Amid the corporate credit meltdowns of recent months even the most highly rated of frequent issuers have been forced to defend their funding strategies and the composition of their balance sheets. GE Capital is a prime example. The financial services company has always been proud of its triple-A rating but it has been less keen in the past to demonstrate to the market and the rating agencies why it should still hang on to it.
Last year it came under attack, notably from key debt investors such as Pimco managing director Bill Gross, about its over-reliance on short-term funding to accumulate acquisitions and subsequently bolster annual earnings growth.
In March 2002, Gross said that with its $11 billion bond offering last year, GE Capital was “sensing its vulnerability to the current mercurial opinion of analysts and managers alike”. The concern was that GE Capital had $50 billion of commercial paper funding that wasn’t backed by bank lines.
The rating agencies began to question its leverage levels and funding mix. “They got away with the ‘we’re so smart, we’re so successful line’ for many years,” says David Hendler, senior analyst, financial services, at credit research company CreditSights. “Now they’ve been taken down a couple of notches in terms of arrogance.”
GE Capital, then, deserves credit for its efforts to reduce short-term debt in 2002 and provide more dependable back-up liquidity. Commercial paper made up 31% of total debt at the end of 2002, in line with the company’s agreement with the ratings agencies that it would keep CP borrowings between 25% to 35% of funding, compared with 41% at the end of 2001. The percentage of CP backed by bank lines also increased to 64% from 29%. “Our agreement with the ratings agencies is that we keep within the 60% to 65% bank line coverage of CP,” said Mark Barber, vice-president and assistant treasurer of GE Capital, at a recent conference.
In 2003, the company’s borrowing will be even more conservative, although it will not further lengthen the maturity of its debt. “Our average debt maturity is 5.5 years and you’re not going to see any adjustments there. We want to remain a matched funding company,” Barber told investors. But the total funding plan for 2003 is $60 billion, compared with over $80 billion of debt financing last year. This will include a new avenue of funding, as GE Capital hopes to raise $7 billion to $10 billion in retail medium-term notes. “We’ve been late to this game,” Barber admits.
The company clearly doesn’t take kindly to criticism. Barber used the same conference speech in December to defend GE Capital’s funding strategy even before last year. He said the company’s reduced reliance on short-term debt during 2002 had nothing to do with concerns raised in March by Pimco’s Gross, and that the company decided to reduce its $117 billion of outstanding CP well before this – at the end of 2001. “We made a few big acquisitions in the last quarter of the year, which we funded in the CP market,” said Barber. “We postponed the term-debt refinancing until 2002 because of the tough conditions in the debt market post September 11, but we were already talking to the rating agencies about that. The fact is we were looking at reducing our CP funding long before that fella on the west coast got up and said anything.”
He does accept that GE Capital could have communicated its plans to the market better, particularly the reasons for its $50 billion shelf-filing soon after the $11 billion issue last March. “In the past, the discussion we had with investors wasn’t a deep one. We didn’t communicate very well to the market,” he says. “Someone like Bloomberg puts reports up on the screen and somehow people believe them. One of our responses to Mr Gross’s comments has been to get information to investors very early on. Now we can broadcast an email directly to thousands of portfolio managers.”
Hendler commends GE Capital’s efforts to communicate better about its funding strategy. “I would give them an A for improving transparency and reaching out to the fixed-income community,” he says. But GE Capital’s other efforts this year to split and strengthen its balance sheet have received a more lukewarm response.
In July 2002, the company said it would split GE Capital’s balance sheet into four new finance divisions with four different balance sheets, with different leverage levels and returns on equity, so that investors could compare the performance of each business with market peers. The four new divisions were GE Consumer Finance, GE Commercial Finance, GE Insurance and GE Equipment Management. GE Capital hired consultants to find out what the average market leverage was for each part of the business and the excess leverage was taken out through a $4.5 billion capital infusion from the parent, downstreamed as an equity contribution to GE Capital.
Accordingly, all but the GE Consumer Finance division had their leverage levels reduced. Consumer Finance had its leverage increased and each division had its return on equity adjusted to reflect the new capital structure.
The plan was to get leverage in line with other high-quality independent finance companies. Now the aggregate debt to equity ratio is around 8%, which is broadly in line with rating agency guidance.
So far so good, as long as these imposed leverage levels on each part of the business can be sustained. But Hendler says the move demonstrates the abrupt change of tack in the management of GE. “Prior to their debt trading more cheaply, they gave the image they were experts. Now they need to talk to outside advisers in order to run a finance company balance sheet.”
The next step to bolster GE Capital’s balance sheet was a plan announced in November 2002, aimed at stopping financial support from the parent entirely by 2005. This included the aforementioned capital injection from the parent company and cutting the dividend GE Capital gives to GE in return for the parent’s investment each year to 10% from 33% of GE Capital’s cash earnings from 2003. GE Capital will also dividend excess capital from GE Insurance to the parent. These three moves together amount in a cut in support from the parent from $17 billion in 2002 to $10 billion, starting in 2003.
Both S&P and Moody’s have said the November plan, along with other efforts to improve the balance sheet and the liquidity profile at GE Capital, have made it a stronger credit. But some analysts believe GE is trying to make GE Capital more financially independent, so it can prevent damage to its rating from a more aggressive growth strategy at the parent company.
“There are two conflicting goals. GE wants to perform well for stockholders, as in the last two years the stock has done terribly,” says Hendler. “But if it wants external growth, there are acquisitions it needs to do and it usually pays in cash, upping leverage and hurting GE Capital. The parent could see its ratings fall below triple-A if it is to meet its aggressive growth targets, so this could be an attempt to immunize GE Capital from the effects of this.”
Credit quality mis-match in assets and liabilities
In December, Mark Barber argued that “losing the triple-A rating is not something we want to do now or ever.” The company concedes that, at the moment, its triple-A rating is dependent on parent support. The main problem is that rating agencies do not think the prospect of a financially independent GE Capital, even with a newly enhanced balance sheet, would be triple-A rated. For a start, there are the risks inherent in the vast array of $473 billion of assets GE Capital underwrites: of these only 5% are related to GE. The company claims to have more understanding of its assets than anyone else, making its delinquency rates lower. But last October it reported a $3.9 billion exposure to the aircraft industry alone and the value of its underlying assets in areas such as aircraft and power is also dropping.
“Their liabilities are triple-A but their assets are more like double-A,” says Hendler, who believes that GE Capital will eventually stabilize as a double-A credit. And the company is still expanding, for example with the purchase of ABB’s structured finance business last September for $2.3 billion.
There is another issue. GE Capital wants to be treated like an independent finance company without being regulated like one, as on its own it would be one of the US’s largest banks. Hendler says: “They want to have their cake and eat it. If you applied bank capital rules, their leverage is twice as high as they say it is in their 10Q report, but they can get away with it because they have a lot more accounting flexibility.”
It’s a long way to 2005, and how much independence GE will allow GE Capital by then is a matter of debate. But the rating agencies are looking at GE Capital closely – Egan Jones downgraded GE’s rating to double-A in January from double-A+. Gone are the days when either parent or offspring could take their triple-A for granted.
