GMAC Case Study

Background
Over the past few years, Parent Auto Manufacturer (PAM) has faced increasing legacy costs and decreasing
market share. As a result their credit rating has fallen from investment grade to non-investment grade. With the
decline in credit rating, Financial Services Company’s (FSC) ability to access the capital markets has been
restricted and thus their cost of funds has increased. FSC is a wholly owned subsidiary of PAM (The table below
shows FSC’s cost of funds for the past 3 years.) Historically, the majority of FSC’s business has been financing
PAM’s vehicles, while also providing PAM with an annual dividend of $2 billion.

Securitized Funding1 Unsecured Funding

Credit Originations Percent Cost of Duration Percent Cost of Duration
Year Rating ($ Billion) Secured Funds (bps) (months) Unsecured Funds (bps) (months)
2004 IG $29 46% Libor + 30 37.5 54% Libor + 8 98.1
2005 IG-NIG $32 90% Libor + 24 34.8 10% Libor + 135 80.3
2006 NIG $30 100% Libor + 21 30.3 0% Libor + 250 NA
IG = Investment Grade, NIG = Non Investment Grade

In early 2006, PAM agreed to terms with Private Equity Firm (PEF) on the sale of a 51% controlling interest in
FSC. (Exhibit A displays FSC’s projected earnings in both a no sale scenario and a sale scenario.) Highlights of
the transaction are listed below.
 PAM to receive approximately $14B in cash over the next 3 years.
 Reinvestment of essentially all FSC earnings in the business for at least the first two years.
 Reduction of inter-company loan between PAM and FSC. (PAM owes FSC)
 Contractual agreements ensuring arms length operating relationship between PAM and FSC for at least
10 years.
 3 Independent Directors, whose primary responsibility is to FSC’s shareholders.
 10 year exclusivity agreement between FSC and PAM to finance customers in accordance with historical
practices, although FSC is allowed to finance non-PAM vehicles.

As a result of this transaction, the rating agencies have stated that they will re-evaluate the credit rating of FSC.
Typically rating agencies consider three factors when assigning a credit rating. The first factor is an evaluation of
the company’s financial and operating performance. At a minimum, rating agencies require several months of
historical performance data. A second factor reviewed by the rating agencies is capital adequacy, as having the
proper amount of capital is essential to achieve specific ratings. The final factor rating agencies consider is the
business risk associated with the company.

Question
You are a new analyst at FSC, and your director has been called to a meeting in one hour to discuss which one
of several businesses FSC should allocate capital to. She has asked you to prepare her for the meeting by
reviewing the information outlined below and recommending the best option. Your recommendation should cover
a strategic, financial and operational perspective (Exhibit B contains a financial comparison of the three options).

1
Secured funding is the process of issuing debt backed by cash producing assets
Option 1: Student Loan Financing

The Department of Education (DOE) last year forecast that students and their parents would take out 12 million
student loans totaling $48.8 Billion in 2006. The Bureau of Labor statistics projects that by 2010, 70% of the
fastest growing jobs in the economy will require some type of training or education beyond high school.
Commercial Banks, Credit Unions, Thrifts, Insurance Companies and non-profit student loan companies all
participate in the market for student loans (Exhibit C).

Federally sponsored student loans are lower risk assets, as they are protected against default by a Government
guarantee. The DOE also subsidizes the rate paid by students by paying the difference between the rate on the
loan and the market rate to the lender. These initiatives help make student education more affordable. In 1990,
only 16% of students received Stafford loans (the most popular type of student loan). The rate of participation
increased to 53% of students by 1995 following significant legislative amendments.

In the past, lenders competed for student loans by providing school financial aid officers with value added
services, including high speed processing systems to streamline the application process. Today, lenders compete
on reduced origination fees, lender margin rebates and flexible payment terms, favoring well capitalized, high-
margin lenders. Lenders historically outsource the servicing2 of the student loans to third parties. The DOE can
reject a guarantee claim by a lender if a loan was not serviced or originated according to DOE guidelines.

Most lenders hold very little student loan collateral on their books, as they find it more attractive to sell the loans to
firms like Sallie Mae (Exhibit D). Lenders can sell the loans in bulk (“whole loan”), or structure the loans as asset
backed securities (ABS) which are subsequently sold to investors. Only a small number of lenders have
origination volume large enough to support an efficient ABS program without purchasing loans from other
originators.

Option 2: Used Car Financing

Sales of used vehicles reached 45 million in 2005, and are expected to grow at the rate of 1.5 million units
annually. This makes the used car market significantly larger than the new car market, which has remained
steady at 16 million units a year. Advances in vehicle engineering and the increased used of leasing as a
financing option have driven the growth in used vehicle sales. PAM dealerships on average sell 2 used cars for
every new car sold.

Used vehicle sales are counter cyclical i.e. they exhibit growth during economic downturns. The average size of a
used vehicle loan ($16,419) in 2005 was significantly lower than a new vehicle loan ($23,534). Chargeoffs3 on
used vehicle loans (1.55%) were much higher than new vehicle loans chargeoffs (0.8%) in 2005, reflecting the
non-prime nature of the business.

Compared to new car financing, used car financing is a much more fragmented industry. Credit unions are much
more active in used car financing, and compete primarily on rate. Additionally, while the majority of new car sellers
are large dealer groups, most used car sellers are independent entrepreneurs.

Used car entrepreneurs typically look for a financier who will be committed regardless of the economic cycle.
National banks tend to leave and enter the business frequently, and are therefore out of favor with most used car
dealers. Successful financiers typically provide a full range of financing services i.e. for used, new and wholesale4.
Getting a single line of business is difficult unless a financier is willing to be aggressive on rates.

2
Servicing is the process of collecting payments from borrowers and distributing the payments to lenders
3
Chargeoffs occur when a default on a loan is actually realized
4
Wholesale refers to the financing of vehicles on dealer lots
Option 3: Expansion of Chinese Operations

Although the auto industry has shown signs of a slowdown in the Chinese market, finance companies continue to
expand into this coveted market. State owned banks pioneered the market 10 years ago and continue to
dominate it. Over $30 billion in outstanding auto loans are in the market today and this number is expected to
continue to grow. The Chinese market remains risky with a non-performing loan ratio of 50%, no central
consumer credit rating agency, and extremely lenient laws on credit fraud and repossession laws. In addition to
these risks the average consumer has little experience in obtaining and managing debt, typically paying at least
80% of any purchase in cash.

FSC has been operating in China for just over 2 years and currently finances 5% of the 800,000 vehicles sold
yearly by PAM. PAM has experienced 30% growth a year, while FSC has grown at 71% per year. To continue
this unprecedented growth FSC-China requires additional capital to achieve a higher coverage of all PAM dealers
in China.
 Case Exhibits

Exhibit A: Projected FSC Earnings

5
Earnings ($Billions)

4.5
4
Sale
3.5
No Sale
3
2.5
2
2007 2008 2009 2010 2011

Exhibit B: 5 Year Scenario Projections

Net Income ROA (%) ROEC (%)

Student Loans 125 12 14
Used Car Financing 150 8 15
ROA: Return on Assets
ROEC: Return on Economic Capital

Exhibit C: Larg e s t Orig inato rs o f S tude nt Lo ans (Millio ns )

Amount Funded Annual % of Industry Volume
2005 2004 Growth (%) 2005 2004
JP Morgan Chase (Incl Bank One) 5,784 5,179 11.7% 14.87 15.80
Sallie Mae 3,160 2,317 36.4% 8.12 7.07
Citibank 2,995 2,542 17.8% 7.70 7.75
Bank of America 2,158 1,938 11.4% 5.55 5.91
Wells Fargo 2,042 1,899 7.5% 5.25 5.79
Wachovia 1,781 1,554 14.6% 4.58 4.74
National City Bank 1,388 1,116 24.4% 3.57 3.40
US Bank 1,031 931 10.7% 2.65 2.84
Pittsburg National Bank 671 619 8.4% 1.72 1.89
SunTrust Bank 661 565 17.0% 1.70 1.72
Total - Ten Largest Originators 21,671 18,660 16.1% 56.00 57.00
Total - All Originators 38,907 32,781 18.7% 100.00 100.00
 Exhibit D: Larg e s t S tude nt Lo an Ho lde rs (Do llars in Millio ns ), 30 S e p 05

Outstanding Balance % Total Market

Volume
Sallie Mae 65,291 41.7
Citibank 16,030 10.2
First Union Natl Bank 7,102 4.5
Wells Fargo 5,913 3.8
National Education Loan Network 4,186 2.7
Brazos Group Tx 3,909 2.5
Key Corp 2,743 1.8
Bank of America 2,549 1.6
Penna Higher Ed Assistance Agency PA 2,545 1.6
Efs Finance Company 2,487 1.6
Total - Ten Largest Holders 112,757 72.1
Total - All Holders 156,467 100.0