Yesterday, General Electric (NYSE: GE ) held an investor day that included a much-anticipated "deep dive" into GE Capital. Investors have battered the conglomerate's shares this year, sending them down nearly 40%, over concerns about the exposures and profitability of its lending arm. While GE did reaffirm its 2009 earnings estimate for GE Capital of $5 billion – a figure that is widely considered to be inflated -- GE's own presentation shows that number is at significant risk.
Look out for the 3-scenario monte
Indeed, the $5 billion corresponds to GE's base scenario, which has unemployment peaking at 8.5% and US GDP declining by 1.8%. GE looked at two other cases based on the Fed's base and adverse scenarios for the U.S. economy, under which it estimates GE Capital would earn $2-$2.5 billion and zero, respectively. Unfortunately, there isn't much to separate GE's base scenario from the Fed's base case which is characterized by unemployment peaking at 9.3% and U.S. GDP dropping by 2%.
Even the Fed's adverse scenario (peak unemployment: 10.1%, U.S. GDP: (3.3%)) looks remarkably achievable. Investors who are focused on a single point estimate ($5 billion) in that context are setting themselves up to be disappointed – I think the likelihood that GE will achieve that number is almost zero.
Take commercial real estate, for example...
In its fourth quarter, Goldman Sachs (NYSE: GS ) , applying mark-to-market accounting, wrote the value of its commercial real estate equity investments down by 25%. Meanwhile, GE's writedowns on its commercial real estate holdings last year totaled less than 1% of their value.
Unlike Goldman, Morgan Stanley (NYSE: MS ) or Merrill Lynch (now part of Bank of America (NYSE: BAC ) ), GE doesn't mark its commercial real estate portfolio against market values, arguing that these are long-term holdings. Instead, it values the assets on the basis of projected cashflows. In principel, I have no problem with that choice, but the discrepancy here is too large to simply put down to Mr. Market's depressive mood.
Who would you rather lend to: Turkey or GE Capital?
Either way, the credit default swap market took some comfort from GE's extra disclosure. The cost of insuring GE Capital's debt fell to 7.5% upfront yesterday (from 9% on Wednesday) and 5% annually (in order to insure $10 million of GE bonds against default over five years, one would need to pay $750,000 upfront and $500,000 annually).
In terms of the annual cost, that is a lot cheaper than that for insurers Metlife (NYSE: MET ) , Prudential (NYSE: PRU ) or Hartford Financial (NYSE: HIG ) , which ranged between 8.5% and 9% on Wednesday. GE Capital is hardly off the hook yet, though – the Republics of Hungary and Turkey are both considered to be better credits. I think stock investors should take a cue from credit default swap traders (here, but not always): the risk that earnings at GE Capital will deteriorate beyond management's expectations are very significant.
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