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.