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.

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.

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.

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.

The Fix is in at Radian

We've been wanting to revisit our enduring love of Radian for sometime now. Over the weekend Barron's wrote an article "Is Radian a House of Cards?", so we just can't put this off any longer.

Experienced money managers put millions of dollars to work without having the facts straight, so we weren't surprised when a young blogger made several factual errors in a Seeking Alpha Blog Post some weeks ago. In that context it also shouldn't be surprising that a well regarded publication makes the same mistakes in their effort to create this week's 50 inches of text.

It's curious though that both made the mistake of saying Radian was increasing upfront premium business in an attempt to hoard cash at any cost. The number unequivocally say otherwise. So does S.A. Ibrahim on the last two conference calls when he has explained that the shift to monthly premium business is the result of pricing and sales incentive changes that reflect Radian management's view that interest rates and refinancing may have finally bottomed.

The Seeking Alpha Blog took the time to explain how denials will be overturned in waves once an initial 12 month waiting period runs out. This is the opposite of reality in which denials can typically only be overturned within 12 months. Barron's is not quite as egregious, noting that "[Denials] represent claims on which paperwork was missing. They are typically reinstated months later and then approved." Oh missing paperwork. Let's just go back to the file and get it.

WRONG!

Have we forgotten how all of these loans were underwritten? Have we forgotten how to spell MERS? If you think Radian is going to accept robo-signed paperwork dated four years after a loan was underwitten, you had better pass whatever you are smoking over here. And as for typically being reinstated and approved months later, Radian published it's denial reinstatement rate going back to 1Q07. A total of five (5) had reinstatement rates over 50%. What's typical about that?

Speaking of vocabulary, Barron's describes Radian Asset as "double-pledged" against it's own policies and those of Radian Guaranty. This is actually known as stacked subsidiaries in corporate finance and it is not illegal for banks to own subsidiaries, in fact it is common. Under this definition in fact any Bank Holding Company (or any holding company) debt or TRUPS would be backed by the "double-pledged" assets that also back operating company deposits.

Listen to Barron's: Radian can deny claims based off missing paperwork that never existed. The fix is in, Radian is solvent. The bigger question for the company now is housing finance reform, including QRM.

Radian: A Capital Answer

“This deal is expected to increase Radian Asset’s statutory capital by $100 million in the first quarter of 2012,” stated Radian’s dreamy Chief Executive Officer S.A. Ibrahim. 

And so our love affair with S.A. and Dominic continues.  S.A. in particular has now stepped beyond just being a great executive - he has shown that The Dragon truly has been focusing on quality rather than quantity lately. In our very last post, we discussed why Radian and Assured would make such great bed-fellows in just this type of transaction. 

The deal is accretive to Assured's economic and rating agency capital. The implications are greater for Radian, which we speculate will be able to apply to NYID for contingency reserve releases to accrete statutory surplus in addition to the $100 million statutory capital mentioned above (which we believe is actually a reference to RAA's policyholder's surplus and RG's capital base.) It's also worth remembering that another $18B of just corporate CDO's will be rolling off the books by year end 2012, opening the door for more contingency reserve releases. 


Now let's hope Radian management finds the opportunity to buy back it deeply discounted 2013 and 2015 bonds. S.A. has performed masterstrokes, and this would be so easy.

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.

HAMP: Data that Doesn't Foretell Doomed

Technicians, chartists and that lot are wizards. Whether you believe in them is up to you. But we just have that feeling that the bottom may have been put in for the solvent MI group: especially Radian, MGIC while Genworth offers less volatility and potential return.

Call it a double bottom, capitulation, or just a long awaited piece of good news. The recent market movements have made for an attractive opportunity amongst the three basic asset classes: redeploying capital into mortgage insurance assets and out of bond insurance assets and especially other assets. Not so much as changed in the bond insurance world, and that's why those assets are an attractive relative source of funds. Other assets - for those who believe in holding such things - remain the most attractive source of funds.

That's why this had to be written now.

What needs to be written is that the one (or the one) source of cure data outside of mortgage insurers supports the case for current reserve levels - or lower. Don't get us wrong: the next few quarters will in all likelihood continue to be ugly, with high loss provisions for the group as the delinquent inventory ages and new defaults remain stubborn. But that doesn't lend credit to suggestions that reserves should be 75% of risk in default for loans over 3 month delinquent (a la Barron's.)

The source is HAMP, see the program's press releases here or visit The Dragon's compilation of the latest two monthly reports here.

The data is broken out with more granularity than the MI's reports and cover two categories: loans from canceled HAMP trials and loans from loans not qualifying for HAMP. In all, 2.1M million loans are covered in the canceled loan and non-qualifying loans. The WSJ estimated their are about 6.3M delinquent loans.

For non-qualifying loans, roughly 0.9M of 1.55M or 58% of disposed loans were either current, paid off, modified or on a payment plan. 57% of 0.6M canceled loans fell into the same categories. Roughly 15% of canceled and non-qualifying loans were categorized as action pending or action not allowed. The remainder were in categories that would likely result in a claim - foreclosure pending, foreclosure completed, and short sale/deed-in-lieu.

If this data were extrapolated to the delinquent inventory at MI companies, they would look comically over-reserved. But this is a biased sample. Those loans not counted might tend to be those with the most hopeless borrowers or worthless properties, not to mention foreclosure process difficulties. On the other side of the scale, these numbers don't account for the 90% higher rate of still-current loans out of 657k permanent non-canceled HAMP modifications.

There's more: this data has no accounting for rescission and denials which might benefit claim payment rates to the tune of 15% or more. All of a sudden 50% of delinquent inventory covered by loss reserves doesn't sound so bad. Volatility be damned: we've used this opportunity to load up for the long haul.

Radian Delinquency Model

Because it is so much fun, I've put together a simple model relating Radian's delinquency inventory to reserves. It should tell you nothing other than I know how to use a spreadsheet and make imaginative assumptions. Nonetheless, you can judge the reasonableness of the assumptions and copy the model into your own spreadsheet to test the implications of your own expectations.

Here's a little bit of the little non-obvious reasoning I put into it my assumptions:
-Claims paid at Q4 actual justified by severity already at 100% though loan size differences are admittedly unknown.
-12% mod rate is consistent with Radian point of view that most of mod benefit has been realized.
-21% total rescission rate reflecting decreasing proportion of poorly underwritten loans overall but bucket over 12 months behind is still dominated by those loans.
-1-in-50 natural cure rate for loans over 12 months behind reflect only debtor windfalls and reformed strategic defaulters.

The model:
 https://spreadsheets.google.com/spreadsheet/ccc?hl=en_GB&key=tzDjiune6Nm0O3LdvNcB5Jw&hl=en_GB#gid=0

MICA Release; MGIC, Radian Data Compiled

MICA cure rate of 112% for February data landed squarely between rates reported earlier by MGIC and Radian of 115% and 109% respectively.

Compared to the same month in 2010, defaults dropped 30% from 68,675 to 48,086 reflecting credit burnout and an improving economy. Over the same time, cures dropped by 33% from 80,758 to 53,944 reflecting the expiration of federal modification programs and an aged delinquency inventory.

While this month shows near peak seasonal benefits, the last two years have not been so good for delinquency inventories. Since peaking in 2010 for most MIs, delinquency inventories have not aged like milk nor wine. Rather it has progressed more like Earl Gray tea; it certainly has not improved but at least it isn't rancid. The uncertainty surrounding this inventory remains extreme. Despite a slower start this year, we think this year will look better than last as portrayed in not only company loss developments but also cure rates.

On another note, both MGIC and Radian having reported several quarters of operating data so The Dragon has compiled that information. The links below have also been pasted on the "Links and Models" page. As always, we take no responsibility for our sloppy work.

MGIC Data: https://spreadsheets.google.com/ccc?key=0AlFMaAd3v9o0dGdRWVBMVmIzVzJvbjMtdHdZM2NFb3c&hl=en_GB

Radian: https://spreadsheets.google.com/ccc?key=0AlFMaAd3v9o0dFU1a0pFNXlEZmhZN2FORWU3RjM2bUE&hl=en_GB

MICA: https://spreadsheets.google.com/ccc?key=0AlFMaAd3v9o0dGRjSGlrZ2NDNmlxU0VMNnNJYWliUXc&hl=en_GB&pli=1#gid=0

Positioning for the Future

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.

Scenario 1.

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.

Scenario 2.

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.