Doing more work on MGIC and Radian Group
Over the last couple of days I lightened up on my position in Radian Group and added to my position in MGIC. While I am nervous that this runs contrary to the claims of analysts (which have been getting on board the Radian train lately) I can’t find a hole in my work and cannot ignore the value I see at MGIC.
A few weeks ago I worked through a “blue sky” estimate for both Radian and MGIC. I was pretty surprised by the results. The following is not intended to be 2013 estimate or really an any-particular-time-period estimate. It is simply a look at what earnings might be once defaults “normalize” and each company’s reserve additions revert back to being those on new delinquencies only.
It is difficult for me to get past the fact that MGIC has very similar normalized earnings per share to Radian, and yet the share price is about a third of the price.
The difference in valuation is, I think, a result of a consensus that Radian has passed through to the other side, whereas MGIC has not. This is partly because Radian has been able to refinance itself and extend out most of its debt maturities, exchanging notes due 2015 for notes due 2017. The exchange offer was successful for about $200 million of a total outstanding principle amount of $250 million which leaves Radian with minimal obligations until 2017. MGIC meanwhile still has about $100 million of outstanding notes due 2015.
A second reason for the gap is because MGIC reserved more aggressively in the second and third quarter, so while Radian’s stock price was able to build up some momentum, MGIC lagged on worries of when and how much the next write-down might be. This caught up to Radian in the fourth quarter, and they had to add to their reserves because they had been assuming too few denials would be resubmitted as claims.
While I am not sure I believe that the lower reserving by Radian reflects some sort of a shell game being played (as Oliver Davies has been suggesting in his Seeking Alpha articles) or if it’s just the fact that Radian has a larger post-2008 book than MGIC, what I do think is that MGIC is adequately reserved at this point (which I wrote about here). I would be really surprised if MGIC has to make any further additions to increase reserves on its existing delinquent book. Given the increase in cures over the past 4 months and the general downturn in delinquencies and foreclosures in Q4 (see this article from DS News) MGIC should be adequately reserved.
And while MGIC’s Q4 headline number is likely going to be ugly because of the Freddie Mac settlement, when I look ahead to Q1 I think it could be a pretty eye-popping result. If you assume the company is adequately reserved on its existing delinquent book, then they are going to be taking reserves on new delinquencies only. Running through the numbers on about 10,000 new delinquencies at $50K per delinquency and assuming a 25% delinquency to default – you get reserving of about $150mm for the quarter.
Quarterly premiums should be around $260 million, and there will be another $30 million from investment income. On the cost side interest expense is $25 million and operating expense is $50 million. That is $290 million of revenue coming in versus total expenses of $225 million, which works out to $65mm or 32c per share before tax, and about 23c after tax. For the quarter.
If I turn out to be right in this assessment, I don’t think the stock will continue to trade at $2.50.
The other concern that analysts have with MGIC is whether their risk to capital is simply getting too high. After the payment to Freddie the entire company’s risk-to-capital may be above 35 and at the MGIC subsidiary it will be somewhere between 30 and 35 (though it was recently pointed out to me that there could be a benefit from the aggregate loss limit cures that occurred this quarter). How high is too high?
I guess I have a few points. First, I believe that the regulators aren’t looking at risk to capital – they are concerned with running cash flow scenarios on the book of business and looking at what the cash levels are. I have focused on this a bunch of times in the past. I think the risk to capital metric is over-emphasized, with its primary problem being that it doesn’t consider the future premiums coming in. And that is a key source of cash (it’s around $1 billion per year) that will help MGIC pay out its book.
Moreover, if I am right that the company is adequately reserved on the existing delinquent book, the risk to capital may very well have peaked.
This is how I think about MGIC’s risk to cap going forward:
First lets start with definitions: risk to capital is risk divided by capital using the following definitions:
Risk – this is quite simply the insurance in force (which is unpaid principle balance or UPB) multiplied by the percentage of that UPB that is covered by the insurance – usually around 25% in the aggregate, less any reinsurance that has been taken out.
Capital – While there are many individual items included in capital, for the benefit of both simplicity and clarity we can say that the essence of capital is the current cash and investments minus the current reserves.
Going forward the top line (risk) is going to stay flat at best. MGIC is not likely to be writing more risk than is peeling off the books due to natural causes. On the bottom line, if MGIC is adequately reserved on the existing delinquent book (again my big assumption here), new reserves are going to come exclusively from new delinquencies. We’ve already calculated that reserves for new delinquencies are going to run at $150 million per quarter and that quarterly premiums are going to more than cover that and expenses. So just using my rough calculations from above, the capital line is actually going to start increasing by about $65mm each quarter.
That is why, in my opinion, the regulators would be silly to prevent MGIC from writing new business even if they are at a risk to capital of 30 or 35 to 1. We are getting over the hump and the slope back down should be fairly steep. The only way I can envision that risk to capitat doesn’t begin to come back down is if MGIC is A. under-reserved on their current book (which I don’t think they are), or B. delinquencies start picking up again (which I don’t think they will).
Finally, one last consideration: When trying to predict what the regulators are going to do we need to look specifically at the individual subsidiaries, in particular the MGIC sub. The regulator is evaluating each sub independently. The fact that the holding company has other subs in run-off isn’t going to affect their decision on the MGIC sub (which is the one, along with MIC, that is writing new business). I haven’t really dug down enough to see how the MGIC sub is doing in relation to the holding co but I’m pretty certain its somewhat better because its risk to capital is 31 vs. 34 for the company as a whole.
I feel like a bit of a lone wolf here, and that really makes me wonder if there is something I am missing. If there is though, I don’t see it, and I would love for someone to point it out for me. Because from what I can tell, MGIC is likely to post some very positive results over the coming year. And those results are in no way priced into the stock.