Wednesday, March 4, 2009

GE's $8 Billion Downgrade Time Bomb

As the market is running on fumes based on some doctored Chinese data, GE keeps probing new depths, hitting another record low of $6.36 at last check. The major concern plaguing the AAA-rated conglomerate today (whose CDS trades at distressed debt levels of about 20 points upfront) has to do exactly with its credit rating. According to a Fortune report, there is a sword of Damocles hanging over GE's head, in the form of a rating agency downgrade. In case GE gets downgraded to a AA- rating, or three notches from its current pristine and totally BS rating, the company would have to pay out $8 billion in cash immediately. This also explains Immelt's focus on maintaining GE's rating by recently cutting the dividend, as an accelerating downgrade impetus could likely doom the company which is projected to earn just 50% more than this mandatory payout. However, GE is caught in a vicious web of complexities due to its relationship with its finance unit, GECC. As we wrote earlier, GE funneled $9.5 billion to GECC to lower its pro forma leverage, ahead of the company's projected $45 billion in upcoming debt issues.

How likely is a rating cut? As everyone knows you can predict a schizophrenic monkey's behavior better than that of the rating agencies (unless you are providing the RA's with compensation for their services... then you can bank on any outcome you are after). As Katie Bonner says:
Many analysts who cover the stock believe Moody's will downgrade GE and its finance subsidiary, GE Capital Corp., at the end of this month, but no one is sure how far. S&P has said that if it were to look at GE Capital as a stand alone company, it would only garner an A+ rating. And in late January, Moody's warned that GE was on review for a downgrade. Both are currently AAA rated, the rating bestowed upon the most creditworthy borrowers.
We discussed the concerns that Moody's has presented previously here, and while Moody's likely doesn't want to take down the only remaining American icon that is not on the verge of bankruptcy, its recent streak of trying to make up for prior transgressions has made it somewhat downgrade happy.

What happens in a downgrade? The Fortune article presents a good summary:

On page 53 of GE's 2008 10k recently filed with the SEC, the company says that at the end of last year, if it had a rating of AA-, GE Capital would have been required to provide about $3.5 billion of capital to support a group of entities that are funded by issuing guaranteed investment contracts (GICs). A GIC provides a fixed return on an mount of capital that the GIC issuer invests.

Another entity at GE Capital also issues GICs and then loans the proceeds back to the finance arm. If GE Capital's rating were to hit AA-, GE Capital would have to provide about $4.7 billion to repay the GIC holders.

The total $8.2 billion GE would owe could swallow up the $4.2 billion freed up by the recent dividend cut as well as further weaken the company's cash holdings. In an environment where it's difficult to raise cash, that would put GE at risk of further ratings cuts - and more ratings cuts would cost the company even more money.

GICs can burn GE in another way. Should the liabilities in the GICs exceed their fair market value, GE Capital would have to provide the difference. As long as GE is not forced to sell these contracts, this should not be a problem. But had the company sold the GICs at the end of 2008, according to the annual report, the fair value of their assets were only $9.2 billion and the liabilities totaled $10.7 billion, which would make a loss of about $1.2 billion.

GE's annual report also says that if the rating on GE, or applicable entities, falls six notches to A-, then covenants will be triggered on its swap, forward and options contracts that force the company to pay money to its counterparties to account for the additional risk. The fair value of this risk was about $4 billion at the end of 2008, according to page 52 of the 10k.

A cut to its short-term debt rating would also be a blow to GE. Should GE's short-term debt ratings fall below A+ (or A1 in Moody's parlance), then it would no longer be eligible to participate in the Federal Reserve's Commercial Paper Funding Facility program.

GE currently has $60 billion in commercial paper outstanding, i.e. short-term loans that roll over every month or so. It is essential that these loans roll over - meaning that lenders continue to let GE borrow on a short-term basis - because these loans fund the company's daily operations.

The problem for Immelt is that he will have to disappoint shareholders, who are anticipating this and have already punished the stock correspondingly. Immelt's choices boil down to an equity issue to raise cash and pay down debt now, or use cash now to pay down debt, and only subsequently raise cash: the question is can Immelt juggle all the variables in the equation including the rating agencies, the government's support, the CDS trading levels on the company's debt, the deterioration at GECC and its increasingly disappointed shareholders.
(hat tip reader Michael)

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7 comments:

CreditTrader said...

Hey Tyler, hearing some crazy scrambling among CDO bespoke dealers hedging their jump risk! MOre than anything this is what is dragging CDS wider. Using any Capital Structure model, GECC's CDS trades cheap (wide) to its equity at these levels (but not as much as one might believe). That AAA badge swings both ways - at least they ca still fund via TLGP!

Anonymous said...

Love to know more on the doctored Chinese data. My belief is they have all the incentive in the world to paint th picture all is well. If you can point out some stories on this be awesome

S said...

anon..

do you think it coincidence that the PMI etc are mocing in step function north above the important benchmark 50 level?

Walter Zweifler said...

Credit Default Swap valuations based on transaction price data is critical to investors in GE and other distressed companies. We want to talk to others who have a prototype report like ours to offer clarity and objectivity where it is greatly needed. wzweifler@zweifler.com

Walter Zweifler, ASA said...

Credit Default Swap valuations based on transaction data are critical to investors in GE and other distressed companies. We want to talk to others who have prototype reports like ours to offer clarity and objectivity where it is greatly needed. wzweifler@zweifler.com

Almeria Property said...

coincidence ... or moral guilt?

Anonymous said...

Given that the CDS is trading upfront I dont see the ratings change to be a driver of the CDS blowing up wider. The bespoke comment above sounds closer to home especially given that the front-end of the curve is 1000bps wider of the 5y point. Default prob is now pricing in 50% over the next 5 years... more here:
http://www.acredittrader.com/?p=14