Wednesday, March 04, 2009

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.


In Debt We Trust said...

Good to see you're back AI.

What is your opinion of this?

I'm primarily an equity and options trader so I don't get to breathe the same rarified air as the abs traders. Still, I think Denninger is making some conclusions here w/o checking all the facts.

santcugat said...

I don't think the government is going to let rating agencies shoot GE at this point.

Given their responsibility in creating this mess in the first place, seriously annoying the government at this point would be contrary to their best interests.

cap vandal said...

I would like to know exactly who has the capital to sell and make good on GE CDS's. Their prices could reflect a supply/demand dynamic that isn't tied to the intrinsic risk of the bonds. There are hundreds of billions of bonds and I don't know who has the kind of money to write these.
Looking to volatile markets for "definitive" clues regarding underlying valuation is a mistake, unless the agencies use volatile market prices as an input into ratings.

AIG wrote credit default swaps on "super senior" multi sector CDO's. This plus buying MBS's with the collateral from their securities lending program did them in.

Without these enormous losses, AIG would have had enough capital to take the inevitable hits that anyone with a trillion in assets faces.

Regardless of GE's lending philosophy, there is no evidence that they wrote a material number of credit derivatives.

I would guess that they take some hits on commercial real estate and in certain countries that are in worse shape then the US.

To the extent that these are whole loans and leases, they can write them off over time if/as they default.

As far as funding, I think that TALF or similar vehicles are perfect for GE. They can securitize new business via TALF and let the old business run off. This is really key to the idea of providing credit. Making sure companies like GECS continue to provide loans.

A lot of their international stuff is very country specific and you can't easily generalize about it. Other then to say that they will take some hits.

If you look at GECS 10k they have fairly decent capital ratios, if you split out the industrial stuff. They do have some goodwill, but also put in $10 billion cash from the holding company.

In this atmosphere, any firm with lots and lots of assets is going to end up with some losses. However, this is no investment bank and critiques need to be more specific.

I'm with kristof in that the rating agencies will try very hard not to be the party to push GE over the ledge.

cap vandal said...

"I'm primarily an equity and options trader so I don't get to breathe the same rarified air as the abs traders. Still, I think Denninger is making some conclusions here w/o checking all the facts."

I believe that CDS's are adding instability to the financial system by making large leveraged trades. In addition, there is a belief that the CDS market is deep and efficient. This needs to be proven rather then asserted.

Further, the purpose of capital markets isn't to provide price discovery. Rather it is to facilitate raising and allocating capital. The burden of proof should be on the CDS market that it add anything to our financial system except instability.

Unknown said...

I wouldnt knock CDS as such. Clearly AIG made poor use of them as they essentially wrote protection to anyone and everyone (though a natural question is why would you buy protection from an entity who will likely not be around once you come to collect).

What CDS has going for it is that it provide a highly liquid and standardized way to trade and hedge credit risk. If CDS didnt exist people would trade bonds and loans (though shorting bonds has always been a royal pain while buying protection is as easy as selling it).

What's interesting in the case of GE is the 50% likelihood of default implied by current (record) levels. More here:

nades said...

AI thanks for the write up. Very insightful. Cap vandal nice comments.

Accrued Interest said...

I've probably seen 50 messages today on GE offerings. Everyone wants to sell.

I do think that CDS are part of the problem and not part of the solution to our financial crisis. The CDS market isn't very deep any more and creates more fear than a drop in the stock can.

But wider CDS are still a symptom of a company that needs to deleverage and isn't going to be afforded the luxury of time to do it.

Unknown said...

If GE has a liquidity problem, say to pay a margin call or a bond maturity, that is easily solvable in these days of zero interest rates.
If there is a solvency problem, where income and cash flows from assets fail to service financing commitments, time alone will tell.
But to buy time, you have to get over the credibility problem: too many people in the market are jumping to the conclusion that GE's accounts are too optimistic, and this is amplified by the glaring mismatch between the CDS rating and the rating derived from the financial reporting.
Other people are saying that the CDS rating is just a manipulation because there are not enough natural sellers of CDS and the market is not transparent to the public.
It seems to me that the way to settle who is right is to have a short squeeze on the CDS buyers. For if the current prices are being transacted in any great volumes, then the buyers face 5 years of steep costs if GE survives.
A squeeze could be triggered by GE getting off a successfully underwritten jumbo bond issue at an AA spread (with a bit of arm twisting / calling in of favours / possibly sweetened with equity warrants).

DAB said...

I don't believe in the no win situation.

...I can't believe nobody beat me to that punch...

Here is where this really hurts, I have a good project for which I could use a GE turbine. In the past, I could run economics on the assumption that in the worst case we could finance the thing for 20 years through GE Capital (expensive turbine, reasonable to expensive financing, if my ROR works everybody is happy). Now, there is no project economic dealflow happening over say a million dollars. You can't get a real project done under a million, even a good project even in today's economy. I therefore can't buy their turbine and I can't generate fees and interest income for their financing service.

I have all along thought that the point about the government bad banking the mortgages and MBS and closely related "stuff" is that the problem in valuation is that nobody but the US Government can realistically assume they can hold the mortgage securities to maturity. Assuming that is true, and I think Krugman would disagree, is that true of whatever else GE is holding? Say the government buys their mortgage exposure (at something like fair value maybe with some kind of equity stake to balance the risk and provide capital) and that their project finance is probably profitable in excess of their loss provisions (that is the business they really know). Is the CDS exposure enough to bring the house down by itself, or are there other structured finance bombs ticking away in GE? Probably a rhetorical question since their CFO may not even know the answer.

Accrued Interest said...

Ralli... there have been two major unsecured, non-FDIC financial bond issues in 2009. One was Goldman Sachs, the other was our friend GE. Didn't help.

DAB: Maybe GE can reprogram the simulation.

Delia said...

Thanks for your article, quite effective info.