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Jul 22

Week 55 Update: The Insurers

The Insurers

I added to all 3 of my insurers in the last two weeks; Radian Group, MGIC, and MBIA. Regarding Radian and MGIC, while the data this week was mixed, I still am of the mind that the worst of housing is behind us. While I’m not ready to jump into home builders or lumber stocks or anything else that is dependent on a robust recovery in prices or demand, I am willing to make a bet on mortgage insurance companies that need things to just stop getting worse. The insurers need prices to stop falling and defaults to continue to slow. I am inclined (albeit skittishly) to believe that will happen.

The housing data this week, while not great, supported that thesis. The market focused on the month over month decline in existing home sales (down 5.4%), but year over year the trend is still to higher sales (4.5%). The trend, while not robustly bullish, appears to be of a bottoming nature.

Perhaps more importantly, inventory continues to decline and the year over year number is down a somewhat startling 24.4%.

Total housing inventory at the end June fell another 3.2 percent to 2.39 million existing homes available for sale, which represents a 6.6-month supply⁴ at the current sales pace, up from a 6.4-month supply in May. Listed inventory is 24.4 percent below a year ago when there was a 9.1-month supply.

Bill Mcbride (of CalculatedRisk) pointed out in a recent post that it is really the inventory number that we should be focusing on:

I can’t emphasize enough – what matters the most in the NAR’s existing home sales report is inventory; what matters the most in the new home sales report next week is sales. It is active inventory that impacts prices (although the “shadow” inventory will keep prices from rising). Those looking at the number of existing home sales for a recovery in housing are looking at the wrong number. For existing home sales, look at inventory first.

Meanwhile the monoline insurers (Radian and MGIC) are writing more new business and this is some of the best business they have every written. I have already written about how strong lending standards are these days. Below is the trend for New Insurance Written (NIW) for the first 7 months of this year.

The returns on the new business should be quite impressive. Mark Devries, the analyst from Barclays that covers the insurers, was quoted in this Bloomberg article on expected returns:

Firms that stay in the business may benefit from a return on equity above 20 percent on new coverage as the exit of some rivals allows remaining insurers to boost prices, and tighter underwriting standards limit claims.

Meanwhile the old book continues to wind down. The delinquency bucket for both insures continue to fall.

The insurers are like those movies you see where there is a big explosion and the movie star starts running and there is this big fire ball behind them and its gaining on them but the movie star keeps running and eventually the big fireball burns itself out. These insurers are trying to outrun their legacy business by printing as much new business as they can to overcome the losses on the legacy. I think when they hit that point that new gains outrun old losses is when they really move.

As for MBIA, the company is less dependent on any specific economic dynamic then they are on the outcome of their court cases with Bank of America. There are signs these cases could be coming to a head, but of course they might not. Its really difficult to say when this will end and whether a settlement will be reached before a verdict. When I tried to analyze the deal between Bank of America and Syncora earlier this week and the conclusion I came to was that you couldn’t extrapolate much of anything to MBIA.

Jul 22

Week 55 Update: Arcan Resource

I’ve owned Arcan before, but I have always had trouble holding onto it. I think that in the aggregate I have probably lost a few dollars on the stock. Yet here I am again to take another stab at it.

Arcan is an excellent example of why I follow the rules of:

Never add to a losing position
Do more of what’s working and less of what isn’t

With Arcan, I eventually sold out for good on March 23rd at $4.75. At the time there wasn’t anything in particular that you could pinpoint that would suggest the stock was about to fall by more than two-thirds. But what concerned me was that the stock wasn’t doing what it should be doing if things were going well. That is, it wasn’t going up.

And then there was the CAPEX. My skittishness with Arcan and most other oil juniors has always been based on their level of capital expenditures in relation to their cash flow. As I outlined in this post back in February, Arcan has been spending multiples more money than its been taking in. You can’t just keep doing that forever. It will work as long as the market sees you as a “growth stock”, but as soon as that music stops, well so do your funding sources.

Arcan has gotten themselves in over their head with funding and now they are going to have difficulty meeting their growth expectations. The near-term outlook for the company is not terribly clear.

So why buy? Well the stock is off 75% from its highs. I think its all price in.

As well the company appears to be changing (perhaps by necessity) its spendthrift ways. President, Doug Penner, said the following in the first quarter press release:

“I am excited about implementing Arcan’s next stage of development. Having expanded rapidly in our first nine years of operation, we are maturing as a company, ensuring that our continued growth also delivers value for our shareholders over time. We are focused on reducing down‐time, operating costs and G&A expenses as we work to bring our capital spending more in line with our cash flow. We are also looking at all of our assets strategically, and we will consider divesting non‐core assets as opportunities arise.”

Of course, with reduced spending will come reduced growth, and that is one of the reasons the stock has been decimated. At $1.50 per share, which is about what it cost me on average to buy a position, we are getting awful close to the value stock territory. The company has a $7+ NPV of its reserves. Their production numbers haven’t been stellar, but they are showing stability and they should be getting past the initial flush declines and into more stable exponential declines on most of their wells. AS well, the company should begin to benefit from the infrastructure spending of the last year, as the pipeline from Ethel brings down operating costs and we begin to see the fruits of the waterflood at Ethel in the second half of this year. As I pointed out in that same article earlier this year, there is a clear difference between the Ethel decline curves and that of Deer Mountain Unit, where there is waterflood.

Arcan is simply a bet that the stock has gone down too far. A move back to $2 would be a 35% gain and I could see it happening with nothing more than a bit of improved sentiment.

Jul 22

Week 55 Update: Phillips 66

I have actually owned Phillips 66 (PSX) for a while now, just not in the account I track online. Phillips 66 is a spin-off from Conoco Phillips. The company has 3 lines of business:

Refining
Midstream
Chemicals

I originally came across the idea of Phillips 66 after reading a Barrons article that was posted on the Investorvillage.com BRY board. Phillips was a recommended pick of Meryl Witmer. The thesis outlined by Witmer was as follows:

Phillips’ 50% of PCChem could earn $1.30 a share this year. These earnings deserve to be valued at a 10 multiple, or $13 a share. The midstream segment owns and operates natural-gas processing facilities and fractionation plants, and a large and valuable natural-gas pipeline system. It also owns 50% of a master limited partnership. It should have free cash flow of $1.20 to $1.30 a share and about a dollar in earnings once it finishes up a couple of projects. It is worth 17 times free cash flow, or more than $20 a share…

So at $35 you get the refining business for free.

My original purchase a few weeks ago was somewhat vindicated after Warren Buffett noted in a Bloomberg interview that his company had bought a large position recently.

The interesting thing about Phillips is that they stand to benefit from the increased liquids production in North America. Below is an excerpt from the company’s CEO at the Citigroup Global Energy Conference:

If you think about natural gas at kind of $2 a day and ethane that was 30 cents and going down I think the last time I looked at it. But ethane at 30 cents is about $5 a million BTUs. So we capture the upgrade from the wellhead at $2 to 5 bucks through the midstream business and then the petchems really pick up at $5 and go to essentially the crude level, which is what the rest of the world competes on when they’re buying naphtha. Think about that at $17 to $18. And while we don’t know exactly where that rent is going to get captured through that chain, by the ownership in DCP and CPChem, we benefit all the way through that chain in the ownership in capturing that margin upgrade. So we really like that position that we have there.

The thing that makes Phillips interesting is that, as was implied by the Meryl Witmer analysis in Barrons, based on the valuation of the company, investors seem to be treating the company as a refiner, when really only a third of the company’s business is refining. Moreover, as the company pointed out at another conference recently, this time put on by UBS, the other two-thirds of the business, midstream and chemicals, have return on capital metric north of 20%.

My only problem with Phillips is finding a price to buy in at. I bought into it in other accounts at under $32. It pains me now to buy at $35-$36. Perhaps we will get a further pullback, though after the Buffett endorsement I kind of doubt it.

Jul 19

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Trying to Decipher what the Syncora deal means for MBIA

Yesterday Syncora and Bank of America announced an agreement to settle outstanding litigation with respect to the residential mortgage backed securities (RMBS) originated by Countrywide and insured by Syncora. The essence of the agreement was as follows:

In return for releases of all claims the Company has against Countrywide and Bank of America Corporation arising from its provision of insurance in relation to five second lien transactions that were the subject of litigation and all of the Company’s claims in relation to nine other first and second lien transactions, the Company received a cash payment of $375 Million.

Obviously the settlement has importance to MBIA. MBIA is also in the middle of litigation with Countrywide to settle RMBS insured by MBIA.

The outstanding question is what Syncora expected to get versus what they ended up getting. Now what they got is easy. Its $375 million. What they expected is a bit trickier.

Alison Frankel, with the help of Barclays, took a stab at this in an article today. She wrote the following:

Barclays analysis of the Syncora settlement estimated that Syncora’s lifetime losses on all of the 14 mortgage-backed securitizations the deal addresses are as much as $1.4 billion, which would mean that Syncora’s cash award of $375 million represents only 27 cents on the dollar.

But there was the following caveat:

But there’s yet another wrinkle. Syncora, which is a successor to XL Capital Assurance, bought back a lot of its obligations in a 2009 remediation campaign. According to a corporate press release, the insurer “achieved 68.4 remediation points,” which apparently means it bought back more than two-thirds of its policy obligations. The Barclays analysis does not seem to discount its estimate of Syncora’s lifetime losses to account for the remediation, which means its cents-on-the-dollar analysis is probably low.

I’ve looked through Syncora’s filing and the press releases and I think the Barclays analysts have it right. Here’s my reasoning:

On slide 13 of the Q4 2008 Syncora Guarantee Inc. Insured Portfolio Summary it states that Countrywide was the largest exposure with $2.607 billion.

If I look back at the press releases associated with Syncora’s RMBS remediation campaign, Syncora was actually very forth coming and specified the total Aggregate Principle Balance being committed on a security by security basis. That can be accessed here.

I parsed through these securities and filtered the Countrywide originations. Countrywide accounts for all of the Countrywide Home Equity Loan Trust and all of the Harborview Mortgage securities (for confirmation that Harborview was indeed a Countrywide entity, take a look at any of the SEC filings for Harborview, for example this one). If you add up the aggregate principle balance of the Countrywide Home Equity and the Harborview Mortgage securities, it comes out to $1.258 billion.

Now the press release I got this data from was released before the tender was complete, but only by a couple of days. If you add up the total committed principle specified in the press release you get $3.537 billion, whereas in Syncora’s final press release on the restructuring the amount was $3.8 billion. So its close.

Subtracting the commuted exposure ($1.349 billion) from the total Countrywide exposure ($2.607 billion) you get $1.349 billion. This is pretty much bang-on what Barclays had estimated.

Muddying Factors

What is less clear to me, and what I really have no way of determining, is whether the $350 million recovery should be compared against the $1.349 billion in securities, or against a much smaller amount.

As Frankel points out earlier in her article, the litigation that Syncora had against Bank of America was for 5 second lien transactions.

Syncora’s last amended complaint against Countrywide, filed in 2010, alleged that the insurer had paid out $145 million to policyholders in five Countrywide home equity-backed securitizations and had received another $257 million in claims from those five deals. That’s a total of $402 million

The complication is that in the press release Syncora talks about an additional 9 securitizations that aren’t a part of the litigation, but that are also part of the settlement with Bank of America.

…all of the Company’s claims in relation to nine other first and second lien transactions

Presumably the 5 plus the 9 securitizations add together to be $1.349 billion in total exposure. And if all 14 securitizations are fraudulent, and Syncora could have expected to recover on all of them, then Syncora’s overall recovery is not that great.

But I’m not sure that is the right way to look at this. There are a couple of considerations that paint a bit rosier picture of the settlement, and provide a bit more hope for MBIA.

First, having become rather familiar with MBIA and their history of litigation, its clear that MBIA was continually adding claims as they found them. That Syncora did not do this, and instead limited the litigation to 5 of the 14 claims, suggests to me that perhaps the other 9 claims weren’t fraudulent. If this is the case, that Syncora was able to release future claims on these additional 9 securitizations is actually a bit of icing on the cake.

A second point is that Syncora did not appear to be expecting anywhere near $1.35 billion in recoveries. Going back to the lawsuit, Sycora was looking for a total recovery of $405 million. In addition, taking a look at the last Annual Statement Syncora said it had put back $1.6 billion in total RMBS and that it expected to recover $212 million on these amounts (Page 14.35):

As of December 31, 2011 and December 31, 2010, the amount of mortgage loans that the Company is seeking sponsors to repurchase aggregated approximately $1.6 billion and $1.3 billion…As of December 31, 2011 and December 31, 2010, the Company estimated that it would realize a net benefit from such recoveries aggregating $212.1 million and $168.5 million, respectively.

These amounts included loans not only from Countrywide but from EMC and Greenpoint. I imagine that these recoveries are in addition to the $405 million Syncora was looking for from the Countrywide litigation. I also imagine that the 9 un-litigated securitizations would be included in this amount, which suggests that Syncora was not looking to recover very much from these 9.

A third and related point is that while the RMBS are experiencing default, it is unlikely that the entire RMBS is in default. Claims will be lower than the total outstanding principle balance. Taking a look at the notes to Syncora’s last quarterly statement, the company said that for the first lien securities:

A loss severity was applied to the first lien defaults ranging from 56.1% to 82.9% based upon actual loss severity observances and collateral characteristics to determine the expected loss on the collateral in those transactions.

For the second liens and HELOCs they did not break out the default so neatly into a percentage but still it could be said that th number will be somewhat below 100%.

Can you project to MBIA?

To sum it up, I don’t think that there was anything wrong with the Barclays analysis noted by Alison Frankel. But I also think there are other mitigating factors that need to be considered before trying to project what this settlement means for MBIA. Without more details as to which of the securities are fraudulent and therefore legitimate put-backs, and what the loss severity on each securitization is expected to be, its difficult to put a number to what the recovery is. In the absence of such detail, I am inclined to take Syncora at its word, and assume that they expected recoveries of around $400-$600 million. If this is the case, then the resolution was well within the range of what would be a nice payday for MBIA if they can settle on similar terms.