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The biggest story of 2005 will be the sputtering breakdown of

General Motors

(GM) - Get Report

, America's largest carmaker.

It's no secret that the Detroit behemoth has gotten through the pastthree years by using easy credit to sell cars and by making hugeprofits in its finance arm, General Motors Acceptance Corp., or GMAC.Yes, the auto business has improved. But on balance it remains a lemon, with the European operations lately burdening the company with hefty losses.

Now there are several signs that GMAC won't be able to take up theslack much longer. Without windfall profits from its finance business, GM could find itself earning as little as $4 a share next year, compared with analyst expectations of $5.15. The rating agencies, which have downgraded GM this year, could easily slap a junk credit rating on the company if GMAC stutters and the auto segment continues to suffer. With over $284 billion of debt, a junk rating would be a real blow.

Wednesday, GM's stock was up 5 cents to $38.23. On analysts' 2005estimates, it's trading on a price-to-earnings ratio of 7.4 times,which looks extremely cheap. But management's failure to get its earnings forecasts right suggests that $5.15 might be hard to hit.Indeed, with a real pullback in the mortgage sector of the economy anddrop in the auto lending business, earnings could slump at GM.

Unit Pricing Reversal

To understand GM's vulnerability, one first has to grasp the interplaybetween GMAC financing and the amount of cars GM sells.

Attractively priced GMAC loans have helped the company move a lot of cars over the past three years without having to reduce prices too much. The low rates ushered in by the

Fed

after the 9/11 attacks meant GM couldlend to boost car sales, and the auto finance arm at GMAC profited fromthe explosion in lending. In the first nine months of 2004, GM earned $3.06 billion -- of which 75% came from GMAC.

Skidding
GM's sinking stock

One statistic that led investors to believe this strategy was working was that revenue per vehicle sold in North America was climbing. This suggested to some that the crazy-seeming incentives weren't so crazy because they enabled the company to increase unit prices and thus maintain margins.

However, in the third quarter, North American per-unit vehicle revenuefell to $18,339 from $18,984 in the year-earlier period. That suggeststhat no matter what promotions are available, car buyers are reallybeginning to care more about price. And the fact that GM is nowoffering whopping $7,500 rebates on 2004 models suggests that GMmanagers understand that customers are growing more demanding on incentives.

As crazy as the rebates may be, they may do little to abet theunit-revenue drop, since interest rates are rising and pushing up thecost of loans.

Also worrying: Auto finance earnings are already taking a turn for theworse. In the third quarter, GMAC's auto finance earnings droppednearly 20% from a year ago, to $259 million.

However, earnings from the mortgage lending business were up nearly the same amount in the third quarter, to $302 million. The likelihood ofrises like that continuing are slim as interest rates rise. To besure, higher rates will help increase the value of GMAC's largemortgage servicing business (by reducing the size of the reserveagainst impairment). But a drop in new mortgage volumes could morethan offset a boost from the servicing business.

Demand Watch

GM insists that GMAC's earnings are sustainable at current levels,even though they're way up on precredit boom levels. GMAC made $2.8billion in 2003, compared with 2001's $1.8 billion. The assumption isthat steadily increasing interest rates won't damage the demand formortgages and car loans too much, and that bad debts won't be aproblem. Both assumptions are questionable.

Demand for new loans could be hurt if the Fed has to raise rates muchmore quickly than people think, and that might happen if the dollar continues to melt down. What's more, at some point individualborrowers are going to feel overburdened by debt. The lagging demandfor "incentivized" car sales could be a clear sign that this is already happening, even though rates have not gone up that much. One of the biggest mistakes bullish analysts make is to underestimate the sensitivity of this highly leveraged economy to interest rate increases.

Bad debts could also be more of an issue for GMAC than GM's defendersallow. With low rates, debt repayments haven't been burdensome. But inthe boom, there are some signs that GM may have become less choosyabout who it lent to. GMAC's second-mortgage business is on the smallsize, but there are signs that delinquency rates on 2004 loans arealready much higher than in previous years, according to data fromGMAC loan pools. This shows up on loans called high loan-to-value (or LTV) mortgages, which simply means that the amount of money lent is morethan the estimated collateral supposedly securing the loan.

After seven months, 1.48% of GMAC's high LTV loans were 30 daysdelinquent, according to data from the loans backing bonds issued in2004. That's much higher than in previous years. The 2002 and 2003loans were at 0.91% and 0.88%, respectively, after seven months.

To be sure, high LTVs are not a big part of GMAC's business. But again, the breakout in delinquencies at such an early stage suggests the company may have been scraping the bottom of the barrel. Investors should keep close tabs on other GMAC loans for credit quality problems, especially since lighter bad-loan provisioning has helped earnings at GMAC.

Finally, investors shouldn't have too much faith in the current GMmanagement. It raised guidance for 2004 earnings in the middle of thisyear, only to cut it back after third-quarter earnings. Managers clearly had no idea how badly they were faring in the auto segment. Indeed, thatmiscalculation is minor compared with the forecast that the companywould make

$10 per share in 2005, a claim Detox immediately doubted.

In fact, the year GM aimed to be posting double-digit earnings couldend up being the year that it finds itself struggling to stay on the road.

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

peter.eavis@thestreet.com.