Monday, February 23, 2009

Property Frights: GE Capital Punishment

By PETER EAVIS General Electric hasn't kept pace with the plunging banks. But its shares have still dived more than 42% this year on doubts over its finance subsidiary. A trawl through GE Capital's balance sheet shows why investors should remain wary. On the surface, the unit looks enviably positioned. It retains a triple-A rating, has no meaningful exposure to U.S. residential mortgages and enjoys one of the highest tangible-common-equity ratios in the financial sector -- a meaty 4.9% at the end of last year, against, for instance, J.P. Morgan Chase's 3.8%. Dig a little deeper, however, and the uncertainty mounts. One reason: GE Capital has large concentrations of other real-estate assets -- commercial exposures and foreign residential mortgages -- that could lead to large losses in a deep recession. Another: Despite some changes, GE Capital still looks like a classic "wholesale" finance company, relying on market funding. This is a drawback when credit markets are skittish and large amounts of long-term debt -- $133 billion this year and next -- are coming due. On the asset side, a big source of jitters is GE Capital's $36.7 billion in commercial-real-estate investments. These are equity-type investments, the first to absorb any losses. As a result, most firms are currently applying big haircuts to this type of asset. In its fourth quarter, Goldman Sachs Group, using mark-to-market accounting, took a 25% write-down, totaling $961 million, on its commercial-real-estate equity investments. GE Capital, which values its holdings using estimates of future cash flows rather than marking them to market, took $300 million of impairments last year, equivalent to less than 1% of the equity investments. That is even more surprising given that GE has booked sizable unrealized losses on its book of securities backed by commercial real estate, which the company does mark to market. These bonds, senior to equity in the investments they fund, are written down by 23%. Admittedly, they are in different deals from GE's equity investments. But the huge divergence in the accounting hits understandably rings alarm bells with investors. In GE's defense: Marks on the debt securities may be exaggerated by extreme stress in the market for such securities. Second, unlike some other investors, GE operates most of the properties in which it has equity-like investments, arguably giving them a higher value. Also, in the vast majority of the equity deals, GE itself provided the debt funding -- not third-party investors -- meaning there could be less immediate refinancing risk to the individual deals. Finally, GE does flag the risks by disclosing in its annual report that its real-estate equity investments' "estimated value" is $4 billion less than the value on the balance sheet. But since GE was a big commercial-real-estate equity investor in the frothy years -- it added $12.6 billion of these assets in 2007 alone -- investors should watch this portfolio very closely. Attention should also be paid to GE Capital's $59.6 billion of overseas residential mortgages, many of which are based in troubled markets like the U.K. Some $3.3 billion of these mortgages are more than 90-days past-due, but GE Capital's loan-loss reserve is equivalent to only 11.5% of the past-due total, up only slightly from 10% at the end of 2007. Cross-bank comparisons should be treated warily because of differences in loan-portfolios. But, for example, Bank of America's reserve for residential mortgages in the U.S. is far higher at just under 20% of nonperforming residential assets. The need to clear up uncertainties about future credit losses at GE Capital is key, not just for stock investors and creditors, but also for the ratings firms. Going by GE's credit-default-swap spreads, the market expects the triple-A rating to go. How much lower depends on how many losses are lurking in the balance sheet -- and the amount credit markets will charge to keep supporting wholesale-funded businesses. Write to Peter Eavis at

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