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:
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.