(FORTUNE Magazine) – This isn't where Paolo Fresco, the former GE vice chairman and overseas eyes for Jack Welch, expected to find himself at the twilight of his career. When the Milan native retired from GE to become Fiat's chairman in 1998, he thought the diversified Italian conglomerate needed to buy and sell a couple of businesses, raise its performance standards, and create a GE-style training path for the young Agnelli scion who would one day run the family-controlled company. Then Fresco could enjoy a comfortable retirement at his seaside home in Portofino.

Instead, Fresco, 69, finds himself in the middle of a Machiavellian plot that threatens to sink him and the company. Gabriele Galateri, his CEO of five months, has quit, and the Agnelli family, which holds 30% of Fiat, tried to oust Fresco too. After a rancorous meeting Dec. 10, Fiat's board gave Fresco its unanimous support, and at a second meeting three days later, the Agnellis gave him their personal vote of confidence. But the bad blood lingers. "There was this big fuss, which doesn't help the company, and I'm pissed at that," Fresco told FORTUNE shortly after the second board meeting in Turin. "This is not the time to abandon the ship. But I would never do this without the blessing" of the Agnellis.

The boardroom fight comes as the company faces a crisis so big that it could send Fiat into bankruptcy. After steadily losing market share to other manufacturers, the company's biggest business, Fiat Auto, is expected to post operating losses of $1.2 billion this year, splashing the overall group with $600 million of red ink. That cash drain, on top of debt built up in Fiat's other businesses, has already forced the company to sell assets, including 34% of Ferrari, and renegotiate with its banks. Fiat shares have fallen 55% so far this year, more than any other auto company's. And layoffs at several plants have touched off a wave of strikes and angry protests throughout the country. "There is no doubt," the urbane Fresco said in November, surrounded in his Turin office by photographs of former GE colleagues, "that the challenge I'm faced with is much bigger than I expected."

As if a power struggle and a business tailspin weren't enough, in typical Italian fashion everyone from Prime Minister Silvio Berlusconi to Fiat's bankers has offered an opinion about what to do. The cacophony of competing strategies may make it impossible for Fresco to carry out a fix-it plan agreed to over the past six months with Fiat's banks, shareholders, unions, and the government--not to mention General Motors, which owns 20% of Fiat Auto and is under contractual obligation to buy the rest of the company if Fiat decides to sell. As a banker at Milan's Sanpaolo IMI, which is part of a consortium that lent Fiat $3 billion, puts it, "This is a terribly convoluted situation."

Yet if Fiat can't fix its auto division and pare its net debt of $5.7 billion to $3 billion by March, the banks may wrest control of the company from the Agnelli family, which has driven Italy's industrial development since Fiat's founding in 1899. That's where some analysts say the company is headed. "I think the company slides ever more deeply into the hands of the banks," if not into bankruptcy, says Stephen Cheetham, an auto analyst at Sanford Bernstein in London. "And that means a spiral into nothingness."

Such an outcome would be devastating not only for Fiat but also for Italy. With revenues last year of $52 billion and 95,000 workers in Italy, Fiat is the country's largest company. In addition to making cars, it is a world leader in agriculture and construction equipment and in light commercial trucks. It owns insurance and publishing businesses in Italy. And its Ferrari division (separate from Fiat Auto, which also includes Alfa Romeo and Lancia) has so dominated Formula One racing in recent years that TV viewers are switching off in droves. For this empire to be dragged down by a money-losing auto business would be a blow to national pride as well as to the Berlusconi government, which desperately wants to keep Italy's auto industry alive.

Fresco's turnaround plan is being undermined by the intrigue orchestrated by Umberto Agnelli, the 68-year-old brother of Fiat's honorary chairman, Giovanni, 81, who is suffering from prostate cancer. Umberto, whose star has risen with the decline of his brother's health, apparently made life miserable for longtime Agnelli confidant Galateri, who made it known he wanted to step down as CEO just prior to the Dec. 10 meeting. According to several sources close to the Fiat board, Galateri said he resigned because of pressure from Umberto and because he found the job too stressful. Galateri told FORTUNE in November that he hadn't wanted the CEO job in the first place but had been persuaded to take it by Fresco and Umberto.

The evening before the Dec. 10 board meeting, Umberto told Fresco he should resign too, because Umberto's choice of a new CEO, Enrico Bondi, a former Fiat man currently heading Italian insurer SAI, didn't want Fresco around. Most of the board members read about these machinations in the Italian press on their way to Turin for the regularly scheduled meeting. Four members friendly to Fresco--Welch, former Lazard chief Felix Rohatyn, former Swiss President Flavio Cotti, and Deutsche Bank executive Hermann-Joseph Lamberti--threatened to quit at the Dec. 10 meeting if the board didn't unanimously support Fresco. Faced with that ultimatum, the Agnelli directors backed down, but "it left a lot of blood on the floor," says one Fiat source. Both Agnellis declined to talk to FORTUNE. Neither is on the board, but they are represented by three family holding-company executives, including John Philip Elkann, Giovanni's 26-year-old grandson and heir to the Fiat empire.

The next three days saw a furious exchange of phone calls between directors, Fresco, the banks, and the Agnellis about how Fiat should alter its restructuring plan and who should succeed Galateri. In the end Fresco got most of what he wanted. His chief operating officer, Alessandro Barberis, was elevated to CEO, and Galateri, who remains a Fiat director, will stay on as a consultant. But the Agnellis extracted their pound of flesh: Franzo Grande Stevens, 73 , a family holding-company director, was named deputy chairman.

As long as Fresco has his job, his crisis plan will go forward. He says he will cut $1 billion in costs by, among other things, shutting factories and laying off 6,550 autoworkers. And he hopes that four models Fiat is introducing next year will bring its European market share up to 10% from the current 8%. "We are still going to have a car business with problems," says Fresco, "but the numbers will look better."

But Fiat's long-term salvation doesn't lie with turnaround plans and financial engineering in Turin. One of Fresco's smartest moves was to team up with General Motors in early 2000. Fresco had almost signed an agreement to sell the auto business to DaimlerChrysler when Jack Smith and Rick Wagoner of GM came calling, offering a less drastic solution. GM paid $2.4 billion for 20% of Fiat Auto, which Fiat converted into a 5.6% stake in GM. The two companies also agreed to form joint ventures in purchasing and powertrains to make their European businesses more efficient. The crowning touch was a put option that gives Fiat the right, beginning in 2004, to sell the rest of Fiat Auto to GM at a price to be negotiated. (The contract sets out an elaborate mechanism for determining the value of Fiat Auto, involving up to four investment banks.) In short, if all else fails, Fiat can simply dump its auto division on GM.

Given Fiat's losses and GM's own weak position in Europe--it lost $424 million there in the first three quarters of this year--GM has told Fiat that it wants to delay the exercise date of the put. "If you're GM, you need this thing like a hole in the head," says Cheetham at Sanford Bernstein. Indeed, GM has already written down its Fiat stake to $220 million. Fresco says he's open to new ideas--GM could gradually increase its stake in Fiat Auto now, or the unit could be merged into GM's European Opel subsidiary. "We are not going to renounce the put unless there's a formula favorable to both parties," says Fresco. "Our noncompromisable objective is to get closer to GM." GM won't comment, but spokeswoman Toni Simonetti acknowledges, "There is a finesse that the companies can arrive at."

Without Fresco, discussions with GM could be jeopardized. That's one reason, sources say, that Fiat's creditor banks violently opposed his resignation. "Fresco is involved with all the big relationships with the government and GM," says one high-level Fiat source. "Why should he go when he's doing a good job?" Other sources say that Umberto wanted to fold the Alfa Romeo brand in with Ferrari and Maserati to form a new luxury-car group, partly owned by Volkswagen, an idea that one of the sources labeled "speculative." "Any change in strategy now is very dangerous for our customers, employees, and creditors," Fresco says. "People hear that Fiat is in crisis and in a fight between banks, and they begin asking if we are going to have spare parts for next year." Sources say Fresco will stay on at Fiat until the GM deal is renegotiated.

At some point Fiat will have to survive without Fresco, but can it survive without cars? Yes, and very well. Fiat Auto accounts for 40% of the group's revenue and most of its losses. Without it, Fiat would be a smaller but healthier company, with about $2 billion less in net debt. "Fiat would have a very bearable financial burden that would be well served by the cash flow of the business," says Fresco, describing a car-less future. "We are not committed to being in the auto business forever."

But Fiat's major nonauto businesses aren't as robust as they could be. Last year they posted about $1 billion in operating profit, with nearly half of that coming from CNH, the agriculture equipment and construction business, and Iveco, Fiat's commercial-truck division. This year both businesses are in slumps, and CNH will barely break even. "CNH and Iveco should have more profits, given their market shares," says Fresco. CNH has 26% of the world tractor market and 35% of the combine market; it is No. 3 in construction equipment. Fiat's best performers, Ferrari and Fiat Avio, the aviation unit, are bit players in their industries. Comau, the industrial automation business, Teksid, the foundry business, and Magnetti Marelli, the auto-parts unit, are all earmarked for sale.

Because of Fiat Auto's problems, other Fiat businesses are under pressure to boost cash flow and profits. Fiat Avio CEO Saverio Strati has postponed some R&D projects and given up plans to make acquisitions. "The current situation has put a brake on our plans," says Strati. Ferrari CEO Luca Cordero di Montezemolo had been discussing an IPO with Deutsche Bank when, in order to raise quick cash, Fresco preempted him by selling a stake to Mediobanca.

Fiat's debt doesn't stem only from the auto division. In 1999, Fresco spent $4.6 billion to buy Case in the U.S., combining it with Fiat's New Holland business to create CNH. Unfortunately Fresco bought at the top of the economic cycle. "One or two years later would have been better," says CNH chief Paolo Monferino, "but no one knew that." To get CNH on track and reduce debt--nearly half of Fiat's net debt is the result of the Case purchase--Monferino is slashing costs by cutting inventory, closing factories, and developing common platforms for its equipment. Still, Monferino says it will be 2004 before business recovers and the full benefit of the merger comes through.

All this should stave off the banks, which are holding a $3 billion loan convertible into 30% of Fiat shares if the company fails to reduce its debt. To keep that from happening, Fresco says he will sell assets and squeeze more cash out of the business. "We are in a financially solid position," Fresco says, "regardless of what people say."

But some insiders believe Fresco is to blame for Fiat's current predicament. They say he relied too heavily on the group's former CEO Paolo Cantarella, who left in June, and on Roberto Testore, the former Fiat Auto chief who resigned in December 2001. Even Fresco acknowledges he should have taken a more active role in the auto business, though he points out that he came to Fiat as a nonexecutive chairman. "You don't accept a job to be chairman of a company as a bridge to retirement," he says, "but certainly I took it at a time when most Americans would retire. I have been much more involved over the last 18 months."

Other Fiat executives blame the deteriorating economic situation in new markets, such as Poland, Turkey, and Argentina, that the company expanded into during the 1990s. But Fresco says that even with the expansion, the company remained too reliant on Brazil and Italy, which together account for 60% of cars sold. The 1996 appointment of Testore, who had little auto experience, resulted in a reduced emphasis on new-product development. With other manufacturers rapidly invading its turf, especially in its traditional small-car segment, Fiat saw its share of the Italian market slip from 45% at the beginning of 1996 to 29% this year. "They had too much Italy, too much small car, and, grafted on top of that, a failure to turn around the product's image, which is one of the lowest in the European car industry," says John Lawson, auto analyst with Salomon Smith Barney in London.

The fatal blow--"the big straw that broke the camel's back," Fresco calls it--came when the Stilo, a higher-priced, technology-stuffed compact, sold far fewer cars than predicted. The car's disappointing debut in November 2001 led Fresco to reorganize the auto division and replace Testore.

The new chief, Giancarlo Boschetti, 63, who has worked at Fiat for nearly four decades, plans to spend more on R&D and speed up new-product development. But Boschetti's toughest challenge has been implementing layoffs. The unions tried, through strikes and protests, to pressure the Italian government to halt the company's plans to close a factory in Sicily and lay off 1,800 workers. The 1960s-era plant is not nearly as efficient as Fiat's showcase factory in Melfi, where workers and managers wear the same magenta and dark-green uniforms and operate assembly lines 24 hours a day, six days a week. The government finally approved the layoffs in early December, allowing workers to collect 80% of their wages from a state-managed fund.

Company officials say layoffs and early retirements will reduce costs by $300 million next year. Additional savings of $700 million are expected through joint purchasing with GM and cuts in logistics, sales, and administrative costs. As long as Fiat sells two million cars next year, the same as this year, Boschetti says, it can stop the cash drain.

But even this might not save Fiat. "Eventually," says Garel Rhys, professor of motor industry economics at the University of Wales, "Fiat cannot stay on its own. That has nothing to do with Fiat but with the economies of carmaking." That is where GM comes in. Together, the two companies would be the largest automaker in Europe, with an 18% market share. Aside from joint purchasing, GM and Fiat envision developing common platforms to cut costs. By 2005, Fiat says, GM's Opel Corsa will share 70% of its parts and costs with the Fiat Punto. Fiat also expects GM to sell Alfa Romeos in the U.S. through its dealer network beginning in 2007. Alfa left the U.S. market in 1995.

When the Agnellis agreed to an alliance with GM, sources close to the family say, they envisioned one day becoming major GM shareholders. Without a significant improvement in Fiat's bottom line, that will never happen. Some insiders say the Agnellis blame Fresco, the great hope from GE. But Fresco has always been more a strategic, mergers-and-acquisitions guy than an operating executive. And, without the GM put, Fiat would be in far worse trouble. The Agnellis may have reached a detente with Fresco, but it's clear that Italy's oldest car manufacturer is running out of road.

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