General Electric was under the microscope Thursday after the release of report alleging the industrial company was hiding US$38bn in accounting fraud sent its bonds wider by 40bp-50bp.
The report claims that GE is committing accounting fraud, insufficiently stocking its reserves for insurance claims and hiding billions of dollars in losses from its oil subsidiary Baker Hughes.
GE said in a statement that the accusations are “meritless” and are an attempt to generate short selling in the company’s stock for a hedge fund that is backing the report.
The author of the report Harry Markopolos, a financial fraud investigator who previously sounded the alarms on the Bernie Madoff scandal, disclosed that he stands to benefit financially.
Regardless of the motivations, the report sent GE’s bonds wider by double digits and its stock tumbling 11% to close at a price of US$8.01.
The company’s 5% 2049 bond widened 47bp to 368bp over US Treasuries on volumes of over US$450m, according to MarketAxess data.
Prior to the report, the company’s bonds were rallying on the view that fallen angel concerns for the Baa1/BBB+/BBB+ rated industrial were overdone.
Now, the majority of its bonds are trading closer to average Double B spreads of 270bp, according to ICE BAML data.
A KNOWN UNKNOWN
Perhaps the accusation that holds the most weight for bond holders is Markopolos’ claim that an accounting rule change for insurance liabilities and significant under-reserving is going to cause GE to take US$29bn in additional reserve hits for its Long-Term Care liabilities, the report states.
To more closely match the reserves built by peers such as Prudential, GE would need US$18.5bn in new cash reserves as soon as possible and another US$10.5bn by the first quarter of 2021, the report claims.
An added charge of that size would make it even more difficult for GE to pay down its more than US$100bn debt stack.
This is a well-know problem among bond investors, but many were likely penciling in a figure about one-third less of what the report claims, David Knutson, head of credit research at Schroders, told IFR.
“These impending losses will destroy GE’s balance sheet and debt ratios,” Markopolos writes in the report.
“Unfortunately, GE has almost no cash … so the odds of them being able to fund US$18.5bn in new cash reserves is doubtful.”
In the statement, GE specifically denied the allegations made against its insurance business.
“We believe that our current reserves are well-supported for our portfolio characteristics, and we undertake rigorous reserve adequacy testing every year,” the company stated.
Carol Levenson, director of research at Gimme Credit, took issue with a number of the report’s assertions, including Markopolos’ claims about exaggerated cash flow numbers at GE, she told IFR.
“It is pretty hard to fake cash and cash flow,” she said.
Nevertheless, Levenson said concerns about the insurance business under the GE Capital umbrella are warranted.
Earlier this year, GE announced a US$6.2bn fourth quarter charge and another US$15bn contribution to GE Capital’s insurance portfolio reserves over the next seven years.
“Needing to pour more cash into GE Capital would be a real issue, although hardly a surprise,” Levenson said.
“I would not be at all surprised if GE Capital turns out to require more cash from the parent at some point, especially regarding the insurance business.”
Falling yields on fixed-income securities across the globe are also expected to impact GE’s insurance business for long-term care.
Even so, said Knutson, GE continues to be a large diversified company with a lot of levers to pull, which affords them time to correct the ship.
“Time heals a lot of mistakes and insurance companies and banks and other entities in the finance field use time to their advantage,” he said.
“The report makes an assumption that all of these things happen all together at once and there is no time to mitigate it, and that’s not how it works.”