A sight of carnage: GE

GE - that Titan of global economy - is under a threat of becoming the next AIG.Although the company is forecasting USD18bn in profits this year (on the back of its industrial arm), GE shares have now dipped below USD6.50, their lowest level since 1991. All due to the GE Capital exposure in the risky commercial and residential lending.

Since October, GE sold USD15bn in new shares and USD31bn in new bonds, cut down its loan book and reduced its reliance on short-term debt funding. GE has cut its dividend by 68% to generate additional USD4.4bn.

Sounds good? Not really. GE has set aside roughly USD10 billion in provisions for losses on its USD380 billion in receivables at the finance unit. The company loans total USD680bn against equity cushion of USD34bn in cash and USD36bn in assets. The latter is taking a hit in the current markets, implying today's equity cushion of only ca USD63bn and falling.

It would take a USD9bn hit to earnings and equity for GE were to write down its real-estate portfolio by 25%, according to UBS analysts. GE has transferred some of its real-estate holdings, into real-estate lending. As a result, its total real-estate assets increased USD6 billion, or 8%, last year.

But let us get back to the USD10bn provision. Here is my view on the share price going forward:

Assume they set aside cash (otherwise this set-aside is itself open to downward revaluations over time). This implies expected impairment provision is 2.63% of receivables. Globally, AAA rated CDOs carry the recovery rate of only 32% on face value, while for mezzanine vehicles the recovery rate is only 5%.

So, suppose GE gets a 25% boost on that via higher debt seniority and tighter loans management, etc. Assume the recovery rate of 40% on higher quality junk (hqj) and 8% on lower stuff. Take a blend on the book at 90% hqj, 10% 'stuff', this gives us an average - across-the-book - expected recovery rate of 37%. Suppose 12% of loans are under threat (rather generous in this commercial and residential real estate markets), allowing for some earlier writedowns that already took place. You have a required impairment provision of 12%*(1-0.37)=7.56% or almost 3 times more than the USD10bn they provided for.

This level of provisioning - if set in cash - will take us into a set-aside of an additional USD18.7bn on top of USD10bn set aside today, bringing equity down to USD17.3bn cash and USD34bn in assets or total equity of USD44.3bn - some 30% haircut. Assume deterioration in the assets part of equity pool at 1/4 of the rate of deterioration in broader assets, i.e. 3%pa, you have additional shave-off of 2% on equity, implying equity cushion fall will depress the overall share price by at
least 30% from today's level.

Now, I suspect that when they quote USD34bn cash equity today, they actually include the USD10bn provision into that as well. If so, the total haircut should be based on USD34.3 equity, implying a cut of 45.6% (provisions) + 2.5% (asset deterioration on equity side) = 48% on
today's share price.

So you have USD3.5USD as the equity-underpinned price target. And that is where the stock heading next, in my humble opinion...