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…And then MGIC released their quarter and it all went to hell (but I bought some)

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.

  1. Uncertainty with respect to a Freddie Mac settlement and Freddie Mac demands
  2. 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.

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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.