General Electric: Kobayashi Maru

Credit default swaps on GE Capital traded as wide as 20 points up front area this morning. For some color on what this means, in the days following Lehman's collapse, Goldman Sachs never traded this wide and Morgan Stanley might have ticked this wide, but only for a day or two.

In my opinion there are a number of things coming together to create this problem, beyond the obvious that GE was highly exposed to various areas of the economy now weakening. First, GE may have had a legitimate AAA-rated business model if one assumed that access to short-term financing was always and everywhere a given. Now that's obviously not the case. You simply can't make the case for any firm being rating AAA who needs constant access to short-term markets. That's even forgetting all about GE's exposures. So GE will be downgraded from AAA, its only a question of when and by how much.

On top of that, there are thousands of investors who bought GE securities over the years with the attitude that "hey, its AAA! What's the risk?" Some of those buyers had dumped the bonds over the course of the last year as it became increasingly obvious that GE would be impacted by the financial crisis. Bill Gross was saying as much on CNBC this morning. These buyers include everyone from big foreign investors to little retail accounts. And why can't I shake the feeling that it also includes Mr. Gross himself?

And remember that a lot of the same people got burned with AIG, which was also AAA-rated just a few years ago.

GE Capital's business model can be boiled down to this: every risk has a price, and we'll price every risk. Note that this was basically the same business model AIG was running. Maybe GE is running it better, but its the same idea. And that's not to say that GE is going to have the same fate as AIG. But consider the conundrum: GE has huge de facto leverage which it needs to reduce. But it cannot sell enough assets at today's distressed prices to actually reduce leverage. You'd like to think that if the assets are good, GE can just let time and normal cash flow solve their problem.

But that isn't a realistic option. First, if ratings agencies downgrade GE Capital enough they'll have to post additional collateral against existing contracts, and that's exactly what the proximate cause of AIG's collapse. Second, GE Capital really can't operate with less than a AA rating or so. The funding costs would be too high. Maybe they could get away with A, but certainly not BBB. But under current circumstances, I really think BBB is the right rating. Again, you'd like to think GE Capital could go into quasi-run off and eventually regain a decent credit rating, but I just don't think market conditions allow for that sort of slow transition.

This is also why I doubt they could do a spin-off of GE Capital. If GE combined is looking at a A-level rating, GE Capital alone would either get a much lower rating, or GE Inc. would have to pledge even more cash to GE Capital in the spin-off. On top of all that, from a shareholder perspective, if you believe in GE Capital long-term, why sell now when valuation is going to be at a minimum?

These kinds of no-win scenarios are an unfortunate consequence of current economic conditions. Firms need to rejigger their leverage and asset mix, but the problem is so universal that no one has the cash to transact. Then you have companies who probably could have survived had they been granted the luxury of time, but no such luxury is available.

What would really help GECC is for the TALF to be expanded such that GECC could unload assets at decent valuations into the secondary market. Or else the Aggregator Bank helps them out. Otherwise its difficult to see what good options GE has.