GMAC Arithmetic

Calculated Risk has a table listing all of the leaked stress test figures so far. As a percentage of assets, the big banks need between 0% and 1.4% in additional capital. But there is one outlier: GMAC, with $189 billion in assets, needs $11.5 billion in capital.

This implies that GMAC is not just low on capital, it has negative capital. If you were to give GMAC $11.5 billion in new cash, it would have $200 billion in assets. The minimum tangible common equity requirement being used for the stress tests is probably in the 3-4% range. If it’s 4%, then the post-recapitalization GMAC would have $8 billion in tangible common equity – which means that right now it has negative $3.5 billion in tangible common equity. (The situation is slightly worse if you assume that it will be recapitalized through a preferred-to-common conversion, or if the threshold is 3%.)

The thing that confuses me is that, on paper, you can’t recapitalize a company with a negative net worth. No investor would pay $11.5 billion to own 100% of the common shares in a company that is worth $8 billion. (You can recapitalize a company that is under-capitalized: if it has $5 billion in capital and needs another $5 billion, then the new investors get 50% of the company.) This is why it is important (from the government perspective) for the stress tests to show that some banks are low on capital, but not that they have negative capital.

Maybe there’s some clever accounting mechanism or financial wizardry I’m missing.

Update: OK, now that I read the stress test document (I must be the last economics blogger to do so), I see there’s a mistake above. According to the stress test, GMAC is sufficiently capitalized now; the problem is that under the “more adverse” (realistic) scenario, its 2009-10 losses will be greater than its capital. So its expected capital at the end of 2010, absent recapitalization in the interim, would be negative.

It is not arithmetically impossible to recapitalize such a company, because we don’t know that this outcome will occur with certainty. I might pay $11.5 billion to own a company that, in the more adverse scenario, will be worth less than $11.5 billion at the end of two years – if I think that the possibility of a better outcome makes the bet worthwhile. Put another way, even if its end-2010 expected value is negative, its current value is still at least a little positive, because of option value. Still, though, it’s a pretty dodgy investment, so GMAC will probably have a difficult time raising new capital by selling common stock to the private sector.

The comment Nemo made below about the difference between market value and book value is true, but I also think my response is true: if anything, market values are below book values these days.

Finally, Felix Salmon also noticed that GMAC is the outlier on the bad end.

By James Kwak

13 thoughts on “GMAC Arithmetic

  1. Dr. Kwak —

    No investor would pay $11.5 billion to own 100% of the common shares in a company that is worth $8 billion.

    There is a difference between having a book value (or tangible common equity) of $8 billion and being “worth” $8 billion. Indeed, companies trade at multiples of their book value all the time.

    If the business has sufficient earning power but a book value of negative $3.5 billion, an investor might well be willing to inject $11.5 billion in order to own the whole operation (at a price/book of 1.3).

    This may or may not be the case here… But in general, I do not think it is true that “you can’t recapitalize a company with a negative net worth”.

  2. James,

    Is there a necessary second step? Where you move from being an essential critic to someone who works with others to effect policy changes?

    To quote the “action-orientation” of Woody Allen’s “Manhattan”:

    Isaac Davis: “Has anybody read that Nazis are gonna march in New Jersey? Y’know, I read this in the newspaper. We should go down there, get some guys together, y’know, get some bricks and baseball bats and really explain things to them.

    Party Guest: “There is this devastating satirical piece on that on the Op Ed page of the Times, it is devastating.”

    Isaac Davis: “Well, a satirical piece in the Times is one thing, but bricks and baseball bats really gets right to the point.”

    James, maybe you are already working behind the scenes? But we’ve all been posting here for months (or in my case, reading along) with the expectation that criticism is all it takes for reform.

    I beg you to consider that more leadership is required, and that you, sir, could provide leadership in coordinating the Bill Blacks, Simon Johnsons and Brooksley Borns to come up with a necessary Plan B that they can more or less agree on.

    This unified support from name-recognition experts would give the Plan B the necessary respect it deserves. And then we can help you to rally around it.

    If this is such a crisis, we need to act (peacefully, but decisively, the metaphorical equivalent Woody Allen’s baseball bats and bricks).

  3. The $11.5 billion has to include new capital (unrelated to legacy assets) that GMAC will utilize as the preferred provider of automotive financing for Chrysler dealers and customers.

  4. Interesting. What amazes me is that it seems like the majority of people have forgotten about Cerberus Capital Management. They owned Chrysler Financial, which seems to have been taken over by GMAC. As far as I know Cerberus still owns 33% of the total equity and roughly 15% of the voting shares of GMAC as well after it was converted to a bank holding company. It was converted to a bank holding company so it could get bailed out. A few like to complain that the UAW could get too much of the Chrysler pie, but Cerberus seems to have snagged a large control of the financial arms of two auto companies.

  5. It is not inherently impossible. Just as there is good P/E (the multiple has gone up) and bad P/E (the earnings have dropped), so there is good negative book equity (stock repurchases exceed invested capital) and bad negative book equity (accumulated losses).

    Clorox has negative book equity, but that doesn’t mean a buyer of new equity would be irrational. If GMAC had intangible assets that were underrepresented on its balance sheet, one might be able to get comfortable putting in new money.

    As a matter of fact, of course, we know that:

    (a) several banks on the list actually have negative book equity if they marked their whole loan portfolios to market;

    (b) the only reason for creating a government stress test was to put the seal of approval on a version that did not reflect (a), thus relieving the pressure on the Administration to take action based on (a);

    (c) the government is not about to let a major bank fail, regardless the cost;

    (d) the government encourages reckless behavior at GMAC because it wants desperately to pump up the auto market.

  6. This is true. Also, note that book value can be more than loan assets – liabilities + capital. Book value can include goodwill (e.g. the value of your base of retail clients), for example. This is why some banks will absorb insolvent smaller banks (in order to gain access to their customers).

  7. I agree, too. Market value often has nothing to do with book value – in the technology industry, for example. Also, as StatsGuy points out, the assets of one company may be worth more in the hands of another company.

    That said, I’m not sure either of these applies to GMAC. And during this crisis troubled financial institutions are trading at far below their book value (see Citigroup and Bank of America, for example).

  8. Remember, there is a significant preferred interest in GMAC via the TARP. This means that the common equity can have negative value without the company having negative equity.

  9. my understanding is that the stress test requires that tce is greater than 3% at the end of 2010 given the losses implied by their adverse scenario. that means that they may have positive equity in 2010 given a good scenario.

  10. StatsGuy,

    Book value includes only that goodwill which it booked by acquiring all or part of another company.

    The value of a company’s base of client will be considered in market value, but it’s not part of book value.

  11. A quick follow-up: since TARP preferred is junior to all liabilities, conversion of TARP preferred to common preserves the value of the TARP interest better than bankruptcy (which never actually unlocks all the asset value) and should at least cover the deficit. The preferred interest most likely has positive value, and that value will transfer to the common equity upon conversion.

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