaranteed by the FDIC -- a key requirement for banks to repay government TARP funds.

The program is also designed as a program for healthy institutions, and the FDIC fears granting CIT access to it involves too much risk exposure.

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.

The Treasury and Fed have been exploring other options for CIT, including the transfer of troubled assets from the holding company to its depository bank unit, which could improve the lender's liquidity position.

Treasury Secretary Timothy Geithner said on Monday that the government is closely watching developments associated with CIT and is confident the government would be able to deal with the lender.

"I am actually pretty confident in that context that we have the authority and the ability to make sensible choices," Geithner said in London in response to a question about how the U.S. government might deal with the company.

CIT's deteriorating condition also comes as the government is asking Congress for authority to dismantle bank holding companies in an orderly manner.

The FDIC currently has the authority to wind down troubled depository banks but does not have similar authority to resolve issues at bank holding companies that have become insolvent.

The Obama administration has proposed expanding FDIC's powers to include bank holding companies.

CIT shares fell 18 cents, or 11.8 percent, to close at $1.35 on the New York Stock Exchange. (For an analysis related to CIT please click [ID:nN13365218]) (Reporting by Karey Wutkowski; Additional reporting by Mark Felsenthal; Editing by Phil Berlowitz, Gerald E. McCormick, Gary Hill)