June 17, 2010

GMAC Service Contracts:

While the huge downturn in GM's auto sales hurt GMAC's service contracts, what forced the finance company to seek a TARP bailout was a really bad bet on home mortgages. Now the government-owned company has become a bank and is pursuing non-GM dealerships.

So how does it feel to be a part owner of one of the world's largest providers of vehicle service contracts?

As we wind down our tour of the automotive sector of the service contract industry, we wanted to do a piece on the insurance companies that stand behind the administrators and the dealers that actually sell the vehicle service contracts. And as we searched for information about the insurance company that stands behind the service contracts sold by many General Motors dealers, we realized that we owned the place.

We all do -- all residents of the United States, thanks to the well-timed investments of the U.S. Department of the Treasury, now own 56.3% of what used to be called the General Motors Acceptance Corp. And GMAC has sold close to $10 billion worth of vehicle service contracts since 2001. Though many have expired on time, those that remain are majority-owned by the U.S. Department of the Treasury.

Unlike General Motors itself, GMAC never actually filed for bankruptcy. Nevertheless, it was completely flattened by the twin declines in car sales and home prices. At the end of 2008 it turned itself into a bank and accepted bank rescue money from the U.S. government, in return for majority ownership of the company.

Little To Do With Automotive Finance?

However, as we tried to make sense of what drove GMAC into the arms of the government, we realized it had little to do with automotive finance, automotive insurance, or automotive service contracts. We believe the trouble started the day that GMAC decided to become a home mortgage company.

The General Motors Acceptance Corp. opened for business in New York City in 1919. It was created to help sell GM cars, by providing financing and later insurance services to GM dealers and their customers. It provided GM dealerships with the financing they needed to maintain their inventories, and it provided consumers with the financing they needed to purchase GM cars and trucks.

Nearly a century later, it all sounds so simple and obvious. But until GMAC was created, dealers had to pay cash to stock their inventory, purchasing just a few vehicles at a time as a result. And consumers had to either pay cash for their vehicles, or secure their own loans from banks, many of which were reluctant to finance automobile purchases.

According to the GM Heritage Center, GMAC financed its four millionth vehicle in 1928 and its 40 millionth vehicle by 1958. GMAC's net earnings surpassed $1 billion in 1985, and peaked at $2.9 billion in 2004. By 2001, GMAC had financed the purchase of more than 150 million vehicles worldwide for a cumulative $1 trillion.

Motors Insurance Corp.

Finance was the core business. Insurance came later. And vehicle service contracts were an even more recent addition to the product line. The Motors Insurance Corp. was formed in 1939, as the in-house underwriter of GMAC's insurance products. In 1973, Motors Insurance Corp. began selling what were then called mechanical breakdown protection plans -- what would nowadays be called vehicle service contracts.

The service contracts were not insurance products. However, they became part of GMAC's insurance business unit. The General Motors Protection Plans (in the U.S.) and the Car Care Plans (in other countries) were sold to consumers by GM-franchised dealers, through their dealerships' finance and insurance departments.

Up until 2002, General Motors itself was the obligor. GM, in turn, would insure its business risk through a contractual liability policy purchased from GMAC Insurance. But then the structure of the business changed, so that it was GMAC selling the service contract to the customer, and it was GMAC that became the obligor.

According to GMAC's financial statements, this change was designed to concentrate all business related to service contracts with GMAC Insurance (where the activities were managed), rather than splitting the business between GM and GMAC Insurance. At the time, since GMAC was wholly-owned by GM, this change was little more than accounting trivia.

Service Contract Sales Figures

The reason we mention all this historic trivia is because beginning in 2002, GMAC began disclosing annual figures for "written service contract revenue," the amount it collected from dealerships that sold GM Protection Plans (and Car Care Plans internationally). The dealers marked up the price of the policies and kept the excess as profit. It worked the same under GM, but GM never broke out the service contract figures separately in its financial statements. GMAC did.

The premiums paid by GM customers for service contracts in any given year would equal the written service contract revenue plus the dealer markups. So what's in the chart below is perhaps only half the story of the rise and fall (and hopefully the rebirth) of GM Protection Plans. The blue columns represent the revenue received by GMAC through the sale (by dealers) of vehicle service contracts.

Figure 1
GMAC Insurance
Vehicle Service Contract Revenue, 2002-2009
(in $m and as a % of total revenue)

Figure 1

As can be seen in Figure 1, the vehicle service contract business, at least for GMAC, peaked in 2004 and 2005, when the company reported more than $1.3 billion in written service contract revenue. The decline began in 2006 and accelerated in 2009, when only $685 million in written service contract revenue was reported.

Compare that record for service contracts to the data in Figure 2, which tracks General Motors' automotive revenue and the corresponding amount of product warranty claims paid from 2002 to 2009. We should note that there is no correlation between service contract sales and warranty claims paid. However, there is a point to be made.

Figure 2
General Motors
Product Warranty Claims Paid, 2002-2009
(in $m and as a % of total revenue)

Figure 2

Notice that worldwide automotive sales peaked in 2007. Notice also that the claims rate was at a relatively low point of 2.55% at the time. By 2009, automotive sales had fallen to $104 billion and the claims rate had risen to 3.92%.

Less Focus on Core Business?

The point we want to make is that while the decline in automotive sales certainly hastened the decline in service contract sales, the peak in GMAC service contract sales came two years before the peak in GM auto sales. So something else must have been causing GMAC to sell less service contracts in 2006 and 2007.

We think we know what it was: a fixation on home mortgages.

For 80 years, GMAC was in business to help GM sell cars. Period. Its finance and insurance operations were meant to help GM dealers and GM customers. Period.

But then the company began to look for ways to grow outside of the GM dealerships, and even outside the automotive industry. GMAC issued home mortgages before 1999, for instance to some of its employees. But in 1999, a deliberate diversification effort began that over the next decade took GMAC far away from its core business of helping GM sell cars.

In that year, GMAC acquired the Bank of New York's asset-based lending and factoring business unit, which became the basis of the GMAC Commercial Finance Group. It also acquired the Ditech Funding Corp. from its owners in 1999.

The International Business Group was formed in 2001 to offer mortgages in Europe and Latin America. Residential Capital LLC was formed in August 2004 as a subsidiary of GMAC Mortgage Group LLC. It focused primarily on residential mortgages in the U.S.

Swift Home Mortgage Growth

GMAC Mortgage, primarily through the efforts of ResCap, as the unit was ultimately nicknamed, quickly became one of the largest mortgage providers in the U.S. In 2005, ResCap accounted for 33% of GMAC's total net revenue, and nearly half its $2.28 billion in net income.

By that point, mortgages were king at GMAC. In contrast, the insurance operation, of which service contracts were a part, and the automotive finance operation, each accounted for only 29% of the company's total revenue in 2005.

As can be seen in Figure 1, service contracts were 9% of total revenue at the time. That's not to minimize their importance. Nine percent of nearly $15 billion is still a huge number, and is one that ranks GMAC as one of the largest -- if not the largest -- obligors of vehicle service contracts in the world.

What we're trying to say is simply that by 2005, service contracts comprised a little less than a third of the insurance sector's revenue, and the insurance sector accounted for a little less than a third of GMAC's revenue. And home mortgages accounted for a third of revenue and nearly half the profits. So it's easy to comprehend how, even at a company founded to help sell GM's cars, automotive was becoming an afterthought by 2005.

Insurance Remains Profitable

Although one could suggest that the importance of the insurance business was declining by 2005, one could never say that it was deteriorating. Throughout the recession, GMAC's insurance business remained profitable, though it continued to shrink in size. Insurance operations in 2007 generated $3.16 billion in revenue and $376 million in profit. Insurance revenue dropped to $2.96 billion in 2008 and $2.27 billion in 2009. Insurance profit actually grew slightly in 2008 to $387 million, but then dropped back to $272 million in 2009. But at least it remained profitable.

We don't know the profitability of individual product lines, so we can't say that vehicle service contracts were more or less profitable than other coverages such as collision or GAP insurance. But the point is that despite the massive decline in auto sales, as is detailed in Figure 2, GMAC's insurance business as a whole remained viable. It declined, but it never deteriorated.

But then the losses at ResCap quickly overwhelmed the entire business. By 2007, ResCap accounted for only 14% of GMAC's total net revenue, as mortgage activity was reduced. But the loans already made by that point generated net losses of $4.35 billion, easily overwhelming the $459 million derived from insurance and the $1.49 billion in net income derived from financing that year.

In 2009, mortgage operations resulted in only $609 million in net revenue (only 9.7% of the total), yet they generated $7.07 billion in net losses (88% of the total). At the end of 2009, ResCap was put up for sale. A buyer has yet to be found.

Selling Half of GMAC

At the same time GMAC's mortgage business was deteriorating, GM was running out of cash. So GM decided to sell half of GMAC. History will determine the wisdom of this move, but we think what made it possible in the first place was the gradual decoupling of GM and GMAC.

GMAC used to be the right arm of GM. Selling all or part of it would have seemed absurd. But starting in 1999, GMAC diversified into lines of business that had little to do with selling GM vehicles. By 2005 it was an arm's length away from its parent. And so, by 2006, it wasn't absurd for GMAC to marry into a completely different family.

In 2006, a group of investors, led by Cerberus Capital Management LP, bought a 51% stake in GMAC from General Motors, which retained a 49% share in its own financing arm. Cerberus is known primarily for two things. First, it bought 80% of Chrysler from Daimler AG in 2007 for $7.4 billion. Second, it is the name of the three-headed dog in Greek mythology (aka Κέρβερος) that guarded the entrance to the underworld.

Cerberus the dog couldn't smell dead people. We suspect that may be a flaw it shared with Cerberus the company. By the time Cerberus invested in GMAC, the folks at ResCap had already made the loans that would later doom the company.

A.M. Best Not the Best?

The ratings companies were also a bit slow to notice the odor. On June 11, 2009, A.M. Best downgraded the financial strength rating of GMAC's insurance companies from A- (excellent) to B++ (good). We think that downgrade was at least two years too late. But that's just an opinion. If we were rating the ratings companies, we'd give A.M. Best a C- (weak) rating for tardiness.

We believe that in 2007, while GMAC's insurance operations were still doing fine, the financial strength of the entire company was being compromised by ResCap's mortgage losses. We believe that the mortgage-related deterioration was apparent in the company's 2007 annual report. And we believe that when A.M. Best reaffirmed GMAC's A- rating in January 2008, it should have seen what was coming.

A.M. Best had downgraded the GMAC insurance companies from A+ (superior) to A (excellent) in June 2003, and from A (excellent) to A- (excellent) in May 2005. But in the service contract business, anything over an A- is good enough to qualify for financing. Anything B++ or below is a problem that is going to adversely impact market share.

In other words, A.M. Best didn't identify GMAC's financial strength to be a problem until June 2009. By that time, GMAC was already majority-owned by the U.S. government.

The U.S. Government's Bank?

Oh, yes. We forgot to mention the U.S. government. On December 24, 2008, GMAC became a bank holding company under the Bank Holding Company Act of 1956, with the Ally Bank as its primary banking subsidiary. A few days later, as part of the Troubled Asset Relief Program, the U.S. government pumped $5 billion into the bank.

And then, after making that initial investment, the U.S. government invested another $7.5 billion in May 2009. As a result of those capital injections, the U.S. government now owns 56.3% of the company. Cerberus Capital Management still holds a 14.9% share, while GM still holds 6.7% and a GM trust now owns 9.9%. The balance of 12.2% is held by other investors.

After converting itself into a bank holding company, GMAC began shedding some of its non-banking operations. One of the first things to go was the auto insurance operation. In March 2010, GMAC Insurance Personal Lines, GMAC�s U.S.-based consumer property and casualty insurance business, was sold to American Capital Acquisition Corp., a unit of American Capital Partners LLC of Hauppauge NY.

AmTrust Financial Services Inc. (a sponsor of this newsletter) owns 25% of American Capital Acquisition Corp. Michael Karfunkel, the chairman of AmTrust, co-founded American Capital Partners. Karfunkel is also a co-founder of Maiden Holdings Ltd., a Bermuda-based reinsurance company that acquired GMAC's reinsurance business in November 2008.

Reasons for the Acquisition

In its latest quarterly financial report, AmTrust said of the acquisition: "GMAC�s consumer property and casualty insurance business is one of the leading writers of automobile coverages through independent agents in the United States. It utilizes a network of 10,500 agents in 12 core markets, as well as exclusive relationships with 23 affinity partners. GMAC�s U.S. consumer property and casualty insurance business had a net written premium in excess of $1,000 in 2008 that encompassed all fifty states. Its coverages include standard/preferred auto, RVs, non-standard auto and commercial auto. The acquisition includes ten statutory insurance companies that write the automobile coverages for GMAC."

An investment newsletter called SumZero recently theorized that the central reason behind these acquisitions is an effort by the Karfunkel team to get into areas of the insurance industry that are more predictable and less volatile.

"The common theme between Maiden�s business with AmTrust, GMAC reinsurance, and American Capital Acquisition Corp. is a focus on low volatility insurance lines with very little potential exposure to catastrophic risks. An insurer of catastrophic risks, such as home insurance protection in an area prone to hurricanes, will either make a very attractive return if there is no hurricane or will lose a lot of money if a hurricane hits. Maiden�s business is far more predictable: lots of small losses that can be fairly well predicted based on actuarial analysis. Examples include small-business workers compensation, product warranty, and auto insurance," the newsletter wrote in a June posting.

However, American Capital Acquisition Corp. left behind the GMAC Insurance Dealer Products & Services Group, which is the unit that oversees the vehicle service contract business and the relationships with auto dealerships. A person within AmTrust who declined to be quoted said there are no plans to acquire that additional line of business from GMAC.

Financing Chrysler Dealerships

So GMAC is still in the service contract business. In fact, it's now looking for opportunities to expand the automotive finance and insurance business outside the GM franchise sphere. In 2009, GMAC Financial Services began financing Chrysler vehicles purchases by consumers at Chrysler dealerships, as well as financing inventory for some of those dealerships.

GMAC's share of the Chrysler dealership business grew quickly. As of the end of the third quarter of 2009, GMAC�s outstanding balance of wholesale financing for Chrysler dealers was approximately $3.3 billion, an amount it said represented 67% of Chrysler's U.S. dealership inventory and 85% of Chrysler�s inventory in Canada. For all of 2009, GMAC financed 4.125 million vehicles for all dealers worldwide, of which 131,000 were Chrysler vehicles.

This second try at an expansion strategy continues into 2010. In February, GMAC announced that DealerTrack Holdings Inc. would add a GMAC option into its consumer credit application, and would then make that available to the network of dealerships that make use of its software, thereby allowing buyers of many other brands of automobiles to possibly select GMAC as their lender.

In March, GMAC announced that it would continue to provide consumer and dealer finance services to Saab dealerships worldwide, following the sale by GM of the Saab brand to Spyker Cars N.V.

Financing RVs for Thor Dealers

In April, GMAC began financing new and used recreational vehicles purchased from Thor Industries dealers in 14 states. If all goes well, the company said the RV financing program is expected to expand to all 1,200 Thor dealers by year's end. "The RV business has been recovering steadily with improvements in the economy, and we are committed to supporting RV dealers in their sales efforts," noted Tim Russi, executive vice president of GMAC North American Operations, in a recent news release.

Last month, the remainders of GMAC were renamed Ally Financial Inc. Ally Bank is offering a relatively generous 1.29% interest rate for its online savings accounts, and GMAC Mortgage is offering a relatively benevolent 4.821% interest rate on mortgage refinances.

General Motors Co., the successor to the now-bankrupt Motors Liquidation Company, reported an $865 million profit on $31.5 billion in sales during the first quarter of 2010. That was demonstrably better than its predecessor fared in its last pre-bankruptcy quarter: a $5.98 billion loss on $22.4 billion in sales during the first quarter of 2009. Meanwhile, GMAC Financial Services reported net income of $162 million for the first quarter of 2010 -- its first profitable quarter since 2008.

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