Sunday, April 19, 2009

The Threat Of GECC's Disappearing Tangible Common Equity Value

One of the biggest threats to the financial system currently is neither Citi, nor Bank Of America, nor any other pure play bank. Over the past month the administration has made it clear that the U.S. would rather print ever more money (and funnel them directly to Citi's coffers) and potentially face default dangers, than allow another Lehman-type event. Right now, the biggest weakness, in my opinion, is the parent company of General Electric Capital, GE Corp, which incidentally is also the owner of such consistent market bottom callers as CNBC's Jim Cramer and Mark Haines.

As in the stress test, the key consideration for "financial" companies is their so called equity buffer, or the "first-loss provision" - the Tangible Common Equity ratio. Rolfe Winkler gives a preliminary estimate of GE's TCE at or around 0, based on the company's earnings release. He goes on to say:
"Shareholders equity declined $4 billion to $101 billion. Subtracting goodwill and intangibles of $95 billion and Buffett’s preferred stock of $3 billion would yield TCE of just $3 billion. That $3 billion supports tangible assets of $666 billion, implying a leverage ratio of, gulp, 222x. And GE has an asset bucket labeled “other” of $122 billion. How much of that pile is intangible?"
Let's back up. Grant's Interest Rate observer is out with an interesting piece which recaptures the speech of Steve Eisman, portfolio manager of FrontPoint Partners, a Morgan Stanley subsidiary, to a Grant's audience in which he focuses on the troubles at GECC. Eisman has some very troubling things to say about the U.S. conglomerate focusing on its Tangible Common Equity ratio:

"It is very critical to track this ratio over time. I learned this by examining Citigroup over many years. If you tracked this ratio on Citigroup, you would have seen massive deterioration. Back in 2002, when things weren't so bad for Citigroup, tangible assets divided by tangible equity was 20 times. By the end of 2007, leverage had increased to 37 times and then Citi cut the dividend and had to raise capital.

So let's look at what has happened to GE over the years. On a tangible assets-to-tangible common equity basis, GE was only 13 times levered in 1992. It is now 142 times levered. Notice that GE has less tangible common equity today than in 1992, while its balance sheet assets are four times bigger. I call that massive deterioration. Even if we include the recent preferred equity raise, it is almost 90 times levered. This is not a triple-A balance sheet; it is not a double-A. It should be junk rated.

So how did it get here? By piling debt on debt. At a leverage ratio of 20:1, GE Capital actually stands tall among finance companies. To achieve this profile, however, Immelt & Co. has journaled billions from the parent - $9.5 billion this year on top of $5 billion in October. Without these capital infusions, GE Capital would be 34 times levered, a level similar to Citigroup at the end of 2007. But GE is very, very sensitive to the ratios of GE Capital, and so are the rating agencies. So, to appease them, GE moved capital to GE Capital. GE is not so sensitive to what the capital ratios look like for the entire
company and for GE ex-GE Capital."
The last issue is a topic Zero Hedge previously wrote about in depth, discussing the potential ticking time bomb hanging over GE Capital in the form of a ratings agency downgrade and how that could be an immediate and terminal end for the finance subsidiary.

How did the finance arm of the company, which for generations has been seen as the cornerstone of the U.S. economy, find itself in such a quandary? A quick look at its various operating segments courtesy of BofA gives some preliminary insight into just which divisions have historically provided both revenues and profit, and why both the top and the bottom line at GECC may both be significantly impaired.

The traditionally strong business segments are currently shrinking, as previously profitable assets are scrambling to generate anything comparable to historical cash flow levels.

Speaking of cash flows - is GECC viable, either in the short-term or the long-term? Bank Of America estimates that based on certain rosy assumptions and some generous governmental support, GECC will be able to meet its 2009 funding requirements.

So Bank Of America believes that GECC, through up to $67.8 billion of governmental guaranteed debt issuance and other sources of funding will be viable in the near term. But how about the long-term?

Going back to Eisman's interview, he brings up some more interesting points:

"Though GE does not mark most of its assets to market, it does so mark its securities portfolio, and the pretax loss on that portfolio at year-end 2008 amounted to $4.8 billion. And do you know how much of that loss management has chosen to run through the income statement? Not $1. Nor should one fail to mention the company's equity investments in an assortment of foreign financial institutions from Dogus GE BV in Romania to Cosmos Bank in Taiwan to Garanti Bank in Turkey. The lot of them are carried at their cumulative $19.3 billion cost. Estimated mark-t0-marked loss is roughly 50%. In my business when you are down 50% - you know, come on, already - you've got to take an impairment at some point."
Here Eisman lists additional GE exposure: $5.5 billion in Swiss franc-denominated residential mortgages in Poland and Hungary, $22 billion of residential mortgages in the U.K., $33 billion in equity commercial real estate and $48 billion in commercial real estate. Eisman adds "the bulk of these problematic portfolios have potential embedded losses of $40-$43 billion. If the reserves are brought up to appropriate levels, the total losses could reach $41 billion to $46 billion. These losses dwarf the company's total tangible common equity, and they exceed GE's tangible equity as well. The combination of these potential losses coupled with GE's enormous leverage makes a very toxic brew."

It is notable that GECC has extensive exposure to Eastern Europe, which in this author's view, will likely be the next major shoe to drop from a global fundamental perspective. As the IMF has lately become more and more antagonistic to the US' rosy worldview, once either Poland or Hungary ends up in default, the forced rapid revaluation of GECC's portfolio could become the catalyst for the fair pricing of this highly overmarked portfolio, and a result in huge charges flowing through the income statement, killing earning per share metrics.
So while most eyes are looking at Vikram and Lewis and applauding their one time benefits from the massive governmental "bank stimulus program", the maker of your parents' microwaves and refrigerators could be lurking in the shadows, waiting to launch the next chapter in the law of unintended consequences.

For interested readers, below is the recent CDS performance of GECC. 5 year default probability based on 682 bps closing price is 44.8%.

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