Cerberus Capital Management may be celebrating its historic acquisition of Chrysler after turmoil in the credit markets delayed the deal, but no champagne is flowing for the
private-equity firm's other landmark purchase in Detroit.
GMAC, the finance arm of
that is 51%-owned by Cerberus, is facing worries in the derivatives markets about bankruptcy at its mortgage-lending unit. The price of credit protection for GMAC's mortgage business, Residential Capital, or ResCap, soared by more than $100,000 a year on Friday, as measured by the credit default swaps market.
"ResCap is trading like it could fail sometime this year," says Justin Monteith, an analyst with KDP Investment Advisors, though he adds that he doesn't expect that to happen.
The credit default swaps market is an immature market, prone to irrational swings as a sudden spike in uncertainty can breed fear among traders. Such fears have spread like wildfire as evidence mounts that credit defaults in the so-called subprime lending market are spilling over into consumers with stronger credit histories, calling into question the reliability of credit ratings on which investors have relied.
Last week, GMAC inspired some confidence with its second-quarter results, despite a 63% year-over-year drop in net income. Excluding a loss of $254 million from ResCap, GMAC's earnings were only down 30%. And though ResCap was in the red, its results marked a vast improvement from the $910 million loss it posted in the first quarter.
GMAC attributed ResCap's latest loss to "severe illiquidity in the nonprime mortgage market." On a conference call with analysts following the release, its chief financial officer, Sanjiv Khattri, sought to assure investors that ResCap's troubles were contained to its subprime business.
James Leda, analyst with Merrill Lynch, said on the call: "In the past, you've said that the losses have been contained to the nonprime portions of the portfolio. Is that still an accurate statement?"
Khattri replied, "Yes, it is. Obviously, even within the prime, though, there is severity issues. So the severity is across the sector. But in frequency, I think that's broadly a fair comment."
ResCap CEO Jim Jones followed up that answer by saying: "I'd say that the one exception attendant to that is probably second mortgages, where we've seen a significant weakening in the second category. I think in that one it's more of a frequency issue. We were already pretty deep on the severity side."
Khattri also said on the call that ResCap will have sufficient liquidity to operate through the current U.S. housing downturn.
"Conditions in the market are quite severe," he said. "If the pressures continue, we expect ResCap's liquidity and capital position to be sufficient to operate through the cycle."
GMAC spokeswoman Gina Proia says the company stands by those comments.
Investors are no longer finding comfort in the notion that lending problems are contained to the subprime market. Already,
( CFC), the biggest independent mortgage lender, has said the troubles have spread to borrowers with more-solid credit records.
American Home Mortgage
( AHM), once the nation's 10th-largest mortgage lender, filed for bankruptcy. Almost none of its $58.9 billion in home loans from 2006 were made to subprime borrowers.
Argus Research analyst Kevin Tynan says brokers at American Home were not checking the credit quality of home buyers when they made loans, and he says the same could be true at ResCap.
"It's probably a lot worse than we've seen in the numbers so far," says Tynan. "The problems we've seen at ResCap are in subprime, but in the days of easy money, I don't think anyone was really checking anything anyway. They weren't doing income checks. They were lending money to anyone who could fill out the form."
The period of record-low interest rates in the early part of this decade spurred a boom in the U.S. housing market that supported consumer spending and economic growth. Now the housing market is slumping, and borrowers who took out loans in the period are having trouble paying their debts.
"It wouldn't surprise me if there was billions in bad auto loans at GMAC too," says Tynan. "You can't tell me that if you walked into a dealer's showroom in the days of easy credit and you were of less-than-good credit quality, they weren't going to sell you a car somehow anyway to get a car off the lot. I'm sure there are a lot of bad loans out there that still haven't been realized."
When Cerberus bought its majority stake in GMAC, ResCap was the only part of the company with investment-grade debt ratings from major credit agencies. GMAC's ratings were previously reduced to junk status, along with the rest of its parent, GM. Cerberus hoped it could restore the finance company's ratings to investment grade in order to lower its borrowing costs and boost its profitability, but that hasn't happened yet.
ResCap continues to enjoy investment grade ratings from Fitch Ratings, Standard & Poor's and Moody's.
"There's a big divergence between those agencies and the market," says Sean Egan, president of Egan-Jones Ratings. "Investors do not trust these ratings right now."
GM already took a $115 million charge in its first quarter on losses tied to ResCap, and it could take more hits from additional troubles. As for Cerberus, the GMAC concerns come just as the firm prepares to overhaul Chrysler, which, like GM and
, has seen sales slide amid competition from foreign competitors.
Having once pledged to keep Chrysler's management team in place, the firm on Monday announced the surprise hiring of Bob Nardelli, the much-criticized former CEO of
, to take the helm at the automaker.
Nardelli said Monday that he approves of restructuring plans that are already underway at Chrysler and that he plans to continue them. Chrysler plans to cut 13,000 jobs and make a $3 billion investment in engine systems designed to improve fuel economy. The company lost more than $1 billion last year as consumers steered clear of its trucks and SUVs amid high gas prices.
The company also hoped to win concessions on labor costs from the United Auto Workers in its ongoing negotiations with the union over a new master labor contract. Chrysler's former CEO, Tom Lasorda, will stay on as the company's president and vice-chairman. With his close ties to the UAW, he will continue to lead the labor negotiations at Chrysler.
Cerberus has made nine other acquisitions in the U.S. auto sector over the last five years, according to research firm Capital IQ. In addition to Chrysler and GMAC, it owns auto-parts makers Tower Automotive and Collins & Aikman.
"After things settle down at Chrysler, Cerberus will probably look to sell off auto brands and other assets that it can get a good price for," says Adam Sussman, analyst with the Tabb Group. "Then it could consider downsizing and combining certain portions of its auto-related holdings, and I also expect it to look for opportunities to move manufacturing overseas where it can take advantage of cheaper labor."