How GMAC's Woes Foretell Consumer Pain

A lot of people who have been hearing about the ubiquitous credit freeze are probably wondering where the heck it is, since their credit card bills and mortgage statements seem to keep coming, unabated. It's even harder to understand how this unseen credit crunch is supposed to bring down the broader economy.

Well, here's one fresh glimpse of how the banking crisis is spreading into the "real economy"—and how the whole spiral is likely to get worse. GMAC, the nation's biggest auto lender, recently said it will lend money only to "prime" borrowers with credit scores of 700 and above. The reasons: rising losses, unstable credit markets, and other factors that essentially mean a lot less money is available for loans.

Prime borrowers with the lowest risk of defaulting on their loans represent about 75 percent of all new-car buyers, meaning GMAC is effectively cutting off one fourth of the market. Used-car buyers tend to have weaker credit, so a larger percentage of those buyers won't be able to get a loan from GMAC, either.

The word subprime has become a nasty epithet, but it's worth recalling that in general, there's nothing wrong with banks lending money to people with subprime credit scores. Banks actually used to make good money off such borrowers. Sure, there's a higher chance they'll default—which is why banks charge them a higher interest rate. In a normal economy, banks can predict with great accuracy what the default rates are likely to be for every class of borrower and charge rates all but guaranteed to cover any losses.

As everybody knows, this is not a normal economy. Overvalued real estate has led to a deep housing bust and woozy bankers who vastly underestimated their losses. In addition to its car-financing business, GMAC has a big mortgage-banking arm, and earlier this decade, it raked in billions from mortgages, as virtually every other bank did. Up until 2006, GMAC was a wholly owned subsidiary of General Motors, and the financing arm consistently produced the bulk of GM's profits, masking automotive operations that were struggling.

In 2006, GM spun off 51 percent of GMAC to a private-equity consortium led by Cerberus Capital Management, the same company that bought most of Chrysler last year. For a bunch of financial wizards, Cerberus's timing has been terrible. GMAC's earnings have plunged since Cerberus bought a controlling stake, owing largely to bad mortgage bets. In the second quarter of 2008 alone, GMAC lost $2.5 billion. And most analysts think mortgage defaults are likely to rise more before they eventually fall back to normal levels, meaning that lenders like GMAC need to brace for even deeper losses.

So to reduce its risks and preserve its capital for an even rainier day, GMAC has decided to stop making car loans to the riskiest quartile of borrowers. No big deal—somebody else will lend to them, right? Actually, don't bet on it. Lenders don't mind higher-risk borrowers, as long as they're part of a portfolio that includes lots of low-risk borrowers as well, for stability. But if GMAC cherry-picks the best customers, that leaves a bigger proportion of problem borrowers for the next bank to deal with. Its likely response: No, thanks.

Even worse, many bank analysts now expect defaults on car loans and credit cards to spike the way they have with mortgages, since falling home values effectively leave consumers with less wealth. A recession's on the way, too, with unemployment likely to rise to 7 percent or more from 6.1 percent today. People who get laid off don't have more money to pay their debts; they have less. So banks that lend to consumers are in for a tough time, and banks that already hold a big stack of bad mortgage-backed securities are precisely the ones none of the other banks want to lend to. Thus, the $700 billion bailout and all the other dramatic efforts to get money flowing between banks again.

GMAC hasn't gotten any of the bailout money yet, and it's not clear if it will. So the lender has imposed its own austerity measures—which will cascade through other parts of the economy. Car sales in September were the weakest in 15 years—largely because of the weakening economy and tighter credit standards for car buyers. And that was before GMAC's latest cutbacks knocked even more buyers out of the market—unless they want to pay cash for a car.

Now, sales in October are heading for even lower levels. Chrysler CEO Bob Nardelli recently warned of the "global collapse of the auto industry," a scenario that could eviscerate Chrysler, since it appears to be the weakest of the world's six big automakers. If auto sales stay at their depressed levels into next year, GM and Ford could also have cash-flow problems, with one or both at risk of a Chapter 11 filing.

That's a doomsday scenario for Detroit: Airlines have been able to operate more or less normally while reorganizing under bankruptcy, because an airline ticket is a one-time purchase and consumers can usually tell if the company is still going to be around when it's time for their flight. But making a big, long-term purchase like a car from a company with an uncertain future is a much tougher sell. It would probably take fire-sale prices and giveaways that would only worsen conditions across the industry.

As banks cut back on loans in such a weak economy, a perverse cycle sets in: Consumers make fewer purchases, manufacturers cut back on production and shed jobs, the economy weakens more, and consumers cut back even more on spending, either because they've lost their job or they're afraid they might. This doesn't mean that GMAC is causing a recession. But when dozens of big banks, just like GMAC, hoard their cash and nurse their losses, the outlook for consumers gets very chilly. So baby that jalopy in the garage. You might need it for a couple more years.