The quick, surprising turnabout at ResCap

Residential Capital, once a wildly profitable colossus in home lending, is sitting on a crumbling foundation.

And the rapid deterioration of the housing and mortgage markets seem to have come as much of a surprise to the lender's management as they have to the homeowners who only a year ago were taking out new loans with little regard for the notion that values might fall.

Unlike some lenders, 2007 for Residential Capital, or ResCap, began right away with a falloff in the performance of its loan portfolio -- the company had a $910 million first-quarter net loss, a stunning turnaround from 2006 net income of $705 million and profit of more than $1 billion in 2005.

By May, however, the company's chief financial officer was reassuring analysts that the problems were in hand.

"We put in place a new plan that we are finalizing right now that will turn this business around in short order," Sanjiv Khattri had said.

The Bloomington-based firm has made a series of layoffs as part of that plan, and will end the year with about 1,100 Twin Cities employees, down from a peak of 1,900 in 2006. It has also closed 50 sales and servicing locations, and has stepped back from making new subprime and other unconventional home loans.

But so far, the moves appear to be the equivalent of turning on the fire hoses after flames are licking out of every window. ResCap cut its subprime portfolio in the third quarter by $19.8 billion compared with a year earlier, but they still represented 61 percent of a $61 billion portfolio. The year before, subprime loans were 77 percent of a $74 billion portfolio.

Most of that investment is in "securitized" loans -- bundled debts, some originated by ResCap and others not. The securities were supposed to be easily traded. But as the housing market fell and more mortgages went bad, those bundles have proved no more attractive to sell than individual loans.

And the rate at which loans are going bad has accelerated. In November, ResCap reported a net loss of nearly $2.3 billion for the months of July, August and September -- about 2½ times the first-quarter loss.

"The loss was much greater than our worst-case expectations," Citigroup bond analyst Ryan O'Connor wrote in a recent report.

Even injections of $2 billion in capital -- and a $750 million tender offer intended to prop up falling bond prices -- has not kept $17.8 billion in ResCap debt -- nearly a quarter of its total debt -- from being rated as junk by Fitch, Standard & Poor's and other rating services. ResCap bonds that have a coupon rate of 6.375 percent interest and maturing in 2010 recently sold at about 63 cents on the dollar, down 37 percent from last summer.

It was a stunning loss of confidence for a company that, as of Sept. 30, ranked eighth in U.S. home loan originations, with year-to-date loan production of $78 billion and loan serving on $427 billion in mortgage debt.

"ResCap is kind of almost a poster child for subprime lending," said John Bartko, credit analyst at Standard & Poor's.

A warning about reserves

In the third quarter, 14 percent of ResCap's loans were nonperforming, meaning not earning interest and more than 90 days late. The company raised its third-quarter provision for losses to $881 million, up from $327 million in the second quarter, but its reserves remain well below the levels typically set aside by other big lenders.

"ResCap's reserves cover only 20 percent of nonperformers," O'Connor warned.

In comparison, reserves in the third quarter represented more than 100 percent of nonperforming loans at Wachovia, nearly 200 percent at Wells Fargo and more than 300 percent at J.P. Morgan Chase & Co., O'Connor noted.

"How much further can it fall and how much longer can it last?'' Bartko asked. "I don't know if anybody has a good feel for the answer to either of the questions."

ResCap executives declined requests for an interview, saying that they cannot comment because of the pending tender offer.

Beyond relying on subprime mortgages for much of its business, ResCap also took on most of its loans from outside firms -- both factors that have since emerged as red flags in predicting which portfolios will pay on time and which will see big defaults.

In 2005, 73 percent of the company's U.S. mortgage loans came from mortgage brokers or correspondent institutions. In 2006, that share rose to 83 percent.

"Conditions in the housing market deteriorated very rapidly in ways we haven't seen before," said Chris Wolfe, a credit analyst at Fitch Ratings, a New York-based company that evaluates the creditworthiness of corporations and governments.

While other financial firms can rely on business lending or other forms of consumer lending to help make up for mortgage troubles, ResCap has few sources of succor.

GMAC, the credit arm of General Motors Corp., which owns 49 percent of ResCap, has put $2 billion into Rescap this year to try to tide it over. It's unclear whether that will be enough, however.

"We view the support from GM as a lifeline, not a rescue," said Wolfe at Fitch. "It keeps them afloat. It doesn't solve all of ResCap's problems. But it gives them the time to work through this."

In the meantime, ResCap is looking for a buyer for some of its business units, a task that won't be easy. And, as the clock ticks, accounting rules could force ResCap to take more loan losses as early as this month.

In an environment in which no one is likely to take subprime and other nonconforming loans off ResCap's hands, the process of recovery is likely to be slow, credit analysts say.

"Obviously, liquidity in that area is pretty well dried up," said Justin Monteith, a market analyst at KDP Investment Advisors in Montpelier, Vt. "If it's not conforming, you can't sell it. If the market remains frozen for a few years, they won't be the only ones that go down," he said.

Mike Meyers • 612-673-1746