GE Capital Downgrade Could Mean Large GE Payment

GE Capital, battered by the credit crisis and battling concerns about its short-term liquidity, faces a likely ratings downgrade that might cause parent General Electric to pay billions. Worse, fears that GE might default on its long-term bonds are also on the rise.

Fairfield, Conn.-based GE Capital is the financial services arm of GE and the nation's largest lender to mid-sized companies. It also provides aircraft leasing and private label credit cards. The unit was GE's biggest moneymaker, contributing $8.6 billion in profit, or roughly half the company's overall net income (PDF link). GE itself employs more than 300,000 people, including about 73,000 at GE Capital.

If GE Capital is cut to a "AA" from its current coveted "AAA" rating, the impact won't be material, Sanford C. Bernstein analyst Steven Winoker told me in an interview. However, if GE Capital is cut to "A", then GE would have to pay $8.2 billion to debtholders, Winoker said. If the unit is slashed to "BBB" then parent GE would probably have to pay back another $2.9 billion, or a total of $11 billion. And, if the unit loses its A1/P1 status it would have to make another $3.8 billion in payments. A1 is the highest short term rating supplied by Standard & Poor's, while P1 is the highest short term rating from Moody's.

But Winoker thinks any severe ratings cut for GE Capital is highly unlikely. "I expect them to go to AA," he said.

A downgrade might even have some positive side effects, according to a joint note from Nicholas Heymann and Matthew Kelly, analysts with Sterne Agee & Leach. "In the event GE were to see its credit rating reduced to AA, different capital requirements exist than for an AAA rating, which would likely free up some incremental capital," Heymann and Kelly wrote in the March 3 note. Moody's and Standard & Poor's are now reviewing GE's debt rating.

GE shares have nosedived since the beginning of the year, falling nearly 60 percent on worries about its diversified manufacturing business in a punishing recession and concerns over GE Capital's solvency. Much of the worry focuses on the unit's reserves for losses, which are low compared to its banking peers, according to Heymann and Kelly. GE Capital, according to press reports, argues that its business model is different than most banks.

Analysts like Winokur, Heymann and Kelly tend to discount those insolvency fears. In their note, Heymann and Kelly wrote that while GE has solid liquidity, investors are focused on "examining potential losses/write downs and the impact on capital."

But GE is restructuring the lender, which has been battered by the credit crunch. In January, GE Capital laid off an unspecified number of workers. This year, GE Capital is expected to account for only 30 percent of GE's total profit -- about $5 billion. Kelly believes GE Capital may have to seek further capital injections, something it may not have considered before.

GE has gone into overdrive to address concerns about GE Capital's liquidity issues. On Thursday, Keith Sherin, GE's chief financial officer, said in a television interview and in a statement that the unit expects to be profitable in first quarter and for the full year.

Sherin also denied the rumor that GE Capital has $45 billion in commercial mortgage backed securities that will need to be marked down. The unit has $2.9 billion of CMBs in its investment portfolio, GE said. "We have a $50 billion commercial real estate loan book. It's a senior secured position and we underwrite each individual property. We have about $34 billion of equity. That's the actual value of the properties, with over 80% of that with no third party debt," Sherin said in a statement.

On Wednesday, GE appeared to deny that it will need to raise additional capital. "This is pure speculation, is inaccurate, and is not based on any input from our company," GE spokesman Trevor Schauenberg wrote in a letter to investors. GE had $48 billion in cash at the end of fourth quarter, which included $37.5 billion at GE Capital. GE has since injected another $9 billion into the unit.

But Schaeunberg's statement left the conglomerate some wiggle room:

Currently, we have no plans to raise additional equity. In the unexpected event that GE Capital requires additional equity, we have a number of options to satisfy that need without seeking external capital.

Investors, however, appear to believe that the risk of a GE default is rising. This week, GE's credit default swaps -- instruments that provide insurance to holders against a GE bond default -- were trading at levels normally only seen at distressed companies. On Monday, GE's CDSes traded at 11 percent "upfront" for the first time, meaning that the banks offering the instruments are requiring big advance payments from investors seeking protection against a default.

My sources tell me that GE is highly unlikely to default on its debt. "I would be blown away if GE defaults, but I would not discount fully," said one private-equity executive, who thinks a mere debt-rating downgrade is much more likely than outright default.
GE has so far resisted tapping federal bailout funds for GE Capital. A spin-off of GE Capital also seems unlikely, Winokur suggests. "Management is so attached to the business," said Winoker. "They actually believe it will return to a positive earnings trajectory over time."

A GE spokesperson didn't return a phone call.