Why I am starting to like the Mortgage Insurers
The mortgage insurance business has been a tough business to understand. I have been working for a number of weeks now trying to wrap my head around it, first with MBIA (which strictly speaking has a financial guaranty business not a mortgage business, but same diff), and then with Radian Group and MGIC. Each company has unique intricacies that take time to work out. Its been a slog.
But while the companies are different in their details, there are some common reasons for the difficulty:
- The accounting of the business (particularly in the case of financial guaranty) is complicated by derivatives that are mark to market and/or on the balance sheet but not fully recourse to the company
- The mortgage industry is soon to see regulations that will change its landscape (these go by the acronyms QM (quality mortgage), QRM (quality residential mortgage) and the future of the GSEs (Fannie May and Freddie Mac)). The final details of these regulations are still very much up in the air
- The remaining legacy losses from the mortgage crisis are going to be determined by the future rate of default of the homeowners the companies have insured. Given that what has occurred in the US Housing market is unprecedented, there isn’t a historical guide to help predict how those defaults are going to play out
Nevertheless, I am slowly working my way through each complication, and as I do the picture that is emerging is one that is certainly ugly but that also holds promise. The reasons that make the mortgage insurance business difficult to understand are the same reasons the companies in the space are trading at bankruptcy like valuations. To put this in perspective, Radian and MGIC both traded at $60 plus per share in 2007. Today they are at around $3. I doubt that either company is ever going to go back to its old high, but the basic business that led to those earlier valuations is essentially intact and with a few things going right, the stock price of each could be significantly higher than it is today.
That basic business, when you get past the accounting jungle, is really pretty simple. These are insurance companies. They write contracts where they agree to pay if a borrower defaults on their home loan. In return they receive a fee (called a premium) either up front or on a periodic basic. They are also required to have a reserve put aside to pay out the claim in the event that there is a default. Until a claim payment is required they earn returns on investing that reserve. In the aggregate, as long that the cash that the insurer receives from its premiums and the returns on its investments exceed the amount that they have to pay out in claims, then the insurer will be making money.
Both Radian and MGIC are still performing that basic business. What’s more, the volumes that they are writing, while down from their pre-crisis, pre-housing bust highs, remain substantial when compared to the current value of their equity. Of late, these volumes are also showing substantial year over year increases.
To illustrate the potential, in 2011 Radian wrote new insurance that will provide $717M of premiums over its life time (compared to premiums collected on existing insurance of $680M). Before the housing collapse caused claims to skyrocket, you could expect returns after claims of at least 10-15% on that insurance. So maybe $70-$100M in earnings. In addition Radian produced investment income of $225M in 2011. Expenses and costs of the mortgage insurance division is about $150M. Radian has about 133M shares outstanding. Adding these elements together you can see that absent the legacy book of business, its not unreasonable that the company would be earnings over $1 per share.
Of course the problem with the insurers is the legacy book. In the case of Radian, that legacy book produced $1.3B in provisions for loss and over $1.5B in actual claims paid. These numbers dwarf the premiums Radian is receiving and any income its earning from premiums and on its investments. The result is a massive loss, particularly on a per share basis.
You could run through the same analysis for MGIC and draw similar conclusions.
My thesis here is that the legacy book will not always be the problem it is now. And it appears that defaults from the book have peaked. House prices in many areas of the US have stabilized and in some areas they are rising. And the regulatory framework being developed seems to creating more space for private mortgage insurance.
I’ll have more to write on both Radian, MGIC and the current regulatory state of the US housing market in upcoming posts. What I wanted to outline here is the potential. It is the potential that makes these companies worth investigating further. If the business does turn around, we are talking about multi-bagger potential. Of course if it doesn’t… well they may be headed for bankruptcy. Now I fully admit that I am still fuzzy on whether the business can turn around before the companies run out of cash to pay off claims in their legacy book. But it appears that the carrot is big enough to justify an attempt to figure that out.