Subprime Bets Haunt GM

Selling a majority stake in GMAC hasn't been enough to offset mortgage missteps.
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After all the measures taken by

General Motors

(GM) - Get Report

to revive itself on CEO Rick Wagoner's watch, last year's sale of a majority stake in GMAC, its finance business, now looks like the most prescient.

For the first three quarters of 2007, GMAC reported losses totaling $1.6 billion, thanks largely to a bloodbath at its mortgage unit, Residential Capital, amid turmoil in the U.S. housing market. If GM were shouldering all those losses, its already precarious circumstances would be far more dire.

That said, GM still owns 49% of GMAC, and many of the loans that are going bad now were made before it sold 51% of the finance company to Cerberus Capital Management last April for more than $14 billion. So while the sale proved to be a timely move, its benefits hardly make up for the disaster that has befallen ResCap.

For its part, GM reported losses totaling $38 billion for the first three quarters of 2007. While the loss was entirely due to a $39 billion accounting charge in the third quarter, ResCap's woes have also weighed down results.

As well, GM's North American auto business is still in the red, and the prognosis is negative for the U.S. auto market in 2008 -- a year that's expected to show a continued slowdown in consumer spending and potentially even a recession.

Speculation in the markets that there is further pain in store for GMAC has sent shares of GM tumbling 38% since its mid-October highs. Back then, the company was riding high after reaching a historic labor agreement with the United Auto Workers union that was supposed to help it achieve cost parity with its foreign-based rivals.

Now, GM's stock is trading at levels reminiscent of those that inspired a 2005 tender offer from Vegas billionaire Kirk Kerkorian -- a bid to shake up the automaker that ended last year when Wagoner won a showdown over whether GM should form a global partnership with Carlos Ghosn's

Nissan-Renault

.

"This could be the end of Wagoner, because at the end of the day, corporate chiefs are judged on their ability to create value for shareholders," says Argus Research analyst Kevin Tynan. "If this is going to be a $25 stock again, then Wagoner is going to face a lot of dissatisfaction."

ResCap, the crown jewel of GM's finance business at the height of the U.S. housing boom, is now flirting with bankruptcy. At the end of the third quarter, GMAC reported that the mortgage unit's net worth at $6.2 billion, down from $8.4 billion a year earlier.

On Wednesday, GMAC announced a $750 million

bond tender offer designed to boost ResCap's fourth-quarter earnings and keep its net worth above the $5.4 billion level.

If ResCap's net worth falls below that level by the end of the year, it could violate covenants on portions of its unsecured credit lines, potentially making it a candidate for bankruptcy. GMAC also said its management team will recommend "as necessary" another capital contribution to ResCap to ensure the lender is in compliance with the covenants.

A spokeswoman for GM, which has four executives on GMAC's board, said the automaker is under no contractual obligation to provide the finance company with any more capital infusions beyond the $1 billion equity contribution it has already made since the sale.

That could leave Cerberus Capital Management on the hook for salvaging its investment in ResCap. A spokesman for Cerberus declined to comment for this story, but GMAC said it was exploring the acquisition of a foreign mortgage finance company with which it could merge ResCap and dilute its losses. It's also exploring a sale.

Meanwhile, analysts are saying that GMAC's problems with bad mortgage loans are starting to spill over into auto loans. Lehman Brothers analyst Brian Johnson said in a research note last week that GMAC has been experiencing a "sharp" increase in delinquency rates among its auto-loan customers since July.

"The precursor of credit loss is delinquency -- and the 60-day delinquency rate is on the rise for recent issues of GMAC auto

asset-backed securities," Johnson said.

Such problems are emerging across the board in the financial industry, but some observers say GMAC was especially aggressive in making risky loans in recent years because it was under pressure to make up for the sharp deterioration in GM's auto business.

"The auto business was not generating the returns that they wanted it to, so they turned to the finance unit," says Sean Egan, president of Egan-Jones Ratings. "GM has had a long history of involvement in the residential mortgage business, but in the past few years there was much more pressure to replace the operating income from the auto unit with aggressive lending. With interest rates going up, they had to take on riskier loans to maintain profit margins."

ResCap plowed into the subprime market in 2003. Last year, it reported U.S. mortgage loan production of $161.6 billion, of which 19% was nonprime. By comparison, the largest U.S. mortgage lender,

Countrywide Financial

(CFC)

, reported production last year of $421 billion, of which roughly 8% was classified as nonprime.

Worries of liquidity troubles are also swirling around Countrywide, and it has faced public criticism for predatory sales practices that pushed risky mortgage offerings. Those include so-called Alt-A loans, which typically require no documentation on borrowers' incomes or employment; interest-only loans; high loan-to-value ratio mortgages; and pay option adjustable-rate mortgages, which allowed a borrower to pay only a fraction of the interest owed and none of the principal during an introductory period.

GMAC also delved deeply into those products, and many of the loans it made with them weren't classified as subprime. Its interest-only loans produced last year totaled $48.3 billion, up 11% from 2005, according to filings with the

Securities and Exchange Commission

. Its pay option adjustable-rate mortgages more than tripled last year to $18.3 billion, while its high-loan-to-value mortgage loans were up 33% to $8.8 billion.

"It doesn't take a genius to conclude that you're courting trouble in the future when you make loans like this," says Egan. "Many of these loans were made on the assumption that housing values would continue to appreciate at an extraordinary rate, and any corporate executive should know that markets never go up forever. When you're making mortgage loans to low-income people that are wagered on that assumption, you're not acting responsibly."

In April, ResCap replaced CEO Bruce Paradis with its president and chief operating officer, Jim Jones. More recently, GMAC hired Robert Hull, a

Bank of America

(BAC) - Get Report

executive, to replace Sanjiv Khattri as chief financial officer. He'll report to Alvaro de Molina, who joined GMAC in August as chief operating officer from Bank of America -- an institution that has certainly had its

share of problems from the subprime loan fiasco.

GMAC's longtime CEO, Eric Feldstein, remains in place, as do the leaders of his former corporate parent, GM.

"

GM execs are ultimately responsible for the corporate direction and the corporate strategy of the company," says Egan. "The managers at GM had a two-and-a-half-year time horizon at most when they got into this mess. The managers at

Toyota

(TM) - Get Report

think in terms of decades."