PE Firms Think Small; ResCap Just Too Large

Last week I was talking to a hedge fund manager from Connecticut (is there any other type?) who's toying with the idea of buying a small mortgage brokerage operation in the New York area. His plan is simple: Buy the thing for a song, convert it to a mortgage bank, expand its warehouse lines, and shift the origination clutch into high gear.

He's not ready to go public with all this, but it doesn't take a genius to figure out the obvious: profit margins on newly originated mortgages are the widest they've been in years and show no signs of tightening any time soon. As any good capitalist knows, it's best to make hay while the sun is shining. (Note: There is no PE money for subprime and alt-A. It's all Fannie/Freddie/FHA.)

Even though some soothsayers believe small mortgage banking firms will get hammered once FHA hikes its minimum capital requirement to $2.5 million (three years away) there's also a school of thought that thinks there's money to be made in raising cash for these small firms. But the key to all this is the word "small." From conversations I've had with investment bankers and boutique advisors over the past year, there appears to be plenty of money available for "small" deals as long as they don't cost an arm and a leg.

Or maybe I should rephrase that: There's plenty of cash on the sidelines "exploring" mortgage opportunities but that doesn't mean Joe Hedge Fund Manager is willing to pull out the checkbook for just anyone. (Talk, as always, doesn't cost anything.)

The message here might be "small is good" which leads me to Residential Capital Corp., the troubled mortgage banking arm of GMAC Financial Services. Recently, when I wrote a news blurb about ResCap losing $4 billion in the fourth quarter, Jeannine Bruin, a GMAC spokeswoman, took umbrage at some editorializing I did.

In the lead of the story I merely noted what I thought was obvious - that ResCap was on the "auction block."

Ms. Bruin said I was all wet, writing, "The company has not said that the ResCap business is up for sale." OK, fair enough. It's not for sale. Maybe.

But let's face the obvious: The reason GMAC can't sell ResCap is that it's too big and in today's current operating environment no one in their right mind is going to pay up for a mortgage banking franchise with both heft ($380 billion in servicing rights) and problems (the prospect of additional writedowns).

GMAC executives contend that after losing so much money and marking down ResCap's mortgage holdings to their "true" (current value) that it should be smooth sailing ahead. In other words, ResCap is now a "clean" shop.

Still, that doesn't mean anyone is willing to buy it. And yes, as I've noted, profit margins are great.

Keep in mind that recently appointed GMAC CEO Michael Carpenter - a Citigroup veteran - now answers to Uncle Sam, which controls 56% of GMAC (after pumping $15 billion in the firm). One industry veteran explained the situation to me as such: "Carpenter is under tremendous pressure," said this advisor. "The government doesn't want all this capital tied up in mortgages. They're already in deep with Fannie and Freddie."

It seems pretty clear to the White House that if ResCap went away, the mega-banks (and a handful of fast growing midtier lenders) would fill the void in mortgage land. But that's not the case in auto lending, which is why the U.S. kept GMAC afloat. Without its bailout of GMAC, General Motors and Chrysler would have been toast. (Chrysler still might be toast but that's not my beat.) Commercial banks tend to hate auto lending for the simple reason that once a car is sold and driven off the lot, it loses value.

Bankers also don't like it when the "collateral" is mobile. It's harder for the repo man to find.

But getting back to ResCap, I have no idea what the future holds for this mortgage firm.

The big boys (Wells Fargo, Bank of America, JPMorgan Chase) won't buy it because they figure, heck, Uncle Sam might just wind up giving the thing away. Or not.

I do know one thing though: Cerberus Capital, which paid $14 billion for a 51% ownership stake in GMAC four years ago, will never recoup its investment. Game over for them.