General Electric, Aig And The Cleansing Effects Of Crisis


Could there be any possible upside to global recession and market declines to rival the Great Depression’ Believe it or not, the answer is yes... General Electric gives answer as to why.


 
Though it seems hard to believe at times, there are positive aspects to a crisis. Just as nature renews itself through a cycle of death and rebirth, markets have to renew themselves too.

A classic example of renewal in nature is the routine forest fire. Over time, brush and debris build up on the forest floor. Meanwhile, old growth trees dominate the landscape. When fire comes, the brush and debris burn up like a fuel ‘ as do the trees that have weakened or died over the years.

Then, after the fire burns itself out, the forest begins the cycle anew. The debris and dead wood of the past cycle have been naturally cleared, making room for new growth. The forest grows back in a healthier state than before.
 
Those of us in the western U.S. are painfully aware of how man has botched this natural cycle. Through a constant pattern of suppressing small fires, hapless forest managers created the conditions in which BIG fires occur.

When debris and dead wood are burned out every few years ‘ as happens with nature’s way ‘ the fuel build-up never reaches catastrophic levels. But when a forest area is allowed to accumulate layer after layer of dry fuel, turned into a tinderbox through many years of overzealous fire suppression, a single spark can touch off an inferno.

At a cost of untold billions in rampant fire destruction, forest managers seem to have learned the hard lessons. But the movers and shakers of global monetary policy have not. Refusing to allow for a downturn ‘ suppressing it at all costs with easy money ‘ is the economic equivalent of overzealous fire suppression. Let the ‘debris’ of bad behavior, bad ideas and bull market hubris build up for too long, and what you get is a tinderbox.

Through poor stewardship of resources, a constant feeding of dry tinder and an utter disregard for risk, we created the conditions that now feed this inferno. Not just one man did this, but many men... Alan Greenspan not least among them, plus a virtual conga line of successors and enablers that followed.

Fire Still Works

So the bad news is, we’ve got our inferno. The fires are raging now. What else can you call it when the S&P is down more than 60% (!) from inflation-adjusted highs and the World Bank predicts a shrinking of the global economy this year for the first time since World War II.

The good news is that fire still works as a cleansing element.
 

A number of gross excesses, bad ideas and flat-out rotten Wall Street practices, born of a long and cushy bull market run, are turning to ash now, hopefully never to return. This is the good that comes of all this pain. So when you look around and wonder whether the incredible wealth destruction was worth it, for the most part the answer is ‘no’ ‘ no one really needed this. But in at least some respects the answer is yes.

That old market stalwart, General Electric (GE:NYSE), is a clear example of the cleansing process at work.

In keeping with our fire analogy, GE has been burnt to a cinder. The mighty colossus that once went head to head with Exxon (XOM:NYSE) for the title of ‘world’s largest company’ now sports a market cap on par with Apple Computer .’

As a business, General Electric has a bit of a split personality. One side builds things, invents things and repairs things. The other side engages in mysterious acts of financial engineering. The troubles now are not to be found in the jet engine or light bulb side of the business. They are in GE Capital , the mysterious financial entity with disclosures so complex that analysts never truly understood it from day one.

Much as a magician pulls a rabbit out of a hat, for many years GE Capital was the black box from which the company pulled out perfectly managed earnings. Quarter after quarter, General Electric would beat estimates by a penny or two ‘ just like clockwork.

Jack Welch, the current CEO’s legendary predecessor, pulled off this smoothing trick by moving things around on the GE Capital side with an eye for gaming the quarter. Assets would be sold or shuffled around to get the numbers just right.

Now that the world has met Bernie Madoff we’re all a little more distrustful of perfectly smooth trends. But back in the halcyon days of the late 20th century bull market, managed earnings were seen as a good thing, not a bad thing.

The Wall Street analysts covering GE may not have been geniuses, but they certainly weren’t idiots. They knew there was a fair amount of hocus-pocus going on... and they knew GE Capital’s disclosures were too complex to be reasonably understood. But Wall Street loved the reliability of that penny or two beat, quarter after quarter, which is why Jack Welch did it. And he was feted as a hero for it.

Some Habits Just Have to Die

Let’s not put any gloss on it: The whole concept of ‘managed earnings’ is dumb.

In the real world, things move around. Earnings go up and earnings go down. Apart from businesses that rely exclusively on locked-in contracts with minimal fluctuation in labor costs and material inputs, hardly any business makes the same amount of profit every single quarter. The idea that a company could hit its estimated target bang on the nose every single quarter, without fail, is silly too. The real world is unpredictable. The real world is lumpy.

But investors like preternatural stability ‘ or at least they thought they did, pre-Madoff ‘ and so they happily accepted the managed earnings process that Welch pioneered. They smiled and nodded and happily ignored the fact that fully half of General Electric’s earnings came from a strangely high-handed entity (GE Capital) that no analyst understood.

These are the kind of bad habits and bull market indulgences we can say goodbye to as a result of the current crisis.
 
Old habits die hard ‘ sometimes too hard ‘ and it can often take a massive, wrenching dislocation to remove them. (Some refer to this as ‘the moment of forced awareness.’ One bumper sticker I like reads, ‘Avoid painful forced awareness: accept reality now.

Now that General Electric has been laid low and forced to ponder the very real risk of its own demise, it is unlikely that the bad old ways of GE Capital will return. And now that investors have taken a collective frying pan to the face as payback for their artificial smoothness addiction, it is unlikely that black boxes will be playing a large role in the post-crisis markets to come.

Reason to Take Hope

All in all, the humbling of General Electric gives us reason to take hope. As mentioned, the jet engine and light bulb side of the business ‘ the bringing good things to life side ‘ will probably survive, and perhaps down the road even thrive once again.

And so when the question arises, ‘What good has come of this crisis,’ we can at least point out that the likes of managed earnings, black boxes, and off-balance-sheet shenanigans are set to go the way of the dodo. The absence of such things will make for a sounder economy and a better investing future.

And we can further point out that, as stubborn and foolish as investors can be on a collective basis, if you hit them hard enough over the head they can still learn something. In rooting out and burning up the entrenched bad habits of yesteryear, the odds are improved for a better tomorrow.
 
This represents the ‘silver lining’ side of things. Next we’ll take a closer look at the AIG mess and plunge into the dark cloud.


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