Posts from the ‘MGIC (MTG)’ Category

Aug 10

Things that worry me about the Mortgage Insurers

I have been devoting a lot of space to the mortgage insurers, and while the stocks make up a decent percentage of my portfolio, it would be impossible to justify the ink spilled if it were judged only in proportion to position size. But this is a new business for me to learn, and it is a complicated business with a lot of risk. Radian and MGIC appear to have a great deal of upside if everything goes right, and a similar amount of downside if everything goes wrong.

Well I did some thinking over the weekend and came up with a list of 5 things that worry me the most about these stocks. Below I have investigated each worry and became familiar (if not comfortable) with the reality of the risk.

1. Rescission and Denial activity assumptions may be off, particularly for Radian

Rescission and Denial activity is my biggest concern and so I am probably going to devote the most space to it.

Both Radian and MGIC are recording historically high levels of rescissions and denials. At the end of the second quarter Radian had $532 million of future expected rescissions and denials baked into their loss reserves, gross of $208 million reserved against the reinstatement of previously rescinded policies (called the IBNR reserve). MGIC had $700 million of booked reductions in losses due to rescissions and denials and $276 million of IBNR reserve.

This is significant in comparison to the capital of each company, which is roughly $1 billion for Radian and $1.5 billion for MGIC. If there were a significant revision to the assumptions involved, it could impact capital quite a bit.

For Radian, of particular concern is the growing number of denials. In the first quarter Radian had $177 million of denials where they held the first loss position (was likely to take a loss on the default) versus only $33.3 million of rescissions. Denials have become much more prevalent than rescissions, which is opposite of how things have been historically.

Below are denials and rescissions at Radian over the last 11 quarters.

What is worrisome about the increase in denials is that a denial is much more likely to come back as a resubmitted claim than a rescission is.

While denials and rescissions are often lumped together, they are quite different in definition. Whereas a rescission occurs when there is something wrong with the original documentation that voids the insurance, a denial occurs when a servicer hasn’t provided all the documentation. Problems with the documentation are difficult to fix, whereas an absence of documentation simply requires that the servicer dig it up and present it. When the servicer comes back to Radian with said documentation, Radian has to reinstate the claim.

Radian put it like this in their first quarter 10-Q:

Due to the period of time (generally up to 90 days) that we give the insured to rebut our decision to rescind coverage before we consider a policy to be rescinded and removed from our default inventory, we currently expect only a limited percentage of policies that were rescinded to ultimately be reinstated. We currently expect a greater percentage of claims that were denied to ultimately be resubmitted as a perfected claim and paid.

Radian assumes that 50% of denials will come back to the company in the form a resubmitted claim.

As we’ve previously disclosed, approximately 50% of the currently outstanding denials are expected to be reinstated mainly as a result of servicers ultimately finding and producing the documents necessary to perfect the claim within the time frame allowed under our master policy.

So Radian has partially accounted for the increase in denials the last couple of quarters by increasing their reserve for expected resubmissions (the IBNR reserve). The IBNR reserve increased from $170.6 million at year end to $249.5 million at the end of the second quarter. While the increase is significant, it’s still a long way from the $177 million of first loss denials that Radian had in the first quarter and the $174.6 million they had in the second quarter. It remains to be seen whether the company has to further add to their reserves to account for the number of denials that come back to the company in the form of a resubmitted claim.

Radian has tried to downplay the impact if they had to do such a reinstatement. The company said the following on the Q2 conference call:

While our experience [with denials] clearly supports this estimate, it is important to note that this assumption is not very material to our overall loss reserve estimate. For example, even if the reinstatement percentage shifted significantly to 75, the resulting addition to our total loss reserves will only be about $97 million.

I’m not so sanguine about the company taking a $100 million hit.

The mitigating factor is that Radian can back up their expectations of future reinstatements with historical data. Every quarter Radian provides a table of how many rescissions and denials have stuck (not come back as a resubmitted claim) as a percentage of paid claims. The data below, which they disclosed in their Q2 presentation, is for the past 9 quarters.

The second column shows rescissions and denials as a percentage of total claims for the period. The third column shows the percentage of claims that have been resolved from that quarters bucket.

For example, if the number of claims resolved is 100%, as it is for Q4 2009 and Q1 2010, then the Projected Net Cumulative Rescission and Denial Rate has been determined completely from the actual finalized settlement of claims. To the extent that the percentage of claims resolved is less than 100%, the Projected Net Cumulative Rescission and Denial Rate may still change as the remaining claims are resolved.

With 80%+ of claims resolved, we can be confident that the final percentage of rescissions and denials is going to be pretty close to the percentage stated in column 2.

Well I wanted to see how well the actuals compared with the original estimates, so I took the above and compared it to the estimates of rescissions and denials that Radian had disclosed for each quarter. For each quarters estimate, I recorded rescissions at face value and cut the number of denials in half to reflect Radian’s estimate that 50% will return as a resubmitted claim.

If Radian was being too aggressive with denials and rescissions, it should show up as a discrepancy between the original estimate and the actual finalized claim settlement.

The conclusion (shown below) was that the eventual rescission and denial to claim ratio matches pretty closely to what the company would have estimated it to be.

Given the above, I don’t know if I really buy the argument that Radian has been more aggressive on its claim management practices than MGIC and that this is going to bite them in the ass at some point. Radian appears to have done a good job in estimating eventual rescission and denial levels.

There are a couple of other conclusions that are worth discussing.

1. Radian clearly has a higher rescission and denial rate than MGIC, especially of late.

Part of the reason for the drop off in rescissions from MGIC is that MGIC is in a dispute with Countrywide, who is rebutting the rescissions that have been putback on them, and they have chosen not to rescind any Countrywide loans until the dispute is resolved. Countrywide makes up about 20% of MGIC’s delinquent inventory. So that’s part of it.

Yet even if you make a liberal allowance for Countrywide loans, at the very most it would raise MGIC’s rescission rate (for example) Q3 2011 to ~13%. This is assuming all remaining unsettled claims belonged to Countrywide and were rescinded. It still wouldn’t put MGIC in Radian’s ballpark. Clearly Radian has something different going on than MGIC. I’m just not sure what it is. Perhaps Radian really is just better at evaluating claims?

2. Radian’s Single Servicer Denials

The above chart is similar to the one I showed earlier. It illustrates the number of rescissions and denials at Radian by quarter, but with the difference that now the denial activity has been broken out a bit further. Beginning with the Q2 2011 quarter, Radian further delineated its denials between those that have come from a single servicer, and those that have come from everyone else.

What you can see is that while rescission rates at Radian are falling, and while denial rates other than the singled out servicer are fairly stable, there has been a huge increase in denials from this one mystery servicer.

Of course, the obvious question is whether Radian’s assumption that only 50% of those denials are coming back into claim is valid given the high percentage of those denials from this one servicer.

I don’t know the answer to that, and we won’t get better visibility until the next quarter when Radian provides their actual rescission and denial to total claim rate percentage. Until that time, what we can say is that based on the data so far, it appears the assumption is on target. The one quarter we can look at is the Q4 2011 quarter, which was when the trend of higher single servicer denials really began to take off. And for that quarter, Radian looks to have predicted eventual rescission and denial rates fairly well. Go back to the chart labeled “Radian’s ability to Predict Rescissions and Denials” and note that for Q4 2011, actual rescission and denial rates have been slightly higher than predicted. And this is with 79% of total claims resolved, so its not a small sample size.

What to make of it all?

I understand the concern; the rescission and denial rates for Radian are high, both historically and versus their competitors. I have no answer as to why they are consistently higher than MGIC. But Iargue that Radian has been running at higher rates since Q1 2011, and with most of the claims from Q1 to Q4 2011 resolved, the evidence is clear that Radian was right on the mark, if not a bit conservative, in its assumptions. Whether this continues with the recent trend of increased denials is open for debate, but as I pointed out, the data we have so far (Q4) again points to the accuracy of Radians estimate.

2. There is an assumption that a large number of late stage delinquent loans will not result in a claim

This one is a concern for both Radian and MGIC. MGIC has already taken a fairly big hit in the second quarter because cure rates on their late stage delinquent loan bucket (ie. loans that have been delinquent for 12 months or more) were not running as high as they had originally expected. The company was cautious on the conference call when discussing whether this was a one time event or whether further revisions might be required in future quarters. They said they didn’t think so, but that they would just have to wait until the data came in.

I’ve talked about this issue in some depth in my post on Radian’s second quarter. While from what I can see MGIC does not provide claim rates broken down by bucket in their material, Radian does. As shown below, Radian assumes that only 47% of the existing delinquencies (net of rescissions and denials) that have been around for at least 12 months will result in a claim.

Intuitively, one would expect something pretty close to 100% of delinquencies that have been around at least 12 months to result in a claim. That it isn’t, is the concern.

The mitigating factor is that, as Radian pointed out in the following slide from its quarterly presentation, a large percentage of these 12+ month delinquencies have been around for 2+ years.

Of course that delinquencies are hanging around for years makes as little intuitive sense as does the idea that only 2/3 of them are going to result in a claim. Clearly something is going on with a large percentage of these loans, and perhaps whatever is going on is going to make them less likely to go to claim, but I have yet to hear a coherent explanation as to what it is that is going on. As a I wrote previously:

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.

Until we actually start seeing these loans clear out, this remains an uncertainty, and with so many loans delinquent and in this 12 month bucket, a little bit of error in the assumptions involved could lead to either a big gain or loss to the companies involved. Going back to Radian’s slide of Primary Loans in Default, the 12+ month bucket accounts for about $1 billion in loss reserves. If Radian is off on its eventual claim rate assumption, we are talking about a whoopsie in the hundreds of millions of dollars.

As I said, at least as far as I can tell MGIC doesn’t provide enough information to determine its late stage claim rate from their quarterly material, so you can’t draw the specific conclusions you can with Radian. But you can back out some information based on comparisons to Radian, what management has said on conference calls and from some of the data that they do provide.

First of all, MGIC said on the Q2 2012 conference call that the claim rate for new loans was assumed to be 25%. Presumably this is referring to 1-3 months delinquents, which would mean that their projection on this bucket is the same as Radian. Now lets compare loss reserves per default. Radian had reserves per default of $28,410 as of Q2 while MGIC had reserves per default of $25,547. The severity on claims paid, which is a basically the amount in $’s that the company has to pay to settle out a claim, has historically been similar for both companies if not a little higher for MGIC, so you can’t really argue that the reserve per default at MGIC should be lower based on severity. Putting it together, if the early stage bucket is the same, and if the severity per claim paid is the same, then the only reason the reserves per default could be lower at MGIC is because they are assuming a lower claim rate on its 3-11 month and 12+ month buckets.

In other words, all else being equal, MGIC may be more susceptible to future revisions of late stage delinquency cure rates than Radian. Moreover, the write down last quarter could be viewed as a catch-up of sorts. But take it all with a grain of salt, because the data is sparse and its difficult to be sure without knowing the intricacies of each insurers current books.

3. MGIC and the Freddie Mac issue

Freddie Mac and MGIC are in disagreement about policy coverage, with the crux of the disagreement being described well by this Reuters article:

The disagreement has been going on for some time, and centers on loss limits on policies that insure Freddie Mac, the No. 2 provider of U.S. mortgage money.

MGIC said in April that it believes the loss limit decreases as policies lapse, while Freddie asserts that the initial limit remains in place until the last of the policies expires.

If MGIC can settle their issues with Freddie Mac in a satisfactory manner the stock will be above $2 again. Simple as that.

The key word is satisfactory. $550 million, which is the amount in dispute between MGIC and Freddie, is a lot of money. Its perhaps not make or break it money for MGIC, which has around $1.25 billion of statutory capital as of Q2, but its awfully close.

MGIC said the following in their disclosure about the lawsuit against Freddie:

“We account for losses under our interpretation although it is reasonably possible that, were the matter to be decided by a third party, our interpretation would not prevail,”

It’s not exactly a reassuring statement of certitude.

The real problem is that Freddie is in the drivers seat here. As one Reuters article put it:

“Freddie Mac has all the leverage, so my sense is that MGIC is going to have to put in at least the $200 million (in new capital) that Freddie wants and it could go beyond that,” said a hedge fund manager, who no longer trades in MGIC shares but has been a long-time investor in other mortgage insurers.

The other risk is that through the negotiations and/or litigation, MGIC and Freddie taint their working relationship.

“While it is likely that MGIC and Freddie come to an agreement, it is not a given that these two firms continue a productive business relationship,” said Jason Stewart, and analyst at brokerage Compass Point Research and Trading LLC.

As for the issue at question, whether or not MGIC or Freddie’s interpretation is right, this article provided the best explanation I have found as to the legal claim at issue, as well as some direct excerpts from the submitted documents from MGIC. Quoting directly from court documents:

“During 1998 and 1999, Freddie submitted an ever-larger number of loans for insurance under the eleven policies,” the complaint states. “As of June 30, 1998, the eleven loan pools included loans totaling approximately $35 billion in initial principal balances. By September 30, 1999, the combined IPBs of the loans insured under all eleven pool policies totaled $76 billion, with a weighted average loss limit of approximately 0.85 percent. After payment of modest losses in the initial years of the policies, the remaining combined aggregate loss limits of the policies – MGIC’s amount at risk – totaled approximately $647 million.”

The large risk exposure constrained MGIC ability to write more insurance policies for Freddie Mac and others, so the two parties restructured the deals to get “new pool insurance capacity,” according to the complaint.

The complaint states: “As agreed by the parties, each of the policies was amended by a substantively identical endorsement that (a) kept each policy separate, but replaced the eleven individual aggregate loss limits with a single, combined aggregate loss limit calculated by combining loans insured under each policy into one ‘mega pool’ for aggregate loss limit purposes; and (b) establishing the combined aggregate loss limit at the greater of (i) the ‘existing aggregate loss limit,’ calculated based upon the respective total initial principal balances and existing aggregate loss percentages for each of the policies, or (ii) 0.69 percent of the combined total initial principal balance of both loans ‘insured’ under the eleven pool policies and loans which ‘become insured’ under those policies.”

The thing that doesn’t make sense about Freddie’s claim, and what MGIC alluded to in the court filing, was that if you go with Freddie’s version then MGIC would be taking on more risk than it was before the pools were aggregated. Indeed MGIC said in the court filing that:

“[Freddie’s interpretation] leads to the entirely illogical result that the mega pool has a constant combined aggregate loss limit of over $1.3 billion for a period of more than ten years – from 2007 until 2018 – lasting many years after coverage has actually ceased for the vast number of individual loan pools at one time insured under the Policy.”

The original coverage before the pools were aggregated was only $647 million and Freddie is suggesting that the amendment made upped the coverage to $1.3 billion? I don’t really understand how they could argue that MGIC would have agreed to such an amendment.

MGIC also pointed out that Freddie has subsequently acted in a way that was consistent with MGIC’s interpretation of the contract. After the amendment, Freddie added new, separate pool policies with MGIC. If Freddie had believed that the coverage on the existing policies was up to $1.3 billion, they would have concluded there was ample room to add under the existing policies.

It should also be pointed out that MGIC isn’t immediately on the hook for the entire $535 million if the dispute goes against them. As of Q2 2012 the company said that past losses would be about $175 million higher. Future losses look like they would be coming in at a rate of $40-$50 million per quarter.

I have to say though, based on the information available, it’s muddy. The language MGIC uses to describe the contract does not specifically say whether pools are to be removed as they cease to be insured. So I whether this is implied is really a matter of interpretation. I do think that the muddiness of the whole thing does make it unlikely that MGIC would have to take the full $535 million hit but it probably also makes it unlikely that they will walk away without any hit. It’s probably going to end up somewhere in the middle, which still will not be great for the company’s statutory capital.

4. MGIC is double leveraging

This is another strictly MGIC issue and I am a little fuzzy on it but I’m going to put it out there and maybe someone might comment who understands it better.

I garnered this issue from the following conference call question and answer (taken from Seeking Alpha)

Questioner: All right. And then second, on MIC, if the third stipulation in the Freddie later were granted and MIC was on the hook for losses on MGIC, what would the incentive be for states that aren’t letting you write business above 25:1 now? Why would they allow MIC to write business even if it’s liable for MGIC losses?

J. Michael Lauer: I mean, you’re talking now about the insurance commissioners, regulatory power. The subsidiary is owned by MGIC. And effectively, he’d be control of both of those entities in some kind of situation. The point is that he believes, as we do, that there’s more than enough resources at MGIC to pay claims, okay? So the issue that Freddie Mac has, obviously, is a theoretical issue that if it weren’t, what are the capabilities of getting money out of MIC. And the only way that you would get money out of MIC in that type of situation was if there was excess capital in MIC. And in the near term, I would say that we’re not using much of the capital, obviously, and it’s got a significant amount of capital in it to write business for the next 5 years. So it really doesn’t have a capital issue going forward no matter how much business we write in it in the next 4 years.

Reply of Questioner: But I guess, my question is, I mean, if MIC is ultimately on the hook for MGIC’s losses, could the California or North Carolina, say, regulators like not allow MIC to write new business even though on a stand-alone basis, MIC would have a really good risk-to-capital ratio?

The basic point that this question addresses is that the $440 million of capital in MIC is also being recognized as capital for the MGIC subsidiary. It is effectively being double counted as capital for the MGIC sub and for the MIC sub.

Presumably as MGIC uses that capital to write business in MIC, the capital available for the MGIC sub becomes less. Either that or any risk in force added at MIC is added at MGIC. Regardless, the way the two subs are laid out makes it appear there is more capital then is actually there.

I was listening to an Old Republic call yesterday and they brought up how they didn’t want to get into the business of double leveraging. Now they didn’t explain what that term meant, but I garner that it means exactly what MGIC is doing. They are double leveraging the $440 million to count against MGIC and MIC.

Of course the insurance regulator of Wisconsin has agreed to this. So its viability as a strategy is in immediate question. I bring it up simply as a concern since it seems to me to be a strange structure for the subsidiaries.

So like I said, I don’t understand this issue well enough to draw any sweeping conclusions, but it seems like a funny business to me.

5. Cure Rates on existing loans

I’m going to distinguish here between the issue I already addressed, which is what appears to be the abnormally low cure rates on loans that have been delinquent for 12+ months, and the more general issue here, which is whether cure rates in general can hold up and improve.

This more general issue is relevant to all delinquent loans. And the answer to the question of whether cure rates are going to improve or get worse, is probably more of a function of the economy than anything else.

I thought that Old Republic did a good job in explaining the factors at play in determining the cure rates. They said that the bucket was highly dependent on the following factors:

Modification opportunities
Re-employment opportunities
View of property values going forward

When asked to elaborate on the trend, Old Republic said the following:

So far we’ve kind of been on trend. I can’t say that I have seen any serious change the cure rate that would portend to a change in the trend long term.

The risk, and potentially the reward, with the cure rate are the risks to the economy and to housing market in general. The modification opportunities, with HARP II, are there. Property values appear to be improving. Employment is up and down but every month we go without an all out collapse portends to an eventual firming up. My basic reason to get involved in the insurers is that while housing may not be about to go into a robust up market, it has stopped going down and can be expected to modestly rise. Moreover, it is my experience that often when things turn, they turn much faster than anyone anticipates. Its human nature to extrapolate the current trend and expect only small deviations from that trend. When the cycle hit the inflection point the result is often much more violent. While I’m not about to predict a robust turn in housing, I wouldn’t be surprised….

Regardless, things are looking better on all fronts, but as we all know, the risk remains…

And with risk comes…

So there you have it. Lots of risk. No question about it. There are multiple pitfalls and trapdoors that these company’s need to negotiate to get to the point where they can see blue sky. But my point, and why I own both stocks, is that these pitfalls and trapdoors are mostly priced in. The stocks, particularly MGIC but also Radian to a degree, are priced for bankruptcy. If they manage to navigate this treacherous terrain successfully, they will not always be so. And as I have written about on a few occasions already, if that comes to pass, the revaluation will be rewarding. For now, I just have to watch the news and the data carefully and see how it plays out.

On one last note, I was encouraged to see that both Radian and MGIC management bought shares over the past few weeks (with MGIC being the more important of the two in this respect). These purchases, which are not insignificant and show that management has not thrown in the towel yet.

Aug 6

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.

Aug 2

4 Comments

…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.

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.

Jul 22

Week 55: Skittish

Portfolio Performance

Portfolio Composition

Click here for last two weeks of trades.

Portfolio Summary

I have reluctantly added some risk over the last couple of weeks My cash position is down to $27,839 from $35,893 two weeks ago, which is a drop to 23% of total assets in my tracking portfolio.

The stocks I have bought have been added because I believe they are cheap. I think that there is a reasonable chance that they will be worth significantly more over time. But I do not add them with complete conviction.

The problem remains Europe. And I remain wary of when the next shoe will drop. Until Friday, the market had forgotten about Europe for the time being, but we have seen this happen before, and always with the same ending. Europe comes back and again trumps all else. With Spanish yields rising to a new high on Friday (7.267%) I am already questioning whether I have made a mistake by purchasing rather than selling stock. I have already considered an about face.

You can see just how skittish I am by looking at how many trades I am second guessing myself on. Three times in the last two weeks I bought a position only to sell it later the same day. These weren’t planned “trades”. I don’t play the day-trade game. These were cases where I took the position and couldn’t handle the weight of it, and decided to sell instead of worrying about whether I had made a mistake by buying.

I am typically not so wishy-washy. That the market has me going through convulsions speaks volumes to the uncertainty that exists at the moment.

As for the stocks I bought, those that I kept that is, I am confident that I got them at a decent price which, in the absence of more macro-malaise, will lead to eventual profits. More on the individual position updates in the post below: