For GM, Mortgages Are the Motor

But how long can it rely on profits from its finance unit?

Given the weak profits in the auto business these days, General Motors (GM ) Corp.'s second-quarter earnings didn't look too bad. GM weathered a weak economy, falling car sales, and a vicious price war to salvage a $901 million profit. The results, announced on July 17, beat Wall Street expectations. Company Vice-Chairman and Chief Financial Officer John M. Devine said GM may be able to hit this year's profit target of $2.9 billion, a goal that management had become less and less optimistic about in recent months.

But hang on a second: GM isn't making all that money selling cars. In fact, the auto maker's all-important North American vehicle operation made a paltry $83 million, down from $1.3 billion a year earlier. So where did the other $818 million in second-quarter profits come from? Try General Motors Acceptance Corp., GM's lending arm. And it's not primarily car loans that helped GM bring home the bacon. Half of those finance profits came from GMAC's mortgage business, including its fast-growing online mortgage subsidiary. These days, GM looks a lot more like a financial institution that happens to sell cars and trucks than a successful auto maker.

GM's reliance on mortgage lending to drive profits could come back to bite. Interest rates have risen almost half a percentage point since mid-June -- and some economists say the refi boom that has sustained so many mortgage companies could run out of gas by fall. Even GMAC Chairman and President Eric A. Feldstein says the finance unit cannot keep up its current lending pace. At the same time, GMAC is shopping around its highly profitable commercial mortgage business. Add it all up, says Morgan Stanley (MWD ) analyst Stephen Girsky, and GM's second-half finance profits could fall one-third, to $950 million. "At some point, the auto business has to start carrying the ball."

Don't count on that happening anytime soon. By the end of June, GM's inventories were running 21% above normal. To address the overcapacity, the auto maker will cut production by 6% for the third quarter. CFO Devine says he is optimistic that the economy will begin to rebound in the second half, but he doesn't see profit-eating incentives going away. As a result, Girsky predicts GM's auto business will lose $150 million in the third quarter. "It's a hope that we can scale back incentives," Devine says. "But we don't build business plans on hope."

Making things worse, GM's weak automotive profits are hurting its finance unit margins. Standard & Poor's downgraded GM to BBB last year, and that rating was affirmed with a negative outlook in April due to eroding margins, fat sales incentives on its cars, and cash obligations to its union retirees. Since downgrades raise borrowing costs and GMAC must borrow billions to keep funding loans, last year's downgrade to BBB cost GMAC $200 million in profits.

Moreover, GM is selling its commercial mortgage unit because its borrowing rates make it too difficult to get sufficient capital and low enough rates to expand. A sale, which could bring up to $1.5 billion, also would help GM bolster its pension fund. But the commercial mortgage business accounted for roughly $100 million of GMAC's $417 million in mortgage profits in the second quarter. During times when demand slackens for residential mortgage refinancing, the commercial mortgage business accounts for an even bigger portion of GMAC profits.

Certainly, the outlook will eventually improve for the auto business. In 2004 and 2005, GM will be replacing as much as 22% of its sales volume with new cars and trucks, much faster than Ford Motor (F ) Co. and even Toyota Motor Corp. If it can avoid deep incentives, the new vehicles could help lift profits next year, says Prudential Financial Inc. analyst Michael Bruynesteyn.

Until then, GM will struggle and remain dependent on its finance arm. The question, says Deutsche Bank Securities (DB ) Inc. analyst Rod Lache, is whether GM can turn around its auto business in time to offset the decline in the finance unit. If not, GM could face lean times once GMAC is no longer minting money.

By David Welch in Detroit

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