Tuesday, November 11, 2014

Getting Gem├╝tlichkeit with Genworth's LTCI

Genworth has shat the bed! This calls for something special: a complete, unedited, typo-ridden, stream of unconsciousness, celebration of the fallibility of human judgement (...hopefully not my own.)

The company reported over $500M each in reserve charges and goodwill writeoffs in Q3. What's more, the circumstances of the charges indicate a large GAAP active life charge in Q4.

The pending charges are the probable reason that Genworth was at one point down over 50% in two days. My current guess is that this pretax GAAP charge will be greater than "Fitch's current rating expectations assume an additional $500 million to $1 billion of pre-tax GAAP charges." 

Rating agencies took disparate views on the news. Fitch put the company on negative watch while expecting more charges. S&P took the opposite position, downgrading the company and noting "Any additional material reserve strengthening could result in a downgrade." Moody's was least committal, placing the company on rating watch negative while it "will use the review period to evaluate the results of Genworth's review of the margins on its LTC active life reserves."

Moody's also quoted it's SVP, Scott Robinson, who said "Genworth has taken prudent actions to protect its capital position and has the capacity to absorb the announced reserve charge, which was higher than we expected. While we will gain insight into the company's long-term care reserve margins during the review process, we believe the company remains exposed to further, significant deterioration in its legacy block of business."

Indeed. The policies in the active life reserve display much better characteristics than those in the claim reserve (other than not being in claim e.g. tighter underwriting, benefit length, daily max, attained age, etc.). However the active life reserve is split into two buckets for GAAP reserve loss recognition testing (LRT) margin, the older of which is markedly worse than the newer. The GAAP LRT margin on this pre-10/3/1995, "PGAAP" group of policies was only $100M on a $2.5B reserve (both are after tax). The newer "HGAAP" block of policies has a $2.9B GAAP LRT margin on a $13.4B reserve.

The Q3 claim reserve strengthening was roughly 15%. Claim reserves are best estimates, which are used to the active life testing margin process to establish the economic balance sheet margin. That margin is then stress tested to come up with the LRT margin. The bad news is that the actual best estimate of the present value of future claims on the active life book was $37.8B at the end of last year. The good news is that the increase to this number should be substantially less than 15% due to the shorter tail and better risk profile of this book. It is harder for claim severity to increase when duration and daily benefits have tighter caps.

The assumption changes appears to expose PGAAP book to considerable negative margins, while the HGAAP book appears to maintain a decent margin. The increase in PGAAP expected future claims will be higher than for HGAAP. The ratio of expected future claims to active life reserve is certainly higher for PGAAP. We can only guess, but perhaps it is as high as 3.5 versus the aggregate ratio of 2.3. Using a 15% increase on this assumption infers a GAAP charge of roughly $1.3B before any remedial action.

As noted, active life reserves are not just best estimates of future losses, they also also include expected future premiums. Increased loss expectations may increase the companies expected future premium rate increases. This led Genworth to note in its earnings report that "the company is developing related management actions, that it expects will offset much, or possibly most, of the reduction on margins from the claim reserve review." So maybe this pretax GAAP charge number we are playing with gets down to $1B.

But Q4 GAAP troubles could be compounded by additional goodwill writeoff of as much as the remaining $300M. The company noted in a November 6th press release responding to credit rating changes that "These changes in ratings or outlook are expected to reduce sales in some of its products." Lower expected sales was one reason for the Q3 writeoff and there is no indication that the company anticipated the rating and outlook changes.

All this GAAP analysis raises one of the central questions surrounding investment management: "who really gives a shit?" Now that we know the actuarial assessment has changed the economics outlook for the book of business, who cares how the bean counters catch up with reality? For one, we will gain more, albeit incremental insight into the book with every quarter and every review. For another, if we switch to statutory accounting, the bean counting determines dividend capacity and could even require regulators to intervene in the subsidiary's operations. 

There are big differences in GAAP and statutory margin tests. A big one for Genworth is how the book is divided. Rather than PGAAP and HGAAP books, Genworth's statutory tests divide the company between subsidiaries: GLIC, GLICNY, and BLAIC (a Bermuda reinsurance entity for GLIC and GLICNY). GLIC is the largest unit with the coziest margins. GLICNY is smallest and has already established an asset adequacy reserve. This reserve was actually reduced by $40M at the end 2013, but the take away for investors is that this margin is nil. This is where the likely statutory charge will come from in Q4.

Any distinct (non-geographic) characteristics between the books of GLICNY versus GLIC are not immediately clear to your blogger, but it is safe to say that GLICNY book is generally better than the claim reserve book and PGAAP book. GLICNY accounts for less than 10% of total active life reserves and probably accounts for less than $3.8B of the $37.8B aggregate PV of claims and expenses.

Being a New York subsidiary GLICNY follows that state's mandates for margin testing. This includes the unique disallowance of any expected but not yet approved rate increases. This nullifies managements main lever in offsetting increased loss reserves. Still the size of the likely statutory charge in Q4 will be a few hundred million or less. While this could drive unassigned surplus and therefore dividend capacity to or below zero for 2014, management has precluded dividends anyways. 

To put this in perspective, the company would have to post a about a $3B pretax reserve charge to take its RBC ratio down to 200% where the company would be required to submit a plan on how it intends to increase the ratio. $3.6B might get the company to a level at which regulators can take action (principally restricting new business). $4.2B is the level at which regulators have the option to take control of the company and either liquidate or - as is more commonly the case - rehabilitate it. At about a $5B the regulators would be required to take control of the life subsidiaries. 

Needless to say, none of those charges are coming out of the NY sub alone anytime soon. The aggregate book meanwhile would need expected losses to increase at twice the rate of the claim reserve book, with no management action to get to a level where Genworth needs to file an company action plan. Its more likely that the claim book loss expectation increase will be more than twice the rate of active life book loss expectation increase and that the latter will be reduced by management action.

Such reserve charges look increasing unlikely given that two of the large drivers of LTC  mispricing are approaching their limits. When underwritten, the oldest books of business were assumed to lapse at a rate of 6.5% and earn a yield of 6.75%. The lapse rate in the 2013 statutory CFT margin is 0.45%. Genworth uses the actual forward rate curve to predict future investment returns. A final 10 year yield that is 220 bps lower would decrease margins at the company about $2B. A final 10 year yield below 1.5% would be needed to to completely erode the 2013 CFT margin. A ten year of approximately 0.3% is needed to completely erode the 2013 economic balance sheet margin on its own. Given where the forward rate is now, this level of adjustment in interest rates will not be coming this year.

What about reserve increases in future years? This is a more valid concern, but Genworth's life insurance subsidiaries book over $500M of pretax profits annually across all busisness lines. Additionally the present value of future profits on new LTC business accretes to margin analysis as it is booked. Combined these add over $700M to margins annually. Meanwhile the oldest, worst business runs off.

Of course, many believe that it's impossible to make money in longterm care insurance. The most common reasons sited are the information advantage of policyholders, the contradictory incentives of insurer and insured, and the difficulty of necessary forecasting. There may be no other form of insurance that suffers so broadly from all three conditions. 

There may be no business today that suffers from such sparse competition and a negative sentiment. This bodes well for future returns. Genworth has shortened its tail risk, tightened underwriting, and increased prices for expected returns above 20% on new business. So prices for new business have risen not just to reflect more conservative assumptions, but also to make more money per unit of new risk. Meanwhile, Genworth has proven the regulatory appetite to allow for significant price increases on existing business to offset extreme deviations from industry forecasts.

While this is a LTC focused post, there just has to be some comment on valuation. The yield on the jr. subordinated 6.15s of 36 spiked above a 10% ytw from around 7% before the earnings blunder. Genworth has $4.4B of carrying value of outstanding debt (excluding debt at in international MI) with $1.1B of cash at the holding company and $3.3B value of its interest in publicly traded international mortgage insurance affiliates. This shows an impressive faith in management's ability to lose money.

Genworth's US MI unit, GMICO is worth $2.9B if valued at 2/3 (an approximation of relative rate of NIW) the enterprise value of larger MGIC. There are several ways to get to the current enterprise value (with debt at carrying value) from here. One way would value all of Genworth's other businesses at 2x 2013 earnings except for LTC which will need a 0x multiple to get us to the 8.8B EV. 

Taking a different view, management has estimated they can achieve a long term RoE of 9%. If they achieve that target, buying at 1/3 of book value will earn a return on market equity of 27%. Of course, what type of consensus makes for 27% return on your investment?

This may look like child's play to veterans of the mortgage insurance meltdown, but it still is uncertain how the market will react to the Q4 charges. Even though many called for $500M in reserve charges in Q3, the end results still drove many to despair. In the meantime we'll be keeping our pockets open and hoping for GNW to be a penny stock again soon.

Tuesday, May 6, 2014

Questions for Radian - How to Prove Clayton Buy Is Not Sofa King Stupid

As expected, Radian announced a lights out operating performance that shows they were on a clear path to earning over $400M. Yay! Balloons! Noise makers!

Scratch the record. Kill the music.

Radian announced it will pay $305M for a business that earned $9M last year. Lets me get out my calculator. Yup that is a little higher than the 6-7x normal PE Radian was on its way to. The yield is also lower than the high teens (mgmt estimate) to arguably 20% ROE that Radian is earnings on it's NIW at it's capital starved subsidiary.

But lets not jump to the conclusion that Radian is buying a 3% yield with a cost of fresh capital in the teens. We can pull up financials from when Clayton was a public company to get an idea of their boom time earnings will be. Surely the next boom can't be too far off. Well the companies peak earnings were $15M in 2003 and it's proforma earnings that year were $9M. Wow that is awful close to last year.

Surely past deal makers saw even more potential in Clayton than our trusty Radian leaders. Nope. Back in the heyday of 2006 the Clayton IPOed for a $125M market cap with about $65M in debt. Then Greenfield took them private in April 2008 at a $135M market cap with $25M in debt. So those valuations seem consistent to each other. They are also both 50-63% of what Radian is paying. Radian's presentation does little to justify such a high price which is why I have composed a few questions that management may wish to ponder:

-In your presentation you describe Clayton as a "Non-capital intensive business" which is fantastic, but aren't you spending $305M of freshly raised capital on it? Or was that broccoli you spent? Or are you just trying to tell us that you value this cash flow stream so highly because it does not have a moat of capital around it?

-In your presentation you describe your purchase of Clayton as having a "Future tax benefit from basis step-up". Should I try to negotiate a higher price for a given bond so that I can depreciate a larger premium? Is this Radian's investment strategy?

In your presentation you state "Acquisition is expected to be breakeven from an accretion/dilution standpoint and modestly accretive excluding the non-cash amortization of intangible assets." Is that for 2014? If yes, analyst estimates have 2015 earnings ex-Clayton growing by 50%. Will Clayton earnings keep pace or is the deal dilutive after year 1?

-This deal could only be considered accretive on a normal basis if Clayton earnings growth is substantially faster than MI earnings growth. Furthermore, Clayton earnings would have to attain a far higher than record level, including boom time GAAP and pro-forma earnings. Radian has also said that they do not know when or how final housing finance reform will shakeout. So, what special insight does Radian have that allows it the vision of such high profits at Clayton?

-Simply, how does Radian see twice as much value as a boom time valuation?

-Given the different lines of business and locations, how much expense reduction can Radian achieve with synergies? How does a cross sell function between deal/servicer products and private mortgage insurance (what are the revenue synergy opportunities)?

-Radian has bought diversification across the mortgage market. An investor can buy the S&P 500 and get diversification across all markets for less than half the cost. That one is not a question.

Well this turned out to be more of a rant (OK a temper tantrum) than a list of questions for management. Maybe this post should have been called "Seeing Red with Radian."

Radian management made some graceful moves in the downturn. They managed the bust better than any other company. But now it seems management is doing anything but a favor for shareholders. Managers use your money to buy things for all types of reasons. It may behoove them to diversify their business so that they have a more steady job. Managing a bigger company surely necessitates paying managers more. Sometimes managers acquiesce to large shareholders who may have their own agenda, like buying more stock in a secondary. Many times experts become so overconfident that they actually become worse at their expertise than lay people.

Even if 1) Radian had no other way to utilize it's tax benefit, 2) we think record profits are sustainable and can grow as fast as PMI profits, 3) we add back a $10M amortization, the current yield on the Radian's Clayton investment would be less than 7.5%. It falls at 6.6% without fudging around for taxes. Radian's average analysts estimate (which this quarter was beat by at least 50% anyway you slice or dice operating earnings) for 2014 is 0.95 and for 2015 of 1.45 per share. If you take the most generous current yield on the Clayton investment and the analyst estimates (which were just beaten). then you have something that looks consistent with management's comment on accretion only applying to 2014. Thereafter it would be sharply dilutive.

The good news for shareholders is that this deal is quite small at approximately 10% of Radian's enterprise value. Far worse is having a management team willing or inept enough to destroy shareholder value. Has noted earlier, Radian reported a lights out earnings performance so these are crosscurrents in the market for RDN stock. The only surprise for this shareholder is management's mistakes.

Friday, May 2, 2014

Genworth and Friends Announce Radian Likely to Surprise

Genworth announced earnings on Tuesday night, slightly beating consensus with strong performance in US MI and Long Term Care making up for poor life insurance mortality.

The US MI unit reported a quarterly loss provision of $63M, the lowest since Q2 2007. This is particularly relevant to Radian because of the similar size and reserves of legacy portfolios and defaults.

Radian ended the first quarter with 53,119 loans in default having had 12,113 new delinquencies and 13,645 cures. Genworth ended with 45,861 loans in default having had 12,100 new delinquencies and 13,678 cures. In a normal quarter, new delinquencies are the main drivers of loss provisioning.

MGIC provisioned about $5.3m for every new delinquency in the quarter compared to Genworth's $5.2m.  

The other big swing factors in operating earnings are mostly determined by actuarial assumptions. While books of business vary, Genworth and MGIC all have a primary reserve per delinquency with a $26m handle (Q4 for AIG had a $25m handle, but they haven't reported Q1 yet.) (Genworth and AIG report the components and not the actual figure. Genworth: 1,197mm reserve, 45,861 defaults. AIG: 1,220mm reserve, 47,518. This is not to be confused with "Flow Reserve per Delinquency.") Radian's Q4 reserve per default stands at $26.7m.

Consider also that Old Republic reported a $22.9M Q1 loss provision in its MI unit with an ending delinquent inventory of 35,042 loans, a lower provision to inventory ratio than Genworth. This looks like the result of beneficial developments in expected roll rates, principal actuarial assumptions. While Old Republic does not report report new delinquencies, its provision per delinquency was certainly less than MGIC and Genworth.

So what's the punch line? Radian Guaranty (the MI unit) will probably put up a loss number within the $65-75M area if actuarial adjustments are neutral. Core revenues (earned premiums + investment income) for the MI unit look like they will be in $220M area and $250M for Radian overall. Mgmt guided other operating expense excluding charges associated with stock price changes at down 10-15% for 2014. That implies quarterly core expenses (Other Op Ex - Stock Px Ex + Policy Acquisition Ex + Interest Cost) of less than $83M. Knowing of no deterioration in Radian Asset's book and the expected recovery of TRUPs losses, a $10M loss provision seems conservative, though this number can be volatile. This all adds up to what I'll call a conservative economic earnings number likely to be north of $60M and comfortably above consensus EPS of $0.21.

There are plenty of chances for this number to be muddled in a single quarter. For instance, we already know that the stock px rose slightly in the quarter so there will be a pretax charge of, oh, say  $10Mish. Maybe there will be a random actuarial provision, a legal charge, a single premium business revenue charge.

Still if you twist my arm,  I might tell you that I really think the economic earnings number will be above $75M. I really don't think it matters though. The only real message that investors need to take away from this report is the same one that has been broadcasted since the start of 2013: the foundation has been poured for a long term earnings renaissance.

Radian's core revenues will pass $1B this year before continuing higher despite today's puny origination market. The investment portfolio will continue to compound tax free for many years. Core op ex looks to level off around $350M. The loss ratio of new business is peaking in the high 20% range. Radian is positioned to be earning $400M in 2015 without a growing mortgage market or housing finance reform, both of which currently look more likely to help or greatly help the MI industry.

Friday, March 7, 2014

Sawadee Kraup JPM Settlement

A few updates on thoughts on Syncora on areas that I've been emailed on.

Banks including JPM persistently acted like they were (or are) in the land of smiles on their exposure to monoline put backs, right up to settling in the realm of 100% of liabilities in the case of JPM/Syncora.  In fact as far as I can tell, JPM has now settled for over 100% of Syncora's gross economic (net of remediation) losses in the relevant deals (JPMF 2007HE1, SACO I Trust 2007-1, and BSSP 2007-r5). Syncora likely had extra leverage given that losses attributable to uninsured CF notes are likely only going to have a shot of recovery through Syncora litigation. All in, as they say in the land of smiles, kapun kraup Mr. Diamond.

I'm not privy to how the 2010 remediation and subsequent deals contracted recovery claims. Without that knowledge I can't say it is impossible that uninsured CF holders won't make a valid claim on part of this settlement. I'm not expecting that though. 

Elephants aren't only disappearing in Thailand. I am expecting Syncora will ultimately get another bump in surplus of 250M-400M above current (very low, maybe 25-50M) recovery estimates on their Lehman Greenpoint claim (JPMF 2006 HE1 ax). But that is the only big boy source of upside to Syncora's insured book, which I think has the more problem credits relative to capital than Assured, MBIA, Ambac, Radian Asset, or American Overseas. 

In the past, I have described ABV without new biz as analogous to maturity value of a zero coupon, if installment premiums are not included and roughly offset op ex. So that ABV is basically net assets - net ultimate losses which you can get too via adjusting a securities-only BS or working off the statutory statements. This is just one way to think about it and it is not a conservative one because (among other things) the yield on liabilities exceeds the yield on assets.  Such an ABV number per share for Syncora is very likely closer to (including under) ten than 20 with a higher risk of being 0 than say Ambac's risk of being worth less than 16.67 in 2023. But there is definitely a wider distribution of possible outcomes both ways for Syncora. Combine that with low liquidity and you've got one spicy dish for sure. 

To say the same thing in a new way Syncora could end happier, but Ambac is the better bet for a happy ending.

Wednesday, February 26, 2014

G'day Bond Insurers

There's nothing surprising in Syncora's announcement of a settlement with JP Morgan. The only "new new" to us is the timing, and while that was highly uncertain it can't be called a surprise. As predicted, the stocks are better indicators of news than headlines. Ambac's stock is telling us that JPM's most recent dose of reality in it's litigation reserves may filter through to the their settlement discussions as well.

Syncora is an easier settlement for the banks than some other FGs because of its size, other trouble spots in its portfolio, and the 2009 MTA restructuring which resulted in about half SYCRF common and all of newly created preference shares being issued to structured finance counterparties. In many cases these were the same banks that were across the table in R&W litigation talks. These all provide opportunities to disguise the actual value of the R&W settlement.

Being a smaller insurer also made it easier to compile the deal level loss data on Syncora. I think I've published this before but regardless you can check it out here. Syncora ought to have targeted full recovery of actual and expected paid claims and we would be surprised if they took anything less than 85%. Not counting losses neutralized by previous restructuring, these loses were definitely over 210M and very likely over 225M. (Note this excludes the BSSP 2007 R5 deal because it's been a while since we've reviewed the indenture in this more exotic securitization trust.) Given the size of Syncora's current R&W recovery benefit and it's claims against Greenpoint, Syncora's economic benefit from settlement is very very likely more than 75M above accounting benefit marks and probably closer to double that.

Whether or not this will be clear in Syncora's financial statements will be determined by the structure of the settlement. For example the full cash value that JPM paid could have been reduced by, trading  Syncora corporate securities or insured securities that JPM likely carried far below market value and farther below par. JPM could also have indemnified Syncora on other exposures.

Ambac continues to be a harder pill to swallow for its R&W counterparties, mostly because of the dolars involved. However, the results and methods we used in this spreadsheet (originally published in this Sept 2012 post) have been confirmed by Bank of America's new disclosure of "over $2.5B" in R&W of Ambac loss compensation claims. Any overestimation of claims in the spreadsheet are most likely compensated for in there being no accounting for other lawsuits and non-litigious recoveries. Furthermore given Ambac's stated intent and position of strength in its breach of contract cases and preliminary success in its fraud cases, the company will likely experience greater than 100% recoveries if only due to interest and legal cost recoveries and not punitive damages for fraud. 

The legacy securities of the DISCs that we recommended buying (and bought) at a rounding error from zero are now at the equivalent of a DISC at 40. And while it's a fair time for a victory lap, Ambac common and especially the warrants still seems like a compelling long-term investment. The warrants offer similar upside to an economic book value as Syncora common, with a higher quality portfolio, better disclosures, and management seemingly more intent on full recoveries of R&W (and maybe even fraud) claims. Both are compelling.

As an aside it's worth noting that while the surplus notes are now trading near par, the perpetual preferred are now trading at 33 by way of Alliance Semiconductor common stock (ALSC, thank you Stephen Pendergast). The Surplus notes are a senior claim and will eventually have cumulative fixed interest (versus non-cumulative non-fixed). I can't figure out if this is a screaming bargain or a trap. Consider for instance that American Overseas (formerly RamRe) is playing hardball with preferred security holders, placing $3 million in a trust to redeem par value of many times that of preferred securities at maturity in 2066. When in doubt, stay without.

That's all for now.

Monday, October 14, 2013

Quick Thoughts on Syncora and Ambac

As expected, Syncora reported its worst quarter since the 2009 MTA last quarter (as measured by change in the Dragon's ABV metric.) If you lightened up in the mid 60s as we suggested, getting back in today at the .52 offer will lock in a good trade. While that trade has been working out, Puerto Rico isn't about to default and JP Morgan is confronting RMBS litigation reality (among other issues) in its litigation reserves. If you made the same trade on Ambac, banking profits there might be wise too. The patient investor will buy and snooze. No need to check headlines, the stocks will tell you when a deal is wrapped up.

Saturday, August 10, 2013

Thoughts from the Back Row

1. Radian's delinquent inventory is now less than half it's peak level. And there are clandestine cures in the current number. Recently we've been thinking a lot about the rescission and denials that never were: the claims that were never reported because the loan files were never found, never delivered to the servicer, and never compiled at all. Eventually, the banks realized robosigning wasn't going to work for them.

At the same time, Radian is writing business at a pace that will likely add close to half a billion in value over the life of the business. In a year, today's headlines about the effect of future capital requirements on Radian will prove to be a fart in the wind. However, a correction would be healthy and could be imminent.

2. Syncora should be reporting it's worst quarter since reorganization. There seems to be a hard bid in the 0.6s. It may be wise to lighten up before an ugly quarter, but we wonder if the bid is JP Morgan or Greenpoint and if it cares how much money the company loses. Meanwhile, Syncora wrapped Detroit COPs trade near 48 for a current yield (variable) of 1% or less. If the paper were 20, 60% of the loss is gone on any repurchased paper. It seems pretty clear where that bid is coming from.

3. If you wiggle the numbers around (student loan losses were higher but surplus note repurchases more than offset that), the most recent report on the rehabilitation of Ambac's segregated account looks better than Scenario One. Scenario One was a projection of Ambac's performance under a base case scenario which was made at the commencement of rehabilitation. Surplus was projected to exceed outstanding notes by $4B in 2020, with another $1.2B in qualified statutory capital. That now looks more likely to happen has soon as the company wraps up its R&W claims, especially considering that reserves on repurchased wrapped paper are not released, and there is a lot of it.

4. Obama's support for the principles of the Corker-Warner bill makes a fall or winter vote a real possibility. It won't rally the house republicans around those principles, but it will pin them into being the only opposition to a bill that rids the nation of the ugly legacy of Fannie and Freddie. That's a brand that neither Hensarling nor Boehner is shooting for.