In a news heavy week for bond and mortgage insurance, the public release of information surrounding a tiny acquisition by Radian Group and an even tinier commutation by RAM Holdings may be the most important.
In its fourth quarter earnings release on Thursday, Radian announced the acquisition of Municipal and Infrastructure Assurance Corp (MIAC), Macquarie Group's scuttled venture into bond insurance. (See a good summary here.) The importance of this acquisition lies in the implications for two plausible scenarios of another bond insurer (re)entering the market.
Radian monetizes all or part of its public finance book by moving it into MIAC and selling the entire or partial interest in that company. This scenario would fit with management's comments and is explicitly cited in Radian's press release. The mention of early stage discussions to potentially reinsure the entire public finance book suggests that a new source of capital is considering an entrance into the business. The Blue Dragon considers it unlikely that MBIA or Assured is on the other side of the table, but we have been wrong before.
Radian is unable to attract an investor at a reasonable price, but over the next 12 to 24 months developments convince Radian to split its structured and municipal businesses and reenter the public finance market. Radian insists that the company continues to focus on mortgage insurance. Nonetheless, Radian's holding company projects year end liquidity of $640M while less than $250MM in capital would be needed to both 1) pass the leverage portion of S&P's proposed criteria beneath the AAA ceiling and 2) insure all of the $15.8B NPO of direct public finance business remaining in Radian Asset. While this is only one portion of one rating agency's proposed criteria, it is also important to remember that a significant constraint on Radian Asset's ratings at both Moody's and S&P is managements intent to runoff the business and extract capital to support Radian Guaranty, the MI sub.
Given the financial stress across Radian, a AAA level is highly unlikely for any unit until circumstances improve. But solid capitalization and an experienced team with an excellent track record at Radian Asset and Radian Group suggest high investment grade ratings may be within reach in this scenario.
S.A. Ibrahim and his team have made three great moves relating to the mortgage crisis. First, before the crisis began they made the conscious decision to avoid residential mortgage exposure in Radian Asset in order to avoid risk concentration across the bond and mortgage insurance businesses. Second, they incurred significantly less permanent capital impairments compared to MGIC and PMI arising from business sales and capital raising at all three companies. Third, they brilliantly expanded Radian Guaranty's sales efforts as competition fled. In the opinion of The Blue Dragon, an implementation of Scenario 2 would be a fourth great but unlikely addition to this list.
Then there is RAM. Since we have given a plug for S.A. and his team, we have to give a plug to David Steel and his Chamber of Secrets. In all seriousness, though Steel and Co. have not been stalwarts of financial transparency, the slow reporting has been part of a successful campaign to reduce operating costs. The prescient commutations of the last couple years by this team, kept RAM alive with a solid though blemished track record.
This brings us to RAM's Thursday Q3 earnings release in which the company announced a $10.3M payment to commutate $123M NPO of exposure "primarily relating to residential mortgage backed securities." The exposure amounts to approximately 1/5 of RAM's combined RMBS and Home Equity exposure as of Q3 2009. Unfortunately for RAM shareholders, it does not appear likely from The Blue Dragon's point of view that this housecleaning was part of a discussion with the same source of capital that has preliminarily connected with Radian. More likely, the only potential acquirer involved was Assured (and maybe Calliope peripherally). Assured probably also is not seriously considering the acquisition, despite our arguments (accessible here.)
The rating agencies may also have been involved - in spirit only of course. RAM has placed assets in trusts for the benefit of its ceding companies. Since RAM was downgraded to junk and had its ratings withdrawn, the amount of assets in those trusts act as a cap on the benefit that Moody's and S&P will recognize in assessing the ceding companies. To appease the rating agencies, Assured would have the highest incentive to reassume ceded exposure with high capital charges and loss reserves like RMBS.
As a side effect of this deal, RAM's risk profile is modestly more stable. This leads us to consider what RAM will look like in 18 to 24 months. Assuming they can resolve their FGIC exposure without exploding, the company's loss reserves can outperform those of its ceding companies due to 30% larger reserves compared to ceded losses (RAM's share of the ceding company's booked loss on the exposure.)
Now consider that as of Q3 2009 RAM's AAA leverage ceiling in S&P's proposed criteria would be approximately 56:1. This implies that RAM would need a $359M capital base to achieve that limit. If unearned premiums were included as capital in S&P's calculation, RAM would probably be within $40M of that number today. Between Q3 2009 and YE 2012, 18.9% of RAM's insured debt service will have run off. While exposure shrinks, the mix of business benefits from shifting more toward longer-tail public finance business. Also, interest, installment premiums, and premium reserves are earned. All this happens in the ordinary course of business, but The Blue Dragon considers it under-appreciated by market participants - including bond insurer employees - traumatized by recent catastrophe.
In short, we think RAM could have a mid-investment grade IFS rating in 2013 without any more commutations or recapitalization. Further, as such a proposition becomes more widely accepted by market participants, the likelihood of commutations or acquisition increase. We see this increase as driven by RAM's desire to reenter the market in the first place or someone else's desire to enter the market in the second. Neither will happen this year unless recovery talks are farther advanced than we expect (which is significantly farther advanced than market expects.)
So there you have it: two tiny deals hidden amidst regulatory developments, rating agency responses, massive losses, and court rulings. Mix in an obsessive compulsive analyst and everybody is investment grade again.