Friday, February 18, 2011

Speculating on a Triad Trifecta

Today Triad Guaranty Inc. released a stunning quarter. Too bad it does not really mean anything for stockholders. The good times will have to keep rolling and then some for the unlikely occurrence of shareholders seeing a dime. And yes, we think it is an attractive, unlikely-to-pay-off speculation.

After MGIC, Radian, Genworth and PMI all reported steep mortgage insurance losses, Triad reported significant net income and a loss reserve release. Despite the steep dip in loss reserves, Triad reported only a shallow dip in its reserves to risk-in-default ratio. Maybe this shows that every book of business is unique but we think it may also show that Triad has no reason to load up an accounting cookie jar unlike its solvent peers.

We continue to view Triad's stock as a far out of the money call option. It just got very slightly less far out of the money. The call is really on the unpredictability of the shadow inventory. The absence of debt in the capital structure gives that call a long life.

Our overly simple base case scenario (available here with our unlikely break-even case scenario) includes a flat 20% loss ratio and high persistency over the next 9 years . In such a scenario, Triad shareholders receive nothing. Triad becomes worth a lot of money if the shadow inventory makes off like the shadow of Peter Pan. That won't happen.

Still, little mice cast long shadows at dusk and dawn. For that reason, we show a scenario representative of the most likely developments that would make Triad over come its deficit over 9 years. The obvious and key characteristic of this scenario is massive reserve releases.

While we don't expect shareholders to receive a penny, they are still making a good bet. We view it as akin to being allowed to buy one lottery ticket with three out of six numbers given to you as correct. While winning remains very unlikely and one should not bet the farm on it, or even the milk cow for that matter, it is still a great bet.

We can't calculate the madness of men nor the movements of the stars. But we can find a good value, even if we expect it to turn into a black hole.

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