GE: Does General Electric need to put aside more cash to handle bad loans at its finance arm? GE says it doesn’t – it even insists it has higher loan loss reserves than the biggest US banks. But investors aren’t fully convinced. And a look at just one small slice of GE Capital’s $650 billion of assets suggests why they are right to be sceptical.

The company’s reserves against losses in its $38 billion of leveraged loans are around 1.2 percent of its book. GE estimates these losses will probably peak next year at around 1.9 percent or slightly less. But this prediction, which would imply GE Capital just needs to set aside another $266 million or so, seems too low when judged against the market.

The average leveraged loan currently trades around 81 cents on the dollar, according to S&P Leveraged Commentary and Data. If marked to market, GE’s debt portfolio might trade close to that level too, based on the distribution of credit ratings on those loans.

While some of the 19 cents on the dollar discount the market now attaches to the average leveraged loan may be a function of illiquidity, a large chunk is the market’s way of suggesting defaults will be far greater, overall, than the 1.9 percent that GE is banking on.

Now, it’s true that GE’s portfolio may be of higher quality than the broader market. If the firm’s boasts about its superior credit management skills are to be believed, it probably has fewer dud loans. The company also claims it is “willing to work longer and harder to recover full value” - even if rivals like Goldman Sachs or JPMorgan aren’t widely known for letting borrowers off the hook easily.

So assume for the sake of argument that GE’s leveraged loans have only lost half as much of their value as the average. That still would suggest potential losses of some $3.6 billion – or eight times its current reserves. That may not seem like a big deal. After accounting for reserves already taken, it would amount to just 5 percent of the finance arm’s total shareholders’ equity. But if investors apply similar arithmetic to the other $600 billion-odd of assets on GE’s books the losses would clearly start to add up.

GE may prove naysayers – and the market – wrong by riding out the downturn and the credit cycle, and getting most of its borrowers to make good on their commitments. But with one small, but important, piece of the puzzle already looking wonky, shareholders can be forgiven their wariness for now.

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GE Capital’s investor meeting took place on July 28. The company predicts losses on leveraged loans should peak in 2010. Under the company’s base case, 1.9 percent will be lost out of a $38 billion portfolio. Under GE’s adverse case scenario, the figure is 2.8 percent. Unlike an investment bank, GE Capital is not required to mark its portfolio to market.

The S&P/LSTA leveraged loan 100 index currently trades at 81 cents on the dollar.

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