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More on Impac Mortgage

Yesterday was another big moving day for Impac Mortgage.  I was nervous adding to the stock last week given that it had risen from $2.30 to over $4 in a single day but I’m feeling better about those purchases now.  I’ve been looking at some of the details of the company, trying to fill in the gaps.  Below are some of the answers I’ve found.

On the Business Strategy…

During the year end conference call the company focused much of the discussion on what they were doing to expand the business going forward. They are focused on expanding retail lending activities, their broker network and on purchase money loans.

I had to look up the definition of a purchase money loan:

Simply put, a purchase money loan is a loan used to buy a home. In some ways, it is easier to describe what a purchase money loan is not. It is not a loan that is taken out after you buy a home such as a home equity line of credit or a home equity loan. It is not a refinance mortgage. A purchase money loan is evidenced by the trust deed or mortgage a home buyer signs at the time the home buyer purchases the home.

Impac is developing a business model that is directed at new home loan originations, as opposed to refinancing. I think this is a good strategy going forward. The refinancing business has been a strong business but at some point, probably in the not too distant future, interest rates are going to go up. The whole thesis behind my idea to get into mortgage servicing rights has been premised on rates going up. When they go up the refinancing business is going to dry up. At the same time, the increase in rates is almost certainly going to coincide with an improvement in the resale market, since rates aren’t rising unless the economy improves and the economy isn’t going to improve until housing improves. Impac is positioning itself well for this turn.

Retail volumes were flat in the first quarter but the company guided to higher volumes in the 3rd quarter. Retail volumes have increased significantly over the past year, up from $60.5 million to $132 million in Q2.

The company also restarted their correspondent lending business in January. I’ve written about correspondent lending before, in my write-up of PHH Corporation, and as I point out in an excerpt from that piece below, I really like the prospects of the correspondent business because everybody is running away from it as quickly as they can:

Consider the following. Imagine a mortgage broker who develops significant business volume, earns the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have traditionally taken a large piece of. Until now. In August Bank of America reported that they were exiting the correspondent lending business. Ally Financial, who lends through GMAC, retreated from correspondent lending back in December before recently announcing that they would get back into the business on a limited basis. Met Life announced that they were winding down their origination business entirely in January.

This isn’t small potatoes. The above 3 companies were in the top 12 correspondent lenders by volume in the third quarter.

There are rumors others are leaving the business. I thought this quote from a Mortgage News Daily article was spot-on:

One can just hear large lenders talking in their boardrooms. “Do we really want to be in this business, given the regulatory, legal, financial, and public relations issues? Where the value of servicing has dropped dramatically in the market, and could drop further depending on Basel III? Where the mortgage insurance tax deductibility has gone away? Where every week brings a new lawsuit – when will we have more attorneys on staff than originators?”

Its a low margin, highly competitive business. But the opportunity is that it could become less so with some of the big players moving on.

Impac is doing exactly what a small, nimble mortgage originator should do. Get into businesses where the big boys are getting out of. We’ve already seen some of the fruits of that. Correspondent lending volumes were $81.9 million in the second quarter versus only $24.7 million in Q1.

On the preferreds…

The company issued the preferred shares in 2004. The preferred shares paid a dividend of 9.5% and were redeemable at $25 per share. The shares also held precedence in the event of a liquidation over the common shares.

And then Impac changed the rules. In the second quarter of 2009 Impac sent out a proxy  to tender the preferred shares. The tender price, at $1.37 for the series B and $1.43 for the series C, was a small fraction of the redeemable.

About a month later Impac amended the proxy. The amendment rather drastically changed the rules of the preferred. It stripped them of their dividends, stripped them of rights to elect members to the board of directors, and stripped them of almost all other rights that made them senior to the common.

Looking back on the event, it could be interpreted that the preferred holders got a raw deal.  But keep in mind this was the spring of 2009, the stock market had recently hit decade lows in March, and most believed that the rally off those lows was a dead cat bounce.  Many of Impac Mortgage peers were going bankrupt.  The preferred holders were probably happy to getting anything and walk away.   The proxy reached its required minimum tender of 66.7% and along with the shares tendered the amendment was passed.

There are now 665,592 series B preferred outstanding and 1,405,086 series C preferred outstanding. The liquidation value at $25 per share works out to about $52 million. I think you have to consider these shares in terms of the detrimental effect they would have on a takeover bid, because if you wanted to take over the company today you would have to pay something above the current market rate for the common, which would work out to greater than $30 million, plus you would have to pay out the $52 million for the preferred shares.

The weird thing about the preferred is that the only value they is in the event of liquidation.r.   They have no value in a change of control (at least as far as I can tell).  So the preferred’s effectively can be ignored unless you are considering a bankruptcy scenario.  If you are considering a bankruptcy scenario, you also probably should not be considering the common.

So I think its fair to ignore the preferred shares in terms of stockholder equity calculations such as earnings per share and such. Because those earnings are not going to be siphoned to the preferred. It is only if you were buying IMH with the intent of benefiting from a takeover or from the liquidation that you would have to consider them.

There is a lawsuit outstanding with respect to the preferreds.  I haven’t been able to dig up a lot of details on the lawsuit and how much of a risk it is.  The original source of the news release of the lawsuit (not put out by Impac) is not available, but there are reproductions are a few message boards.  The essence of the complaint was explained here:

Silverman says a condition of the tender offer was that at least two-thirds of the holders of the Preferred B and at least two-thirds of the holders of Preferred C shares tender, with the purpose of obtaining sufficient “exit consents” to eliminate the valuable quarterly dividends, preference rights, voting rights and other valuable rights of preferred holders refusing to tender their shares. In this way, the linked tender offer/consent solicitation was deliberately structured to coerce the preferred shareholders into tendering for reasons other than the economic merits of the transaction and into voting for amendments to the terms of the Articles Supplementary of the preferred shares they were selling. Holders of the Preferred B and C shares had to tender or face the prospect of losing virtually all of the economic value of their shares.

This is something I will have to continue to monitor and dig up information on.

A Capital Raise

I think its pretty likely that Impac is going to raise capital here at some point. During the AGM Impac’s CEO,  Joe Tomkinson, said flat out that was part of the plan.

We’ve done a great job on recovery.  When all the competition was declaring bankruptcy, and that quite frankly it would be have been the easiest thing in the world for us to walk away and start a whole new company.  We didn’t do that.  We’ve done everything we can to preserve the shareholders equity.  We haven’t gone out and raised capital, although quite frankly I intend to raise capital which will dilute the shareholders.  I’m told that we’ll get sued for that but my feeling is that its better to have 20% of $100 million dollars than 20% of $20 million dollars.  And so to increase the overall efficiency of the company we’ve got to raise capital.

It was actually a pretty interesting comment.  It was about as blunt of a response as I’ve ever heard to the question of a capital raise.  No fluff about exploring our options or being proactive or some other two-bit turn of phrase to obscure the obvious.   Tomkninson said yup, you bet, we need the cash.

The thing is, they do need cash.  They are growing like a weed and what is beginning to hinder their growth is their warehouse line and the capital required for holding on to servicing.

A warehouse line is a short term line of credit that provides cash for Impac to extend money for the period of time between when the loan is made and the company sells the loan off to Fannie or Freddie.

Warehouse lines are short term and relatively safe so they don’t require a large capital cushion, but they do require some. The main risk is with respect to loans that are made but that can’t be subsequently sold.  This could be because the loans have problems with the documentation (Called scratch and dent), or because the eventual loan purchaser decides not to buy the loan.  A good description of the risks of warehouse lending can be found here.  The article describes the key key evaluation metric for a warehouse lender:

Take any mortgage banker’s financial statement and see how much you need to deduct from loans held for sale to trigger insolvency. Divide that by the average loan amount for that customer. That’s the number of unsaleable loans it will take to put the customer in the tank, and it is typically not going to be a large number.

Tomkinson said that if they raised capital, they could increase their warehouse lines by $70 million for every $700K they had. Right now warehouse capacity is about $140 million (top of my head) and so you could raise $1.5 million and double that.  $1.5 million at $5 per share would be less than 5% dilution.  Even if they doubled that amount, the dilution would not be significant and the money raised would allow the business to continue to grow.

The company has also been growing its servicing portfolio.  I have talked extensively about how I feel the servicing business is a great business to be in, including this article I published on SeekingAlpha. As I wrote in that article:

Mortgage servicing rights are one of the most attractive opportunities in the market right now. There is the potential for returns as much as 30-40% IRR for the companies involved.

I believe the opportunity is being ignored by a market for three reasons:

  1. The market lumps mortgage servicing rights in as just another housing play, and housing is still 2-3 years away from recovering
  2. Mortgage servicing rights are complicated and most market participants don’t want to take the time to understand them
  3. Mortgage servicing rights have traditionally been a crappy business and over the past 5 years they have been a really crappy business

If the company uses capital to grow its servicing business at 30% returns, I would be ok with that.  This is a case where a little dilution may not be such a bad thing.

Limitations on acquisition and change in control ownership limit

The last item that I have been researching but have not had much success in understanding is whether there are obstacles to a potential take over.  With the 10-K risk factors was the following statement:

Our Charter and bylaws, and Maryland corporate law contain a number of provisions that could delay, defer, or prevent a transaction or a change of control of us that might involve a premium price for holders of our capital stock or otherwise be in their best interests by increasing the associated costs and timeframe necessary to make an acquisition, making the process for acquiring a sufficient number of shares of our capital stock to effectuate or accomplish such a change of control longer and more costly. In addition, investors may refrain from attempting to cause a change in control because of the difficulty associated with such a venture because of the limitations.

Unfortunately I have searched and cannot find any clarification on this.

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Reviewing MGIC’s Complaint against Freddie Mac

I was fortunate enough to find a link to the original court document of MGIC’s Complaint for Declaratory Relief against Freddie Mac.  It was posted on MGIC’s yahoo board.

The document describes the pool insurance dispute between the two companies. This is the same dispute that I wrote about here, and that has caused much turmoil to the MGIC stock price and left many proclaiming an imminent bankruptcy for the company.

Having read through it over my lunch hour yesterday, and then again when I got up this morning, my takeaway is that MGIC has a decent case against Freddie Mac, and that the primary impediment to their success is simply the leverage (read: bullying) that Freddie Mac can inflict upon them.

What’s at issue

The disagreement revolves around 11 pool insurance policies.  Each of these policies contain a number of pools of loans that MGIC has agreed to insure for Freddie Mac.  The insurance is designed to be in force up to a limit defined by a percentage of the principle balance of each pool.

To get an idea of how these policies work, I’m going to go through a simple example.  Let’s assume we have one policy and it contains two pools of loans. Each pool contains loans worth $1 million dollars.   Let’s also assume that the policy is structured such that MGIC has agreed to insure a maximum of 1% of the principle balance of the pools within it.  MGIC therefore has an aggregate loss limit (meaning the maximum amount that they could potentially be on the hook to pay if a lot of the loans in the pool started to go sour) with respect to the policy of $20,000.

The disagreement between Freddie and MGIC stems from what happens once insurance on one of the pools expires.  Going back to our example, let’s assume one pool was added to the policy in 2000, and the other was added in 2007.  Both of the pools have insured agreements for 10 years.  Time passes and 2010 rolls around and insurance on the first pool reaches its expiration.  According to Freddie’s interpretation MGIC is still responsible for $20,000 of losses (less what had been incurred up to 2010) because Freddie believes that the aggregate loss limit of the policy is based on the total principle balance of all loans ever included under the policy.  Under MGIC’s interpretation, the aggregate loss limit is determined by the total principle balance of loans insured under the policy, so when the first loan pool runs off, it is no longer included in the calculation.  Under MGIC’s interpretation, the aggregate loss limit would drop to $10,000.

In this example, the difference between the two interpretations is $10,000 of insurance that MGIC may have to pay on defaults in the remaining pool.  In the actual contract between MGIC and Freddie the difference between the two interpretations is $550 million.  And $550 million could be the difference between life and death for MGIC.

Points raised by the declaration

As I said, there were a number of points raised in the declaration that made me think that MGIC has a fairly strong case.  The key points that were raised in the document were:

  1. The premium paid by Freddie for the policy insurance was consistent with the interpretation of the agreement by MGIC.  Freddie paid premiums that were consistent with the 10-20 year periods that each pool was to be insured.  Freddie did not pay anything extra that could be construed to reflect the extra insurance coverage that Freddie’s interpretation results in.
  2. It was only in 2008 that Freddie began to reinterpret the agreement.  Prior to that time Freddie acted as though they agreed with the MGIC interpretation.  Specifically, Freddie created additional policies with MGIC after 2007.  These policies were used to insure new pools.  This coincided with when the existing policies began to wind down.  If Freddie had believed at the time that the insurance in force was not dependent on whether the existing policies were winding down, they would have just added new pools to the existing policies.
  3. Before 2000 the 11 policies existed separate from one another.  In 2000 Freddie and MGIC changed the agreement so that the 11 separate policies were combined into a “mega” policy whereby the losses to all policies would be aggregated and a single loss limit would be applied to the “mega” pool.  When this change was made, the language of the change specifically referred to the loss limit being determined by “loans insured” and “loans that become insured”.  MGIC’s position is that the language is clear that once a loan is no longer covered by the insurance, it should be removed from the aggregated volume.  I would say this sounds in line with the language.
  4. With respect to the mega-pool Freddie Mac’s reading of the contract would have resulted in an increase in the regulatory capital requirements of MGIC when the agreement to combine policies into a mega pool was made.  This is in conflict with one of the objectives of both Freddie and MGIC for creating the mega pool.  The mega pool idea was conceived to reduce capital requirements for MGIC so they could write more pool insurance for Freddie in the future.   MGIC argues that it makes no sense to accept Freddie’s interpretation, which would have menat that Freddie was constructing an agreement that would accomplish the opposite of that.
  5. There is an element of incompetence assumed on the part of MGIC implicit in the Freddie interpretation.  There are these policies outstanding.  MGIC is allowing Freddie to continue to add pools of loans to these policies.  These pools of loans, because they are new, are extending out the life of the policy and increasing the total UPB that has been added to the policy.  So with Freddie’s interpretation that the limit of the insurance is independent of whether older pools have expired, those newer pools are effectively having higher and higher loss limits.  This would be a ridiculous business decision on the part of MGIC.
  6. In 2007 the individual pools within the mega pool began to wind down. Under MGIC’s interpretation this would have meant a corresponding reduction in aggregate coverage of the pool.  Under Freddie’s interpretation, the coverage would have remained the same.  Yet Freddie, beginning in 2007, created new policies with MGIC that were not part of the mega pool.  Naturally the inference is that they did so because they would receive better coverage from a new policy than from the existing policies that were winding down, which means that at that time they understood the nature of the agreement as being consistent with the MGIC interpretation.
  7. During 2008 there was an email communication between MGIC and Freddie where the two parties discussed how MGIC could reduce exposure on the some of the policies.  In that exchange, Freddie noted that most of the risk in these policies would be unwinding due to their natural expiration dates during the remainder of 2008 and throughout 2009.”  With the interpretation of the agreement Freddie has, this would not have been the case and the risk would be continuing for a number of years hence.

What I’m doing

With MGIC back to $1.20, it is at a level that no longer prices in imminent bankruptcy.  I have been debating taking some of my position off at this level, and reducing the size back down to around one half of what I own in Radian.  I still may do that, but, given that MGIC does have a decent case against Freddie Mac, I would not want to eliminate my position completely.  I want to keep some skin in the game because a reasonable settlement to the court case with Freddie would likely result in a move in the stock price back to $2.

Week 59 Optimism

Portfolio Performance

Portfolio Composition

(note that US stock prices are converted to equivalent Canadian dollar prices)

Click here for the last two weeks of trades.

Portfolio Summary

If we lived in a world where we could have perfect understanding, there would be no such thing as an optimist or a pessimist.  In such a world we would be able to comprehend the extent of all current conditions and evaluate the events to come by extrapolating those conditions into the future.

Instead, however, we live in a world that is too complex to understand with much certainty at all, and therefore our predictions are at best educated guesses.

Of course there are times when pessimism is warranted.   Times such as the fall of 2008, where, if you understood the intricacies of the mortgage market and the speculative excesses that it had come to embody, you could have drawn a number of pessimistic conclusions with sufficient certainty, and having that pessimism would have been profitable.

And, to be sure, there are many times when the best course of action is to shrug your shoulders and walk away.  I’ve done just that on more than one occasion over the course of my investing life and over the life of this blog.  There is little tolerance for a hero in this game.

But you can’t walk away from everything, and rarely can conclusions be clearly drawn.  If a choice is to be made, the eventual direction often comes down to whether you look upon the current set of conditions optimistically or pessimistically.  And I think in the end the choice is as much determined by the view of the world you wish to embody than your evaluation of the cold, hard facts.

As a general rule, while I allow myself to be swayed from optimism to pessimism with the market, I prefer to be on the optimistic side and I tie my rope securely to that dock for the long run.

The reality is that focusing on the negatives is a tough way to make money. How many great ideas are conceived within the depths of despondency?  I think it’s a rare soul that has the constitution of someone like Jim Chanos; to devote themselves to the discovery of the flaws created by others and use that to their own advantage.

I think that when I am too pessimistic I have a lot of difficulty seeing the potential of what something might become.  And because of that I will err on the side of caution and miss out on opportunity. While caution is often prudent, caution alone will not beat the market.  Caution will doom you to a life of mediocre returns.

It simply does not pay to be too pessimistic.  For every 2008, where the bears rule the day and laugh at the collapsing bulls, there are years upon years of bull markets, in this sector or that, usually born out of the depths of a pessimistic bottom.  I realize that we can focus today on the outsized debts and unfixed Europe, and we do indeed need to keep a ready eye on both.  But are we really so sure the dire ends we are told these debts forebode is so inevitable?  I think we often forget just how much healing a good dose of growth can do, how little we understand what truly underpins growth and  how often our expectations of growth turn out to be wrong.  In particular, the United States is now 7 years into a massive and probably once in a life time housing correction.  What if it ends?

We rarely ever identify the turn ahead of time.  It is only looking back that we can point to signs that in retrospect appear unmistakable.  But at the time those signs appeared as a one-off fluke to the upside or a dead-cat bounce.  It is only after a stock breaks out that it becomes inevitable that it would do so.

Yesterday I posted about Impac Mortgage, which I bought last week.  Two weeks ago I talked extensively (and hopefully realistically) about the problems that MGIC and Radian have and why I was willing to optimistically bet that they will find a way out of what still remains quite messy.  I am finishing up a piece on PremierWest Bancorp, which looks to me to be turning around after a miserable performance over the past year.  In all cases I am carefully weighing my conclusions, never getting to zealous in my conviction, but, above all, I am trying to look optimistically at what might happen if things start to go a bit right.

It is a strategy that has worked better for than a pillow.

Impac Mortgage: Out of Nowhere

Sometimes you have to act before you know the whole story.

I’ve been on holidays all week and have had pretty limited access to the internet.  I’ve checked my emails maybe once a day at most.  On Tuesday night I checked and I noticed the following google alert (by the way I would highly recommend using google alerts for all key words and company names.  Its an invaluable tool).

I had never heard of the company but I’ve been looking for other ways of playing the origination and servicing industry, especially through smaller companies.   So I read the earnings release.

50 cents per share earnings in the second quarter. Most of the earnings appear to be coming from plain vanilla mortgage origination (same business as PHH).  The company almost doubled origination revenue year over year.  They also hold on to their servicing rights and appear to be growing their servicing portfolio.

Then I check the stock price on yahoo.  The stock had a $2.30 close before the earnings release.

Wait a minute.  This company just earned 50 cents in the quarter and its trading at $2.30 per share?

Well before I went to bed I thought about what I needed to clarify before the market opened the next day if I were going to buy the stock.  I needed to make sure that the share structure was what it appeared.  I needed to make sure that the earnings were legitimate (that they were coming from mortgage origination and not from a one time mark to market valuation change).  And I needed to make sure that there wasn’t some sort of debt or financing issue (for example some sort of GSE putback overhang) that would put the company close or perhaps over the precipice.

I read through the 10-Q, which was released with earnings, and I read through the 10-K risk factors. I didn’t see any red flags.  So I took the optimistic attitude that maybe this stock was simply mispriced.  Maybe it was like all the other mortgage related stocks and the mortgage industry itself and it was just hated to the point where it no longer reflected reality.

First thing in the morning before everyone woke up and I had to get off the computer (it was a vacation after all) I bought some stock.  I took a 1% position in each of my portfolios, including the one followed here:

By the end of the day, the stock was trading over $4.

I give this history in part because I hate to write up a stock after its had a run like Impac has.  I’m sure its going to sound to some like a pump and dump or an unlikely piece of luck.  Yet this blog is about the stocks I’ve bought so that’s what I have to write about and that’s what I’m doing.

As well, specifically regarding the outlook of Impac Mortgage, even though the stock has run up a rather ridiculous 100+ percent in the last 4 days, I think it may go a lot higher.  If I’m reading it right and not missing anything (which keep in mind I very well could be), the stock has room to run.  After all this was a $250 stock in 2005 and even after the run up, the market capitalization is a miniscule $30 some million dollars (though there are additionally some preferred’s outstanding). I’m not just talking the talk.  I doubled my position on Friday at $4.26.

So with a word of warning that any stock that has risen 100% in less than a week should be carefully considered before buying, let’s take a look at what the company does.

On to the company…

The story here is a simple one. Impac is a mortgage originator that has been growing it origination volumes substantially for the past year, and that growth has finally reached the inflection point where it has become profitable.

The company originates mortgages through retail, wholesale and correspondent channels.  A breakdown of origination volume by channel for the second quarter is illustrated below:

The company has developed a significant retail platform.  Retail lending is when the company deals directly with the borrower, as opposed to wholesale and correspondent lending where they are acting through independent brokers and correspondents who are originating the actual loans which are then sold to them.

The retail business is more often the higher profit business (because there is no middle man taking a cut) but it also requires more up front capital and fixed costs as you have to develop the infrastructure, the marketing, the people and the relationships required to interact with the borrower directly.  These higher start-up costs were at least partially responsible for the losses incurred in previous quarters.  The company made the following statement with respect to this in the year end 10-K:

 In 2011, the mortgage lending operations has been successful in increasing its monthly lending origination volumes to be in excess of $100 million. However, although the mortgage lending revenues increased in 2011, expenses associated with the mortgage lending activities significantly increased also. The increase in expenses was primarily due to start-up and expansion costs with opening new offices, hiring staff, purchasing equipment, investing in technology and the supplemental default management team as discussed above. Specifically, as the Company attempts to build a purchase money centric platform with a significant amount of retail originated loans; the related start-up costs for this type of origination platform will be higher than a wholesale refinance focused mortgage operation. In addition, the Company has made small investments in proprietary technologies that will further support our expansion of retail originated purchase money mortgages along with more competitive recruitment of realtor direct loan officers. The Company believes this is the right strategy in the long term as interest rates on mortgage loans are expected to rise in the future, which will greatly reduce the percentage of refinance transactions to more historical percentages. In order for the mortgage operations to achieve profitability, we will need to (i) increase overall origination volumes, (ii) improve lending revenues by originating a higher percentage of retail loans and products with wider margins and greater loan fees and (iii) reduce lending operating costs through increased operational efficiencies, or some combination of them.

While in the second quarter most of the growth was from the wholesale channel, future growth is expected to be driven from retail.

Second quarter volumes in the wholesale and correspondent lending channels led to significant volume increases over the first quarter; however, retail expansion during the second quarter is expected to lead to a corresponding increase in retail production during the 3rd quarter. Retail production is also expected to increase from the opening of the previously announced Reverse Mortgage operations.

Moving on to margins, Impac’s margins on mortgage lending look comparable to other companies I follow.  The company booked mortgage lending gains and fees of $15.1 million on $531.9 million of loans originated.  That is a total gain of 283 basis points.  To compare, PHH recorded a total gain on loans of 308 basis points in the second quarter.  Nationstar meanwhile recorded gain on sale of 306 basis points.

The company also earns money from mortgage servicing, and they have been growing their servicing portfolio every quarter.  I appreciated the company’s comments that they saw opportunity in holding on to the service rights of the mortgages they are originating given the ultra-low rates and high quality loans that are being written.

Excel expects to continue building its mortgage servicing portfolio as management believes a servicing portfolio of agency loans during a period of low interest rates and high credit quality focus is a good investment for the Company.

It’s the same line I’ve been saying for months now.

The company hasn’t been reporting the total balance of loans serviced for very long, but below the increase over the last 3 quarters is illustrated:

The company hires a subservicer to perform the servicing activities.  Assuming 25 basis points for the servicing fee and 7 basis points going to the subservicer, the company stands to pull in around $2 million in servicing revenues per year.

All of the loans originated and serviced are conforming, meaning they are being sold to Fannie Mae, Freddie Mac, or Ginnie Mae.

Things to be concerned about…

With this all said, the company does have some hair.

For one, they do not do a very good job of explaining their mortgage lending revenues.  While PHH and Nationstar both provide enough information to determine what they are valuing the capitalized servicing rights at, I can find no way of doing that with what Impac provides.

Second, the company appears to mark to market just about everything, including their long term debt. As noted in the 10-Q:

…long-term debt had an unpaid principal balance of $70.5 million compared to an estimated fair value of $12.0 million

Huh?  I don’t know if I am misunderstanding this or what because I have never seen a company mark to market their own debt and I didn’t even know you could do that.  Nevertheless, it seems to be what they do and its something worth contemplating the implications of.

Potential upside from The Long Term Mortgage Portfolio

An interesting sort of call option that Impac has embedded into its value comes from their residual interest in a number of securitization trusts.   Before 2007 the company originated and packaged mostly sub-prime loans and sold them off to investors through non-recourse trusts.  The company kept a residual interest (the equity) in these trusts.  The residual interest was the lowest rung on the ladder, being the first to not receive payment in the event of defaults within the trust.

These trusts are basically securizations of mostly Alt-A loans (meaning loans where the borrower does not have full documentation of income or net worth or some other metric that Fannie Mae and Freddie Mac requires).

Probably the most important thing about these trusts is that they are non-recourse to the Company, so the economic risk is limited to the residual interest only.

A break-down of the current fair value estimate of residual interest in the trust by year (taken from the 10-Q) is shown below:

These trusts are carried at fair value and the debt associated with them is also carried at fair value.   The difference between the expected fair value of the trusts (which is $5.469 billion) versus the debt (which is $5.446 billion) is $23 million.

While Impac seems to point to this number in its 10-Q I don’t think its terribly relevant.  For one, the future value of the trust assets (the mortgages within each trust) are based on a lot of assumptions, including future default rates, prepayment rates, interest rates, and so on.

Probably more importantly, at maturity the debt associated with each trust has to be paid in full, not at fair value.  While the overall fair value of the trust assets is a little less than $5.5 billion, the outstanding principle balance of the debt is $9.1 billion.  So clearly the debt outstanding outweighs the trust assets.  Nevertheless, the trusts are clearly not all a worthless asset.  In the second quarter the company collected $4.4 million in cash from the trusts, representing residual interest payments from those trusts that are presumably in a strong enough position to meet the collateral requirements that must be met before cash is paid to the residual interest holder.   Value is being realized and the potential for more value to be realized exists.

What I think is worth highlighting is that the future cash flow potential of these residual interests is basically a pure play on the US housing market.  Less defaults, stronger cash flow performance from the underlying mortgages, and Impac stands to take in a decent amount of cash from these trusts.  If housing goes down for a triple dip, well then you can probably write them off to something pretty close to zero.

Conclusions…

The stock is a bit of a flier, no question about it.  The market capitalization is miniscule, the analyst and brokerage following is non-existent, and the disclosure is not as complete as I would like it.

Nevertheless, the industry is right and, if my thesis about the housing market bottoming and potentially surprising to the upside pans out, the timing is right.  The company, if you ask me, is doing exactly the right thing at the right time by building its origination business and retaining as much servicing as cash flow will allow.  I’ve taken a position and added to it once.  If it continues to play out as it appears to me it could, I will continue to add on the way up.

Things that worry me about the Mortgage Insurers

I have been devoting a lot of space to the mortgage insurers, and while the stocks make up a decent percentage of my portfolio, it would be impossible to justify the ink spilled if it were judged only in proportion to position size.  But this is a new business for me to learn, and it is a complicated business with a lot of risk.  Radian and MGIC appear to have a great deal of upside if everything goes right, and a similar amount of downside if everything goes wrong.

Well I did some thinking over the weekend and came up with a list of 5 things that worry me the most about these stocks.  Below I have investigated each worry and became familiar (if not comfortable) with the reality of the risk.

1. Rescission and Denial activity assumptions may be off, particularly for Radian

Rescission and Denial activity is my biggest concern and so I am probably going to devote the most space to it.

Both Radian and MGIC are recording historically high levels of rescissions and denials.  At the end of the second quarter Radian had $532 million of future expected rescissions and denials baked into their loss reserves, gross of $208 million reserved against the reinstatement of previously rescinded policies (called the IBNR reserve).  MGIC had $700 million of booked reductions in losses due to rescissions and denials and $276 million of IBNR reserve.

This is significant in comparison to the capital of each company, which is roughly $1 billion for Radian and $1.5 billion for MGIC.  If there were a significant revision to the assumptions involved, it could impact capital quite a bit.

For Radian, of particular concern is the growing number of denials.  In the first quarter Radian had $177 million of denials where they held the first loss position (was likely to take a loss on the default) versus only $33.3 million of rescissions.  Denials have become much more prevalent than rescissions, which is opposite of how things have been historically.

Below are denials and rescissions at Radian over the last 11 quarters.

What is worrisome about the increase in denials is that a denial is much more likely to come back as a resubmitted claim than a rescission is.

While denials and rescissions are often lumped together, they are quite different in definition.  Whereas a rescission occurs when there is something wrong with the original documentation that voids the insurance, a denial occurs when a servicer hasn’t provided all the documentation.  Problems with the documentation are difficult to fix, whereas an absence of documentation simply requires that the servicer dig it up and present it.  When the servicer comes back to Radian with said documentation, Radian has to reinstate the claim.

Radian put it like this in their first quarter 10-Q:

Due to the period of time (generally up to 90 days) that we give the insured to rebut our decision to rescind coverage before we consider a policy to be rescinded and removed from our default inventory, we currently expect only a limited percentage of policies that were rescinded to ultimately be reinstated. We currently expect a greater percentage of claims that were denied to ultimately be resubmitted as a perfected claim and paid.

Radian assumes that 50% of denials will come back to the company in the form a resubmitted claim.

As we’ve previously disclosed, approximately 50% of the currently outstanding denials are expected to be reinstated mainly as a result of servicers ultimately finding and producing the documents necessary to perfect the claim within the time frame allowed under our master policy.

So Radian has partially accounted for the increase in denials the last couple of quarters by increasing their reserve for expected resubmissions (the IBNR reserve).  The IBNR reserve increased from $170.6 million at year end to $249.5 million at the end of the second quarter. While the increase is significant, it’s still a long way from the $177 million of first loss denials that Radian had in the first quarter and the $174.6 million they had in the second quarter.  It remains to be seen whether the company has to further add to their reserves to account for the number of denials that come back to the company in the form of a resubmitted claim.

Radian has tried to downplay the impact if they had to do such a reinstatement.  The company said the following on the Q2 conference call:

 While our experience [with denials] clearly supports this estimate, it is important to note that this assumption is not very material to our overall loss reserve estimate. For example, even if the reinstatement percentage shifted significantly to 75, the resulting addition to our total loss reserves will only be about $97 million.

I’m not so sanguine about the company taking a $100 million hit.

The mitigating factor is that Radian can back up their expectations of future reinstatements with historical data.  Every quarter Radian provides a table of how many rescissions and denials have stuck (not come back as a resubmitted claim) as a percentage of paid claims. The data below, which they disclosed in their Q2 presentation, is for the past 9 quarters.

The second column shows rescissions and denials as a percentage of total claims for the period.  The third column shows the percentage of claims that have been resolved from that quarters bucket.

For example, if the number of claims resolved is 100%, as it is for Q4 2009 and Q1 2010, then the Projected Net Cumulative Rescission and Denial Rate has been determined completely from the actual finalized settlement of claims.  To the extent that the percentage of claims resolved is less than 100%, the Projected Net Cumulative Rescission and Denial Rate may still change as the remaining claims are resolved.

With 80%+ of claims resolved, we can be confident that the final percentage of rescissions and denials is going to be pretty close to the percentage stated in column 2.

Well I wanted to see how well the actuals compared with the original estimates, so I took the above and compared it to the estimates of rescissions and denials that Radian had disclosed for each quarter.  For each quarters estimate, I recorded rescissions at face value and cut the number of denials in half to reflect Radian’s estimate that 50% will return as a resubmitted claim.

If Radian was being too aggressive with denials and rescissions, it should show up as a discrepancy between the original estimate and the actual finalized claim settlement.

The conclusion (shown below) was that the eventual rescission and denial to claim ratio matches pretty closely to what the company would have estimated it to be.

Given the above, I don’t know if I really buy the argument that Radian has been more aggressive on its claim management practices than MGIC and that this is going to bite them in the ass at some point.  Radian appears to have done a good job in estimating eventual rescission and denial levels.

There are a couple of other conclusions that are worth discussing.

1. Radian clearly has a higher rescission and denial rate than MGIC, especially of late.

Part of the reason for the drop off in rescissions from MGIC is that MGIC is in a dispute with Countrywide, who is rebutting the rescissions that have been putback on them, and they have chosen not to rescind any Countrywide loans until the dispute is resolved.  Countrywide makes up about 20% of MGIC’s delinquent inventory.  So that’s part of it.

Yet even if you make a liberal allowance for Countrywide loans, at the very most it would raise MGIC’s rescission rate (for example) Q3 2011 to ~13%.  This is assuming all remaining unsettled claims belonged to Countrywide and were rescinded.  It still wouldn’t put MGIC in Radian’s ballpark.  Clearly Radian has something different going on than MGIC.  I’m just not sure what it is.  Perhaps Radian really is just better at evaluating claims?

2. Radian’s Single Servicer Denials

The above chart is similar to the one I showed earlier.  It illustrates the number of rescissions and denials at Radian by quarter, but with the difference that now the denial activity has been broken out a bit further.  Beginning with the Q2 2011 quarter, Radian further delineated its denials between those that have come from a single servicer, and those that have come from everyone else.

What you can see is that while rescission rates at Radian are falling, and while denial rates other than the singled out servicer are fairly stable, there has been a huge increase in denials from this one mystery servicer.

Of course, the obvious question is whether Radian’s assumption that only 50% of those denials are coming back into claim is valid given the high percentage of those denials from this one servicer.

I don’t know the answer to that, and we won’t get better visibility until the next quarter when Radian provides their actual rescission and denial to total claim rate percentage.  Until that time, what we can say is that based on the data so far, it appears the assumption is on target.  The one quarter we can look at is the Q4 2011 quarter, which was when the trend of higher single servicer denials really began to take off.  And for that quarter, Radian looks to have predicted eventual rescission and denial rates fairly well.   Go back to the chart labeled “Radian’s ability to Predict Rescissions and Denials” and note that for Q4 2011, actual rescission and denial rates have been slightly higher than predicted.  And this is with 79% of total claims resolved, so its not a small sample size.

What to make of it all?

I understand the concern; the rescission and denial rates for Radian are high, both historically and versus their competitors.  I have no answer as to why they are consistently higher than MGIC.  But Iargue that Radian has been running at higher rates since Q1 2011, and with most of the claims from Q1 to Q4 2011 resolved, the evidence is clear that Radian was right on the mark, if not a bit conservative, in its assumptions.  Whether this continues with the recent trend of increased denials is open for debate, but as I pointed out, the data we have so far (Q4) again points to the accuracy of Radians estimate.

2. There is an assumption that a large number of late stage delinquent loans will not result in a claim

This one is a concern for both Radian and MGIC.  MGIC has already taken a fairly big hit in the second quarter because cure rates on their late stage delinquent loan bucket (ie. loans that have been delinquent for 12 months or more) were not running as high as they had originally expected.  The company was cautious on the conference call when discussing whether this was a one time event or whether further revisions might be required in future quarters.  They said they didn’t think so, but that they would just have to wait until the data came in.

I’ve talked about this issue in some depth in my post on Radian’s second quarter.  While from what I can see MGIC does not provide claim rates broken down by bucket in their material, Radian does.  As shown below, Radian assumes that only 47% of the existing delinquencies (net of rescissions and denials) that have been around for at least 12 months will result in a claim.

Intuitively, one would expect something pretty close to 100% of delinquencies that have been around at least 12 months to result in a claim. That it isn’t, is the concern.

The mitigating factor is that, as Radian pointed out in the following slide from its quarterly presentation, a large percentage of these 12+ month delinquencies have been around for 2+ years.

Of course that delinquencies are hanging around for years makes as little intuitive sense as does the idea that only 2/3 of them are going to result in a claim.  Clearly something is going on with a large percentage of these loans, and perhaps whatever is going on is going to make them less likely to go to claim, but I have yet to hear a coherent explanation as to what it is that is going on. As a I wrote previously:

Clearly these loans are broken.  I mean there is a servicer at the other end of these loans and that servicer has every interest to get that loan through to foreclosure as quick as possible.  I find it hard to believe that there are servicers out there eating the costs on defaults for 2+ years before getting the loan foreclosed on.

Until we actually start seeing these loans clear out, this remains an uncertainty, and with so many loans delinquent and in this 12 month bucket, a little bit of error in the assumptions involved could lead to either a big gain or loss to the companies involved.  Going back to Radian’s slide of Primary Loans in Default, the 12+ month bucket accounts for about $1 billion in loss reserves.  If Radian is off on its eventual claim rate assumption, we are talking about a whoopsie in the hundreds of millions of dollars.

As I said, at least as far as I can tell MGIC doesn’t provide enough information to determine its late stage claim rate from their quarterly material, so you can’t draw the specific conclusions you can with Radian.  But you can back out some information based on comparisons to Radian, what management has said on conference calls and from some of the data that they do provide.

First of all, MGIC said on the Q2 2012 conference call that the claim rate for new loans was assumed to be 25%.  Presumably this is referring to 1-3 months delinquents, which would mean that their projection on this bucket is the same as Radian.  Now lets compare loss reserves per default. Radian had reserves per default of $28,410 as of Q2 while MGIC had reserves per default of $25,547.   The severity on claims paid, which is a basically the amount in $’s that the company has to pay to settle out a claim, has historically been similar for both companies if not a little higher for MGIC, so you can’t really argue that the reserve per default  at MGIC should be lower based on severity.  Putting it together, if the early stage bucket is the same, and if the severity per claim paid is the same, then the only reason the reserves per default could be lower at MGIC is because they are assuming a lower claim rate on its 3-11 month and 12+ month buckets.

In other words, all else being equal, MGIC may be more susceptible to future revisions of late stage delinquency cure rates than Radian.   Moreover, the write down last quarter could be viewed as a catch-up of sorts.  But take it all with a grain of salt, because the data is sparse and its difficult to be sure without knowing the intricacies of each insurers current books.

3. MGIC and the Freddie Mac issue

Freddie Mac and MGIC are in disagreement about policy coverage, with the crux of the disagreement being described well by this Reuters article:

The disagreement has been going on for some time, and centers on loss limits on policies that insure Freddie Mac, the No. 2 provider of U.S. mortgage money.

MGIC said in April that it believes the loss limit decreases as policies lapse, while Freddie asserts that the initial limit remains in place until the last of the policies expires.

If MGIC can settle their issues with Freddie Mac in a satisfactory manner the stock will be above $2 again.  Simple as that.

The key word is satisfactory.  $550 million, which is the amount in dispute between MGIC and Freddie, is a lot of money.  Its perhaps not make or break it money for MGIC, which has around $1.25 billion of statutory capital as of Q2, but its awfully close.

MGIC said the following in their disclosure about the lawsuit against Freddie:

“We account for losses under our interpretation although it is reasonably possible that, were the matter to be decided by a third party, our interpretation would not prevail,”

It’s not exactly a reassuring statement of certitude.

The real problem is that Freddie is in the drivers seat here.   As one Reuters article put it:

“Freddie Mac has all the leverage, so my sense is that MGIC is going to have to put in at least the $200 million (in new capital) that Freddie wants and it could go beyond that,” said a hedge fund manager, who no longer trades in MGIC shares but has been a long-time investor in other mortgage insurers.

The other risk is that through the negotiations and/or litigation, MGIC and Freddie taint their working relationship.

“While it is likely that MGIC and Freddie come to an agreement, it is not a given that these two firms continue a productive business relationship,” said Jason Stewart, and analyst at brokerage Compass Point Research and Trading LLC.

As for the issue at question, whether or not MGIC or Freddie’s interpretation is right, this article provided the best explanation I have found as to the legal claim at issue, as well as some direct excerpts from the submitted documents from MGIC.  Quoting directly from court documents:

“During 1998 and 1999, Freddie submitted an ever-larger number of loans for insurance under the eleven policies,” the complaint states. “As of June 30, 1998, the eleven loan pools included loans totaling approximately $35 billion in initial principal balances. By September 30, 1999, the combined IPBs of the loans insured under all eleven pool policies totaled $76 billion, with a weighted average loss limit of approximately 0.85 percent. After payment of modest losses in the initial years of the policies, the remaining combined aggregate loss limits of the policies – MGIC’s amount at risk – totaled approximately $647 million.”

The large risk exposure constrained MGIC ability to write more insurance policies for Freddie Mac and others, so the two parties restructured the deals to get “new pool insurance capacity,” according to the complaint.

The complaint states: “As agreed by the parties, each of the policies was amended by a substantively identical endorsement that (a) kept each policy separate, but replaced the eleven individual aggregate loss limits with a single, combined aggregate loss limit calculated by combining loans insured under each policy into one ‘mega pool’ for aggregate loss limit purposes; and (b) establishing the combined aggregate loss limit at the greater of (i) the ‘existing aggregate loss limit,’ calculated based upon the respective total initial principal balances and existing aggregate loss percentages for each of the policies, or (ii) 0.69 percent of the combined total initial principal balance of both loans ‘insured’ under the eleven pool policies and loans which ‘become insured’ under those policies.”

The thing that doesn’t make sense about Freddie’s claim, and what MGIC alluded to in the court filing, was that if you go with Freddie’s version then MGIC would be taking on more risk than it was before the pools were aggregated.  Indeed MGIC said in the court filing that:

“[Freddie’s interpretation] leads to the entirely illogical result that the mega pool has a constant combined aggregate loss limit of over $1.3 billion for a period of more than ten years – from 2007 until 2018 – lasting many years after coverage has actually ceased for the vast number of individual loan pools at one time insured under the Policy.”

The original coverage before the pools were aggregated was only $647 million and Freddie is suggesting that the amendment made upped the coverage to $1.3 billion?  I don’t really understand how they could argue that MGIC would have agreed to such an amendment.

MGIC also pointed out that Freddie has subsequently acted in a way that was consistent with MGIC’s interpretation of the contract.  After the amendment, Freddie added new, separate pool policies with MGIC.  If Freddie had believed that the coverage on the existing policies was up to $1.3 billion, they would have concluded there was ample room to add under the existing policies.

It should also be pointed out that MGIC isn’t immediately on the hook for the entire $535 million if the dispute goes against them.  As of Q2 2012 the company said that past losses would be about $175 million higher.  Future losses look like they would be coming in at a rate of $40-$50 million per quarter.

I have to say though, based on the information available, it’s muddy.  The language MGIC uses to describe the contract does not specifically say whether pools are to be removed as they cease to be insured. So I whether this is implied is really a matter of interpretation.  I do think that the muddiness of the whole thing does make it unlikely that MGIC would have to take the full $535 million hit but it probably also makes it unlikely that they will walk away without any hit.  It’s probably going to end up somewhere in the middle, which still will not be great for the company’s statutory capital.

4. MGIC is double leveraging

This is another strictly MGIC issue and I am a little fuzzy on it but I’m going to put it out there and maybe someone might comment who understands it better.

I garnered this issue from the following conference call question and answer (taken from Seeking Alpha)

Questioner: All right. And then second, on MIC, if the third stipulation in the Freddie later were granted and MIC was on the hook for losses on MGIC, what would the incentive be for states that aren’t letting you write business above 25:1 now? Why would they allow MIC to write business even if it’s liable for MGIC losses?

J. Michael Lauer: I mean, you’re talking now about the insurance commissioners, regulatory power. The subsidiary is owned by MGIC. And effectively, he’d be control of both of those entities in some kind of situation. The point is that he believes, as we do, that there’s more than enough resources at MGIC to pay claims, okay? So the issue that Freddie Mac has, obviously, is a theoretical issue that if it weren’t, what are the capabilities of getting money out of MIC. And the only way that you would get money out of MIC in that type of situation was if there was excess capital in MIC. And in the near term, I would say that we’re not using much of the capital, obviously, and it’s got a significant amount of capital in it to write business for the next 5 years. So it really doesn’t have a capital issue going forward no matter how much business we write in it in the next 4 years.

Reply of Questioner: But I guess, my question is, I mean, if MIC is ultimately on the hook for MGIC’s losses, could the California or North Carolina, say, regulators like not allow MIC to write new business even though on a stand-alone basis, MIC would have a really good risk-to-capital ratio?

The basic point that this question addresses is that the $440 million of capital in MIC is also being recognized as capital for the MGIC subsidiary.  It is effectively being double counted as capital for the MGIC sub and for the MIC sub.

Presumably as MGIC uses that capital to write business in MIC, the capital available for the MGIC sub becomes less.  Either that or any risk in force added at MIC is added at MGIC.  Regardless, the way the two subs are laid out makes it appear there is more capital then is actually there.

I was listening to an Old Republic call yesterday and they brought up how they didn’t want to get into the business of double leveraging. Now they didn’t explain what that term meant, but I garner that it means exactly what MGIC is doing.  They are double leveraging the $440 million to count against MGIC and MIC.

Of course the insurance regulator of Wisconsin has agreed to this.  So its viability as a strategy is in immediate question.  I bring it up simply as a concern since it seems to me to be a strange structure for the subsidiaries.

So like I said, I don’t understand this issue well enough to draw any sweeping conclusions, but it seems like a funny business to me.

5. Cure Rates on existing loans

I’m going to distinguish here between the issue I already addressed, which is what appears to be the abnormally low cure rates on loans that have been delinquent for 12+ months, and the more general issue here, which is whether cure rates in general can hold up and improve.

This more general issue is relevant to all delinquent loans.  And the answer to the question of whether cure rates are going to improve or get worse, is probably more of a function of the economy than anything else.

I thought that Old Republic did a good job in explaining the factors at play in determining the cure rates.  They said that the bucket was highly dependent on the following factors:

  1. Modification opportunities
  2. Re-employment opportunities
  3. View of property values going forward

When asked to elaborate on the trend, Old Republic said the following:

So far we’ve kind of been on trend. I can’t say that I have seen any serious change the cure rate that would portend to a change in the trend long term.

The risk, and potentially the reward, with the cure rate are the risks to the economy and to housing market in general.  The modification opportunities, with HARP II, are there.  Property values appear to be improving.  Employment is up and down but every month we go without an all out collapse portends to an eventual firming up.  My basic reason to get involved in the insurers is that while housing may not be about to go into a robust up market, it has stopped going down and can be expected to modestly rise.  Moreover, it is my experience that often when things turn, they turn much faster than anyone anticipates.  Its human nature to extrapolate the current trend and expect only small deviations from that trend.  When the cycle hit the inflection point the result is often much more violent.  While I’m not about to predict a robust turn in housing, I wouldn’t be surprised….

Regardless, things are looking better on all fronts, but as we all know, the risk remains…

And with risk comes…

So there you have it.  Lots of risk.  No question about it.  There are multiple pitfalls and trapdoors that these company’s need to negotiate to get to the point where they can see blue sky.  But my point, and why I own both stocks, is that these pitfalls and trapdoors are mostly priced in.  The stocks, particularly MGIC but also Radian to a degree, are priced for bankruptcy.  If they manage to navigate this treacherous terrain successfully, they will not always be so.  And as I have written about on a few occasions already, if that comes to pass, the revaluation will be rewarding.  For now, I just have to watch the news and the data carefully and see how it plays out.

On one last note, I was encouraged to see that both Radian and MGIC management bought shares over the past few weeks (with MGIC being the more important of the two in this respect). These purchases, which are not insignificant and show that management has not thrown in the towel yet.

Week 57: Belatedly

Portfolio Performance

Portfolio Composition

Click here for the last two weeks of trades.

Portfolio Summary

I’m a bit late on this update because I was away for most of last weekend.  I wrote the update below over the weekend and to some extent, my concern about under-performance has been mitigated by the out-performance over the last couple of days.  So with that said…

I hate it when the market goes up and my stocks don’t follow.

Such was the case over the last two weeks.  The market soared, but many of the stocks I own did not. There was the case of company specific news (MGIC) and the collateral damage to other companies in the same industry (Radian and MBIA).  There was rumor and innuendo and still no settlement with Bank of America (MBIA).  There was the continued malaise of a sector in a prolonged bear market correction (gold and its producers, OceanaGold, Atna Resources).  And there were the stocks that I have maybe gotten into a bit too early (Arcan Resources, JC Penney).

Its unfortunate.  But I’m not ready to throw in the towel on any of these stocks just yet.

As I have already written about, in the last couple of days I added to my positions in Radian Group and MGIC.  I’m not sure whether this is going to prove to be a mistake or not.  MGIC has a market capitalization of $150 million.  Radian’s market capitalization is about $300 million.  Both of these companies insure billions of dollars in insurance, earn premiums on insurance of more than $600 million per year and are talking losses on the insurance written on their old book of anywhere between $200 million to $550 million per quarter.

My point here is not to give an analysis as much as it is to point to the magnitude of numbers involved relative to the size of the companies.  The reason these stocks have fluctuated to such extremes in the past and present is because small changes in assumptions about future losses have an outsized impact on the share price. MGIC came out and said this week that the embedded run-off value of their existing insurance book is $1.9 billion.  Meanwhile, many analysts are writing writing the company off as bankrupt.  When the range of scenarios of future value is between a 10-bagger and a complete loss, you end up with a wildly volatile stock.

As for the oil stocks…

I’m kicking myself for selling out of Mart a couple of weeks ago.  I got too cute.  I thought that with the news out and the move up I would be able to get back in around the low $1.30s.  It even reached that level briefly, but I wasn’t quick enough to the trigger and now the stock is flying towards $1.70 and potentially $2.  This is simply a case of missed opportunity.  Take the hit (or lack of gain in this case) and move on.

Arcan hasn’t seen the lift I have been expecting.  There have been a lot of comments and rumors about the company over on the Stockhouse board.  I’m not going to go into the details here, you can read it for yourself, but if its true (and who knows if it is), then there are potentially some issues that the company has to work through.  Nevertheless, at $1.40 per share I am not very afraid of holding my shares.

The Canadian Dollar is killing me

Another lead weight in my portfolio over the last couple of weeks has been the Loonie.  Living in Canada, I am pricing my portfolio in Canadian dollars.  Yet I own a lot of US stocks.  The price of these stocks in Canadian dollars is hurt when the Loonie goes up.  That has happened over the last few weeks.  The dollar has traded up some 4% since the end of June.  That is a difficult headwind to combat.   The good thing about the movement of the dollar is that it tends to act counter trend to the stocks I own.  Its a natural hedge, which is appreciated during a market malaise, but a bit frustrating right now.

Sticking it out with MGIC

As I wrote about Friday, I had a small position in MGIC going into earnings, and after earnings were released and the stock tanked I added to that position on three occasions.  The stock price movement after that left me waffling, but in the end I decided to hold on to my shares of MGIC and see how this thing plays out.  In fact, I ended up buying a few more shares on Friday afternoon in the high 70’s.  The position is still not near the size of the other insurers I own, MBIA or Radian, and its admittedly the most risky stock I have owned in a while, but the upside is there and when I think through the outcomes I see more positive potentialities than negative ones. Hopefully this is the right decision; if not it will certainly be a learning experience.

I listened to the second quarter conference call a couple of times over the weekend and there were a few points that stuck out to me.

1. The Regulator is not a problem

On the call the company said on a number of occasions that there are no issues with the Wisconsin Commissioner of Insurance (OCI).  This is a Freddie issue.  The OCI is on-board with their capital plan and has been since 2009.

Interestingly, it was pointed out that the original capital plan approved by the regulator called for sending MGIC into run-off when it breached the 25:1 risk to capital ration and from that point writing all new business from MIC.  It was the GSE’s that balked at that plan and preferred the revised one they are now going with whereby MGIC writes in states it can write in, and MIC writes in the states where MGIC can’t.

It is also interesting to note that the ultimate goal is to write all business out of MIC.  They just have to get the GSE’s on board to do so.  To see how this could play out, consider the following.  MIC has about $440 million of capital.  It can write business up to a 20 to 1 risk to capital level.  Therefore it can write about $8.8 billion of risk in force, or $33 billion of insurance in force.  MGIC is writing new business at about a $20 billion per year clip right now, so MIC has enough capital to write business for MGIC for about a year and a half as a stand alone entity.

It was asked on the call if any of the other state regulators might balk at the arrangement to write through MIC.  CFO J. Michael Lauer responded that he “couldn’t conceive” of a scenario where that would happen.  Fannie Mae has also approved the plan without condition.

It seems that Freddie is the only one with a problem.

2. No liquidity problems

They must have said on at least three or four occasions that the company has a risk to capital problem, not a liquidity problem.  The point here is that while the MGIC subsidiary has breached the 25:1 risk to capital ratio and that has to be dealt with, there are no issues with the resources of the sub to pay claims.   The OCI does not believe that MGIC will be in need of the capital from MIC.

The analysts pressed on the issue as to how the OCI determines that the claims paying resources are adequate.   Do they do their own work, or just sign off on the work of MGIC?  Management responded that the OCI runs their own numbers.  They run off the current pool of business at the MGIC sub based on their own loss assumptions and check to see whether the cash and investments on hand, plus the premiums received over time, are more than enough to cover the losses that are incurred.  The outcome of this analysis has been that the OCI is comfortable with the resources in the MGIC subsidiary and its ability to pay all the claims that come in.

The OCI analysis is that MGIC has sufficient claims paying resources.  They hire advisors to look at MGIC on a run-off basis and they keep coming up with that conclusion.  He’s comfortable with our claims paying resources and therefore he is satisfied with our plan.

At particular issue with Freddie is whether the MGIC sub has access to MIC capital.  Clearly, one of the objectives Freddie Mac was trying to achieve in the letter they sent to MGIC was to get more capital into the MGIC subsidiary and to remove constraints of getting capital out of the MIC subsidiary and into the MGIC subsidiary.  Now whether this is an objective because Freddie is actually concerned with the claims paying ability of the MGIC subsidiary, or whether its because they are using it as a leverage tool in order to get their dispute with MGIC settled is another story.  But the company stated on the call on numerous occasions that this concern is Freddie’s alone, and that OCI, and presumably Fannie Mae too, have no such concerns.

Probably in an attempt to allay some of the solvency fears, management also did something they haven’t done in quite some time, and provided an estimate of the run-off value of the MGIC sub.  They said that the value is $1.9 billion.

If you’ll recall, back in April 2010 was the last time we published the estimate of the assets remaining after the completion on the runoff. Then we estimated, which was as of March 31, 2010, that the consolidated insurance operations had excess claims paying resources of approximately $2.1 billion. Using a similar methodology but clearly with updated assumptions, we would estimate that as of June 30, the excess claims paying resources were approximately $1.9 billion. Now that $1.9 billion amount makes no provisions for any adverse contingency development that could arise from disputes with Countrywide, Freddie Mac or the addressing [ph] is not is a stress scenario. It’s kind of a baseline scenario.

$1.9 billion is about $10 per share.  I know that number does not include any potential Freddie settlement, any further write downs due to changes in the cure rates, but I’m just saying…

3. This is a negotiation

At first, the analysts on the call seemed to default their phrasing of questions as if to concede that it was a foregone conclusion  that MGIC was going to have to downstream $200 million of capital from the parent and pay $550 million to Freddie to settle the issues with the pool insurance.  Maybe that turns out to be the case but based on the language of management during the call it didn’t sound inevitable.  Here was what was said in response to a question from Conor Ryan about the authority of the OCI to grant Freddie’s requests (again courtesy of SeekingAlpha):

I mean, it’s a negotiation. Certainly, they have — it’s a 3-way, obviously, negotiation with the company, the commissioner, as well as the GSEs. And the issue there, and always has been, and the ability of getting any dividends out of MIC relative to needs of MGIC. Our position going in has been that there is excess capital where it won’t be needed. Freddie Mac wants to discuss some type of agreement with the commissioner about some formula where it would come up, and we’ve agreed to negotiate that with them and have meetings with the OCI on that subject.

This seems to me to be somewhat underlined by the timing of the letter.  Freddie delivered the letter to MGIC the night before earnings were released.   They knew that MGIC would not have time to talk to the board about the letter, or to the OCI about the letter.  Freddie clearly intended to put MGIC in an uncomfortable position.  They are trying to get something.  Likely, that something is a resolution to the issue with pool insurance.

4. The worst case scenario is still not the end of the world

Ok so let’s assume that Freddie gets everything that they want.  I don’t think this is going to happen, in fact I think that even in the act of delivering that letter Freddie underscored that there is wiggle room; if MGIC had no negotiating position it would have never come to a 24th hour tactic like this.  But let’s look at what happens if the nightmare comes to pass.

In this worst case scenario the MGIC sub loses $550 million of capital that it pays to Freddie to settle the pool insurance.  This is mitigated by the $200 million of capital they get from the parent.  So the loss is $350 million total.  I estimate that puts total capital at MGIC at around $950 million, and the risk to capital ratio at the MGIC sub is around 37x.  While 37x is not a wonderful risk to capital level to operate at, it perhaps isn’t the end of the world scenario that it is being made out to be.  Genworth is operating at a risk to capital level of 34x right now.  From what I can discern, apart from the 25 to 1 ratio constraints that have already been breached, there is nothing else out there that will trigger based on risk to capital.  At the end of the day, what matters to the OCI is claims paying resources, and if you take management at face value, claims paying resources are sufficient and a run-off leads to over $1.9 billion in positive net present value, so more than enough to absorb the $350 million hit.  Certainly it puts MGIC closer to the edge than they were before, but they are not quite peering over it on their tiptoes as the stock price would suggest.

At this point, MGIC is writing business out of MIC.  At the very least 38% of total new insurance written would be coming out of MIC.  So going foward, risk to capital at the MGIC sub will go up more slowly as only 62% of new insurance written will be out of MGIC.  Meanwhile the parent holding company, while certainly being less capitalized then it was, still would have $210 million in cash and another $70 million in unrealized investment gains.  This is against medium term maturities of $100 million in bonds due 2015.  There are longer dated maturities of $345 million in 2017 and $389 million in 2036, but these are a long ways off and I think the position of the company will be settled before we have to worry about either.

Now I don’t think this scenario is actually very likely and I am just running through it to look at the extreme.  I think its much more likely that MGIC finds some middle ground with Freddie.  But even if it did, is bankruptcy really imminent?  I’m not so sure.  The question that begs is why is the stock price assuming it is?

I think that when it comes right down to it, the fate of MGIC is going to be determined by the same factors as were going to determine it before earnings.  The housing market needs to level out.  Delinquencies on the old book need to see further decline.  The company needs to write business on the new book to realize the 20% plus returns that it is going to deliver.   The Freddie issue creates uncertainty and will potentially make the company position more tenuous, but I don’t see it as the showstopper that the stock price seems to imply.

I’m sticking with that story until I see evidence otherwise.