A smaller focus: what the future holds for GE Capital

General Electric’s decision to sell off most of its financial operations by 2018 to “create a simpler, more valuable industrial company” has been broadly welcomed. But just what does the major shakeup at GE, a 125-year-old conglomerate, mean for the model of financial arms of large corporates?

Under the plan unveiled by GE chief executive Jeff Immelt, the operations of GE Capital will be wheeled back to their original function of only providing credit and services that directly support GE’s core industrial businesses.

GE plans to continue financial operations such as aircraft leasing, energy and healthcare financing, as all three complement the sales of some of GE’s best-known products: jet engines, electric turbines and medical equipment.

Industrial focus

Announcing the move in April, Mr Immelt said: “This is a major step in our strategy to focus GE around its competitive advantages. GE today is a premier industrial and technology company with businesses in essential infrastructure… They will be paired with a smaller GE Capital, whose businesses are aligned with GE’s industrial growth.”

GE Capital had $499bn in assets at the end of 2014, but by 2018 GE expects to generate only 10% of its profits from its financial services arm, while its industrial businesses will provide 90% of its profits, up from 58% in 2014. And GE Capital’s assets are expected to shrink by about three-quarters to about $90bn, say GE executives. Deane Dray, Royal Bank of Canada’s capital market analyst in New York, says it is not unusual for the model of financial arms of large corporates “to get pushed to excess”.

The expansion of the financial services side of GE really heated up during the tenure of Jack Welch in the 1980s and was continued more moderately by Jeff Immelt up until just before the financial crisis. Mr Dray says: “People forget GE owned an investment bank, Kidder, Peabody & Co.” This was a US-based securities firm that, following heavy losses, was sold to Paine Webber in 1994. GE also became involved and then sold a reinsurance business in 2005.

There was also an investment in Japanese consumer lending company Lake, which GE sold in 2007 but only after it made a substantial loss. And GE had “a very small but very expensive exposure” to subprime lender WMC Mortgage, says Mr Dray. But it was not until the housing bubble started to burst and WMC had lost $1bn that GE disposed of it.

In the 1980s and 1990s GE Capital “really leveraged up its private store credit card business in the US and then took that around the world. And… it built out the middle-market lending and leasing business and took that, as well, overseas,” says Nicholas Heymann, an industrial analyst at William Blair & Co who has followed GE for decades.

The expansion thrived before the 2008 financial crisis, so much so that GE Capital’s share of GE’s annual profits exceeded 50%. But this success was not what GE’s investors wanted. They felt the large financial arm was a distraction from GE’s real identity, says Gary Mozer, managing director of George Smith Partners, a US debt and equity financing firm.

GE'S vulnerabilities

The stupendous growth of GE Capital’s assets and loans also had vulnerable underpinnings; it relied on the issue of bonds and short-term debt called commercial paper. Before the crisis, GE Capital was the biggest US issuer of commercial paper and GE’s AAA credit rating enabled it to borrow funds at lower interest rates than any pure financial company. Meanwhile, GE’s credit rating was based on its strong industrial earnings and its tangible assets, such as turbines and jet engines.

Furthermore, when GE Capital lent the money on to third parties – its customers and clients, which was part of the strategy – it could arbitrage the difference between its low cost of borrowing and higher lending rates, particularly in emerging markets and developing countries, where it expanded its operations.

There was also no such thing as Tier 1 capital requirements and the regulation of a non-bank financial arm, such as GE Capital, was practically non-existent before the financial crisis, say analysts.

But then in March 2008, global investment bank Bear Stearns failed, lenders in short-term debt markets fled and “GE had a near-death experience because of the illiquidity of its commercial paper programme, which threw GE Capital into a crisis”, says Mr Dray.

Too big to fail

From a regulator’s point of view, the possibility of GE’s demise was much worse – in terms of the potential impact on the financial system – than that of insurance conglomerate AIG, which was bailed out by the US government.

Deemed too big to fail, when GE requested support the US government stepped in and guaranteed billions upon billions of dollars of GE Capital’s commercial paper. It was a de facto bailout, according to many analysts.

Simultaneously, GE lost its AAA credit rating, which it had cherished for 40 years, forcing the group to slash its dividend for the first time since 1938. It was a humbling experience for the US’s best-known conglomerate and a 'never again' moment for GE executives when GE Capital put the parent at risk, say analysts.

From that time, GE started selling off some of GE Capital’s assets. But Mr Immelt was under pressure to shrink GE Capital much more radically, to win over investors and shareholders who were dissatisfied with a GE stock price that had underperformed since the financial crisis compared with some of its industrial competitors, such as Honeywell, that do not have big financial arms. Shareholders felt that GE’s stock was being punished for having what the market perceived as a risky finance business.

Investor approval

So when Mr Immelt decided this April to remake GE as a more focused industrial company and minimise its dependence on GE Capital’s earnings, investors applauded. GE shares rose 11% on the day of the announcement, one of the largest one-day gains in a Dow Jones index stock in years.

Explaining the change, Mr Immelt said: “The business model for huge wholesale-financed companies has changed, making it increasingly difficult to generate acceptable returns going forward.”

Put another way, in a post-financial crisis world, GE can no longer rely on GE Capital to help it pay dividends, buyback shares and finance GE’s industrial operations, say analysts, who add that this is because a further tipping point behind GE’s radical overhaul is that after the crisis the US Federal Reserve became GE’s regulator.

Following the Dodd-Frank Wall Street Reform Act, GE was one of the first non-bank entities  to be designated a systemically important financial institution (SIFI), by the new Financial Stability Oversight Council (FSOC). That led to additional capital and liquidity requirements being imposed on GE and greater scrutiny by regulators.

“That [designation] is something that is constraining to GE, and that it does not want to be burdened with,” says Mr Heymann.

Furthermore, in December 2014 the Federal Reserve proposed new capital surcharges for SIFIs, ranging from 1% to 4.5% of risk-weighted assets. The new rule also takes into account how much a SIFI bank or non-bank entity relies on short-term wholesale funding which, as well as being more expensive than collecting deposits, is uninsured. The proposal therefore increases the costs of regulation for GE and any other wholesale-funded financial arms of corporates as, essentially, it requires SIFIs to self-insure such funding liabilities, which are vulnerable to runs in a crisis.

FSOC compliance

So it is a key part of GE’s plan that with the shrinking of GE Capital’s assets, GE will be able to obtain a reversal of its SIFI designation. It plans to start that process as soon as possible. “The change should generate substantial benefits for investors and lower risks for the financial system. From a regulatory standpoint, this eliminates a large, wholesale-funded, non-backed SIFI, consistent with the goals of the FSOC,” said Mr Immelt.

However, Mr Heymann says: “[Many analysts are asking why] GE has chosen to dismantle what is essentially one of the top 10 banks in the country, when there is ample liquidity in the markets; [they are asking] whether this is a blueprint for reducing the inherent risk at other SIFI entities that have not been able to dramatically improve their overall returns and performance since the crisis; [and they are asking] whether this could happen to a Citibank or a Bank of America… If GE can do it why can’t somebody else?”

Other examples of exits of financial arms of large corporates in the US have not been nearly as orderly or methodical as the plan to dismantle GE Capital.

Take Westinghouse Electric Corporation, a century-old company that ceased to exist in 1997. In many ways Westinghouse was similar to GE. The company’s main industrial businesses – defence, electronics, electricity generation, refrigerated transport and nuclear engineering – were technologically sound.

But in the late 1980s, Westinghouse, like other conglomerates, appeared to lose sight of why it had set up a financial services arm, which was to help finance deals for customers and make it easier for the company to win contracts. Instead, it began to treat the unit as a source of growth, investing in speculative ventures including unsecured commercial building projects and leveraged buyouts. When those markets fell, the division left a $6bn hole in Westinghouse’s balance sheet and the corporation failed.

Another case is Ally Financial, founded by General Motors in 1919 as General Motors Acceptance Corporation (GMAC), originally to offer loans to car dealers and buyers of GM cars. But over the years, GMAC moved away from its core function and expanded into insurance, direct banking, commercial finance and mortgages. In the run up to the financial crisis, similar to other mortgage companies, it was aggressive in the subprime market, making risky loans and then taking huge losses when the housing bubble burst. It lost $9.2bn in two years, mostly from record defaults on subprime mortgages.

Now, with the demise of GE Capital, analysts say there are no examples left in the US of a broad-based financial arm of a big corporate.

BOX: Dismantling GE Capital 

Over the next two years, GE will conduct one of the biggest sales of financial assets ever attempted. Keith Sherin, GE Capital’s chief executive since 2013, gives an idea of what the task of dismantling the firm’s international assets has been like.

“Over the past six years, we have sold more than $100bn of businesses and assets, while realising $4bn of gains," he said during a GE analysts conference in April. "We have sold banks and bank shares in Thailand, Turkey, Russia and central America. We have sold out consumer financial companies in the Nordics, Switzerland and Singapore. We have done straight asset sales, platform sales, instruction sales and initial public offerings [IPOs],” he added.

Meanwhile, in May GE agreed to sell about $12bn, or more than half, of GE Capital’s private equity lending unit, to Canada’s biggest pension fund, the Canada Pension Plan Investment Board. The US business lends money to private equity firms to takeover and operate medium-sized companies and it is considered one of the most successful in the field.

In another big US divestment, GE spun off a minority stake in its US store credit business, now known as Synchrony Financial, in a $2.9bn IPO in 2014. The company had total assets of $75.7bn as of December 2014. GE is holding on to the rest of Synchrony stock until late 2015, when it plans to carry out a tax-free distribution of the remaining shares to its stockholders, assuming regulators approve.

In April 2014, GE struck a deal to dispose of the bulk of GE Capital’s $26.5bn portfolio of investments in office buildings and other commercial property to funds managed by the Blackstone Group, a private equity firm, and Wells Fargo, the fourth largest US bank.

Commenting on the agreement, John Stumpf, chief executive of Wells Fargo, said in an April 30 interview on Fox Television: “These loans are very much like the loans we make and we’re the largest commercial real estate lender in the country. This is a kind of once-in-a-lifetime opportunity. Rarely does a big player in the market exit.”

Mr Sherin is leading the process of selling GE Capital’s remaining businesses, which amount to about $165bn in assets altogether. They include, among others, a portfolio of loans to US small and medium-sized enterprises (about $74bn in assets); an international commercial lending business (about $31bn); and an international consumer banking unit (about $37bn in assets).