Derivatives and hedging
We conduct our business activities in diverse markets around the world, including countries where obtaining local funding may not be efficient. The nature of our activities exposes us to risks of changes in interest rates, currency exchange rates and commodity prices. We manage these risks using a variety of straightforward techniques, including issuing debt funding that matches the interest rate nature and currency denomination of the related asset. In addition, we selectively use derivatives to reduce our exposure to interest rate and currency risk. For example, if we make a fixed rate loan and fund that loan with variable rate debt, we will enter into an interest rate swap
to pay a fixed rate of interest and receive a variable rate of interest, and designate the swap as a hedge of the variable rate borrowing. We apply strict policies to manage each of these risks, including prohibitions on derivatives trading, derivatives market-making or other speculative activities.
To qualify for hedge accounting, details of the hedging relationship must be formally documented at inception of the arrangement, including the risk management objective, hedging strategy, hedged item, specific risks that are to be hedged, the derivative instrument and how effectiveness is being assessed. The derivative must be highly effective in offsetting either changes in fair value or cash flows, as appropriate, for the risk being hedged. Effectiveness is assessed at the inception of the relationship. If specified criteria for the assumption of effectiveness are not met at hedge inception, effectiveness is assessed quarterly on a retrospective and prospective basis. Ineffectiveness is also measured quarterly, with the results recognized in earnings.
For derivatives that are not exchange-traded instruments, we use internal valuation models that incorporate market-based information. With the exception of foreign currency forwards and commodity derivatives, we also obtain valuations from our derivative counterparties to validate the valuations produced by our own models and to value a limited number of products that our internal models do not cover.
Cash flow hedges
Our cash flow hedging arrangements use simple derivatives to offset the variability of expected future cash flows. We use interest rate and currency swaps to convert variable rate borrowings to match the nature of the assets we acquire. We use currency forwards and options to manage exposures to changes in currency exchange rates associated with commercial purchase and sale transactions, including commodities. These instruments permit us to reduce the cash flow variability, in local currency, of costs or selling prices denominated in currencies other than the functional currency. For derivatives designated as cash flow hedges, we record changes in fair value in a separate component of equity to the extent effective, then release those changes to earnings contemporaneously with the earnings effects of the hedged items. If the hedge relationship is terminated, then the change
in fair value of the derivative recorded in equity is recognized contemporaneously with the earnings effects of the hedged item, consistent with the original hedge strategy.
At December 31, 2005, amounts related to derivatives qualifying as cash flow hedges amounted to a reduction of equity of $822 million, of which we expect to transfer $151 million to earnings in 2006 along with the earnings effects of the related forecasted transactions. At December 31, 2005, the amount of unrecognized losses related to cash flow hedges of short-term borrowings was $1,019 million. At that date, the maximum term of derivative instruments that hedge forecasted transactions, other than interest rate swaps designated as hedges of commercial paper (discussed in note 18), was 27 years and related to hedges of anticipated bond purchases. Funding for those purchases is provided by contractual premiums on insurance policies of similar duration.
Fair value hedges
Fair value hedges are hedges that reduce the risk of changes in the fair values of assets, liabilities and certain types of firm commitments. We use interest rate swaps, currency swaps and interest rate and currency forwards to hedge the effects of interest rate and currency exchange rate changes on local and nonfunctional currency denominated fixed-rate borrowings and certain types of fixed-rate assets. We record changes in fair value of a derivative designated and effective as a fair value hedge in earnings, offset by corresponding changes in the fair value of the hedged item.
Fair value adjustments decreased the carrying amount of debt outstanding at December 31, 2005, by $114 million.
Net investment hedges
Net investment hedges consist of currency forwards and currency swaps that reduce our exposure to changes in currency exchange rates on our investments in non-U.S. financial services subsidiaries. For qualifying net investment hedges, changes in the intrinsic value of the derivative are recorded in equity. Amounts excluded from the measure of effectiveness of net investment hedges are recognized in earnings in the period in which they arise. Derivative gains included in equity amounted to $977 million and $867 million at December 31, 2005 and 2004, respectively.
Derivatives not designated as hedges
We must meet specific criteria in order to apply any of the three forms of hedge accounting discussed above. For example, hedge accounting is not permitted for hedged items that are marked to market through earnings. However, we use derivatives to hedge exposures when it makes economic sense to do so, including circumstances in which the hedging relationship does not qualify for hedge accounting, as described in the following paragraph. Derivatives that do not qualify for hedge accounting are marked to market through earnings.
We use swaps, futures and option contracts, including caps, floors and collars, as economic hedges of changes in interest rates, currency exchange rates and equity prices on certain types of assets and liabilities. We sometimes use credit default swaps to hedge the credit risk of various counterparties with which we have entered into loan or leasing arrangements. We occasionally obtain equity warrants as part of sourcing or financing transactions. Although these instruments are considered to be derivatives, their economic risks are similar to, and managed on the same basis as, risks of other equity instruments we hold.
Earnings effects of derivatives
In the context of hedging relationships, “effectiveness” refers to the degree to which fair value changes in the hedging instrument offset the corresponding expected earnings effects of the hedged item. At December 31, 2005, approximately 35 percent of our total interest rate swaps were exempt from ongoing tests of their effectiveness as hedges. For derivatives designated and qualifying as hedges but not qualifying for the assumption of effectiveness, we use a variety of techniques to assess effectiveness and measure ineffectiveness, including cumulative dollar offset and regression analysis, depending on which method was selected at inception of the respective hedge. Certain elements of hedge positions may be excluded from the measure of effectiveness, for example, changes in the value of purchased options attributable to volatility and passage of time.
The following table provides additional information about the earnings effects of derivatives.
Pre-tax gains (losses)
| December 31 (In millions) | 2005 | 2004 | 2003 | ||||||
|---|---|---|---|---|---|---|---|---|---|
| Cash flow hedges | |||||||||
| Ineffectiveness | $ | (31 | ) | $ | 2 | $ | (19 | ) | |
| Amounts excluded from the measure of effectiveness | 17 | 25 | — | ||||||
| Fair value hedges | |||||||||
| Ineffectiveness | 4 | 11 | — | ||||||
| Amounts excluded from the measure of effectiveness | (8 | ) | 3 | — | |||||
For hedge relationships discontinued because the forecasted transaction is not expected to occur by the end of the originally specified period, any related derivative amounts recorded in equity are reclassified to earnings.
In 2005, we recognized an insignificant loss related to hedged forecasted transactions and firm commitments that did not occur by the end of the originally specified period.
In 2004, we recognized a pre-tax loss of $46 million, before cancelation penalties, for terminating a forward euro contract when our customer canceled its hedged, firm order for equipment and services.
Additional information regarding the use of derivatives related to our financing activities is provided in note 18.
Counterparty credit risk
The risk that counterparties to derivative contracts will default and not make payments to us according to the terms of the agreements is counterparty credit risk. We manage counterparty credit risk on an individual counterparty basis, which means that we net exposures on transactions by counterparty where legal right of offset exists and include the value of collateral to determine the amount of exposure to each counterparty. When the net exposure to a counterparty, based on the current market value of transactions, exceeds credit exposure limits (see table below), actions are taken to reduce exposure. Actions can include prohibiting the counterparty from entering into additional transactions, requiring collateral from the counterparty (as described below) and terminating or restructuring transactions.
Swaps are required to be executed under master agreements containing mutual credit downgrade provisions that provide the ability to require assignment or termination in the event either party is downgraded below A3 or A-. To mitigate credit risk, in certain cases we have entered into collateral arrangements that provide us with the right to hold collateral when the current market value of derivative contracts exceeds an exposure threshold. Under these arrangements, we may receive rights to cash or U.S. Treasury or other highly-rated securities to secure our exposure. Such collateral is available to us in the event that a counterparty defaults. We evaluate credit risk exposures and compliance with credit exposure limits net of such collateral.
Fair values of our derivatives assets and liabilities represent the replacement value of existing derivatives at market prices and can change significantly from period to period based on, among other factors, market movements and changes in our positions. At December 31, 2005, our exposure to counterparties, after consideration of netting arrangements and collateral, was $779 million.
Following is GECS policy relating to initial credit rating requirements and to exposure limits to counterparties.
Counterparty credit criteria
| Credit Rating | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| Moody's | S&P | ||||||||
| Foreign exchange forwards and other derivatives less than one year | P-1 | A-1 | |||||||
| All derivatives between one and five years | Aa3 | (a) | AA- | (a) | |||||
| All derivatives greater than five years | Aaa | (a) | AAA | (a) | |||||
| (a) | Counterparties that have an obligation to provide collateral to cover credit exposure in accordance with a credit support agreement must have a minimum A3/A- rating. |
Exposure Limits
| (In millions) | ||||||
|---|---|---|---|---|---|---|
| Minimum rating | Exposure (a) | |||||
| Moody's | S&P | With collateral arrangements |
Without collateral arrangements |
|||
| Aaa | AAA | $100 | $75 | |||
| Aa3 | AA- | 50 | 50 | |||
| A3 | A- | 5 | — | |||
| (a) | For derivatives with maturities less than one year, counterparties are permitted to have unsecured exposure up to $150 million with a minimum rating of A-1/P-1. |
FinanCial inStrumEntS
| 2005 | 2004 | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Assets (liabilities) | Assets (liabilities) | ||||||||||||||||||
| December 31 (In millions) | Notional amount | Carrying amount (net) | Estimated fair value | Notional amount | Carrying amount (net) | Estimated fair value | |||||||||||||
| GE | |||||||||||||||||||
| Assets | |||||||||||||||||||
| Investments and notes receivable (a) |
$ | (b) | $ | 573 | $ | 625 | $ | (b) | $ | 3,465 | $ | 3,545 | |||||||
| Liabilities | |||||||||||||||||||
| Borrowings (c)(d) | (b) | (10,208 | ) | (10,223 | ) | (b) | (11,034 | ) | (11,144 | ) | |||||||||
| Other financial instruments (a) | (b) | — | — | (b) | (758 | ) | (855 | ) | |||||||||||
| GECS | |||||||||||||||||||
| Assets | |||||||||||||||||||
| Loans | (b) | 223,855 | 224,259 | (b) | 216,035 | 217,155 | |||||||||||||
| Other commercial and residential mortgages held for sale | (b) | 6,696 | 6,696 | (b) | 5,143 | 5,113 | |||||||||||||
| Other financial instruments | (b) | 4,138 | 4,494 | (b) | 2,972 | 3,184 | |||||||||||||
| Liabilities | |||||||||||||||||||
| Borrowings (c)(d) | (b) | (362,069 | ) | (369,972 | ) | (b) | (355,501 | ) | (362,851 | ) | |||||||||
| Investment contract benefits | (b) | (9,877 | ) | (9,862 | ) | (b) | (12,539 | ) | (12,520 | ) | |||||||||
| Insurance — credit life (e) | 2,365 | (8 | ) | (8 | ) | 2,210 | (13 | ) | (13 | ) | |||||||||
| (a) | 2004 amounts included financial instruments associated with VUE that were settled in 2005. See note 16 for further information. |
| (b) | These financial instruments do not have notional amounts. |
| (c) | Included effects of interest rate and cross-currency swaps. |
| (d) | See note 18. |
| (e) | Net of reinsurance of $292 million and $105 million at December 31, 2005 and 2004, respectively. |
Assets and liabilities that are reflected in the accompanying financial statements at fair value are not included in the above disclosures; such items include cash and equivalents, investment securities and derivative financial instruments. Other assets and liabilities – those not carried at fair value – are discussed below. Apart from certain of our borrowings and certain marketable securities, few of the instruments discussed below are actively traded and their fair values must often be determined using financial models. There is no assurance that such estimates could actually have been realized at December 31, 2005 or 2004.
A description of how we estimate fair values follows.
Loans
Based on quoted market prices, recent transactions and/or discounted future cash flows, using rates at which similar loans would have been made to similar borrowers.
Borrowings
Based on discounted future cash flows using current market rates which are comparable to market quotes.
Investment contract benefits
Based on expected future cash flows, discounted at currently offered rates for immediate annuity contracts or cash surrender values for single premium deferred annuities.
All other instruments
Based on comparable market transactions, discounted future cash flows, quoted market prices, and/or estimates of the cost to terminate or otherwise settle obligations.
Additional information about certain categories in the table above follows.
Residential mortgages
Residential mortgage products amounting to $12,633 million at December 31, 2005, were either high loan-to-value loans or those permitting interest-only payments. We originate such loans either for our portfolio or for sale in secondary markets. In both cases, higher yields compensate for the increased risk. The portfolio was geographically diverse, with Europe and North America the most significant market segments.
Insurance — credit life
Certain insurance affiliates, primarily in Consumer Finance, issue credit life insurance designed to pay the balance due on a loan if the borrower dies before the loan is repaid. As part of our overall risk management process, we cede to third parties a portion of this associated risk, but are not relieved of our primary obligation to policyholders.
loan CommitmEntS
| Notional amount | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| December 31 (In millions) | 2005 | 2004 | |||||||
| Ordinary course of business lending commitments | |||||||||
| Fixed rate | $ | 4,648 | $ | 2,260 | |||||
| Variable rate | 7,026 | 8,145 | |||||||
| Unused revolving credit lines (a) | |||||||||
| Commercial | |||||||||
| Fixed rate | 779 | 1,210 | |||||||
| Variable rate | 20,779 | 21,411 | |||||||
| Consumer — principally credit cards | |||||||||
| Fixed rate | 170,367 | 141,965 | |||||||
| Variable rate | 281,113 | 200,219 | |||||||
| (a) | Excluded inventory financing arrangements, which may be withdrawn at our option, of $11.4 billion and $8.9 billion as of December 31, 2005 and 2004, respectively. |
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