General Motors'

(GM) - Get Report

lending business is the only thing keepingAmerica's largest automaker from falling into the abyss. So it'sunnerving to see this finance arm, called GMAC, report low-quality first-quarter earnings.

In the first quarter, GMAC -- short for General Motors Acceptance Corp. -- earned $729 million, while GM's auto business lost $1.83 billion. On a consolidated basis, then, GM lost $1.1 billion, or $1.95 per share.

The company had warned investors that the loss was coming, but not until mid-March. Up to that time, it was telling investors to expect earnings of $4-$5 per share in 2005. Now the company says it expects to make just $1-$2 per share.

The reduction in earnings guidance, along with fears that rating agencies will downgrade GM's debt to junk and news that GM's unions aren't likely to bow to cost-cutting measures, has crushed GM's stock. It closed down a dime at $26.09 Tuesday. That's nearly 50% below the stock's 52-week high.

Detox first

took a bearishstance on GM three years ago, greeting with skepticism thecompany's prediction back then that it would make $10 per share in2005.

Sticky Wicket

To assess just how dangerous a slowdown at GMAC would be, one must understand the gamble that GM made after the 9/11 attacks.Automakers have a notoriously sticky cost base, which means any slowdown in sales can tip a carmaker into a loss very easily, as can be seen with the recent reductions in earnings forecasts.

GM feared the terrorist attacks would reduce demand for car purchases, so it had GMAC unleash a tidal wave of cheap credit to motivate people to buy cars. Car sales did respond, and GMAC also made money from its large mortgage operations during the easy-money boom that took over the entire U.S. financial sector.

However, this strategy always threatened to come undone ifinterest rates rose or if demand for GM's products dropped off, due to saturation or competition. Surely enough, these factors are hurting GM now, forcing the company's managers to try a deeprestructuring.

However, a full-blown crisis could occur if GMAC started to show real signs of stress. Clearly, anyone looking at GM's stock simply has to watch GMAC for any signs of weakness. And the unit's first-quarter results, as well as management comments, do raise some uncomfortable questions. The big fear is that GMAC used hard-to-repeat gains to boost earnings at its mortgage operations.

GM spokeswoman Toni Simonetti says that GMAC's mortgage earnings were not overly dependent on one-time gains: "GMAC's performance is quite extraordinary, given the more difficult environment in which it operates."

There was a big, but expected, drop-off in earnings from GMAC's auto-financing and leasing division. Net income there in the first quarter fell to $248 million from $442 million in the year-earlier period.

Despite this drop, GM's auto sales were far more dependent onGMAC financing. In the first quarter, 54% of retail sales were funded by GMAC, compared with 41% in the year-earlier period. That shows that if GM had to cut back on auto financing due to fears over leverage, auto sales would drop off sharply.

Also scary was the large jump in the proportion of retail leases. These jumped to 20% of retail sales in the first quarter, compared with 14% in the year-earlier period. That 20% figure is well above 2004 levels and thus suggests that leasing is back as a way to shift units at GM. If so, GMAC may once again become exposed to the risk that the value of leased autos will be lower than predicted when the cars are returned.

At $95 million, GMAC's insurance earnings were marginally up from the first-quarter 2004 figure of $91 million.

Great Leap Forward?

However, it was the mortgage operations that raised mosteyebrows. Bizarrely, mortgage earnings soared 67% to $385 million in the first quarter from $231 million in the year-ago period.

Given that there's been a slight cooling in the mortgage market over the past 12 months, the giant leap in earnings had analysts looking for reasons other than GM's explanation, which was that it made more mortgage loans and picked up market share.

GMAC observers wondered whether any outsized gains took place to produce the blowout number. When asked on the earnings conference call Tuesday to what extent gains from selling mortgages contributed to the mortgage unit's performance, GMAC CFO Sanjiv Khattri said: "I don't think I want to disclose the number," but did add that "It was a very nice piece of change."

Khattri also acknowledged that mortgage earnings had benefited from a write-up in the value of so-called mortgage servicing rights, which are balance sheet items that represent the expected earnings from administering payments on mortgages.

The MSRs tend to get marked up when interest rates rise. However, no number for GMAC's first-quarter MSR gain was given out. And if there was a big jump in the value of these in the first quarter, it could easily be reversed this quarter, as interest rates have fallen.

GMAC's overall earnings took a big dent in the first quarter from a rise in interest costs, which were $3 billion in the first quarter vs. $2.2 billion in the year-earlier period.

GM's Simonetti says that GMAC has made great strides in protecting itself against an increase in interest rates and that should protect the unit against any further rises in rates.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to