Wednesday, March 4, 2009

Memo to Jeffrey Immelt – if you are going to lie you have to do it more convincingly than this

  • GE sold its mortgage insurance business before the crisis broke.  That was high quality risk aversion.
  • They sold their bond insurer (FGIC) to a combination of private equity and PMI Inc.  I figure the private equity buyers are hurting – PMI trading at less than a dollar surely is.  Again this is the mark of superlative judgement.
  • I know the guys who run the Australian mortgage business.  They started cutting back risk very early.  The staff who used to get paid on volume are very unhappy indeed because – well – as credit standards tightened volume dropped.  Another mark of superlative judgement.
  • They sold their life reinsurance business to Swiss Re.  I suspect Swiss Re is hurting - and indeed Swissy had to sell a big stake in itself to Warren Buffett - I suspect to partly cover those losses.
  • They sold their P&C reinsurance business as well.  That is probably doing OK – but it carries a long tail risk.
  • They sold their long term care insurance business.  That player – now part of Genworth – is the best company in the world in one of the worst businesses in the world.  The risks were high.

GE Finance in other words cut back on risk.  A lot of risk.  Mostly the right risks.  And they cut back on risk early – before the crisis hit – when they got good prices for rubbery assets.

I have argued at times that Immelt is the best CEO in the world for that. I even owned the stock for some of the fall in the price (though I have not owned it for a while). 

It was an article of faith for me that when you see consistent bad behaviour by a bank or an insurance company in one area it is usually rife.  You can’t know everything in a bank balance sheet.  Not even the CEO and CFO have a hope of that.  

Symmetrically if you see consistent good behaviour then you can guess that the good behaviour pervades the book.

When analysing a financial all you can judge is the culture – and if the culture was cleverly cutting risk in areas you knew really well it was probably cutting risk everywhere else.  

GE looked pretty good to me.  The behaviour exhibited was smart and consistent.

The problem

In finance you make profits in normal times by carrying risk.  The more risk you carry generally the higher your "normal time" profits are.

If you cut risk – as GE did – then your "normal time" profits will fall.  GE Capital profits did not fall as they cut all that risk.  That was very strange.

There is no question that GE fudged its results a little bit in order to keep reported profit momentum when actual profits were falling.  Gradient Analytics did a solid report on GE showing how they had systematically stripped reserves in many businesses.  

The bears travelled from the analysis of fudged accounts to guessing (and it can only be a guess) that GE must be full of toxic assets.  

I thought the negative reports were overly bearish.  I watched what they did more than I watched the accounts and what they did told me they were very good.  

The summary was that they were doing the right thing and their profits were falling for good reasons – and they were lying about the profit fall.  

Normally I have the view that a company that lies about its earnings in small ways has a lot to hide – there never been only one cockroach – but I was desperately impressed at the big-picture things that GE was doing.  To the accounting junkies GE was diabolical – because they lied.  To them sanctity of accounts is the true mark of quality of a business.  I am a little less pure than that – but maybe I should listen more.  I went long GE in the thirties.

Now my buy case for GE depended on them being a capital equipment exporter with costs in US dollars and with Asia growing like crazy.  This was the decoupling fantasy that cost a lot of investors (including me in this instance) some pretty coin.  As the world now knows China fell into the economic abyss sometime in the third or fourth quarter of last year and the upside case for GE (capital equipment sales) collapsed.  I sold for a bad loss – but it would have been a worse loss had I held.  

Anyway it is not true that GE kept cutting back risk.  They took a few too many risks in commercial property and even Immelt admits problems in UK mortgages.  The risk de-jour though is that they tied themselves up in Eastern Europe – and until very recently they were boasting about as a presentation show made in September last year shows.  (That presentation seems to have disappeared from their website).

Still according to Immelt’s letter GE Capital made $9 billion last year.

Sorry – I do not believe it.  Indeed the claim is comical.  Here from GE’s recently released annual report is a table of non performers and reserves.

In almost every financial company reserves have had to rise faster than non-performers over the past year.  Why?  Well consider how a non-performer becomes loss.  We will do it in the case of a mortgage:

  1. The customer stops paying full interest.  They do this because they have had a hiccup in their business or life that is temporary or semi-permanent.  If they are an electrician and fell of a ladder you can bet that once their broken leg is healed the non-performing loan will again perform.  But if they are an auto worker who loses their job they might not get another one for a year or two.  You are probably going to foreclose.  The chance of a non performer defaulting goes up with unemployment.

  2. Then once the loan defaults you need to sell the property.  If you haven’t noticed the loss given default has gone up sharply.  
In summary the chance of a non-performer turning into a loss has increased sharply so the ratio of reserves to non-performers should go up sharply.

What if I told you that the reverse was true at GE.   In many of the lines of business reserve coverage went down – often down sharply.  Not great.  Not even plausible.

Real GE profits

The funny thing is that it never needed to be this way.  GE was still – even on my adjusted numbers – profitable last year.  I have seen some bear-case estimates of the loss on the ground in various GE businesses and they look high to me.  These are guys who estimate losses by looking at accounts – and the losses GE will take are – in my view – substantially less than market because – on the ground – I have seen them operating in a lower-risk manner than their competitors.  

The problem of course is you do not know.  Summary: mostly good behaviour – bad accounts.  Sure I have heard some instances of bad behaviour – but they are thinner on the ground than the good things.  

Jeffrey Immelt in his letter says that he takes responsibility for the loss of reputation of GE.  If that were an operational responsibility he would resign.

And on the basis of his accouting he should.  

But I am not calling for his resignation.  On the risk management described at the top of this blog post he remains possibly the best CEO in the space - and he is way better than any obvious replacement.

GE as a parallel for America

Speaking as an outsider I have to agree - America at its best is a wonderful place.  It is amazingly productive.  The degree of specialisation of people and the cities they live in is wondrous.  The innovation is jaw-dropping and it has changed the world.  

Silicon Valley is a wonder of the modern world.  But so are half a dozen fecund places in America.

So is General Electric.

America has plenty to recommend it - and if I did not love Australia so much you would see me on the plane yesterday.

But the accounting sucks.  It sucked when the broker certified the taxi driver's income at $350 thousand for the purpose of the no-doc loan and it sucks when Immelt certifies the reserves in GE's accounts.  

It sucked when the Bush administration regularly and systemically misestimated the US budget deficit and it sucked when the SEC went after truth-telling short sellers rather than easily provable frauds by powerful people.  

But beyond all that accounting when the mess is cleaned up the good stuff about America will probably still be there.  

Will GE will still be there?  Well I think it will probably will - but without a huge run through the accounts and without your lie-detector running full blast - well it is very difficult to know.

I am trying to do the work.  But hell - this one is really hard.  Six Sigma precision - that I cannot deliver.


Disclosure: no position but leaning long.


Anonymous said...

Thanks, I enjoyed reading the post. I own a small position in GE with a basis of about 9/sh. I haven't tried to tackle the accounting on the premise that even if I could figure it out, the available information would be incomplete. So I'm holding on because I figure if GE disappears, there may be larger issues than the loss of a few thousand dollars.

Anonymous said...

GE is no doubt improperly reserved, but I don't believe Jeff Immelt is at fault for it. Back when Jack Welch was the CEO, GE it seemed, changed their accounting estimates or principles on a quarterly basis, but at that time, the street always believed whatever Jack had to say, even if it was obviously false. Immelt doesn't have that same benefit of the doubt, so the opaque accounting at GE is discounted beyond what the actual results probably are.

As an aside, I believe that GE started the GECC part of the business in 1929 after their regular customers were unable to get credit from banks or even loan sharks. Seems fitting if GECC was to see a grim death it would happen in a similar environment to it's start.

Anonymous said...

I think this was one of the best blog posts I've read all year. I posted a link on my site and recommended that everyone read it.

Thanks and keep up the great writing.


Anonymous said...

too much junk on GE Capital's balance sheet.

1) US$ 30B in credit card receivables, mostly subprime. Consider that AXP is already seeing 8% plus in charge-offs and their book is of better credit quality.

2) US$ 53B in off-balance sheet assets which means that GE Capital's leverage ratio is understated.

The market has spoken and I believed that this time round, the verdict is true.

John Hempton said...

Dear Anon - can you use a name - even a nonsense one - so i can answer you.

If there is 30 billion in subprime credit cards and the charge offs are 15% (which could be where they are) that is $4.5 billion per annum.

That does not hurt GE - which will have maybe 18 billion in pre-tax earnings - most of which will be retained now they have cut their dividend.

If that is the limit of the problem - you would BUY BUY BUY.

There is plenty more junk I have found - but the worst credit cards were sold (as you will see in a future post).

I am hoping that people will identify bits of junk I do not know about. 30 billion with 15% charges won't hurt you from a $7 stock price.

Now 100 billion with 25% chargeoffs will.

That is not impossible - but I do not know the assets that will cause it.

Really seeking.


Anonymous said...

I really, really liked this post.

We've reached a point where we're choking to death on our own cleverness. The most effective response is for investors like yourself to loudly proclaim, "produce an understandable balance sheet or I will no longer invest here."

If we start to see a "simplicity movement" emerge, I'll feel we're moving on the right track.....

Ronit said...

Possibly the best piece I've read on GE recently

OKL said...

You go John!

Six Sigma event? Unreadable financial statements?

No wonder the markets are once again in "shoot first, ask later" mode.

I also recently read a piece on Biology and Economics;

I doubt the govt, or indeed, even the human mind, is capable of "intelligent design".

Once again, even if I do not quite understand, I do appreciate your posts.

williambanzai7 said...

Excellent post.

Anonymous said...

Thanks for the post. Please explain how: "In many of the lines of business reserve coverage went down – often down sharply."

However, at least from your extract of the accounts, the contrary seems to have been the case from '07 to '08.

Are you referring to '08 to '09??

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