What Do AIG, FNM, FRE (and GE) Have in Common?

Good Evening: Investors were handed various and conflicting pieces of news this morning, but hope for the future won out over worries about the present by day’s end. Word of a second stimulus package being readied in China, some kind words for the stock market from Steve Leuthold, and a couple of decent pieces of economic data represented the positive news that helped boost share prices. On the negative side, some weaker than expected economic news and a continued slide in the shares of GE helped to limit today’s gains. Since GE has received quite a bit of attention of late, I will conclude by offering an opinion of what I think might be driving this AAA-rated company’s share price lower than many investors had ever thought possible.

Global stock markets and U.S. stock index futures were higher overnight in response to a story out of China that another economic stimulus package might be on the way. As a nation of savers, China can probably afford to pump more funds into its economy, a situation U.S. citizens can only witness with distant envy. This proposal boosted not only the CSI 300, but global indexes and even commodities. Index futures here were up 1% prior to the release of the first batch of economic statistics. Mortgage purchase applications plunged to new depths in the latest reporting week, while two different glimpses of the U.S. employment picture were mixed. The Challenger Job Cut report portrayed a slowdown in the intensity of announced layoffs in February, while the ADP report estimated that the U.S. lost almost 700,000 jobs during the same period.

Given ADP’s track record as a misleading employment indicator, market participants seemed to shrug off the gloomy report and pushed stocks almost 2% higher at today’s open. Thirty minutes into the day saw the release of the ISM services survey, and it came in just a hair better than had been expected. The S&P 500, which had easily topped the 700 mark in the early going, eased back to test this level an hour into the session. When 700 held firm, buyers for various ” China plays” emerged and propelled the major averages to new highs by lunchtime. Bloomberg may have added a bit of a tailwind to equities when it posted a story that the well respected money manager, Steve Leuthold, was expecting a rally (see below). And while a sickly Beige Book (see below) and a heaviness in all securities bearing the GE name may have bothered the bulls, they were still able to push the averages to gains of 4% gains in the afternoon before a late bout of selling left the indexes ahead by 2.25% (Dow) to 4.8% (Dow Transports).

Treasurys sank in response as yields rose 6 to 10 bps on supply concerns. The U.S. government will likely have to auction off a cool $2 trillion during calendar 2009, a figure which defies both one’s imagination and quite possibly the combined appetites of global central banks. It wouldn’t surprise me in the least to see the Fed feel the need to put a floor under Treasury prices at some point this year. No doubt it was some of these same worries that knocked the dollar index down 0.8% today. Commodities, however, were Wednesday’s big winner. Dreams of renewed demand from China pushed almost everything but gold higher, and the CRB index closed with a gain approaching 4%.

GE’s stock price approached retirement age earlier this decade, but its shares now fetch no more than hat sizes. So why are both the equity and fixed income securities of this AAA-rated company under so much pressure? Guests on CNBC (which seems to tout its GE parentage less often of late) can’t stop talking about it almost as much as investors can’t stop selling the stock. One reason has to do with capital structure arbitrage. New owners of various fixed income obligations bearing the GE name have been selling short the common equity as a hedge. Momentum and fears that what happened to previously AAA-rated AIG could happen at GE are also exerting a gravitational pull on the share price.

Perhaps the real reason GE shares keep circling the drain has to do what it has in common with not only AIG, but with Fannie Mae and Freddie Mac as well. AIG, FNM, and FRE all hit the wall bearing the highest possible debt rating from Moody’s, S&P, and Fitch, and many rightly worry if GE will suffer the same fate. How is it possible that AAA-rated companies can so suddenly come a cropper? Simply blaming the ratings agencies for not doing their jobs, while correct, does not get to the heart of the matter. Nor does short-sighted management at the firms in question go far enough in explaining these amazing falls from grace.

To me, the real reason AIG, FNM, FRE (and perhaps GE) got into financial trouble had to do with their AAA rating and management’s desire to exploit it — even arbitrage it. Borrowing at the best interest rates available to non government entities, companies like GE and AIG found they could fund sizable financial units much more cheaply than could have been possible if the financial units (AIG Financial Products and GE Capital respectively) had to be funded without parental support. Knowing that the ratings agencies would be loathe to downgrade them (thus admitting a mistake), GE pushed its borrowing as far as they could and bought all sorts of assets with yields higher than its AAA funding costs. Call it a reputational ratings arbitrage, if you will.

GE exploited this “rep arb” so far that PIMCO’s Bill Gross felt forced to publicly cry “foul” a couple of years ago in one of his “Investment Outlooks”. PIMCO even boycotted GE’s commercial paper in protest of this arbitrage because it amounted to nothing more than a huge carry trade. As any carry trader will tell you, the risks are simple: The cost of funding your trades can go up, or the assets you’ve financed can go down. Enough of either can lead to ruin and both scourges are at work inside the opaque GE balance sheet these days. The hubris of GE’s CEO, Jeff Immelt, is only partially to blame. The GE culture under his boss, Jack Welch, set an impossible precedent when GE always beat its quarterly guidance by one penny. Can any assortment of fine industrial businesses be so predictable without a few financial levers being pulled now and then? A financially massaged, “Beat the Street” mentality was in place well before Mr. Immelt took the reins, but it seems to this outsider’s eyes that eventually he eventually tried to engineer what the global economy could not deliver. These thoughts are only a theory — one I readily admit to being unable to prove. But it’s easy to see the results. Too much borrowing was undertaken to buy too many risky assets, and the stock price is itself at risk until this situation somehow reverses.

While slightly different forces were at work when AIG (too much CDS exposure), FNM & FRE (too much residential mortgage exposure) all fell apart, the desire to abuse their AAA-rated funding advantage lay at the heart of all the leverage they took on and later came to regret. The legendary Michael Milken used to look with scorn upon AAA-rated paper, and not just because of the skimpy yields over Treasurys they gave investors. “Things can only get worse at those companies and their ratings can only go down”, he said on more than one occasion. Looking at GE and the others today, I’ll bet even Mr. Milken is struck by just how right his timeless warning has become.

— Jack McHugh

Stocks Rise Around the World; Commodities Gain, Treasuries Fall

Leuthold Says Stocks Will Surge, Depression Avoided

GE Shares Fall Fourth Day on Concern for Finance Unit

Beige and Bruised.pdf

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