General Electric: The Next Enron?

In My Humble Opinion
1

Yesterday, forensic accountant and investor Harry Markopolis dropped a bombshell report which argues over the course of 170 pages that accounting fraud at General Electric is larger in scale than we saw with Enron, that the company is effectively out of operating capital, and will be unable to meet a $13 billion insurance reserve requirement in Q1 2021.

Direct link to the PDF report. Has summary, than a powerpoint slide deck.

Caveats: Reports similar to this are released all the time. It’s not an uncommon tactic of short-sellers to spin rumors and arguments so that the price of companies they have shorted go down, and many times corporations will make the argument that this information is released precisely to make the stock go down. And, the report discloses that it was written by an unnamed hedge fund, so Markopolos and his team aren’t doing this out of the goodness of their hearts. And, yes, the share price of GE has gone down. But it’s been going down for years (check the 5-year trend).

Caveat to the caveat: However, (1), Harry Markopolos is the guy who discovered the Madoff fraud… in 2002, 6 years prior to Madoff going down (the SEC ignored his repeated requests for investigation), (2) he specializes in insurance fraud and has not been wrong since the Madoff call, and (3) if the bad news isn’t there to begin with, the shorts couldn’t report it, pp&s.

All right, let’s get down to what this report says… and if GE collapses, this can be the discussion thread as well.

My guess: Markopolos is right. And we may not know for another year or so. But… I think not.

One last thing: There are two sides to this report - the insurance stuff and the Baker Hughes acquisition stuff. I’m much stronger on the insurance stuff, so if someone wants to step up on the M&A part of the report, that would be greatly appreciated.

Going to finish this off with some quotes from the summary, then respond with my view about the insurance side of it.

*Quick explanation: “Long-Term Care” is an insurance policy which pays you (and providers) for out-of-hospital assisted living expenses when you have lost the ability to perform 2 (of 7) regular daily activities (going to the toilet, feeding yourself, washing yourself, etc), which occur as you get older.

The argument is effectively this:

  1. GE needs to reserve $29 billion cash against future projected insurance claims as per regulations. They will be required to take a $10 billion hit in Q1 2021, but are still $18 billion short.
  2. GE also has hidden a $9.5 billion loss on its Baker-Hughes acquisition, which will need to be realized.
  3. When these losses/reserves hit the balance sheet, GE’s debt-to-equity ratio shoots up from $3 of debt to $1 of equity, to $17 of debt for every $1 of equity.
  4. When this hits, many covenants in currently unknown contracts will have heretofore unfathomable calls - “GE’s in financial trouble, therefore according to page 42 of our agreement under the debt-to-equity provisions, we have the right to our money back. Pay by 5pm as per page 43. And I’m sorry to do this, but I’m responsible to my shareholders. It’s how the game is played.” Multiply this X an unknown number and you have AIG, Lehman, Enron, etc.

Anyway, for us money and financial nerds, this is very fascinating and worrisome. And, from the insurance side, it’s completely expected. More on that later.

2

(Much of the report is in powerpoint slides, so many references will be to the PDF page number without a direct quote - sorry, but that’s the breaks of this text-only format.)

Again: http://fm.cnbc.com/applications/cnbc.com/resources/editorialfiles/2019/8/15/2019_08_15_GE_Whistleblower_Report.pdf

When I worked at MassMutual, one of their big products was Long-Term Care insurance (LTC or LTCI), which helps support the insured as they grow increasingly dependent as they age - these contracts pay for home health services, cleaning people, modifications to the home, etc, once you lose the ability to perform 2 of 7 defined life activities (feeding yourself, washing yourself, going to the bathroom, etc). It was an… OK… insurance product back in 2016, but the people who were there for a while would talk about the crazy LTC products that MassMutual sold back in the 1990s - 2007 or so, which if you were lucky enough to buy one, you were in great retirement shape.

These early vintage policies were:

  1. Guaranteed Issue. In other words, if you were willing to pay the premium, you could get it regardless of health.
  2. Flat premium. Premiums can’t go up unless certain covenants were met… and many contracts were just flat premiums, period.
  3. No lifetime maximum benefits. Live to 106, incur $2 million of LTC expenses? Well, congrats on buying a LTC policy in 2002 for you just paid $24,000 and got $2 million back.
  4. New, so there was very little actuarial or financial data to support the premiums.
  5. Because of 4, above, many policies were sold with the assumption that interest rates would continue to be at 3, 4, 5, 6% for all time, helping buttress any potential lack of premium. What’s the rate today?

So… think for a second about an insurance policy. Most insurance policies are specified event policies - die, your survivors get paid. Wreck your car, it gets paid. Tree falls on your roof, it gets paid. Have surgery, it gets paid. Even cancer… it may last for years, but once it’s done, it’s done. It gets paid.

But think about a LTC policy… it just pays and pays and pays and pays, for once you lose 2 of your 7 daily activities, you almost never get them back, and losing these daily activities… well, losing those activities really don’t do anything to shorten your life. And… even worse from a financial perspective, the use of the LTC prolongs the life of the insured, incurring even more cost upon the carrier, cost which thereby increases the lifespan of the insured… until the guy finally dies because he’s beyond the care provided to him by the LTC policy.

…

Then you have what’s known as the reinsurance market. The reinsurance market is vast and largely unknown to the general public (sort of like, say, derivative markets), and what it does is buy insurance contracts from producing carriers (like, say, AFLAC or Humana or State Farm or MassMutual - people with agents on the street) at discounted rates, allowing them (the reinsurer) to collect the premiums… and pay the claims.

You, the insurer, (MassMutual) want to offload your bad (high claims) contracts and keep your good (few claims) contracts.
You, the reinsurer (GE, which is why you probably didn’t even know was in insurance), wants to buy MassMutual’s good contracts and stick MM with the bad contracts.

So, for an example of a reinsurance deal, look at page 50 (PDF), 44 (slide deck), then for further detail go to 158/152. MassMutual (MM) sold these early vintage LTC contracts to our friends at GE, and check out the 2018 numbers (and the trends):

MM had a projected LTC $244 million premiums and $85 million in claims for 2018. They struck a reinsurance deal with GE which led to this result:

MM: $160m in premiums, $2m in claims, $158m net.
GE: $83m in premiums, $83m in claims, $0 net!

… and given, as stated above, the nature of these contracts (and the reinsurance market), the premiums GE is being paid will not go up, but the claims they are paying are guaranteed to increase, unless there is a massive mortality event striking all MM LTC reinsureds, which would be, easily, the biggest news of the year were it to happen (we’re talking 25,000 contracts, iirc). And that’s just on this one agreement with MassMutual.

(sidebar: This is horrible. But I’m still laughing as this is all so familiar. Remember the AOL-Time Warner merger? Everybody said it was a bad deal, and it was! It cost TW $99 billion+ in writeoffs!

But… you know what? It wasn’t such a bad deal for AOL shareholders, was it? You had an inflated share of literally nothing and you traded it in for Time Magazine and CNN and a bunch of other high-brand, cash-flow generating properties with proper accounting practices. Not too shabby, eh? Might have destroyed TW’s market value, but them’s the breaks. /sidebar)

In a nutshell, this is part of what’s happening with GE - they, like AIG, made massive insurance bets that are completely blowing up in their faces and, in time, will destroy the company unless addressed… and Markopolos is arguing that it’s already too late.

3

On the other hand GE has several strong businesses.

4

Possibly true. But they aren’t spinning off the $38 billion of cash to fund these liabilities, which is the entire point. And the size of the liabilities are unknown, due to the nature of the contracts which they agreed to honor - that $38 billion is the floor, as in, it’s what’s required by law and financial reporting today. (Well, $10 billion can be put off to Q1 2021, but still. :rolleyes: )

As people continue to use these lifetime benefit contracts to prolong their lives at GE’s expense, as well as new claimants coming on every day, GE’s liabilities in this sector will only rise.

It’s the same damned thing (well, almost) as what happened to AIG’s Financial Products unit - they reinsured products with low premiums, insane projections, and an near-unlimited downside… and it cost us $189 billion to fix.

5

I thought in recent years they’d sold or spun off everything except for power turbines, wind turbines and aircraft engines.

6

If, at the start of the Subprime Mortgage Crisis, President Bush had said that the Federal government would cover the difference in the impact that the interest rate change had made, the total cost would have been about $39 billion.

As it ended up, Bush set aside $300 billion and then Obama passed a second bill to push $787 billion into the economy.

The key point is this one, in JohnT’s initial post:

Depending on how quickly people act, and how much the people that GE owes money to trust the effectiveness and honesty of those actions, the issue can almost certainly be resolved with minimal effect.

A slow and/or dishonest response could cause the issue to snowball and take everything out, leaving everyone at a loss for far more than if the issue had simply been fixed early and honestly.

7

Effectively, to use an analogy, there’s a strong chance of a panic at the Bank of GE, with people demanding their money, which will kill GE.

8

It would be sad if the company closes, given its long history (although it’s already a shadow of its former self).

9

The shade of Nikola Tesla chuckles: “Finally!”

10

I am reminded of this thread: Epic takedown of Herbalife as a pyramid scheme scam

Not that there’s any direct connection between the two cases, and Markopolis could well be successful where Ackman disastrously failed. The real point is that people who are motivated to profit from short selling can sometimes put together presentations intended to bring down their target which are much more impressive to the lay mind than to the professionals whose money is on the line. So it’s a mistake for someone who is not themselves a true expert in these fields to put too much stock in the impressiveness of the initial presentation.

I myself would not invest in GE (it has major issues even absent Markopolis’ concerns) but I wouldn’t short it either. But anyone who accepts Markopolis’ thesis can make some serious money via shorts or put options, since he believes it will go bankrupt.

11

Wasn’t Tesla allied with George Westinghouse in that rivalry? Because as a company, Westinghouse is long gone. At one time, though (and not that long ago), it was roughly the same size as General Electric, and in many of the same businesses (power systems, appliances, light bulbs, etc). And BTW, a few months ago I saw a trailer for a movie called The Current Wars about the rivalry. I think it’s supposed to be released shortly.

12

General Electric started going downhill with Jack Welch, the biggest evangelist of the quarterly returns must be higher every time idea that has brought so many other companies since to grief. Now it’s GE’s turn, and it’s a shame.

13

Goldman says that GE’s reserves are on par with that of other insurance companies.

Posted for information’s sake - I don’t know about this stuff enough to have an opinon.

14

After acrimoniously parting ways with Edison, a notorious credit-stealer.

Not all deals are complete, but yes. Power is weak, in a rapidly sunsetting industry, and has had mass layoffs. The Renewables business is solid but not that big. Only Aviation (which is now a lot more than just engines) is strong, but on its own it would be, let’s say, an affordable acquisition.

The age of the conglomerate seems to be over in general, and this is just a prominent example.

15

There is nothing sad about watching companies that deserve to crumble die!

16

As an aside, what Harry Markopolis (and others) are doing is a consistent way to beat the market. Conventional wisdom is, of course, that you can’t beat the market because the market moves unpredictably and prices in all the information you have access to.

But in Markopolis’s case, he is able to create the market movements. (and is obviously sitting with a huge investment set to benefit from the movement). And it isn’t legally insider trading, but the benefit is the same - access to information before the market does.

Part of this game though is he has to be credible every time but the last time. The moment Markopolis does an expose on a company that is not in financial straits will be the last time he can make money from this.

If I day traded I’d be shorting GE right now, though of course the most favorable options are all bought up.

17

Can you explain more of the business reasons why this is true? What has changed?

I take it that Apple, Google, Microsoft, or Shell/BP/Exxon aren’t conglomerates because while they have a huge number of products, they are all closely related businesses?

18

Bizarre, this wanting 280,000 people to lose their jobs. Why does GE “deserve to crumble”?

19

Because it’s inefficient as a business. Corrupt as well if this expose is correct.

With today’s employment market, this means that other companies can in turn fill 28,000 of the estimated 1.6 million open positions.

The people who won’t do so well are going to be older employees who’s primary skills are highly specific to GE.

20

GE might be dying; I don’t know about that. But it’s certainly not the next Enron. GE has actual products that they sell to make money. Enron was never anything but just smoke and mirrors.