Riders on the storm

If Rob Hull's language wasn't apocalyptic, it was close. On a July 31 conference call with analysts and reporters, Hull, GMAC LLC's chief financial officer, called the vortex of ills roiling the finance giant a "perfect storm" that shows no signs of blowing over.

Indeed, the same forces now assailing U.S. automakers are taking a heavy toll on their finance affiliates. At GMAC, General Motors Corp.'s auto- and home-loan arm, a brutal combination of soaring gas prices, a feeble economy, plummeting demand for gas-guzzling SUVs and trucks and a weak housing market gave rise to a $2.5 billion net loss in the second quarter. It was GMAC's largest quarterly loss ever and, Hull remarked, more than GMAC lost "in all of 2007."

The bad tidings also worsened the odds of New York-based Cerberus Capital Management LP turning a profit on the $7.4 billion that, along with co-investors, it paid to buy 51% of GMAC from GM in November 2006. Since then, GMAC's losses have steadily mounted, sidetracking Cerberus' grand designs for the business. To judge by the write-downs GM has taken on its 49% stake, the value of Cerberus' investment has slid by more than half.

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Now, some experts say, Cerberus may be lucky to hang on to the value that remains. Even though GMAC fortified greatly its capital position in June with a $60 billion debt refinancing, some question its ability to ride out the storm for another two or three years, should the storm last that long. If conditions don't improve, says a well-known auto industry consultant, GM, which itself has racked up massive losses, conceivably could go under and take GMAC with it.

"GMAC's health is highly dependent on GM's health, and GM's health is highly dependent on what happens in the marketplace," the consultant says. The "big question," he continues, is whether GM could survive a three-year period of high oil and raw materials prices and depressed sales volumes and vehicle resale values.

"Conditions are unbelievably bad; the worst I've seen in 30 years of studying this industry," he says. "If GM goes bankrupt, that would make GMAC almost unviable, in my view."

For Cerberus, moreover, the harm could spread well beyond GMAC. The $27 billion-in-assets firm reportedly has sunk $3 billion to $4 billion of its own into GMAC and Chrysler LLC, the troubled automaker Cerberus bought 80% of a year ago. If the industry's woes eventually drive GM under, chances are that Chrysler, GM's smaller, less diversified rival, would find itself on the brink. Though for now Chrysler has cash to burn, according to Standard & Poor's, its reserves could run dry next year. What's more, a third Cerberus portfolio company, Japan's Aozora Bank Ltd., could see its own $500 million bet on GMAC, which it made as part of the Cerberus-led group in 2006, reduced to scrap.

If the industry's woes trigger a string of blowups for Cerberus, it could do lasting damage to the firm's image as a master of tricky bailouts and ambitious turnarounds.

That GMAC and Chrysler today are even mentioned in the same breath as high-risk cases must gall Cerberus. From the start, it approached the automaker, whose travails were well known, as an arduous challenge. But GMAC was supposed to be different.

In early 2005, when the GMAC deal was hatched, the business' core auto finance operations and its Residential Capital LLC home loan subsidiary were riding high. The previous year, the former recorded $880 million in net profits, while ResCap earned $1.02 billion. GMAC's parent, GM, by contrast, was fraught with problems -- its debt downgraded to junk, its sales slipping, its biggest parts supplier, Delphi Corp., a former subsidiary, heading into bankruptcy. GM's problems, in turn, were creating headaches for GMAC, dragging down its credit ratings and driving up the cost of financing sales of GM's cars.

To inoculate GMAC from GM's struggles, GM struck a deal to carve out GMAC as an independent platform and sell a majority of it to Cerberus. In addition to the $7.4 billion the Cerberus consortium paid to GM, the automaker collected a $2.7 billion dividend from its old finance arm. Nothing unusual there: GM had long milked GMAC for cash. But this was to be the last dividend GM would rake off for the near future.

Indeed, to bolster GMAC's capital base and reinforce its credit rating, GM agreed to kick back $1.4 billion into new GMAC preferred stock, with Cerberus buying an additional $500 million of preferred. The automaker further pledged to reinvest its dividends in GMAC for the next two years, whereas Cerberus would plow back its dividends for five years. Still other provisions designed to shore up GMAC's finances and lessen its exposure to GM were included.

Provided that GMAC and ResCap remained healthy, the deal would infuse billions of new capital back into GMAC over the next five years -- money GMAC would use to expand. "We have been on defense," GMAC's chairman at the time, Eric Feldstein, told The Deal. "Now it's time to go on offense and grow again."

But GMAC's disentanglement from GM failed to produce the hoped-for ratings bump: S&P and Moody's Investors Service continued to grade GMAC a step below investment grade and maintained ResCap at a step above. Subsequent events showed the agencies were right to be skeptical.

By early 2007, the subprime mortgage market was starting to tank, and ResCap -- once GMAC's crown jewel -- swung to a $911 million net loss in the first quarter. Through last year and the first half of 2008, the home-loan unit racked up $7.2 billion in losses. That performance prompted Moody's to slash its rating by seven notches, to Caa1. (S&P cut its evaluation to triple C.) The loss also dangerously eroded ResCap's capital base.

As ResCap's plight worsened, GMAC was forced to shelve its own dreams of growth and channel much of its cash into the ailing home loan unit. By early 2008, ResCap's net worth had tumbled from $7.6 billion to $5.8 billion, just $400 million above a minimum it had to maintain to avoid tripping debt covenants.

To keep ResCap afloat, GMAC and Cerberus have bestowed more than $9 billion in cash and other support on the unit. Their largess has included equity infusions, open-market purchases of ResCap debt, acquisitions of ResCap assets and noncore operations and credit extensions.

So far, the cash drain hasn't devastated GMAC, which funds its auto finance and other operations separately from ResCap. Through the end of the first quarter of 2008, in fact, the company's auto finance and insurance operations were in the black, although Moody's and S&P had continued to hack away at GMAC's rating because of all the billions ResCap was siphoning off.

But now a steep drop in GM's sales of SUVs and trucks has begun to take a toll on GMAC's auto finance results. Not only has revenue suffered, but plunging demand for used gas guzzlers has depressed resale values. GMAC, which in addition to making car loans buys thousands of cars, trucks and SUVs itself and leases them out, is burdened with huge inventories of used, off-lease vehicles worth far less in today's market than GMAC had expected. And auto leasing, once a high-margin business, has become a severe drag on profits.

That has cast into doubt GMAC's continued willingness to prop up ResCap and has fueled worries about GMAC's viability. GMAC's second-quarter results are revealing. The auto finance segment posted a $717 million loss on $544 million in net revenue, compared with a $395 million profit and revenue of $1.2 billion a year earlier. A drop in financing assignments was partly to blame, but the main culprit was a $716 million pretax write-down in the value of GMAC's lease book, nearly all due to tumbling demand for SUVs. Said Hull, the CFO, during the July 31 conference call: "We were only able [to recoup] an average 75% of what we had originally expected" on used vehicles GMAC sold off during June. Were it not for a risk-sharing arrangement GMAC has with GM, the damage would have been even worse.

The heftiest loss came at ResCap, which ran $1.86 billion in the red, due to the continued unraveling of ResCap's mortgage business and losses on sales of distressed loans and mortgage-backed securities. It was ResCap's worst showing since the Cerberus deal. A rare bright spot was GMAC's auto insurance operation, which enjoyed a $135 million profit in the quarter. Shortly before the results were released, Moody's chopped GMAC's senior debt rating to B3 -- five levels below its Ba1 rating for the company in late 2006 -- and S&P cut its credit rating to a corresponding B-.

GMAC has reacted to this mauling by retreating into a financial shell, hardening its defenses and selling off distressed holdings. In June, with roughly $4 billion of ResCap debt falling due this summer and fall, the company pulled off an elaborate, multitranche, $60 billion refinancing with the help of J.P. Morgan Chase & Co. and Citigroup Inc. Nearly $9 billion of ResCap bonds were retired at a steep discount, supplanted by $5.7 billion of higher-yield paper maturing in two to seven years. ResCap also won a one-year extension on its $11.6 billion bank line, and the troublesome loan covenant requiring that ResCap keep its net worth above $5.4 billion was scrapped.

What's more, GMAC beefed up its own capital reserves by $5.4 billion with a new $11.4 billion, three-year credit line. Lastly, it buttressed ResCap, further granting it a two-year, $3.5 billion credit line, $750 million of which Cerberus and GM have guaranteed.

"We reduced the amount of debt outstanding, extended the maturities and improved the collateralization model," summarizes Hull. "But we did so at a cost. I can't say we got any great arbitrage on interest rates." A key reason GMAC broadened its own borrowing lines, he adds, was to ensure it could bail out ResCap if the latter runs short of cash. As of June 30, GMAC and ResCap had $85.6 billion in cash and undrawn borrowing capacity, including dedicated auto-financing lines, according to its latest 10-Q.

Along with replenishing its coffers, GMAC has hunkered down and retrenched operations. GM and GMAC last month sharply scaled back their auto-leasing activities, joining Ford Motor Co., which is shrinking its leasing operations, and Chrysler, which is doing away with them altogether. GMAC has tightened lending standards across the board and dumped billions of dollars worth of troubled securities and assets -- shrinking ResCap's total assets by half, to $73 billion. A new corporate brain trust, led by CEO Alvaro de Molina and Hull, both of whom are former Bank of America Corp. executives, and former Bear, Stearns & Co. mortgage trading chief Thomas Morano, who was named ResCap's CEO in July, is sizing up GMAC's businesses with an eye to selling those that aren't "core," Hull says.

Hull adds that GMAC has raised the rates it charges for certain services while trying to find cheaper sources of capital. In particular, it hopes to make more liberal use of its GMAC Bank unit, a government-insured bank catering to large institutions, as a low-cost funding conduit.

"We have a plan to maintain our liquidity over the foreseeable period, and we believe we have the tools to do it," Hull says. "We still have a pretty robust auto [business] model, insurance model and international model. On the ResCap side, the only good news is that [the business] is stabilized, and they now have a trajectory to go and redefine the size of that business."

Not everyone shares Hull's tank-half-full view of GMAC. Craig Emrick, a credit analyst who covers ResCap for Moody's, scoffs at the notion the operation is stable.

"I would not use that word to describe ResCap," Emrick says. "It has a very tenuous liquidity position." If it weren't for asset sales and the largess of its owners, ResCap would have a tough time making it, he says. "If GMAC and Cerberus should decide they're no longer supporting ResCap, that would certainly increase the probability it would have to file for bankruptcy," says Emrick.

Meanwhile, GMAC's other flank is exposed to GM. Moody's recently downgraded the automaker's senior debt to B1, two steps above GMAC's, after it reported a $15.5 billion second-quarter loss.

For GMAC, experts agree, a byproduct of GM's going bust would probably produce a sharp downdraft in GM's sales and in purchase financing and a shift toward leasing. Explains one: "I can't imagine that consumers would want to take the resale-value risk if GM went bankrupt. If they want a GM car, they'd want to lease it. GM may not be able to afford to do leasing, but that's all consumers may want to do."

Though GMAC's auto finance revenue certainly would plummet if GM failed, opinion is divided on whether it would suffer GM's fate. Some believe it could dodge Chapter 11 by suspending new financings, slimming down and living off asset sales.

"Finance companies are different from manufacturers" in that they don't have plants and equipment to maintain, notes Moody's Mark Wasden. "If GM were to go bankrupt, GMAC could go into shrink mode and generate enough cash flow to retire debt and keep operating" -- for a time.

In response to an e-mail asking whether the firm now regrets buying GMAC, Cerberus managing director Timothy Price sidestepped the question, emphasizing instead that Cerberus "is more focused than ever" on "making sure GMAC is strong and solid."

At least for now, Cerberus, sources say, is committed to backing ResCap and helping GMAC ride out the storm. If the firm can salvage a decent profit from this wreck, it will be hailed as a miracle worker. But the odds of that occurring are looking increasingly remote.

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