Posts from the ‘MGIC (MTG)’ Category

Week 55 Update: The Insurers

The Insurers

I added to all 3 of my insurers in the last two weeks; Radian Group, MGIC, and MBIA.  Regarding Radian and MGIC, while the data this week was mixed, I still am of the mind that the worst of housing is behind us.  While I’m not ready to jump into home builders or lumber stocks or anything else that is dependent on a robust recovery in prices or demand, I am willing to make a bet on mortgage insurance companies that need things to just stop getting worse.   The insurers need prices to stop falling and defaults to continue to slow.  I am inclined (albeit skittishly) to believe that will happen.

The housing data this week, while not great, supported that thesis.  The market focused on the month over month decline in existing home sales (down 5.4%), but year over year the trend is still to higher sales (4.5%).  The trend, while not robustly bullish, appears to be of a bottoming nature.

Perhaps more importantly, inventory continues to decline and the year over year number is down a somewhat startling 24.4%.

Total housing inventory at the end June fell another 3.2 percent to 2.39 million existing homes available for sale, which represents a 6.6-month supply⁴ at the current sales pace, up from a 6.4-month supply in May. Listed inventory is 24.4 percent below a year ago when there was a 9.1-month supply.

Bill Mcbride (of CalculatedRisk) pointed out in a recent post that it is really the inventory number that we should be focusing on:

I can’t emphasize enough – what matters the most in the NAR’s existing home sales report is inventory; what matters the most in the new home sales report next week is sales. It is active inventory that impacts prices (although the “shadow” inventory will keep prices from rising). Those looking at the number of existing home sales for a recovery in housing are looking at the wrong number. For existing home sales, look at inventory first.

Meanwhile the monoline insurers (Radian and MGIC) are writing more  new business and this is some of the best business they have every written.  I have already written about how strong lending standards are these days.  Below is the trend for New Insurance Written (NIW) for the first 7 months of this year.

The returns on the new business should be quite impressive.  Mark Devries, the analyst from Barclays that covers the insurers, was quoted in this Bloomberg article on expected returns:

Firms that stay in the business may benefit from a return on equity above 20 percent on new coverage as the exit of some rivals allows remaining insurers to boost prices, and tighter underwriting standards limit claims.

Meanwhile the old book continues to wind down.  The delinquency bucket for both insures continue to fall.

The insurers are like those movies you see where there is a big explosion and the movie star starts running and there is this big fire ball behind them and its gaining on them but the movie star keeps running and eventually the big fireball burns itself out.  These insurers are trying to outrun their legacy business by printing as much new business as they can to overcome the losses on the legacy.  I think when they hit that point that new gains outrun old losses is when they really move.

As for MBIA, the company is less dependent on any specific economic dynamic then they are on  the outcome of their court cases with Bank of America.  There are signs these cases could be coming to a head, but of course they might not.  Its really difficult to say when this will end and whether a settlement will be reached before a verdict.  When I tried to analyze the deal between Bank of America and Syncora earlier this week and the conclusion I came to was that you couldn’t extrapolate much of anything to MBIA.

Why I am starting to like the Mortgage Insurers

The mortgage insurance business has been a tough business to understand.  I have been working for a number of weeks now trying to wrap my head around it, first with MBIA (which strictly speaking has a financial guaranty business not a mortgage business, but same diff), and then with Radian Group and MGIC.  Each company has unique intricacies that take time to work out.  Its been a slog.

But while the companies are different in their details, there are some common reasons for the difficulty:

1. The accounting of the business (particularly in the case of financial guaranty) is complicated by derivatives that are mark to market and/or on the balance sheet but not fully recourse to the company
2. The mortgage industry is soon to see regulations that will change its landscape (these go by the acronyms QM (quality mortgage), QRM (quality residential mortgage) and the future of the GSEs (Fannie May and Freddie Mac)).  The final details of these regulations are still very much up in the air
3. The remaining legacy losses from the mortgage crisis are going to be determined by the future rate of default of the homeowners the companies have insured.  Given that what has occurred in the US Housing market is unprecedented, there isn’t a historical guide to help predict how those defaults are going to play out

Nevertheless, I am slowly working my way through each complication, and as I do the picture that is emerging is one that is certainly ugly but that also holds promise.  The reasons that make the mortgage insurance business difficult to understand are the same reasons the companies in the space are trading at bankruptcy like valuations.  To put this in perspective, Radian and MGIC both traded at $60 plus per share in 2007.  Today they are at around $3.  I doubt that either company is ever going to go back to its old high, but the basic business that led to those earlier valuations is essentially intact and with a few things going right, the stock price of each could be significantly higher than it is today.

That basic business, when you get past the accounting jungle, is really pretty simple.  These are insurance companies.  They write contracts where they agree to pay if a borrower defaults on their home loan.  In return they receive a fee (called a premium) either up front or on a periodic basic.  They are also required to have a reserve  put aside to pay out the claim  in the event that there is a default. Until a claim payment is required they earn returns on investing that reserve.  In the aggregate, as long that the cash that the insurer receives from its premiums and the returns on its investments exceed the amount that they have to pay out in claims, then the insurer will be making money.

Both Radian and MGIC are still performing that basic business.  What’s more, the volumes that they are writing, while down from their pre-crisis, pre-housing bust highs, remain substantial when compared to the current value of their equity.  Of late, these volumes are also showing substantial year over year increases.

To illustrate the potential, in 2011 Radian wrote new insurance that will provide $717M of premiums over its life time (compared to premiums collected on existing insurance of $680M).  Before the housing collapse caused claims to skyrocket, you could expect returns after claims of at least 10-15% on that insurance.  So maybe $70-$100M in earnings.  In addition Radian produced investment income of $225M in 2011.  Expenses and costs of the mortgage insurance division is about $150M.  Radian has about 133M shares outstanding.  Adding these elements together you can see that absent the legacy book of business, its not unreasonable that the company would be earnings over $1 per share.

Of course the problem with the insurers is the legacy book.  In the case of Radian, that legacy book produced $1.3B in provisions for loss and over $1.5B in actual claims paid.  These numbers dwarf the premiums Radian is receiving and any income its earning from premiums and on its investments.  The result is a massive loss, particularly on a per share basis.

You could run through the same analysis for MGIC and draw similar conclusions.

My thesis here is that the legacy book will not always be the problem it is now.  And it appears that defaults from the book have peaked.  House prices in many areas of the US have stabilized and in some areas they are rising.  And the regulatory framework being developed seems to creating more space for private mortgage insurance.

I’ll have more to write on both Radian, MGIC  and the current regulatory state of the US housing market in upcoming posts.  What I wanted to outline here is the potential.  It is the potential that makes these companies worth investigating further.  If the business does turn around, we are talking about multi-bagger potential.  Of course if it doesn’t… well they may be headed for bankruptcy.  Now I fully admit that I am still fuzzy on whether the business can turn around before the companies run out of cash to pay off claims in their legacy book.  But it appears that the carrot  is big enough to justify an attempt to figure that out.