GM's subprime woes

Automaker's mortgage operation, ResCap, could weigh down GMAC for the rest of the year.

By Katie Benner, Fortune reporter

(Fortune Magazine) -- In 2006 General Motors appeared to be back from the dead, thanks in part to selling 51% of its best-performing division--GMAC--to buyout firm Cerberus Capital Management. But instead of printing money, the finance company is now minting worries because of its mortgage operation Residential Capital (ResCap), a lender whose subprime mortgages make up a fifth of its revenues.

At GMAC's investor conference last month, CEO Eric Feldstein assured attendees that subprime lending is being slashed, but he also acknowledged that ResCap could weigh down all of GMAC for the rest of the year. This admission marked a major shift from 2005, when ResCap accounted for nearly half of GMAC's net income.

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But like other subprime lenders, ResCap saw its 2006 earnings plummet--falling more than $800 million, to $182 million. The company posted a fourth-quarter loss of $651 million, compared with earnings of $118 million the year before.

That is bad news for GM (Charts, Fortune 500) because the automaker was counting on a percentage of GMAC's earnings to help fuel a turnaround, but it is worse news for Cerberus. As GMAC's chief financial officer, Sanjiv Khattri, told investors, "Cerberus has bet its franchise on [GMAC's] success"--and that success depends largely on better credit ratings for GMAC (and ResCap) corporate bonds.

Currently, GMAC's junk rating forces it to pay bond buyers higher interest rates to reward them for the additional risk of backing the company rather than, say, the AAA-rated Toyota. Not having investment-grade bonds also hurts GMAC because it limits the number of institutional investors allowed by their charters to hold GMAC debt. The finance company had little hope of a rating upgrade until Cerberus entered the picture last November.

In GMAC, Cerberus nabbed what was essentially a retail bank with ties to booming worldwide auto sales for $7.4 billion in cash. The price tag made the GMAC purchase seem like a smart yet nervy move for the private-equity firm--compared to Capital One's $14.5 billion buyout of North Fork bank. One key difference: Capital One bonds were recently upgraded, in part because North Fork had almost no exposure to the subprime debacle.

In contrast, GMAC ratings are frozen and ResCap ratings have a negative outlook, meaning they could be downgraded to junk.

A ResCap downgrade would put further pressure on GMAC. It could also force Cerberus to sell the wounded unit, though it is essential to the company's diversified platform, or Cerberus (and GMAC) could continue to cover ResCap's operating costs until the company's credit outlook improves.

In Cerberus's defense, "no one when they entered into the deal would have known where nonprime loans would be today," says Brad Rubin, an automotive trading specialist at BNP Paribas. And it's not as if the $23.5 billion private-equity firm didn't vet the deal.

"The GMAC deal went through a stringent diligence process, the most intense I've ever seen," says Tim Price, the senior operations manager of Cerberus. He says that more than 85 of the roughly 275 Cerberus employees pored over GMAC's books, and that "watching the number of people we had looking at the deal was like watching honeybees on a flower."

In addition to supporting GMAC management as it scrambles to stanch the subprime red ink, Cerberus must win over the credit analysts before they smile on GMAC's bonds. Moody's and Standard & Poor's say the near-term outlook is good for GMAC because Cerberus is determined to make the deal work. The long-term outlook is anybody's guess. But while operating agreements tie GMAC to GM for the next decade, analysts note that Cerberus can sell its stake in GMAC after five years.

"It's not known what will happen after five years, and we have to consider that uncertainty," says S&P's Scott Sprinzen.

Cerberus must also prove that there are no conflicts with GM over GMAC's plan to provide auto loans to other automakers--possibly Subaru or Hyundai. Cerberus's Price is confident that ResCap can be rehabilitated and says that his firm is in GMAC for the long haul.

For now the Cerberus acquisition of GMAC seems an isolated example of macroeconomic events overtaking a deal cut during last year's M&A binge. But if borrowing costs go up across the board, as many economists expect, Cerberus could find itself with plenty of company.  Top of page