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.

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.  Continued...