Does GE Capital Deserve That AAA?

No question, GE Capital Corp., the financial arm of General Electric Co. (GE ), is a global market powerhouse. Its assets alone make it the fourth-largest U.S. financier, just behind Bank of America (BAC ). It operates a mixture of consumer and commercial finance, insurance, and leasing businesses around the world.

But GE Capital has a privilege granted to few financial companies: It enjoys a AAA credit rating from Standard & Poor's (or an Aaa from Moody's), thanks to its diversified, industrial parent, which guarantees its debts. GE Chief Executive Jeffrey R. Immelt has often said few things are more important to GE than maintaining its top-graded debt--both for GE itself and the finance unit.

It's easy to see why. Keeping GE Capital's AAA rating is essential for GE, which gets 40% of its earnings from the unit. A high grade keeps borrowing costs down. With a AA rating, interest on its long-term debt alone would annually be between $100 million and $200 million more. And almost all of GE's debt is lodged in GE Capital.

GE means business when it says it is determined to maintain GE Capital's AAA rating. Its commitments are spelled out in the company's 10-K for 2001. For example, if GE Capital's earnings fall below 110% of the unit's "fixed charges"--defined as interest costs plus a portion of rental expenses--GE has to put enough cash in to bring the ratio back up to 110%. If GE Capital's debt-to-equity ratio rises above 8 to 1, the parent company also has to add cash. As of yearend, earnings at GE Capital were 170% of fixed charges. But the unit's debt-to-equity ratio was over 7.3 to 1--on the high end for most finance companies.

Moreover, GE Capital has more than $43 billion in securitized loans, including credit-card debt, commercial mortgages, and equipment financing held in special-purpose entities (SPEs) off the company's balance sheet. These SPEs, which currently share GE's rating, have triggers that require GE Capital to put up collateral or buy them back if, for example, a surge in defaults forced a downgrade. If the SPEs' ratings were to fall below AA-, GE Capital would have to provide "substitute credit" of $14.5 billion, although J.P. Morgan Chase & Co. analyst Joseph McCusker says this possibility is remote.

But how might GE Capital stack up if it were independent? "On a pure standalone basis, GE Capital Corp. would be rated lower than the current Aaa level," says Robert Young, an analyst at Moody's Investors Service. How much lower? A comparison with Citigroup (C ), which analysts say is its closest peer, suggests it would take quite a hit. Citi has similarly global reach and is highly acquisitive, though much of its earnings come from volatile investment banking. Like GE Capital, it has a history of steady earnings growth.

Moreover, on many measures, Citigroup is a better performer. The bank's return on assets is 1.43% vs. GE Capital's 1.36%. Citi is also less leveraged: its debt-to-capital ratio is about 82%, vs. 88% for GE Capital. And as a retail bank, Citi has a cheap, secure source of funding: $57 billion in deposits. "[What] stands out is the size of its income, its strength, and its strong business lines," says Moody's analyst Peter Nerby.

All that earns Citigroup an Aa rating--the highest rating of any U.S. bank, although below GE Capital's Aaa. That difference costs Citi about $400 million a year more in interest on its long-term debt. In finance, as in life, it sure helps to have rich relations.

By Heather Timmons in New York, with Diane Brady

— With assistance by Diane Brady

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