Can the Fed Bring Good Things to Light?

With shares down 59% this year and profits plunging, General Electric, a bellwether stock for the US economy, became one of the first companies to test the Federal Reserve's commercial paper facility, with American Express fast on its heels.

Companies use commercial paper as a short-term financing mechanism for day-to-day operations.

Will GE's borrowings be enough to buoy the damaged conglomerate (GE) and its distressed finance arm, GE Capital, which can no longer fuel half of the parent's profits?

Will GE's short-term borrowings be enough to save its hallowed triple-A rating, a gold-plated status it uses to borrow cheaply in the markets, given that GE's tangible net worth is slowly submerging under an eye watering debt load?

Dozens of companies had registered with the Federal Reserve to access the program, which debuted Monday. GE, which borrowed an estimated $5 bn from the Fed facility, is the biggest player in the commercial market and is eligible to borrow up to $96 bn through the program.

In a sign of investor unease, yields on 30-day paper have risen. The market upheaval has forced GE to sell more paper with shorter durations, increasing borrowing costs. 

GE says it has $62 bn in bank credit lines and can tap its $59.8 bn cash and marketable securities to get it through the credit crisis.

But just as the industrial conglomerate's sprawling operations provide a perfect mirror of the US economy, so too do GE's complex debt financings provide the ultimate example of the economy's swollen underbelly.

GE Capital Under Pressure

GE Capital is the country's largest non-bank financial company, a unit that deals in commercial real estate, credit cards, mortgages and airplane leasing. With $678 bn in assets--82% of its parent's assets--GE Capital is in the league of the top ten largest financial companies in the country.

GE's financing arm is under severe duress, as GE Capital's operating earnings plunged 33% in the first nine months versus the prior year period.

GE says its finance unit will now fuel 40% of its profits, down from 50%.

Analysts expect GE Capital will be hit with pre-tax losses of up to $6.6 bn this year and up to $9 bn in 2009.

In its defense, GE has said that GE Capital has had lower losses than other comparable financial institutions, as it is geared toward conservative mid-market finance businesses with strong risk management, and that it also has low leverage ratios and high return on equity.

But take a closer look at GE's balance sheet (see below) and you'll see some fire-engine red warning signs.

Also, GE has already flashed an unusually pointed and detailed filing to the Securities & Exchange Commission filled with warnings that it fears its triple-A rating could be threatened as its borrowings costs inexorably rise.

GE Scrambles

Despite avowals to the contrary that its funding was secure, GE is making several moves to preserve its cherished triple-A rating.

GE announced it will try to cut back its dependence on commercial paper, and curtail GE Capital's financings. Within the past month GE suddenly had to raise $15 bn in equity. It also had to stop a stock buyback plan and freeze its dividend, the first time in 32 years it has not increased the annual pay-out.

And despite its claims that everything was fine at the company, GE was forced to sell at a steep price to Warren Buffett's Berkshire Hathaway's $3bn of its preferred stock with a rich 10% dividend as part of its $15 bn equity raise.

Berkshire's stake at $22.25 a share is now underwater. (Worth noting too that GE made the classic Wall Street mistake. Through its stock buyback program, it was buying high in the $30s, but with the Berkshire sale, it was selling low at $22).

The Federal Reserve Steps In

The commercial paper problems began with the Lehman Bros. bankruptcy, which triggered a flight out of money funds that had invested in Lehman securities. Investors fled for the exits when three money funds "broke the buck"--meaning, investors would not get back all the cash they put in because the funds failed to keep assets of at least $1 for every dollar invested.

Money funds are large buyers of commercial paper. As panic spread, the volume of U.S. commercial paper outstanding has declined by about $350 bn, or 20%, to $1.45 tn.

For the first time in its history, the Federal Reserve recently announced it will provide a commercial paper backstop to nonbanks, what analysts believe was a lifeline tossed toward GE as it owns the country's largest nonbank, GE Capital.

The Fed's new lending program is an attempt to defrost the now smaller $1.45 tn commercial-paper market, though it could take weeks before this short-term financing market loosens up.

Specifically, the Federal Reserve offered up to $540 bn of help to money market mutual funds in an attempt to get credit flowing more freely again.

Under the new program, the Fed will provide financing to a series of five private-sector facilities run by JPMorgan Chase. The funds will buy commercial paper issued by highly rated financial institutions, as well as CDs, bank notes and other eligible short-term debt.

GE Capital Under Fire

Whether the Fed's new commercial paper facility will help GE remains to be seen. The company is struggling with a problematic balance sheet that has a sizable debt overhang, at last count $54.7 bn in illiquid securities it can't readily sell, and off-balance sheet vehicles that house another $53 bn in debt securitizations that GE doesn't want hitting its weak balance sheet.

Fortune Magazine's Geoffrey Colvin, a topnotch business journalist, reports that some of those off-balance sheet assets are hooked to interest rate swaps with counterparties that are now in trouble, such as ABN Amro.

If loaded back onto its balance sheet, those off-balance sheet sums would swamp GE's tangible net worth, or book value based on its hard assets (see blogs "What Buffett May be Missing at GE" and "Worrying New Disclosures From GE").

Also, the Financial Times reports that an estimated one in six U.K. mortgages held by GE Capital are now delinquent.

Berkshire Hathaway's GE Investment Under Water

With shares trading as low as $17 recently, Warren Buffett's Berkshire Hathaway's $3bn investment in GE's preferred stock at $22.25 is underwater.

However, Berkshire, which also dropped $5 bn on Goldman Sach's preferreds, will reap a rich dividend of 10% on its GE and Goldman stakes.

Don't doubt for a second that Buffett is not fully aware of investing in shaky companies. His company bought a $700 mn investment in Salomon Brothers in 1987, a Wall Street titan which nearly collapsed after a 1991 trading scandal (the Travelers Group bought Salomon in 1998, later subsumed into Citigroup).

The 12% stake at the time was the largest ever taken by Berkshire Hathaway, which became Salomon's largest shareholder and Buffett moved in as a director.

Buffett then had to parachute in to help fix Salomon after a bond trading scandal. In 1991, the US government caught Salomon submitting false bids to the U.S. Treasury in a vain attempt to buy more Treasury bonds than permitted by the rules. The Treasury then banned Salomon from bidding in government securities auctions.

Of course GE is not Salomon--instead, GE's financials are mined with numerous quality of earnings problems.

GE Fights for its Triple-A Rating 

GE is one of six industrial companies that sport a gold-plated triple-A rating, which allows it to borrow cheaply in the credit markets. Keeping its triple-A rating is vital to its business.

Historically, GE's triple-A rating enabled GE Capital to borrow cheaply and buy its way to profit growth.

Specifically, GE Capital uses that triple-A rating to help its parent execute its acquisitions and divestitures on the cheap, a just under the wire, limbo game of last-minute moves it has typically executed to grease the way toward meeting or beating its quarterly earnings estimates. 

GE Capital also has historically provided cheap financing to customers of its parent to buy all sorts of products, from locomotives to jet engines. Backed by the parent's assets and triple-A status, GE Capital gets to lend and borrow at cheap rates.

But as the commercial paper market has frozen, GE has hit a wall in conducting its short-term borrowings to run its business and to make its last-minute moves.

GE has $88 bn in commercial paper, borrowings it needs to fund its day-to-day operations. Those borrowings have steadily risen in cost.

GE's Flash Warning

The same day General Electric announced that Buffett's Berkshire Hathaway planned to invest $3 bn in the conglomerate and that it planned a new $12 bn stock offering, GE shot a little noticed filing over to the Securities and Exchange Commission that gave fresh detail on the unhealthy state of the company.

Publicly traded companies are required to make periodic risk disclosures about the state of their businesses, however, GE's disclosures were unusually pointed and detailed.

"Failure to maintain our triple-A credit ratings could adversely affect our cost of funds and related margins, liquidity, competitive position and access to capital markets," GE warned.

GE said that following its announcement of its recent capital raise, Standard & Poor's reaffirmed its ratings as well as the ratings for GE Capital's "AAA" long-term and "A-1+" short-term corporate credit ratings. GE noted that Moody's Investor Services did likewise.

But watch out here.

GE also warned about its moves to shore up its balance sheet: "However, there can be no assurance that we will successfully complete these steps or, in the event of further deterioration in the financial markets, that completion of these steps and any others we might take in response, will be sufficient to allow us to maintain our triple-A ratings."

It added: "Failure to do so could adversely affect our cost of funds and related margins, liquidity, competitive position and access to capital markets."

In a significant disclosure, the filing warns that GE gets "a large portion" of its borrowings via the commercial paper markets, but that "there can be no assurance that such markets will continue to be a reliable source of short-term financing for GE Capital."

GE's Limbo Dance Stymied

GE also confessed that the tight credit markets mean less last-minute acquisitions and asset divestitures for it to execute each quarter, which could hurt future profits.

"The success of our business depends on achieving our objectives for strategic acquisitions and dispositions," GE said, but added, "we may not be able to identify suitable candidates at terms acceptable to us."

It also warned that "when we decide to sell assets or a business, we may encounter difficulty in finding buyers or alternative exit strategies on acceptable terms in a timely manner," noting "or we may dispose of a business at a price or on terms that are less than we had anticipated," as tight credit markets have hurt the financing for these deals.

That Includes Its Eroding Commercial Property Business

When the real-estate market was booming, GE's commercial-property business earned the nickname "the honey pot" among insiders because the company could increase earnings simply by selling a building or two, Fox Business's sister publication the Wall Street Journal reports.

But now, the opposite is true. GE's difficulty selling its office buildings, shopping centers and other commercial property is dragging down its financial results, the Journal says.

Lower property sales contributed to earnings shortfalls at the Fairfield, Conn.-based conglomerate in both the first and third quarters, the WSJ reports. GE, whose $88.7 bn real-estate portfolio is one of the world's largest, posted a 62% decline in its third-quarter profit on real estate, to $244 mn from $640 mn a year earlier.

GE's Cash Flow Weakens

Also, cash from GE's operating activities in the first nine months dropped 18% to $13.6 bn, down from $16.7 bn for the same period a year ago. That cash drop was due to a $3.6 bn decrease in the dividends the parent gets from GE Capital, among other things.

GE's Creaky Balance Sheet

A look at GE's latest balance sheet shows the industrial conglomerate's leverage ratios, the amount of money it borrowers against its assets, are rising. 

GE has $548 bn in borrowings, $536 bn of which sit at its finance unit, GE Capital. The total of $548 bn is up 7% from $514.1 bn at year end 2007, but as GE is trimming its borrowing lately, that figure is down slightly from $556 bn in the second quarter.

However, here's a danger zone.

The parent's net worth has dropped in value, to $112 bn from $118 bn just a quarter ago, and $116 bn at year-end 2007. On just this basis, GE leverage ratio looks okay, at five to one, meaning for every dollar of assets GE has borrowed $5.

However, a whopping $99 bn of that $112 bn in assets is in the form of goodwill and intangible assets, hard-to-pin-down ephemera that represent the premium (or potential overpayments) GE paid in acquisitions as well as things like the value of its patents, among other items. It's a price tag the company assigns itself to these assets, with the help of auditors.

So GE's tangible book value, its net worth based on its hard assets, is just $13 bn. On that basis, GE is levered up 42 to one. Factor in its $53.2 bn in off-balance sheet debt, its debt picture blows out to $601 bn. In turn, its leverage ratio balloons to 46 to one.

Similarly, GE Capital's net worth has dropped in value, to $56 bn from $60 bn in the second quarter ago, and $58 bn at year end 2007. That $56 bn supports $536 bn in borrowings, a leverage ratio of about 10 to one.

However, a full $30.5 bn of GE Capital's $56 bn in net worth also is in the form of ephemera. Similarly, GE Capital's tangible book value, its net worth based on its hard assets, is just $25 bn.

On that basis, GE Capital's leverage ratio blows out to 21 to one. Factor in the off-balance sheet cornucopia of who knows what, and the ratio rises to 24 to one for GE Capital.

Buried in GE's Disclosures

As noted, GE Capital has shoved into off-balance sheet vehicles a big $53.2 bn in securitizations, assets backed by credit-card debt, commercial and equipment financings, as well as trade receivables. This information is not in GE's latest third quarter earnings release.

These vehicles get to sport GE's gold-plated triple-A rating, even though these assets are backstopped by a weak $2.7 bn in credit support.

The vehicles come with triggers that force GE to pony up credit or buy them back, say, if a spike in defaults occurs. Putting them back on the balance sheet would hurt GE Capital's debt to equity ratios-as well as the ratios for the parent.

Moreover, GE Capital has $15.9 bn in illiquid assets, the toxic level 3 assets, that the company can't get a price tag on because there is no market to mark them to. So they sit dormant waiting to be unloaded. Again, this information is not in GE's latest third quarter earnings release.

It's got another $38.8 bn in level 2 assets, which may be more easily sold than its level 3 assets, though the credit markets for them still largely remain in blackout mode.

These sums in total easily swamp the $13 bn tangible book value of GE.

GE's Commercial Paper Problems

GE currently has around $88 bn of commercial paper, and with interest rates spiking higher, GE is facing a lot of trouble with higher funding costs-a reason why it did the capital raise in the form of a new $15 bn stock offering.

GE says its common stock offering, as well as the Berkshire investment, gives GE some breathing room for now to not have to draw on its $62 bn in bank credit lines or tap its nearly $60 bn cash and marketable securities.

However, the company does say ina recent disclosure that "the volatility in the Fed funds rate has been a recent influence on pricing as has the spike in LIBOR," although it claims "the affect on our entire CP [commercial paper] portfolio is not significant." It does add that it hedges its interest and currency risk "over time." 

GE Elbowed Out?

GE is undergoing a massive restructuring which involves asset divestitures, but it could be elbowed out in a bum's rush to a very crowded exit door in its asset sales by Citigroup (C), JPMorgan Chase (JPM), and Bank of America (BAC) and just about any other financial services firm caught in the downdraft.

Specifically, GE has already announced it would sell its businesses that make light bulbs, appliances, and certain electrical equipment.

However, Reuters reports that China's largest home appliance maker, Haier, isn't planning to bid for the appliances unit of General Electric (GE) until there is a clear sign of U.S. market recovery. In May, GE CEO Jeff Immelt said Haier, LG Electrics and Arcelik could be possible bidders for the unit.

Analysts Go Negative on GE

Already, Citigroup analyst Jeffrey Sprague has cut his earnings estimates for GE for not just the next year, but for the next three years.

Deutsche Bank Securities has already lowered its earnings per share estimates by 9% for 2008, to $2 and to $1.95 in 2009, and cut its stock price target to $26 due to "deterioration at GE Capital, driven by tighter credit markets, asset shrinkage and a debt pay-down."