It was quite the day today. While most of the market was focused and affected by the workings and non-workings of the ECB, many of my stocks were far more affected by MGIC’s 2nd quarter results.
First of all, I did buy some MGIC today. While everyone else was bailing, I decided to do the opposite, go against my position of not adding to a losing one, and basically tripled down on the stock.
I had been, to some extent, waiting for this sort of opportunity in MGIC. Of course I didn’t expect it to be quite the “opportunity” it turned out to be, but nevertheless, leading up to today MGIC was a very small position in my portfolio. It made up a little less than 1%. My hesitation with MGIC, when compared to Radian, had been the Countrywide and Freddie Mac litigation, which I didn’t fully understand, and, as it turns out in the case of Freddie, showed itself to be a rather large iceberg.
I’m going to get into my take of what’s going on but before I do let me just say that both Radian and MGIC are dangerous little companies right now. While I own both, and indeed I added to MGIC today, I will only own them in my accounts where I am willing to accept volatility and loss. I wouldn’t touch either in the accounts I am in charge of for others. The is unquestionably some uncertainty here.
Ok, with that said, onto the MGIC quarter.
I can identify two main reasons that MGIC went down and stayed down today.
- Uncertainty with respect to a Freddie Mac settlement and Freddie Mac demands
- Cure rates are declining
So um, about those Cure rates…
Cure rates are the rates at which loans that are delinquent (so those that have missed one or more payments) cure and become current again. Cure rates are an assumption that goes into the determination of the reserves that an insurer needs to set aside to meet expected claim payments. The insurer basically subtracts the expected cures from the delinquent loans when they are coming up with the eventual claim rate.
This quarter MGIC took a hit as it added to its reserves because cure rates in May and June were below the expected trend and the company, projecting out that trend, found that they were under-reserved for the number of delinquent loans that would result in a claim.
This is EXACTLY the worry I was talking about yesterday as being my primary concern with Radian. I am very suspicious that the assumptions that the insurers are using on the eventual claims on their delinquent book is going to turn out to be too optimistic. Radian gave me some solace yesterday when they described the mechanism by which the later stage buckets may not be eligible for claims. However the news today from MGIC again raises the question of whether Radian is also being too optimistic and is going to see a similar kind of write down next quarter.
The S&P extrapolated the news on cures from MGIC today in their downgrade of the mortgage insurance group and specifically to Radian.
We believe the risk of a significant adverse reserve adjustment has increased, which could hurt Radian MI’s capital adequacy and future earnings. Although new notices of delinquency (NODs) decreased incrementally to 17,945 in second-quarter 2012 from 18,659 in first-quarter 2012, cure activity (loans returning to current status) declined more quickly to 13,486 from 19,397 during the same period.
S&P also chimed in on the specific concern of the late stage bucket that I voiced in my post yesterday.
We are also concerned about the growing proportion of the delinquency inventory in the late stage (12 payments missed or more) relative to the cure activity within this bucket. That proportion increased to 59% in second-quarter 2012 from 53% at year-end 2011, while the cure rate (not factoring in cures of pending claims) deteriorated to an estimated 2.4% in second-quarter 2012 from approximately 4.5% as of year-end 2011.
These are legitimate concerns and as I said yesterday, to some extent their acceptance or denial is an act of faith (or lack their of) in management. At the moment I’m not inclined to reduce my position in Radian based on the concern, but I will be watching the cure and delinquency rates closely going forward.
The Freddie issue
While the cure rates are an industry problem, I don’t believe that the stock dropped 68% on account of a poor cure number. You get the cures alone and the stock ends up down to maybe $2 at worst. What really killed MGIC today are their Freddie Mac issues. From the MGIC risk factors included in the news release today is a description of the ongoing issue with Freddie Mac:
MGIC and Freddie Mac disagree on the amount of the aggregate loss limit under certain pool insurance policies insuring Freddie Mac that share a single aggregate loss limit. We believe the initial aggregate loss limit for a particular pool of loans insured under a policy decreases to correspond to the termination of coverage for that pool under that policy while Freddie Mac believes the initial aggregate loss limit remains in effect until the last of the policies that provided coverage for any of the pools terminates. The aggregate loss limit is approximately $535 million higher under Freddie Mac’s interpretation than under our interpretation.
$535 million is not small potatoes. I’m not sure of the exact number, but given the $42.3 billion in risk in force, less $7 billion of reinsurance and policies in default, and the 27.8x risk to capital, MGIC currently has capital of about $1.25 billion. So $535 million is a significant portion of that. In fact if you take away that capital you to the 45x risk to capital level that PMI was at before the plug was pulled.
And that’s why the stock was down so much today.
But the above dispute was known about going into the quarter. To an extent I think there is an expectation that the settlement will not be so adverse to MGIC. What has not been known by anybody until just yesterday was that Freddie was going to put the screws to MGIC to come to a settlement by stipulating a number of strict conditions that had to be met before Freddie would agree to let MGIC write business in its MIC subsidiary.
What has happened is this: MGIC has gone above the 25 to 1 risk to capital ratio, and there are some 16 states that have a requirement that you can’t write new business if you go over this ratio. In some of those states MGIC has been able to get waivers to write above that limit, while in others it has not been able to get waivers. To avoid not being able to write in the states where it could not get waivers, MGIC set up another insurance sub, called MIC, to write business in those states. It capitalized MIC with some $440 million dollars. They MGIC approached Fannie and Freddie for permission to write business out of MIC that would subsequently be sold to the GSE’s. Fannie said sure, but Freddie has balked and put conditions on their approval.
The conditions Freddie put on MGIC were stated in a letter than was included as Exhibit 2 in today’s 8-K filing. Below is the excerpt of the 5 conditions that Freddie put on MGIC before they would give the company approval:
One of the misconceptions that I saw reported in a couple cases was that MGIC was being forced into raising capital by Freddie. This isn’t exactly true. The requirement from Freddie is to downstream capital from the parent (MGIC Corp) to the subsidiary (MGIC Inc). The holding company has over $400 million plus in cash and investments and Freddie is asking for $200 million to go to down to the sub. So even in the case that MGIC does have to downstream capital, it is not going to put the holding company in immediate peril. The holding company will still have plenty there to pay interest and pay off the first wave of debts. Its the 2017 debts that aren’t covered by current cash but that’s a long way away.
And I think its still pretty uncertain whether they actually end up having to downstream this capital, I’m not sure what game Freddie is playing, but I suspect this is a tactic by to force a settlement on the litigation.
Freddie Mac certainly holds the upper hand. MGIC sells all their insurance to Fannie and Freddie. Lenders usually don’t know ahead of time which agency a loan will ultimately go to, so not being able to write business for Freddie would create a big obstacle to winning business in general. Freddie knows this and I think is using it as leverage to get MGIC to settle the pool insurance policy dispute with them.
It is worth keeping in mind that all of this only apply to the few states that have a risk to capital limit above 25:1 and that wouldn’t provide MBIA with a waiver. Of the 16, six have so far provided waivers. Three have denied the request. MGIC is waiting on a response from the other seven.
The big question, and the one that I think leaves the black cloud over the stock, is how the litigation goes and whether MGIC is indeed forced to pay up any, some or all of the $535 million discrepancy between their estimate of losses and the estimate of Freddie Mac. I don’t know the answer to this but I do wonder whether Freddie was sliding an offer onto the table by throwing out that $200 million number that had to go from the parent to the sub.
Think of it like this. It’s not really in Freddie’s best interest to send MGIC to the brink. They might, but MGIC has written a lot of Freddie insurance and that insurance is going to be in jeopardy if MGIC is moved into receivership. When the same happened to PMI, they were put on a program where fully insurance claims were no longer paid. As well, Freddie is now run by the government and the government has been pushing for a larger place for private mortgage insurance. Does it really make sense for a government run agency to basically run one of the largest private insurers into the ground?
$200 million, or thereabouts, would make sense as a starting offer for settlement. I can only speculate here, but you have to wonder about the significance of that amount?
So why buy?
I bought today because I don’t believe that a bankruptcy is imminent, I am skeptical that Freddie Mac’s intention is to push MGIC into one, and I believe that there was a lot of misinformation going around today about capital raises and liquidity issues that don’t reflect the reality. Its probably just a trade that the negativity outweighs a reality. Its not an assertion that the negativity is unwarranted. The stock is perhaps not getting back over $2 any time soon, but its reasonable to see it move well above $1 again on some speculation of a positive result with Freddie Mac. If it did I would lighten up once again, because this play right now is all about risk and reward, and the risk is quite large so the potential return has to be equally so.