Saturday, February 9, 2013

The House that S.A. Built

We called a bottom to the MI stock rout on 8/25/11 here. Since that time the worst performer, Genworth, beat the S&P by 4% returning 41%. Radian returned 200% after answering The Dragon's Capital Question by implementing precisely the commutation solution that we had suggested. We reasserted our view of Radian in response to Barron's November 6th article asserting Radian was "A House of Cards."

Now we will justify why market prices of Radian and MGIC diverged in 2012 and what that means for investments now. While we have hardly mentioned MGIC on these pages before, we did and do consider the company solvent in the sense that there exists value in equity if liquidity does not get in the way. But liquidity does look likely to get in the way.

MGIC will have a holding company cash position of $187M in Q4 after accounting for $200M in contribution commitments to its operating subsidiary and $13M in non-deferable interest payments on Sr. Notes. The company has $100M of Sr. Notes maturing on 11/1/15 and will need to make $26M in interests payments for each of the next three years. This means that without any other sources or uses of cash, MGIC will have approximately $9M at the holding company at year end 2015.  Without a large downward revision to its expected claim rate on its legacy book, MGIC will likely still exceed a 25:1 risk-to-capital ratio at that time.

The future of the company then, is dependent on access to capital markets. The Dragon guesses that they will have it, but price is wildly uncertain. For that reason, the best place in the capital structure looks to be the subordinated debenture 9% of 2063 recently trading around 46 with substantial deferred interest. (The securities are 144a meaning only qualified institutional buyers may purchase them, thanks for looking out for the little guy big brother). We see this trade returning 40% annualized through 2016 if a liquidity solution is realized. The odds are good, but we think we can do better. Playing the market access game has never been our favorite bet.

We claim no exceptional forecasting power in forcasting market access, a clear hurdle to committing capital here. There is an attractiveness to this trade in so far as it is robust to long term perceived uncertainty of the role of PMI. However, the Dragon  believes that role is more certain than the market suspects. Old Republic, a market insider, and newcomer Arch Capital are betting that way. Old Republic acquired a minority stake in MGIC common stock and Arch announced the acquisition of PMI Group, Inc assets.

For the PMI industry's future, the big question on everybody's mind is QRM and housing finance reform. Whether the initial QRM proposal is revised or not, PMI on qualified mortgages is going to be the main show for low down payment mortgages. Retaining a 5% interest might increase cost, but hardly makes the product unworkable. QRM implementation would also likely come after a QM-like exemption while the GSEs remain in conservatorship. Meanwhile FHFA Acting Director Edward DeMarco has voiced support for an expanded role of PMI. DeMarco faces hostility from Senate Democrats over his resistance to principal reduction, but such an idea would fit with any FHFA director's duty to fulfill a mandate to "foster liquid, efficient, competitive, and resilient national housing finance markets (including activities relating to mortgages on housing for low- and moderate-income families involving a resonable economic return that may be less than the return earned on other activities)."

With that in mind, we would rather continue to focus capital on the greatest franchise in the industry. Radian's handling of the housing collapse was nothing short of a masterstroke. The firm aggressively expanded sales efforts just as pricing firmed and competitors retreated from attractive business. Peripheral businesses were sold (or commuted) when capital was needed but after valuable income had been earned and saleability improved. The maturity of the financial guarantee book coincides with debt maturities at the holding company. The company has shifted to more monthly (versus upfront) premium business in anticipation of higher interest rates and longer persistency. Interest cost reimbursement agreements with subsidiaries and the opportunistic repurchase and extension of debts has ensures holding company liquidity until 2017. By that time, dividend capacity and operating earnings will likely be at a record.

Even with S.A. Ibrahim at the helm, Radian will probably lose share within the PMI industry as new entrants and re-entrants fight for a piece of the pie. Meanwhile, refinancing activity will decrease. But the overall PMI market will grow with household formation and home purchases (even in the current low interest rate environment refinancing accounted for only 38% of Radian's NIW in the first 9 months of 2012). All in, Radian's levels of NIW are sustainable. Almost as important, slow moving prices and rising interest rates will keep persistency high on a book of business that is focused on monthly premiums.

Radian publicly says that it expects every $10B of NIW to generate $75M net present value. This appears to be consistent with 70% persistency and a 50% combined ratio. A persistency of 80% would be the lowest in since 2007. The expense ratio has been under 25% four of the last five years (2008 was 29%). Finally, the 2010 book of business is performing at a loss ratio under 10% YTD in it's second full year, a time period normally associated with close to peak losses. From this seat, a persistency at 80% and a combined ratio of 35%, the NPV of $10B looks more like $125M. If so, Radian added value of half a billion dollars, or 2/3 of it's market capitalization, in 2012 alone. But NIW in 2013 has the momentum to be even higher.

That is why we won't settle for an expected 40% per year for 4 years on jr. subordinated MGIC paper.

In the short term for Radian, CFO Bob Quint's expectation as of the Q3 call for "a larger MI operating loss as the negative impact of seasonality on both new defaults and cures is expected to result in significantly higher incurred losses for the {4th} quarter." However both defaults and cures were slightly better while claims paid were about 1% higher.

We never invest based on market witchcraft: technical analysis and chartism. Stoicism has served us better than fast-money market timing. However, watching the telltale signs of this sorcery fascinates us. Two things speak to us from the charts: the fast money is in, but for the real money looking to enter, the pain trade is higher.

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