GE Part 3: Contemplating GE Capital

Besides the recent weakness at Power and Oil & Gas, GE has been grappling with legacy issues at GE Capital.  Although it has been downsizing for more than a decade now – reducing its assets from $660 billion at the end of 2008 to $136 billion at June 30, 2018 – GE Capital still represents 40% of GE’s consolidated assets and it has not reported a profit since 2014.

This year, GE Capital heaped more angst onto investors when it announced a $6.2 billion charge in January related to its legacy run-off insurance business, North American Life and Health (NALH), followed by a $1.5 billion reserve charge in April for a potential settlement of a Department of Justice (DOJ) FIRREA investigation into its WMC subprime mortgage operations in the lead up the 2008 financial crisis.

GE Capital remains a source of concern to Wall Street, as noted in a recent article in the WSJ.  Investors and analysts still worry about the possibility of additional charges or write-offs at GE Capital and whether GE will be forced to inject more capital to shore up the business.  On the heels of the insurance and WMC charges, management said in June that it may contribute $3 billion to GE Capital in 2019 to allow it to achieve its targeted capital level – a debt-to-equity ratio of 4X – sooner.

GE now plans to reduce GE Capital’s assets by $25 billion by the end of 2019, up from $15 billion at the beginning of the year.  At year-end 2017, GE Capital had assets of $156.7 billion, including $76 billion of assets in its three core businesses: GE Capital Aviation Services (GECAS), which had $40 billion of assets, Energy Financial Services (EFS), which had $10 billion, and Industrial Finance (IF), which had $26 billion.  The remaining $80.7 billion assets included $25 billion of cash, $38.2 billion of investment securities (substantially all of which are associated with its run-off insurance operations), $5.9 billion of discontinued operations (including WMC) and $10.9 billion of miscellaneous assets.

According to an earlier plan for GE Capital (described at the time of the announcement of the $6.2 billion insurance-related charge), GE intended to shrink EFS’s and IF’s assets by about $15 billion (retaining only EFS’s financing origination capabilities).  It is not immediately clear where the additional $10 billion in targeted asset reductions will come from.  Part of it could come from additional sales at EFS and IF, but some could also be raised by reducing assets in discontinued operations or the miscellaneous assets.

Since the beginning of this year, GE Capital has focused on reducing “excess debt” (i.e. debt that is no longer needed to finance its business).  To date, it has reduced external debt by $7.6 billion.  Along with the proposed $3 billion 2019 capital contribution by GE, this suggests a determined effort to support its credit rating.  Although GE Capital is significantly smaller today, it still requires a strong credit rating to obtain the lowest possible financing rates and support its counterparty obligations.

Reducing Insurance Exposure.  Although management says that it is exploring options to reduce its insurance exposure, any significant action may not occur in the immediate future.  NALH is a reinsurer whose primary regulator is the Kansas Insurance Department (KID).  Of its total insurance book, 60% is tied to long-term care benefits (i.e. skilled nursing. assisted living and home healthcare costs), 35% to structure settlement annuities and 5% to life reinsurance.  NALH has reinsured the books of primary insurers (including Genworth Financial) and has itself bought reinsurance from other insurance companies, known as retrocessionaires.

Under an agreement with KID, GE, the parent company, has guaranteed maintenance of minimum statutory capital levels of NAL.  It is also reasonable to assume that GE has provided some form of guarantees to the retrocessionaires.

In January, GE announced $6.2 billion after-tax charge ($7.5 billion pre-tax) related to an agreement with KID to support NALH’s capital requirements.  Under that agreement, GE injected $3.5 billion of capital into NALH in the 2018 first quarter and will contribute $2 billion annually from 2019 through 2024.  This agreement follows its own comprehensive “deep dive” review of NALH’s long-term care exposures that arose from adverse claims experience in 2016 and 2017 on a younger book of business.  As is the nature of this type of insurance, small changes in assumptions can have a large impact on claims estimates when spread over many years.

The $6.2 billion reserve charge is significantly below the present value of the $15 billion of total expected statutory capital contributions.  Under GAAP, GE can base its determination of required reserves on its best estimate of claims experience.  Under statutory accounting, however, it is required to assume moderately adverse experience.  If GE’s best estimates are correct, its cumulative capital contributions will be lower than that specified in the $15 billion KID settlement agreement.  Capital requirements at NALH will be reassessed on an annual basis.

While the agreement presumably puts NALH on a sound capital footing, it may not be so easy for GE to reduce its insurance exposure from here.  In order to be released from any part of its insurance exposure, GE will have to obtain the consent of KID and probably also of the retrocessionaires.  Presumably both KID and the retrocessionaires will require that any insurer who assumes GE’s obligations have a stronger credit rating than GE, which has a current credit rating of “A2/A”.

While finding another insurer to assume NALH’s insurance exposure may be possible, it is evident that GE will have to pay the acquirer at least the present value of the expected $11 billion of future capital contributions required by the KID settlement and possibly more to guarantee it a return on its investment.  The actual amount of the payment would depend upon the buyer’s own actuarial analysis of the required capital contribution.

Offloading the legacy insurance obligations would almost certainly be viewed as positive by investors and analysts because it would presumably eliminate the possibility of future reserve charges.  With GE currently focused on reducing debt, however, it is unclear whether the company will be willing to borrow or use existing cash balances at GE or GE Capital to fund a payment of $6 billion or more to the buyer.  For that reason, GE may decide to wait until it receives some of the cash proceeds anticipated from the sale of Transportation and the separation of Healthcare and Oil & Gas before making a move.

Resolving WMC Lawsuits.  Besides the $1.5 billion charge to cover the estimated cost of settling a potential DOJ FIRREA lawsuit, WMC still faces litigation from several parties over alleged losses that they suffered on mortgages originated by WMC.  GE Capital and WMC have been working aggressively to reduce this potential exposure.  At June 30, GE said that total claims asserted were $1.18 billion, down from $3.66 billion at December 31, 2017 and $3.4 billion at March 31, 2018.  Also at June 30, GE reported that its reserve for settling claims totaled $294 million, down from $416 million at the beginning of the year, as a result of negotiated settlements.  One large remaining lawsuit by TMI Trust Company, asserting losses of $425 million on $800 million of mortgages, went to trial in January and concluded closing arguments in June.  GE has warned of the possibility that WMC might file for bankruptcy in the event of an adverse ruling in the TMI case.  Even so, it appears that the WMC exposure from both the DOJ and private lawsuits is winding down and that any potential additional reserves to fund final settlements, if required, will be manageable.

Putting GE Capital Asset Sales in Perspective.  With an estimated $7 billion of asset sales/runoffs completed to date, GE Capital’s total assets could be reduced from by another $18 billion from $136.1 billion at the end of June to $118.1 billion at the end of 2019, not including reductions in cash from additional paydowns of excess debt, reductions in investments to settle insurance obligations, dispositions of discontinued operations and other asset moves.  Even so, after the separations of Transportation, Healthcare, Oil & Gas and Lighting, GE Capital would still represent 49% of GE’s total consolidated assets on a pro forma basis using year-end 2017 figures.

Elimination of the legacy insurance operations would reduce GE Capital’s balance sheet by $40 billion or so, excluding any cash used by GE Capital to finance the sale.  GE could conceivably consider other portfolio moves, such as selling a majority stake in GECAS, which would further reduce the size of GE Capital.  Actions taken to reduce the size and scope of GE Capital would support CEO John Flannery’s mission to simplify GE.

Although GE Capital does seem top of mind for investors because of the recent negative surprises at NALH and WMC, investor anxiety will subside over time, as the memory of those surprises fades.  Further asset reductions at GE Capital would make the company easier to understand and follow; but any discount in GE’s share price that is attributable to uncertainty at GE Capital should still decline over time even without them, as long as there are no new negative surprises and especially if GE Capital returns to at least a barebones level of sustained profitability.

Valuation.  Given the persistent losses and limited disclosure, it is difficult to put a value on GE Capital at this time.  Management’s preliminary assessment of another $3 billion capital injection into GE Capital in 2019, although intended to support Capital’s credit rating, adds further to the view that GE Capital is unable to stand on its own, which suggests that its value may be zero.  Even if GE Capital’s value turns out to be zero, however, equity has option value today (on the hope that it may eventually be worth something); so if it were public, GE Capital’s equity would most likely trade at some discount to its book value.

Excluding the WMC charges, GE Capital has posted only a modest loss so far this year.  This raises the hope that with further cost cutting and a focus on improving net asset yields, the segment may be able to return to sustainable profitability eventually.

With an equity book value of $11.7 billion and $29.3 billion of intercompany loans at June 30, GE Capital has an effective equity capitalization of $41.0 billion (after recording the $6.2 billion NALH reserve charge and the $1.5 billion WMC settlement charge).  Hopefully, it will be able to demonstrate in time that it is worth at least one times book value (equal to $4.72 per share).

July 29, 2018

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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