Summary
- General Electric built it's reputation under Jack Welch as one of the leaders in financial engineering, producing outstanding financial results quarter after quarter after quarter.
- Now, this performance is coming under criticism and well-known whistle-blower, Harry Markopolos fo Bernie Madoff fame, has accused GE of "engaging in accounting fraud."
- Seems the basic problem is one concerning the assumptions made in insurance contracts, a problem faced by many organizations in this age when people are living longer-than ever.
Earlier, I have written about General Electric Co. (NYSE: GE) and its use of financial engineering.
I wrote that "the latter part of the 20th century was the age of financialization, a subject that I have written about many times and a subject that I am currently writing a book about. It was an age when focus was transferred from valuing cash flows attained from production and output to the value of assets and financial instruments."
"It was an age where a conglomerate like GE could diversify to the extent that for several years running its financial subsidiaries produced well more than 50 percent of the total profits earned at GE."
"It was an age when a company could become very opaque about its internal financial dealings, yet continue to produce almost constant increases in earnings and a steady return on stockholders' equity."
And, it was this latter attribute of financial engineering that has drawn a lot of negative commentary over the years. The question always was, "how could these companies practicing financial engineering turn in such a constant increase in earnings?"
Well, the question has risen again, this time in the hands of Harry Markopolos, an accounting expert, whose bio contains the fact that he was the one that raised the red flags about the Ponzi scheme created by Bernard Madoff.
Mr. Markopolos has now accused General Electric of misusing its accounting efforts "to mask its financial problems by filing inaccurate or fraudulent information with regulators.
Last Thursday, Mr. Markopolos accused GE "of engaging in accounting fraud worth $38 billion, saying the company is hiding massive losses and heading for bankruptcy."
Note that it is reported that Mr. Markopolos "first became suspicious of GE's accounting when he attended industry luncheons where portfolio managers and analysts said they didn't believe GE's numbers could be true because they met or beat earnings estimates every quarter, year after year."
One point of contention is that GE has miscalculated the cost of caring for people who lived longer than expected. This is an annuity problem…it deals with how do you account for life-time contracts when the most crucial issue in determining the reserves is the expected life of those seeking the contract.
Mr. Markopolos claimed that "the $15 billion hit GE took two years ago when it miscalculated the cost of caring for people who lived longer than expected was "a nasty market surprise and it's about to get $29 billion worse."
He said GE should have taken action to boost its reserves years earlier to cover its unfunded long-term care liability, but instead waited until a new management team was in place.
Other experts step up to defend GE. For example, GE is said to be not alone "in underestimating the reserves needed to cover long-term liabilities. Private companies and public pension funds alike have struggled to keep up with the growing cost of providing health care to an aging population that's living longer than expected."
I have just completed a two-year study of Continuing Care Retirement Communities (CCRC) and let me tell you that one of the results of the study was that no two CCRs' had the same business model. The reason this conclusion was reached was that each community was using different assumptions about the aging population and consequently their annuity conclusions came out different. Hence, they produced different business models to reflect the different assumptions used in their modeling.
