My Take on Radian’s Quarter

Things continue to get better at Radian.  I stepped through  the news release this morning when it came out.  I really liked what I saw and when the stock opened weakly I checked my doubts at the door and bought a chunk more.  Below is the receipts from the practice portfolio I track here.

Having since reviewed the conference call transcripts and presentation slides, I am comfortable in my purchases.

But you have to ignore the GAAP number

Before I get into what the quarter was, first a little bit about what it wasn’t.  The first quarter operating results had nothing to do with what was posted in most of the headlines you read about Radian today.  You have to ignore the GAAP number.  Whenever you read a GAAP number in an article discussing the earnings of a mortgage insurer, I think you have to get more details about what’s going into it, and maybe question the intelligence of the source.  Because GAAP for an insurer is more often than not going to include mark to market adjustments that will dwarf the earnings or losses of the real business.

This quarter’s GAAP for Radian was obscured by the commutation (commutation is an agreement to make an up-front pay-out in return for the elimination of the exposure) associated with the default of insurance they had written on a large collateral debt obligation and 6 trust preferred securities .  The statutory impact (meaning in the eyes of the regulator) of these reductions in exposure was positive to the company, but because of the accounting oddity that is financial insurance accounting, Radian had to consider the impact to its own viability as a going concern when originally booking the expected loss on these securities, meaning  that the exposure was booked on the balance sheet for much less than the actual anticipated loss.  The result of the commutation was to realize the rest of the loss (less any net benefit Radian realized from the commutation) so they had to write down a$96 million dollar non-cash loss for the quarter.

And that’s why GAAP is generally a meaningless number for the mortgage insurers.

Radian explains their reserving methodology

So getting past GAAP, my biggest reservation about Radian has been whether they have booked sufficient reserves to meet their claims.  In particular, Radian has always booked a surprisingly low claim rate on loans that have been delinquent for 12+ months.  As the slide below (from the Q2 conference call presentation) shows, Radian is anticipating a 57% claim rate on the bucket of loans that have been in default for 12 months or more.  This number drops to 47% when you account for rescissions  and denials of those claims.

Now intuitively, the idea that a loan that has been in default for the last 12+ months only has a 57% chance of resulting in a claim seems somewhat absurd.  But Radian has stated on numerous occasions that this is what the historical numbers show.  During the conference call today Radian provided some numbers to help back up that claim.

Radian provided the above breakdown of the loans in the 12+ month bucket.  28.8% of that bucket have been in default for 2-3 years.  Another 28.3% have been in default for 3+ years.  In addition, the company pointed out that “many of our older delinquencies remain in the early stages of resolution, meaning that no foreclosure action has started.”

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.

This is the basic argument that Radian has made in the past.  If 57% of the loans in 12+ month bucket have been around for 2 years or more, then clearly something else is going on.  And if something else is going on, then maybe the expectation that 43% of those loans aren’t going to result in a claim is not such a bad one.

What was really interesting was that the company provided a bit more color than usual with respect to how these late stage lingerers may never result in a claim against Radian.

Based on our preliminary analysis, we believe that a meaningful percentage of these delinquencies, to the extent they do become claims, will be subject to claim curtailments or denial and thus will not become fully paid claims.

You can see in the footnote on the above slide that Radian is reviewing some of these older defaults to see whether they have breached the  time limitations.  On the conference call one of the questions was with respect to this, and Bob Quint (CFO) expanded on this by saying:

Yes, we mean, we — the servicers are required to begin the foreclosure within 6 months from the default and then may have 1 year to perfect the claim after that. So those are the general time frames within our master policy. Now of course there could be some things within the law that extend that, but those are the general guidelines. So we’re really looking at 18 months from default that the — that’s the time frame: the 6 months plus the year.

If I understand what he is saying correctly, it suggests that potentially a large number of the claims past 18 months due could be in breach of the master policy and therefore not valid for claim.  Of course, going back to the original slide, that means that some 57%+ of 12+ month.

So this helps. Now I understand the mechanism by which these late stage delinquencies can be written off without claim.  Perhaps I can rest easier about this… well at least a bit.

Provisions down sequentially and year over year

Another pleasant surprise was that provisions on the mortgage insurance book was down sequentially (from $234 million to $208 million).  Based on the company’s first quarter guidance and comments I had really thought this number would be up quarter over quarter.  That is was down was encouraging.  The company did not, however, reduce their provision guidance for the year, deciding instead to leave it at $1.1 billion.  However when pressed on the issue in the Question and Answer Quint seemed to buckle a little to the point that they might be sand-bagging this one a bit.

Premiums down as well

I was a little surprised that net premiums earned were down from the first quarter.  At first I thought this was simply margin compression. Radian wrote a lot of business in the quarter, and the net insurance written was up some $3 billion, so for overall premiums to be down the old business running off must have a higher premium than the new business.  Radian is taking market share, after all, and so it wouldn’t be too unexpected if the company was doing so by shrinking their margins.

But I think that the larger impact is re-insurance.  Some of the premiums are getting redirected to the reinsurance companies.    You can see when you compare insurance in force with risk in force.  Insurance in force expanded to $130.4 billion in Q2 from $127.5 billion in Q1.  But risk in force dropped from $33.2 billion to $31.9 billion.  The difference is reinsurance agreements that Radian has entered into.

But even if margins are being compressed some, I am not overly worried about it.  Margins have expanded significantly since pre-2008 when the mortgage and financial guaranty companies were writing business with 20 basis point margins.  Radian looks like they are writing it with 55-60 basis points now.  Of course only time will tell if this sort of margin is sufficient, but I am willing to bet that it will be.

And that leads me to my second point.   I am fairly confident that the business being written now is going to turn out to be great business in the long run.  With credit being as tight as it is, with the US having gone through its consumer debt binge and bust, with the business being 99% prime, 75% with 740+ FICO scores, and only 1.3% with loan to value of greater than 95% I just think we are in a new world here where defaults on new loans trend below rather than above.

Its also not clear how much of the margin compression is due to a move down the risk ladder.   If Radian insures more loans in a quarter that have lower loan to values, and from borrowers that have higher FICO scores, premiums are going to come down but that does not necessarily mean the company is taking on more risk.

Keep-in on writing business

Remember that as I wrote a couple weeks ago, the insurers are like movie stars trying to outrun the fireball of their legacy book, and the only way that they stand a chance of doing this is if they keep running by writing new business.  Indeed Radian continues to write a lot of new business.  In addition to the $8.6 billion in new insurance written in the quarter, Radian wrote another $3.4 billion in July.  This is the 7th month in a row that Radian has wrote an increasing amount of new business.

I think that Radian’s strategy of writing as much business as they can, taking market share, and growing, is exactly the right one.  I mean clearly this is an example of doubling down.  They bet on insurance in the early and mid 2000s and that bet bombed, and so they basically have the choice of walking away (which would likely result in little or no equity for shareholders), or leveraging up and hoping the new business can outweigh the bad.  They are leveraging up.  As the company pointed out on the conference call today:

If the pace of our new business volume continues, we expect that, by mid-2013, our book of business written after 2008 will be larger than the book written in 2008 and prior.

I like where this is headed.  As I said, I decided to buy more stock today near the open.  Now we’ll see how it plays out.