Saturday, October 11, 2008
A shocking series of events that forever changed the financial markets.
Equally as staggering, just hours after reports surfaced that Bank of America broke off of talks to buy Lehman, BofA unleashed the news that it would pay $50 billion to scoop up Merrill Lynch, another iconic Wall Street name.
As if that weren't enough, American International Group, the nation's largest insurer, said that it planned to sell some of its troubled assets in order to raise cash and boost investor confidence.
Concerns about the credit crisis grew increasingly dire, even though the government had already pledged to backstop Fannie Mae and Freddie Mac up to $200 billion just one week ago, and months earlier engineered JP Morgan's purchase of Bear Stearn's with a $29 billion guarantee.
But it looked like that wouldn't be enough, so Sunday afternoon the Federal Reserve, along with 10 banks, announced a $70 billion pool of funds to aid troubled financial firms. The U.S. central bank also loosened its lending restrictions.
NEXT: Monday, Sept. 15 - The collapse
In the worst day on Wall Street in seven years, the Dow Jones industrial average tanked more than 500 points after Lehman Brothers' epic collapse of the buyout of Merrill Lynch
By Monday night, AIG was in fact hit with a downgrade, as Fitch bumped the insurance group down a notch. With $1.1 trillion in assets and 74 million clients in 130 countries, investors feared AIG's collapse would severely hurt consumers and further tighten already strangled credit.
Also Monday, news cropped up that the nation's largest savings bank, Washington Mutual was in search of a white knight.
NEXT: Tuesday, Sept. 16 - The Fed steps in
Next, several rock-solid money market funds began to falter, dipping below the $1 per share benchmark.
Meanwhile the Fed was scheduled to meet on Tuesday afternoon. Wall Street analysts, who just a week ago expected the Fed to hold rates steady, began to anticipate a rate cut. But the central bank chose not to succumb to panic and unanimously decided to hold rates steady at 2%.
Markets cheered the decision, and the Dow jumped 140 points at the close.
After the bell, British bank Barclays agreed to buy up $2 billion worth of Lehman's brokerage assets and real estate holdings, and Morgan Stanley reported better-than-expected earnings.
But the big news came later that night when the government announced that it would stage a staggering $85 billion bailout of AIG, and take an 80% stake in the company.
NEXT: Wednesday, Sept. 17 - Another free fall
The Dow dropped 450 points by the end of the day, dragged down by bank stocks in a tail-spin. Despite reporting better-than-expected results, Goldman Sachs shares dipped below $100 a share for the first time since 2005. Morgan Stanley took a tumble as well, as rumors circulated that it would merge with troubled bank Wachovia.
Many Wall Street analysts blamed the stock market's collapses on so-called "naked" short sellers, who short stocks without ever buying the security. Subsequently, the U.S. Securities and Exchange Commission stepped in and banned naked short selling.
NEXT: Thursday, Sept. 18 - The bailout
Meanwhile, AIG was tossed out of the Dow Jones industrial average and replaced with food giant Kraft.
The stock market soared towards the close of the session, with financial stocks rebounding. The Dow added more than 400 points on rumors that an even more extensive federal bailout of the banking industry was in the making. Investors cheered early these reports that the Treasury would create an independent federal agency to take bad loans off bank of balance sheets.
Late Thursday night, Treasury Secretary Henry Paulson met with Congressional leaders to hammer out the details of a large-scale bailout.
NEXT: Friday, Sept. 19 - The confidence boost
The Treasury also said it would insure up to $50 billion in struggling money market fund investments at financial companies, guaranteeing that the funds' value will not fall below the standard $1 a share. The Fed also said it would make unlimited funds available to banks to finance purchases of asset-backed commercial paper from money market funds.
In a press conference, Treasury Secretary Paulson outlined the government's plan to put up hundreds of billions of dollars to help stem the crisis, saying "the financial security of all Americans ... depends on our ability to restore our financial institutions to a sound footing."
Later, President Bush held a separate press conference, flanked by Paulson, SEC Commissioner Christopher Cox and Fed chief Ben Bernanke, saying it was "essential" that the government step in to save the economy.
Investors cheered the moves, sending stocks soaring throughout the day.
Although the U.S. government had set various bailouts in motion to the tune of roughly $1 trillion, investors finished the week with renewed confidence that Wall Street may be broken - but not beyond repair.
"It is a big package because it's a big problem," President Bush told reporters at a morning news conference. "The risk of doing nothing far outweighs the risk of the package."
The Democrats who run Congress initially indicated they were receptive to the Treasury proposal. But as the day wore on, there was a theme sounded by the leadership.
Democrats will seek to "insulate Main Street from Wall Street and keep people in their homes by reducing mortgage foreclosures," said House Speaker Nancy Pelosi, D-Calif., indicating her party would seek other actions aimed at benefiting taxpayers.
NEXT: Sunday, Sept. 21 - The end of an era
"The biggest help we can give the American people is to stabilize our financial system right now and to prevent the system from clogging up, because if it does clog up, this is going to have an adverse effect on people's abilities to get jobs, on their budgets, on their retirement savings, on lending for small businesses," Paulson said on ABC's "This Week."
Still, the Democrats said the plan lacked necessary safeguards for taxpayers and homeowners.
"We will not simply hand over a $700 billion blank check to Wall Street and hope for a better outcome," Speaker Pelosi said.
But even as the details of the bailout were being hammered out, there were yet more staggering developments in the crisis, effectively ending an era on Wall Street.
Late in the day came the news that Goldman Sachs and Morgan Stanley, the two remaining independent Wall Street investment banks, would be converted into traditional bank holding companies, which will increase their regulation by the federal government.
The move was designed to prevent the storied brokerage firms from suffering the same fate as Lehman and Bear Stearns, by giving them access to cheaper, and more stable sources of funding from the retail banking business and from the Federal Reserve.
NEXT: Monday, Sept. 22 - Second thoughts
A day after its status change, Morgan Stanley announced it agreed to sell up to a fifth of the company to Mitsubishi UFJ Financial Group, one of Japan's largest banks.
Meanwhile, news of the massive federal bailout that was greeted with relief on Friday, sending the Dow up 369 points, began to sink in, and questions emerged. Taxpayers were enraged that Wall Street fat cats would get a handout while ordinary citizens were left to flounder. Members of Congress on both sides of the aisle began gearing up for Tuesday's hearing, expressing concern at the notion of handing Treasury a blank check, and at the plan's lack of oversight.
The markets expressed their own dismay, with the Dow closing down 373 points as investors fretted about the bailout. The dollar was crushed, posting its biggest single-day drop in four years as traders absorbed just how diluted the bailout would leave the U.S. currency. Meanwhile, oil surged more than $25, its biggest dollar gain ever, to $130 a barrel before settling at $120 as big investors scrambled to fill obligations as the October contract expired.
NEXT: Tuesday Sept. 23 - A spirited debate
Sen. Richard Shelby of Alabama, the top Republican on the committee, said the government's previous efforts to save mortgage giants Fannie Mae and Freddie Mac, as well Bear Stearns, show the limitations on attempts to fix markets.
"You can't assure us this will work because you thought the other plans would work," Shelby said.
Sen. Jim Bunning, a conservative Republican from Kentucky, said that he could not support the proposal.
"It will not help struggling homeowners pay their mortgages. It will not bring a halt to the slide in home prices," Bunning said. "This massive bailout is not a solution. It's financial socialism and it's un-American."
Lawmakers were also concerned about the program's risk to taxpayers. But Bernanke stressed that most or even all of what the government spends to buy the assets would be recovered when the assets are eventually sold.
Drafts of counterproposals emerged from both chambers, led by Chris Dodd, D-Conn., in the Senate and Barney Frank, D-Mass., in the House. They want the government to get an equity stake in the companies it helps; more assistance for those at risk of foreclosure; more oversight of the program; and curbs on compensation of executives of participating companies.
There was also some good news. After the market close, Goldman Sachs announced that it will raise capital by selling $5 billion of preferred stock to Warren Buffett's Berkshire Hathaway.
NEXT: Wednesday, Sept. 24 - Closer to a deal
Back in Washington, the debate about the Bush administration's proposed $700 billion bailout raged on, this time in front of the House Financial Services Committee, which grilled Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke over the plan's details.
Progress was reported toward an agreement. Paulson agreed that the bill should curb executive compensation at firms that sign up for the rescue plan, one of the Democrats' key demands. But he remained opposed to allowing bankruptcy judges to change mortgage terms because it's "inconsistent with what we're trying to do, which is increase the flow of funds."
Still under discussion was whether the government should get an equity stake in companies that participate in the plan, and whether the government will encourage foreclosure prevention for the troubled loans it purchases.
Members of Congress demanded to know how they could justify a bailout to their enraged constituents.
President Bush made a televised speech Wednesday night to make the case for his plan. "We are in the midst of a serious financial crisis," he said. "Our entire economy is in danger."
NEXT: Thursday, Sept. 25 - Deal, or no deal
The proposal would help homeowners, curb executive pay packages at participating firms and provide oversight of Treasury's actions. The Treasury would receive the $700 billion in installments and would also get an equity stake in the companies being helped by the bailout.
A few hours later, when Congressional leaders and presidential nominees Barack Obama and John McCain met with President Bush and Secretary Paulson at the White House, the negotiations broke down, revealing a split between Democrats and House Republicans.
House Republicans issued a statement of economic rescue principles that called for Wall Street to fund the recovery by injecting private capital - not taxpayer dollars - into the financial markets. The plan also called for participating firms to disclose the value of the mortgage assets on their books, ending Fannie Mae and Freddie Mac's securitization of "unsound mortgages," reviewing the performance of the credit rating agencies, having the SEC audit failed companies to ensure their financial standing was accurately portrayed, and creating a panel to make recommendations for reforming the financial industry by year's end.
Late-night talks between lawmakers and Treasury Secretary Henry Paulson failed to end in agreement, shattering any hopes of a clean, bipartisan legislative effort, and putting in jeopardy chances of passing a bill by the end of the week.
Then, in another stunning event, Washington Mutual collapsed late Thursday night, marking the biggest bank failure in history. But after the troubled thrift was seized by the FDIC, federal regulators helped orchestrate a deal in which JPMorgan Chase paid $1.9 billion for WaMu's assets.
NEXT: Friday, Sept. 26 - Back to the bargaining table
Capitol Hill negotiators returned to the bargaining table Friday to work on details of the plan, while President Bush and leading lawmakers offered assurances that Congress and the administration would hammer out a deal.
Stocks stumbled through much of the day, but they rallied toward the end of the session on news that bailout talks has resumed, with Republicans and Democrats working towards a compromise. Investors positioned themselves for a Monday rally, on the hopes that a deal would be made by Sunday.
For a time, the first presidential debate that was scheduled for Friday night hung in the balance. Sen. John McCain, R-Ariz., said that working on the bailout was more important than campaigning, and he decided to return to Capitol Hill to help work on a plan. But Sen. Barack Obama, D-Ill., said there was no need to cancel or postpone the debate.
In the end, the candidates decided to go ahead and face off at the University of Mississippi, where the nation's economic crisis took center stage early on.NEXT: Saturday, Sept. 27 - Bailout breakthrough
Signs of progress appeared early on from both Republican and Democratic lawmakers who said they were shooting for a deal by Sunday.
But a group of House Republicans said they would not be held to any "artificial timelines." Still, they remained confident a deal could be reached that helped the financial system but protected taxpayers.
Negotiators had talked by phone with billionaire investor Warren Buffett for guidance, and according to two sources, he warned if congress did not act, the nation would face the "biggest financial meltdown in American history."
Finally after midnight, congressional leaders said they reached a tentative deal and were aiming to craft final legislation by Sunday evening - in time for the start of financial markets around the world.
Key points included who would oversee the program, when the money would go out, government stakes in companies to mitigate taxpayer losses and curbs on executive compensation.NEXT: Sunday, Sept. 28 - Hard-won agreement
But the bill, which will go to the House for a vote on Monday and to the Senate on Wednesday, contains provisions addressing some of lawmakers' concerns about the burden that the bailout could have on taxpayers.
The $700 billion would be disbursed in stages, with $250 billion made available immediately for the Treasury's use. And although experts expect Treasury to be able to sell the troubled assets for more than they bought them for, the bill says that the president must propose legislation to recoup money from the financial industry if the rescue plan results in net losses to taxpayers at the end of five years.
In addition, Treasury would be allowed to take ownership stakes in participating companies. The legislation also requires the government, as the owner of mortgage loans, to try to modify more troubled loans. There will be limits on executive compensation for participating companies, and two oversight board established to guide the program.
As history was unfolding in Washington, there was yet more drama developing. In Europe, Dutch-Belgian bank and insurance giant Fortis NV received a 11.2 billion euro ($16.4 billion) lifeline by authorities in Belgium, the Netherlands and Luxembourg. And on Wall Street, a bidding war erupted for the troubled bank Wachovia between banking giants Citigroup and Wells Fargo.
NEXT: Monday, Sept. 29 - Crushing defeat
The defeat shocked the world, following pledges by leaders of both parties to work together to avert economic disaster. Markets in the U.S. and abroad reacted with alarm. The Dow plunged 777 points, its largest one-day point drop ever, while Japan's Nikkei lost 4%, Australia's markets fell 4.3% and Taiwan's stocks retreated 3.6%.
It was unclear how Congress would proceed with the legislation.
Earlier in the day, Citibank agreed to buy Wachovia bank's assets for $2.2 billion in an FDIC-arranged deal, while Lehman Brothers sold its Neuberger Berman investment management unit to a pair of private-equity firms for $2.15 billion.
Additionally, a federal grand jury launched an investigation into accounting and disclosure issues at Fannie Mae and Freddie Mac, the mortgage finance giants that were taken over by the government earlier this month.
NEXT: Tuesday, Sept. 30 - Rebound
The Dow Jones industrial average rose a whopping 485 points, making up much of the historic 777 point loss in the previous session.
But the credit markets remained frozen. And several closely watched measures of bank lending fear hit all-time highs, as firms continued to hoard funds.
Most of the gains came late in the session after the Federal Deposit Insurance Corporation said it wants to temporarily increase the amount of money it can insure.
The agency's request to raise its $100,000 insurance limit was aimed at making anxious businesses and consumers less likely to withdraw funds from struggling banks. It was also seen by many as an attempt to sway critics of the $700 billion bailout plan.
House lawmakers adjourned for the day in observance of the Jewish New Year. President Bush, meanwhile, took to the airwaves to express his disappointment in the bailout's failure.
"Our economy is depending on decisive action from the government," Bush said. "The sooner we address the problem, the sooner we can get back on the path of growth and job creation."
The bill was set to head to the Senate Wednesday.
But lawmakers came through Wednesday night, as the Senate passed a modified version of the bill that the House of Representatives rejected on Monday.
The Senate version included a number of new provisions aimed at Main Street, and intended to attract more votes from House Republicans, two-thirds of whom voted against the initial bailout plan. The modifications include temporarily raising the FDIC insurance cap to $250,000 from $100,000, extending renewable energy tax breaks and another year of relief from the Alternative Minimum Tax.
The revised measure was passed by a vote of 74 to 25 after more than three hours of floor debate in the Senate. Presidential nominees Sens. Barack Obama, D-Ill., and John McCain, R-Ariz., voted in favor.
NEXT: Thursday, Oct. 2 - Wait and see
Meanwhile, investors feared that the economy needed a boost beyond the government's plan. Economic reports showed signs of continued weakness Thursday. Weekly jobless claims soared to a seven-year high Thursday, alarming investors ahead of Friday's big monthly report. And factory orders slumped to a 2-year low.
Fearing a weakening economy would further quash demand for petroleum products, oil prices fell more than $4. The Dow closed down 348 points.
Fears of a recession only made the stranglehold on credit even tighter. Key measures of lending showed banks hoarding cash with an historically high aversion to risk.
As a result, analysts and economists began to predict that the Federal Reserve would cut its key funds rate by as much as a half percentage point to boost liquidity in the markets, in an attempt to stave off a recession.
NEXT: Friday, Oct. 3 - Bailout becomes law
The 263-to-171 vote was the result of strong lobbying on the part of the White House and other supporters of the bill all week. After being amended by the Senate to include key sweeteners, including several tax breaks and an increase in the FDIC insurance cap to $250,000 from $100,000, members on both sides of the aisle agreed to switch their votes from "No" to "Yes." President Bush signed the bill into law later in the day.
Earlier Friday, Wachovia and Wells Fargo announced plans to merge, just four days after Citigroup said it would pay $2.2 billion for Wachovia's banking assets. Citigroup demanded that Wachovia and Wells Fargo terminate the proposed deal, valued at approximately $15.1 billion.
Banks weren't the only one scrambling for cash. California Gov. Arnold Schwarzenegger told the Treasury Secretary that the credit freeze had shut down funding for the state, which may need a $7 billion emergency loan from the federal government.
The Dow closed down 818 points for the week, it's worst week in seven years.
NEXT: Saturday and Sunday, Oct. 4-6 - Battle of the banks
On Saturday, a New York State Supreme Court judge temporarily blocked the merger of the troubled bank with Wells Fargo.
That ruling was overturned on Sunday, but then Citigroup appealed the decision. Wachovia countered that the Wells Fargo deal would be better for shareholders and taxpayers, since the FDIC backstopped the original Citi deal.
Also Sunday, Massachusetts asked both the Treasury and the Fed for help in raising short-term funds amid the frozen credit markets. Much like the request made by California on Friday, Massachusetts wanted loans to help pay for state operations.
On Sunday night, bailout news began to emerge from Europe. The German government announced it would rescue Hypo Real Estate AG for $69 billion, and guaranteed all of its deposits.
And in a deal with the Belgian government, French bank BNP Paribas took a 75% stake in fast-sinking Belgian bank Fortis NV.
NEXT: Monday, Oct. 6 - A bigger lifeline
The Fed said it would make $600 billion available to banks through its Term Auction lending facility, and it signaled that number could increase to $900 billion later in the year.
But as investors realized that the government's bailout bill was not a cure-all, stocks went into a tailspin. The Dow sank a record 800 points before recovering somewhat, but it closed below 10,000 points for the first time since 2004.
Later Monday afternoon, Bank of America reported a 68% drop in profits and cut its dividend. The bank, which rescued both Countrywide Financial and Merrill Lynch in 2008, said it will raise $10 billion through a stock sale.
Meanwhile, Wells Fargo and Citigroup both agreed to a legal standstill in their battle for Wachovia.
NEXT: Tuesday, Oct. 7 - New kind of bailout
The short-term lending market had frozen, and companies began to worry that they would not be able to get the loans necessary to pay their bills or make payroll. The Fed stepped in hoping to restore confidence to a corporate borrowing market that had shrunk by 11% in three weeks.
But the news didn't do much to unfreeze the credit markets. Several key measures only eased very slightly, while the yield on the 3-month Treasury momentarily jumped above 1% for the first time in two weeks.
In a speech that day before the National Association of Business Economics in Washington, Fed chief Ben Bernanke said the economic outlook had worsened, and the financial crisis will hurt the economy well into next year. He also implied that more interest-rate cuts were on the way.
Later, the Fed reported that borrowing by consumers fell in August for the first time in more than 10 years, as budgets tightened and credit became scarcer.
Investors didn't like what they heard, and stocks fell to five-year lows. The Dow tanked another 500 points.
NEXT: Wednesday, Oct. 8 - Global coordination
Investors weren't impressed, and stocks fell worldwide. Then, in an attempt to boost economies around the globe, at 7:00 a.m. ET, the central banks of the United States, Canada, England, the European Union, Sweden and Switzerland announced a coordinated plan to cut interest rates.
The Fed cut its key funds rate to 1.5% from 2%, and most other banks slashed rates by a similar amount.
The plan was at first met with cheers, but then skepticism again took hold, and stocks fell. Credit market measures soared to all-time highs, signaling no change in the tight lending market.
NEXT: Thursday, October 9 - The search for a bottom
But the market registered a vote of no confidence anyway. The Dow closed down 687 points Thursday -- off over 2,200 in the previous seven trading sessions.
Credit remained in a deep freeze; the level of outstanding commercial paper fell by $56.4 billion, or 3.5%, in just the past week, to $1.55 trillion.
U.S. automakers were also on the ropes, after Standard & Poor's said that it was putting both GM and Ford on credit watch negative. Shares of GM closed down 31% to $4.76, while Ford fell nearly 22% to $2.08, effectively putting two American industrial icons on death watch.
NEXT: Friday, October 10 - Vertigo
It was a volatile day on Wall Street as further signs of economic distress emerged. At one point the Dow dipped below the 8,000 mark, but ultimately closed down 128 to 8,451.19.
Market bellweather GE reported a 22% drop in net income to $4.3 billion for the third quarter, in line with expectations. Earnings from continuing operations fell 10% to 45 cents per share while revenues grew 11% to $47.2 billion.
Oil prices plunged more than $9 to a 13-month low Friday on fears that the weakening global economy would drive down demand for oil.
And General Motors had to issue a statement denying that it was considering bankruptcy after its shares lost 31% on Thursday, when it closed at just $4.76, the stock's lowest price since 1950. GM shares ended Friday's session at $4.86.
Meanwhile, news emerged that House Democratic leaders are assembling a second economic stimulus package, which could cost as much as $150 billion, and will be geared toward helping struggling state and local governments.
The week wrapped with the finance ministers of the world's leading industrialized nations, the G-7, set to meet in Washington over the weekend to hammer out a plan of coordinated actions that will restore confidence and stability to world markets.
(source cnn money.com)
courtesy to cnnmoney team members.
kpastroakella.
GE under siege
For years GE Capital's profits powered its parent's earnings and helped finance its vast array of businesses. Now GE's biggest asset has turned into a liability that puts the future of the entire company at risk.
(Fortune Magazine) -- When Warren Buffett went to bed at his Omaha home on the evening of Tuesday, Sept. 30, he asked his wife, Astrid, to wake him in the morning at 6:55 a.m. He had an important call coming in. By 7:30 the call was over. Buffett walked into the kitchen, still wearing an old robe he likes, and announced to a breakfast visitor that he had agreed to send General Electric $3 billion of Berkshire Hathaway money in return for a new issue of preferred stock and warrants allowing Berkshire to buy an equal amount of common stock over the next five years.
It was the beginning of one of the more dramatic days in GE's 130-year history.
The deal was done, but the news wasn't yet out, and in the meantime GE's world was deteriorating fast. By 9:14 Eastern time, a GE spokesman had e-mailed the media with a message that Congress must act "urgently" on the pending financial bailout package. By 11 an analyst at Deutsche Bank had announced that he was sharply cutting his forecast for GE's 2008 profits - though only three months remained in 2008 - and the stock dropped 9% almost immediately. By 11:23 the price of credit default swaps - lenders' insurance - on the bonds of GE Capital had rocketed: The market was saying that the bonds of this great and storied company, one of only six corporations on planet Earth with a triple-A credit rating, were junk.
Finally, at 1:44 p.m., GE (GE, Fortune 500) announced its deal with Buffett and said it would sell $12 billion of common stock to the public the following day. The statement contained an important sentence from Buffett: "I am confident that GE will continue to be successful in the years to come." GE stock edged up - though by day's end it was still way down since the start of the year.
So here's what had just happened: General Electric had arranged to raise $15 billion on a few days' notice. For perspective, remember that in March, Visa had culminated months of preparation by staging the largest stock offering ever, raising $18 billion. In other words, GE needed a sudden, huge, and utterly unexpected emergency infusion of cash. Only six days before, when a Wall Street analyst had asked GE chief Jeff Immelt about the possibility of the company's selling new equity, Immelt had answered unequivocally: "We just don't see it right now. We feel very secure about how the funding looks."
The idea that GE might ever be desperate for cash would have seemed ludicrous a year ago and looked unworthy of concern even this past summer. After all, this is history's most famously well-managed company. But now the stock trades for less than half its price 12 months ago. More than $200 billion of value has vaporized.
In its most recent earnings announcement, on Oct. 10, GE said profits fell 22% in the third quarter, driven down by a 38% drop in earnings from financial services; profits there should continue to decline, the company said. GE remains highly profitable; analysts expect it to earn about $20 billion this year, but that's 10% less than last year, a sharp change from earlier forecasts of robust growth. And for the first time in memory, investors are pricing GE at a level that indicates that they expect it to shrink rather than grow, a surreal situation.
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Managing this crisis is certainly the sternest test Immelt has faced in his seven years as chief, and it may well become the episode that defines his legacy. Says Tom Priore, who runs the credit hedge fund ICP Structured Investments: "If you thought AIG was important, GE is many times a multiple of AIG." And now GE's future, like the economy's, looks as if it could tip either way.
To see how GE got so badly beaten up, consider first what the company really is. Its strength and curse is that it looks a lot like the economy. Over the decades GE's well-known manufacturing businesses - jet engines, locomotives, appliances, light bulbs have shrunk as a proportion of the total. Like America, GE has long been mainly in the business of services. The most important and profitable services it offers are financial. In fact, though the average citizen probably thinks of GE as a great industrial company, its industry classification in the Fortune 500 is diversified financials. It is by far the largest company in that industry group. The next biggest - and here we begin to glimpse GE's troubles - are Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500).
The reality is that for years, about half of GE's prodigious profits have come from General Electric Capital, a 100%-owned affiliate that files its own reports with the SEC. GE Capital, headed by 29-year GE veteran Michael Neal, has ventured into practically every kind of financial service, from making car loans in Europe to investing in commercial real estate in Florida. If you have a credit card from Wal-Mart or Lowe's, it's really from GE Capital. The business owns almost 1,800 commercial airplanes and leases them to 225 airlines. Until last year it made subprime mortgages in the U.S.
But GE Capital is more than just a major profit contributor to GE. The relationship is symbiotic. GE Capital helps GE by financing the customers that buy GE power turbines, jet engines, windmills, locomotives, and other products, offering low interest rates that competitors can't match. In the other direction, GE helps GE Capital by furnishing the reliable earnings and tangible assets that enable the whole company to maintain that triple-A credit rating, which is overwhelmingly important to GE's success. Company managers call it "sacred" and the "gold standard." Immelt says it's "incredibly important."
That rating lets GE Capital borrow funds in world markets at lower cost than any pure financial company. For example, Morgan Stanley's cost of capital is about 10.6% (as calculated by the EVA Advisers consulting firm). Citigroup's is about 8.4%. Even Buffett's Berkshire Hathaway (BRKA, Fortune 500) has a capital cost of about 8%. But GE's cost is only 7.3%, and in businesses where hundredths of a percentage point make a big difference, that's an enormously valuable advantage. And thanks to the earnings strength of GE's industrial side, GE Capital can maintain its rating without holding much capital on its balance sheet.
GE Capital also performs another critical function: It helps GE manage earnings. Though earnings management is a no-no among good-governance types, the company has never denied doing it, and GE Capital is the perfect mechanism. Since financial assets are, under normal conditions, far more liquid than tangible assets, the company can buy or sell them in the final days of a quarter so that reported earnings rise with comforting smoothness, right in line with Wall Street expectations. Investors happily pay extra for companies whose profits rise steadily rather than erratically, so this function is valuable. Michael Lewitt, president of the hedge fund Harch Capital Management, says GE Capital "has become such a necessary part of GE's legendary earnings results that General Electric could not perform as well or consistently if anything happened to it."
For GE Capital, the business world from 2002 to 2006 was a nearly perfect environment. Executives Gary Wendt and Denis Nayden had aggressively globalized the business, and now all the major economies (and most of the minor ones) were growing simultaneously at healthy clips, an unprecedented occurrence. Interest rates were low. Every kind of asset seemed to be appreciating. For a big finance operation with low funding costs, opportunity was everywhere. During that period GE Capital levered up, growing its ratio of debt to equity from 6.6 to 8.1. Profits quadrupled to almost $11 billion, more than the profits of Procter & Gamble or Goldman Sachs.
Good times never last forever, but GE is known for seeing changes ahead of time - recognizing early, for example, that it had to go "green" - and responding to them faster and more creatively than the competition. Last year, however, signs began turning up that this admirable pattern wasn't holding at GE Capital. For example, the company had left the home mortgage business in 2000 but reentered it in 2004 when it was flying high, buying a subprime lender called WMC Mortgage from a private equity firm (the price was never announced). Home prices peaked in June 2006, yet it wasn't until a year later, with the subprime crisis on the front page of every newspaper, that GE Capital finally decided to bail out. WMC lost almost $1 billion in 2007 before GE dumped it in December. A Japanese consumer-lending company called Lake was another lousy business, but GE Capital again didn't face the music until it was too late. GE took a $1.2 billion loss on it last year after deciding in September to sell it - but by then consumer credit was deteriorating so fast that unloading it (to Shinsei Bank) took another year.
This emerging pattern of confronting problems only after they could no longer be fixed was disturbing, but Immelt remained confident in GE Capital coming into this year. Despite its stumbles, GE has a long history of strict financial discipline. Immelt told shareholders in February, and repeated to employees recently, that GE had no exposure to collateralized debt obligations (CDOs) or structured investment vehicles (SIVs). It uses derivatives for hedging, which is relatively safe, but prohibits speculating in them, which is dangerous. It subjects its financial positions to shock tests - for example, assuming that interest rates rise a full percentage point across the board and stay there for a year; if that happened in 2008, Immelt said at the beginning of the year, GE's positions were so well hedged that the effect on profits would be negligible. His upbeat conclusion in February: "Our financial businesses should do well in a year like 2008."
That was more than just talk. In late 2007 and early 2008, Immelt spent about $10 million of his own money buying GE stock at prices in the middle to upper 30s.
Evidence that such optimism wasn't justified - and a hint of much bigger problems to come - finally arrived with a bang in April. That's when GE announced that first-quarter profits had fallen short of Wall Street's expectations by $700 million, a mammoth miss that by GE standards is historic. It's what prompted former CEO Jack Welch to rant on CNBC that he'd "get a gun out and shoot [Immelt] if he doesn't make what he promised now" for following quarters.
Making matters worse, Immelt had assured investors only 18 days before the quarter's end that everything was on track. GE's just-released annual report was titled "Invest and Deliver," significant because inside GE "deliver" is a special word. You deliver on commitments - always. As Welch said on CNBC, "Just deliver the earnings. Tell them you're going to grow 12% and deliver 12%."
So Immelt committed the ultimate GE sin and failed to deliver. How come? That's easy. He reassured investors on March 13, and the quarter ended on March 31. But something unimagined happened in between: Bear Stearns failed, causing credit markets nationwide to freeze up. GE had been counting on GE Capital to do its usual end-of-quarter rescue act, but this time it couldn't.
Result? Uproar and a further slide in the stock. Investors felt betrayed and disillusioned. Analyst Nicholas Heymann of Sterne Agee spoke for many when he wrote: "Investors now understand that GE uses the last couple weeks in the quarter to 'fine-tune' its financial service portfolios to ensure its earnings objectives are achieved. It turns out it really wasn't miracle management systems or risk-control systems or even innovative brilliance. It was the green curtain that allowed the magic to be consistently performed undetected."
Unhappily, the causes of that first-quarter debacle haven't disappeared. GE's managers, like everyone else, failed to foresee how bad things could get in today's vast, interlocking financial system. Managers thought they were being bold in stress-testing their model against a percentage-point jump in rates, but didn't conceive of a sudden and nearly complete stop to interbank lending, a total absence of buyers for some securitized debt, and investors so panicked they're willing to accept negative interest rates to gain the safety of T-bills. In that world even GE Capital's business model doesn't work the way it's supposed to. Bad news piled up through the summer. GE had announced it would sell its businesses that make light bulbs, appliances, and certain electrical equipment (yes, the company founded by Thomas Edison wanted out of light bulbs); profits were piddling and unlikely to improve in these commodity-like businesses. But it was too late. In a slowing economy no one would pay a respectable price. GE also wanted to sell its private-label credit card business, but again - too late. In traumatized credit markets, no one wanted to buy $30 billion of credit card receivables, much of which was owed by subprime borrowers, according to company statements. So GE is still stuck with those businesses. The stock, which had been around $40 a year ago, drifted down into the 20s over the summer before collapsing in mid-September as the financial crisis entered its acute phase with the failure of Lehman Brothers. Desperation Immelt, wanting to avoid another disastrous earnings surprise (and escape getting shot by Welch), announced five days before the quarter's end that profits would be lower than previously forecast by about $700 million. Yet that's also when he set the stage for a different jolt to investors by saying he foresaw no need to sell new equity. Six days later he sold new equity. The desperation of that move is even greater than its unseemly haste may suggest. Remember the importance GE attaches to acquiring low-cost capital. Equity is not low-cost - it's more expensive than debt - and the special preferred shares issued to Buffett carry a 10% coupon, which is paid out of after-tax profits. So that $3 billion was about the most expensive capital it's possible to get. But Immelt, who has journeyed to Omaha for meetings with Buffett and has consulted him often, was willing to pay a steep price for the reassurance the famed investor's endorsement would bring. He and CFO Keith Sherin also agreed to hold at least 90% of their personal GE stock until Berkshire's preferred shares are redeemed (Immelt had long ago promised never to sell a share in any case). There was further evidence of the company's dire state in the stock offering: Until late September, GE had been buying back its own shares on the open market. Last year it bought about $14 billion of them and this year over $1 billion, all at prices in the 30s. Now, just six days after suspending the repurchase program, it was selling $12 billion of shares to the public at about $22. That is, it was buying high and selling low. Why was it so desperate for cash? The company offers only the blandest reasons for its move, but investors were clearly worried that commercial paper was an important factor. Commercial paper is how corporations borrow for short periods, typically just a few days, for immediate purposes; it's attractive because companies borrow only what they need, and interest rates are low. Lots of firms use commercial paper, frequently just for paying day-to-day bills, but no company uses it anything like GE. GE Capital alone has about $74 billion of commercial paper outstanding; the next largest player, J.P. Morgan, has about $47 billion. GE understood there was risk in relying so heavily on this source of funding but believed it was well prepared for any disruption through access to other sources, such as bank lines of credit. On the morning of Oct. 1, the markets swirled with rumors that GE couldn't roll over its commercial paper coming due. Like so much else that has happened in recent weeks, this possibility would have seemed outlandish just a month before; a spokesman insists the company has experienced no such problems. But in light of GE's huge commercial paper obligations and the disruption of global credit markets, the rumors became just barely plausible. That's when the stock suddenly dropped 10%, and the price of GE credit default swaps jumped. Regardless of how realistic the market's fears were, the episode puts the Fed's decision five days later to backstop the commercial paper market in a new light, as a signal of support for the commercial paper market's biggest player. What's next? Which leaves GE where? All the bad news in its recently lowered full-year profit forecast is in GE Capital; its profits should fall by 20% to 25% from last year's. The other side of the company, the part most people think of when they think of GE, hasn't shown signs of deterioration, at least not yet. Power turbines, locomotives, jet engines, CT scanners - the world still wants lots of those, and the profits they produce at GE are still rising strongly. Of course, should the financial crisis spark a widespread recession, virtually all of GE would suffer. What's not in doubt is that GE Capital will be changed profoundly by these events. Immelt has announced a goal of "resizing" GE Capital so that it accounts for just 40% of total GE earnings (down from 46% last year), but that may be making a virtue of necessity. It appears he'll reach his goal next year with no problem whatever. The company's big problem now is that investors just don't know how the galloping financial crisis will affect GE. For example, the company holds some $53 billion of off-balance-sheet assets that are pieces of securitized debt, some of which are hooked to interest rate swaps with counterparties that are now troubled, such as ABN Amro, owned by Fortis and RBS Group. Individually, none of those is enough to cause a major problem. But investors are justifiably spooked by the poorly understood web of connections interlocking global financial firms, which have caused such havoc over the past month, and they're unsure how GE might ultimately be affected. Another example: GE Capital says that some of the debt it holds is extra-safe because it's covered by credit insurance. But in today's environment, how reliable are the credit insurers? Investors worry also because GE Capital oversees one of the world's largest commercial real estate portfolios. Tom Shapiro of GoldenTree InSite Partners, a real estate investment firm, says commercial property values have declined 10% to 20% in some regions and are still falling. In addition, GE's portfolio includes residential-mortgage-backed securities, some with subprime exposure, for which there's virtually no market now. More uncertainty for investors. Another concern is that the leverage in GE could be much higher than stated. Egan-Jones, an independent rating agency, calculates that GE is levered ten-to-one, a more conservative and higher number than the company's eight-to-one figure. Cofounder Sean Egan believes that, depending on the off-balance-sheet holdings, actual leverage could be still higher. His firm rates the company single-A. In addressing these many uncertainties, Immelt has hammered home the message of GE's commitment to its sacred triple-A rating. He took several steps to conserve capital, such as deciding not to increase the dividend next year and suspending the stock buybacks; Moody's (in which Buffett's Berkshire Hathaway is the largest shareholder) and Standard & Poor's immediately reaffirmed their ratings on the company. But Immelt may be fighting a battle that investors no longer care so much about. The credibility of bond ratings in general tumbled when it was revealed that securitized subprime mortgages had been rated double- or triple-A. GE's rating clearly meant nothing to investors who bid credit default swaps on company bonds up to a price of 700 basis points (the price subsided recently to about 500). Remember, triple-A means creditworthiness on a par with that of the U.S. Treasury, and credit default swaps on Treasury bonds have never traded above 35 basis points. The message of the markets: The rating agencies can say what they like; we'll decide for ourselves. Recent events raise the question of whether Immelt's job is safe. The stock is down by half since he took over in September 2001, one reason the company has lost a number of excellent executives. A source close to the board says it still supports him, and he has done a good job of involving directors in major decisions. They regard the present crisis as a 100-year flood that Immelt is managing about as well as anybody could. He may take solace in the story of Reg Jones, GE's chief from 1972 to 1981. The stock, adjusted for inflation, went nowhere during his tenure. But it was a terrible era for stocks generally, and just before he retired, Fortune asked the Fortune 500 CEOs to name the company and the CEO they admired most. The winners were GE and Jones. Whether Immelt and GE can ride out the current crisis with their reputations intact is unknowable at the moment. But given that the company is a microcosm of the world's economic health, we'd all better hope that they can. |
source cnn money.com
courtesy to cnn money &author of article
