Is General Electric Next?

I just read Joe Nocera's recent column in the New York Times where he finally asked the question - Will General Electric fail?

Nocera, who is an outstanding columnist, is not the first to ask the question. After the last week he recognizes that the signs are all to familiar - a bunch of pronouncements that there is no problem, dividend cut followed by bunch of appearances on CNBC by the CFO, followed by a promise to disclose everything in 2 weeks. He ends by saying that he hopes GE will not go bust. Hope may work for some but, unfortunately, as we have learned from our election of Barack Obama, it doesn't make for a good financial strategy and isn't going to prevent financial failures.

When Nocera relies on hope he fails to mention some obvious problems. First, we don't know what is inside of GE Capital. This beast has been years in the making and is full of the most complicated financial instruments ever known to man. Therefore, nobody knows what is inside, and we won't know after GE comes clean in two weeks. What we do know, however, is enough to take the company down easily however. The company's liabilities are mainly composed of exposure to consumer credit, commercial real estate and even aircraft and they are enormous.

Now, Jeffrey Immelt, the company's chief denier, has been saying that GE Capital's contribution to the GE bottom line this year will be down to 30% from 50% in previous years. This statement entirely ignores some plain realities that we are looking at balance sheets and not income statements now. It doesn't really matter what the contribution to the bottom line is. The question is what it will take to mark GE Capital's liabilities down to market. A simple 8% markdown in the value of GE Capital's liabilities - something that is practically certain in light of exposure - would have such a devastating effect on GE's bottom line, leaving it with negative book value. Negative book value will in conjunction with the certain and severe credit rating downgrade, cause such a significant number of defaults that the entire company will immediately fail.

The effects of a GE failure will be much more significant than anything we have seen previously from Lehman, AIG or Citi. The amount of money that would be required to prevent negative knock-on effects caused by the fact that GE's debt has been treated as cash until recently will be extraordinary. Immelt is reported to be having secret meetings with Warren Buffett regarding a bailout. We are unfortunately talking about such sums that neither Buffett nor the US government will be able to prevent a catastrophe.