Thursday, January 22, 2009

GE May Lose AAA Rating

GE is one of America's most successful companies, and has a large finance division that relies crucially on its AAA rating to get business, and cheap funding. The AAA rating is a competitive advantage that is hard to duplicate. It has paid an annual dividend since 1899, and has not had a year where they lost money in decades. And many are betting it will lose that rating this year.

But the worldwide recession, and potential write-downs in its finance unit, put this at risk. Its implied volatility is around 80 as its price fell over 50% in the past year and realized volatility often hit the 100% annualized level. Its spread to Treasuries out 5 years is about 326 basis points, which is really bizarre, a spread that most junk bonds had in 2006. The biggest risk factor for a AAA company, is showing that it isn't a sure thing on the profit front. This is much more material that the leverage. Indeed, I know many people in financial restructuring, and their pitch is pretty simple: you have 100% equity, why not swap 50% of that with debt, and get the same profits at half the capital! You can buy a big house with the proceeds and still have control, and get about the same dividend. Sure, the interest expense goes up, but not much. I imagine Microsoft will adopt this strategy at some point in the next 10 years (it has zero debt), and anticipating this currently buffets the stock.

In fact, my debt model calculations show that an exogenous increase in debt from 0 to 50% is pretty immaterial on the probability of default for a profit making company, so debt buyers are willing to facilitate such a deal. But it is the income that is key to GE's plumb financial status, and I don't think there is much they can do here. I would hate to see GE issue shares, because I think that would have a second order effect on its debt rating, because it won't help if GE actually posts an income loss next year. It's all income, not leverage, for GE, at this point, and I doubt there is much Immelt can do, top down, to affect this strategically.

1 comment:

Anonymous said...

my understanding is there are a few big option positions, not 'many' ppl betting. and i bet one of them is jpaulson whose comeuppance is long due. but buffet is already on board and anyone who thinks he doesn't have a word at moodys in these times is smoking smth. also immelt is buddy-buddy with the chief-tax-cheat ergo the guarantee to 2012. so i'm pretty sure they won't lose it. and the most important thing...did i mention i'm long?