Tuesday, November 15, 2011

Radian: The Capital Question

Radian's 10-Q filed this week revealed that a long-watched and troubled CDO defaulted, triggering a statutory loss reserve at Radian Asset (FG) in Q4. This would have brought Radian Guaranty's (MI's) risk-to-capital ratio very close to the important 25-1 ratio before taking into consideration a $50M contribution to the mortgage insurance unit.

While the default has been anticipated for years, the occurrence highlights Radian's shrinking financial flexibility. Radian may be able to finance approximately $300M more in mortgage insurance net operating losses through holding company contributions and $50M per year from financial guaranty earnings after contingency reserve builds. With just these sources and existing MI capital, it appears that $400M-$500M in near-term MI statutory net losses (not loss provisions) would put the unit over the 25-1 ratio, increasing it's dependence on regulatory waivers.

While there is good reason to believe that dependence on such waivers would be brief due to profitability starting in 2013 or 2014, avoiding such a reliance on Leviathan may be the better route. Radian has discussed unlocking embedded value in FG to the benefit of MI capital since it stacked the corporate structure. The attractiveness of such a transaction increases as Radian approaches the time when capital will be most valuable.

Such a transaction could look very similar to the FGIC-MBIA muni-only cut-through insurance transaction of 2008. Indeed, MBIA's (NPFG's) analysts may have already looked under the hood at Radian and that company is certainly a viable counterparty. But the easiest piece of business to commute would be the $20B reinsurance book which is about 95% municipal and 95% ceded from Assured Guaranty Ltd. subsidiaries.

Assured is not only familiar with all the credits involved, but they are a motivated actor. While Radian Asset's insured portfolio may have been one of the best or the best performer of the financial guaranty sector in the blowup, the units ratings have been pulled down by its runoff status, capital extraction, and corporate family. For Assured, this means the rating agency benefits of reinsurance are vastly reduced; recapturing the book would quickly provide rating agency capital if done for approximately the unearned premium minus loss reserves (nominal) and the deferred acquisition costs (likely ~20%) which largely represents the ceding commission that Assured already collects on this business.

There is good reason why Radian hasn't pursued more extensive commutations so far. Over the last two years, Radian Asset has generated significant economic and statutory income. As statutory income is earned, contingency reserves are built, increasing the potential treasure trove of capital for Radian Guaranty. There are several alternatives which Radian can enact in a timely manner. Those include direct municipal and/or reinsured municipal exposure commutations with Assured Guaranty, MBIA, or even itself a'la MIAC. Also, a future transaction could materialize with a potential insurer backed by the National League of Cities.

This all may be unnecessary. In addition to holding company funds, MI capital, and FG statutory net income, the FG contingency reserve should release capital by the end of 2013 by which time 50% of the structure finance portfolio will have matured; 65% matures by year end 2014. Additionally, the preliminary estimate of its pro-forma risk-to-capital ratio does not appear to include the corresponding contingency reserve release. That release would include $40M of the reserves built in the first three quarters and whatever reserves would otherwise be established in Q4.

Turning to MI, Radian Guaranty will earn well over $200M in premiums from post-2008 business in 2012; this portion of the MI book was underwritten to higher standards and at lower real estate values. Credit burnout has taken hold: Q3 new defaults were 57% of the Q3 2009 level. About 2/3 of "New Defaults" in Q3 2011 were actually redefaults versus a much lower proportion in 2009 (the term "New Default" refers to the default making the loan "new" to the default inventory compared to only the immediately prior quarter). These factors support a view for lower operating losses going forward and while uncertainty surrounding the default inventory remains extreme, it is much less than it was two or even one year ago.

All in, it seems that Radian can finance about $600M of net operating losses in the near term after considering the potential for FG capital initiatives. Radian could breach that level by recording an additional $1.6B of loss provisions through 2012, 5 quarters - the company currently predicts it will lose that much over the entire life of the book. At the same time, the stress losses of recent years have become less likely.

Even if Radian does manage to breach that level, the capital position can reverse quickly - as evidenced in FHA's press release today. Regulatory restrictions on writing new business have - and likely will continue - to boil down to projections of financial health of the specific insurance company. Such an approach increases the cushion for adverse loss developments. Whether or not to rely on such regulatory forebearance will likely be Radian's decision on how to manage its capital.

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