Possible $1 Billion GM Mortgage Charge

In light of recent profit warnings and loan loss allowance increases by some subprime players, Lehman Brothers analyst Brian Johnson estimates that the pre-tax “true up” cash contribution GM may need to pay Cerberus for the close of the GMAC sale may be between $900 million to $950 million, rather than the originally estimated amount of $300 million to $400 million.

Johnson said he believes one cause for the delay of GM’s fourth quarter 2006 earnings announcement is because the book value of GMAC — and therefore the Cerberus purchase price — needs to be adjusted. In January, GM said it was delaying the announcement because it needed to restate prior years and address derivative accounting issues at Residential Capital, and because it needed to determine the final balance sheet of GMAC as of Nov. 30, 2006 — the closing date of sale of 51-percent interest in GMAC to a consortium of investors led by Cerberus.

If the final balance sheet shows the final book value of GMAC is under $14.4 billion as of the Nov. 30 closing date, GM will need to pay the difference, Johnson said.

“The mortgage book value as of the close of the GMAC sale … may still be a moving target,” he said. “Other mortgage banks reporting to date have generally increased loan loss provisions or reduced residual valuations to reflect some modest deterioration in credit results.”

Johnson pointed out the recent fourth quarter 2006 profit warnings by New Century Financial and HSBC due to deteriorating conditions in the U.S. markets affecting 2005 and 2006 vintages. While New Century said it will restate results for 2006 and expects a fourth quarter net loss due to provisions for repurchased loans and valuation of residuals, HSBC said its 2007 provision for credit losses is likely to be $2 billion above prior consensus of $8.8 billion.

ResCap’s provision stood at $1.088 billion in the third quarter 2006, compared to $1.048 billion in the second quarter and $0.971 billion a year earlier, according to the report.

“Judging from the increases in loan loss provisions at other subprime lenders we estimate ResCap will need to increase its allowance for loan loss to about 250” basis points, Johnson wrote.

Johnson believes that GM may need to strengthen ResCap’s loan loss provisions by $750 million for mortgage loans “held for investment” and raise mark-to-market adjustments on residual interest in trading securities by $100 to $200 million. It was originally estimated that GM would need to contribute about $330 million to GMAC because loan loss provisions at ResCap would be boosted by $230 million for mortgage loans “held for investment,” as a larger base of receivables was applied, and mark-to-market adjustments on residual interest in trading securities would be about $100 million.

The Lehman report notes that of HSBC’s additional charges of up to $2 billion, the correspondent channel was indicated to be the major factor.

The revised assumptions for the impact on GM reflect ResCap’s heavy presence in the correspondent channel, and in subprime. About 80 percent of ResCap’s mortgage loans “held for investment” are subprime, Johnson said, “and general credit deterioration would impact its losses from bad debt.”

“While we regard GMAC as a quality underwriter, it is unlikely to be immune from the broader pressures,” he added, noting that ResCap 2005 and 2006 subprime vintages, with $32 billion outstanding, have been showing credit performance more typical of the 2002 and 2003 tranches as opposed to the very strong performance of the 2004 and 2005 vintages

“In addition, valuation of mortgage securities held for investment on the balance sheet — much of which may be lower rated tranches not sold to the public — is model driven and subject to varying interpretations,” the analyst said.