Pros, Cons of Unplugging GE Capital from Its Parent

Second of three parts

General Electric Co. may not be forced to sever GE Capital, but the prospect of much tougher supervision of the latter could push the conglomerate away from financial services.

Under the Treasury Department's revised plan for regulatory reform, GE's entire $658 billion-asset finance arm would become part of the Federal Reserve Board's watch. That would be a big change from the relatively light touch that comes with oversight of GE Capital's $18 billion-asset thrift and $11 billion-asset industrial bank, both in Utah.

"Heightened prudential standards," like stricter capital and liquidity requirements, could weaken GE's business case for keeping GE Capital. Speculation persists that GE will have to raise a massive amount of capital to absorb heavy credit losses and shore up its finance arm's equity cushion.

GE says it is committed to GE Capital, though the parent company has been shrinking the business through dispositions and runoff, trying to make it "more focused, high-return, connected to the core," as Chief Executive Jeffrey Immelt recently put it.

Last month GE demonstrated its commitment by strengthening an agreement to give GE Capital financial support in tough times, a voluntary move that was designed to comfort buyers of the unit's debt.

In the years before the recession, GE Capital accounted for about half of the parent company's profits. Some analysts say that when credit losses subside, the unit's contribution could roar back to a similar level, if thinned-out competition leads to fatter margins.

There is "a significantly rationalized competitive environment, and it's more favorable to the guys that are still leftover," said C. Stephen Tusa, an analyst with JPMorgan Chase & Co.'s securities unit.

The big question, however, is whether this "rationalization" that has ground up risk-hungry lenders will be enough for GE to rationalize staying in the field should regulations tighten.

GRANDFATHERED

A few months ago it looked as though a guillotine was about to land between GE and its lending arm.

The Obama administration's June regulatory reform outline said that all companies that control insured depositories "should be subject to the nonbanking activity restrictions" of the Bank Holding Company Act, and be given five years to comply with them. Effectively, the proposal would have required companies like GE to separate from their lending businesses.

GE has dodged that blade. Under draft legislation released by the House Financial Services Committee and the Treasury last month, nonbank companies would not have to divest banking operations.

They would, however, have to be reorganized under a bank holding company subsidiary that would be subject to severe restrictions on transactions with affiliates. (The House proposal would prohibit additional commercial enterprises from becoming owners of banks.)

Steven Winoker, an analyst with Sanford C. Bernstein & Co., called the draft legislation "a significant milestone for" GE.

"It alleviates the bigger questions about extreme circumstances of forcing them to separate, which would be very difficult," he said.

GE Capital would not make executives available for interviews. Russell Wilkerson, a spokesman, said the company is "pleased that there will be no forced separation of commercial companies and their financial subsidiaries." But he said it objects to restrictions on transactions with affiliates that "as currently drafted could have significant unintended consequences for lending."

Among other provisions, the bill would prohibit a company's commercial divisions from offering or marketing the products and services of its lending arm, and vice versa. This threatens one of the principal ties between GE Capital and its parent: the unit offers financing to buyers of the rest of the company's wares. (The Fed would be authorized to grant exceptions to such restrictions.)

The House legislation would likely also increase GE's regulatory burden elsewhere.

Winoker said that the potential consequences to the financial system and the economy in the event of a meltdown at GE Capital would "almost certainly" be deemed significant enough to subject the company to stiffer prudential supervision under the House proposal.

Oversight by the Fed would "be a whole new world," he said. (The Office of Thrift Supervision is currently the consolidated regulator for GE Capital, which is not a bank holding company.)

Capital requirements and other elements of the House's proposed framework would ultimately be up to regulators, and how strict they are would be critical in determining the size of GE's finance operation, or whether the company stays in the business at all.

"The higher the equity requirements, the lower the leverage, the lower the returns for them, and it makes it a less attractive proposition over time," he said. GE has said that it supports systemic-risk regulation and is prepared for it — including the possibility of higher capital and reserve requirements.

But a positive impact could be that the House legislation would mean "probably a little more risk aversion" at the unit, Winoker said.

(Senate Banking Committee Chairman Chris Dodd, D-Conn., introduced his own regulatory reform bill Tuesday. See story on page 1.)

Tusa said the finance business would continue to be attractive to GE even if it were forced to hold additional capital, or if capital became more expensive. Profitability could be maintained with higher loan pricing, he said.

Though there is a risk of heavy-handed action, Tusa said, regulators are likelier to phase in new capital standards to avoid a disruption that could crimp lending in a fragile economy. Such an approach would give GE Capital time to build up capital through earnings, he said.

BANKING AND COMMERCE

Obama's white paper in June said that some owners of industrial loan companies, credit card banks and similar entities "have been able to obtain access to the federal safety net, while avoiding activity restrictions and more stringent consolidated supervision" that apply to bank holding companies.

Citing "conflicts of interest, biases in credit allocation, risks to the safety net, concentrations of economic power, and regulatory and supervisory difficulties generated by such affiliations," the proposal said "the wall between banking and commerce should be … strengthened."

The fight over ownership of banks by commercial enterprises has a long history that includes aborted bids by Wal-Mart Stores Inc. and Home Depot Inc. for industrial loan company charters. The two retail giants withdrew from their efforts after encountering fierce opposition from the banking industry, which advocated for legislation to block them.

GE has argued that companies with banking and commercial operations did not cause the financial crisis and that splitting them up would unnecessarily stifle major sources of credit.

Tusa agreed. He contrasted the mostly secured lending done by GE Capital with the exotic activities that undid firms like American International Group Inc. and Lehman Brothers. "These guys go and lend money to a restaurant to be able to buy restaurant equipment," he said of GE. "This is not the stuff that system failures are made out of."

Indeed, in the current cycle GE's financial business has drawn support from the rest of the conglomerate, rather than being infected by problems at other units.

Last month GE strengthened the terms of an "income maintenance agreement" under which it funnels cash to GE Capital when the division's earnings fall below a certain threshold. For example, GE now must give five years' notice before terminating this mechanism, instead of three years. (GE injected $9.5 billion into its financial services business in the first quarter. Last month the company said it did not expect to add more funds next year, but would be required to put $2 billion to $7 billion into the operation in 2011 if performance in 2010 is no better than in 2009.)

But GE Capital has relied heavily on dispensations designed for banks. It issued $60 billion of debt under the Federal Deposit Insurance Corp.'s emergency guarantee program.

"The fact that they had to go to uncle for subsidies tells you that they had a lot of risk," said Christopher Whalen, a managing director at Institutional Risk Analytics.

During the crisis, GE Capital has also dramatically increased its reliance on deposits. Its deposits more than tripled in 2008, though they fell 1.3% in the first three quarters of this year, to $36.4 billion. About $20.9 billion of those were at bank units outside the country; the domestic portion came almost entirely from brokered accounts.

Tusa has estimated that GE Capital will need to raise $10 billion to $15 billion late next year or in early 2011; others have pegged the eventual need at $40 billion to $50 billion.

TIES THAT BIND

Just as GE Capital's financing helps General Electric move merchandise, so does the lender benefit from being a part of General Electric.

Deep, stable earnings from the industrial divisions stand behind the finance arm's debt and lower the cost of the funds it lends out.

Tusa said a near-term split is not practical, since GE Capital has been booking the tax benefit that its losses and use of shelters create when set against the rest of the company's earnings. Without that arrangement, GE Capital would have to raise a "pretty significant amount of capital."

In each of the four quarters through Sept. 30, GE's financial services arm has recorded pretax losses — about $3 billion in total. But tax benefits of about $5 billion over the same period lifted it to a net profit.

Still, in several years, "if it's a better economy, and the business is much more self-sustaining and the book value is built up enough, they could do something with it," Tusa said.

Winoker said that, with the crisis having laid bare the weaknesses of wholesale sources of capital, the need to ensure access to liquidity could propel significant additional changes to GE's funding model — for example by merging the consumer finance business with a traditional depository and taking a minority stake in the combined company.

For now, GE calls GE Capital a keeper, though it plans to slim the business down to a balance sheet of about $400 billion by 2012.

GE put its credit card business on the block in December 2007, but about a year later it said it had stopped looking for a buyer because of the poor environment for a sale. The company has continued to shed other consumer finance businesses around the world.

During GE's third-quarter conference call last month, its chief financial officer, Keith Sherin, said the finance operation had "a green light" to build business in "core commercial finance activity, on the middle-market activity, on the things that are connected to GE."