Detroit will miss a payment on it's pension obligation certificates, setting in motion a slow mechanism to raise taxes "without limit as to rate or amount."
Missing payment on this obligation is interesting for several reasons. Traditional unlimited tax GOs are normally paid by taxes that are levied above and beyond statutory limits in good times and bad. These POCs are not. This means that once the unlimited tax mechanism is implemented mandating payment of vested pension obligations of the retirement system and therefore the POCs that have a acquired those rights, the city's budget will be unaffected because the payments will be covered by new revenues.
Things will get messy in the meantime. Normal unlimited tax general obligation securities would be enforceable by Mandamus and these will be too. But if the city or other parties wish to put up a fight, the unusual nature of the pledge may result in a lengthier implementation of the remedy. The ultimate outcome is more certain than the timing, the Michigan Supreme Court has determined that pension funding payments are constitutionally mandated and that a court can compel a municipality to make them by raising taxes or levies without limit.
Syncora may opt to novate the exposure from SCA to SGI under this scenario and implement a claims moratorium, though we are not sure they would want or are able to implement either of these alternatives. The company was confident enough to increase it's SCA exposure to this credit in the first quarter by buying a $25M chunk of the FGIC-insured bonds for about 67% or par.
The secondary news sources we have seen indicate that Detroit also plans to default on it's ULT and LT GO bonds. ULT GO debt payments may be made by money that would not otherwise be available to the city, so defaulting on these makes no financial sense. The calculus of politics and public relations never makes sense, so we won't dwell on it. Assured Guaranty, NPFG, Syncora and any other guarantors of this debt will face the smoothest process of compelling the city to caugh it up.
LT GO holders and guarantors such as Ambac are sadly screwed unless they have an additional security interest such as state aid. Otherwise their only hope for timely payments of principal and interest is state intervention. Even with a default, actually expunging any of LT GOs for good still seems unlikely without a bankruptcy filing or creditor agreement.
In sum, Detroit is on track to follow the Vallejo model: crushing weak securities while having no choice but to make strong ones whole or near whole. Look for LT GOs to be slashed along with OPEB and non-vested employee benefit liabilities.
Friday, June 14, 2013
Thursday, June 13, 2013
Prospects for Detroit's Unusual Bond Pledges
Despite the emergency financial manager protestations to the contrary, Kevyn Orr is almost certainly going to recommend a Ch. 9 filing for Detroit. The governor's approval is a significant hurdle to that recommendation becoming reality, especially considering that the emergency manager law stipulates that the city plan and budget to repay debt service in full. Orr's recent comments suggests he does not seek to abide by that statute.
Of course, Orr's attempt to reduce debt service may be inspired by public relations more than bona fide expense reduction. OPEB liabilities are generally written in graphite, not ink, even before considering the special powers vested in the emergency manager. Detroit's $6B liability can go as low as Orr needs it to go, but attacking malicious Wall Streeters will give him and his supporters cover to take actions with less legal hurdles.
Imposing losses on debt holders and insurers will take a bankruptcy filing, and even then, only limited tax general obligation bonds would be in serious danger. These LT GOs are an emperor with no clothes: while they are called general obligations, they are not the unlimited tax GOs that are the pinnacle of legal security in muniland. The LT GOs must be paid for out of available sources in the general fund, and as such their credit has more in common with traditional Certificates of Participation and lease revenue bonds than ULT GOs. COPs and lease revs traditionally are secured by a leased asset while LT GOs are basically just an unsecured credit of the general fund. Based solely on the pledge behind the bond, Detroit LT GOs could fair worse than Vallejo's golf course COPs. Lobbying by the cult of GOs would be the best hope for these bonds should a Ch. 9 filing occur. Detroit has uninsured and Ambac-insured LT GOs outstanding.
Pension Obligation bonds traditionally have LT GO pledges, but Detroit bucks the trend here too. The city's Pension Ob structure is technically a lease revenue, but has all the strength of an unlimited tax general obligation. More specifically, the credit has all the strength of vested benefits of a pension plan including an unlimited taxing authority should the city miss a payment, legally transferred to it with that transfer receiving the blessing of a court. Detroit's Pension Obligation Certificates are insured by FGIC and Syncora. NPFG/MBIA and Assured Guaranty insure some true ULT GOs.
Like Vallejo, Detroit's essential service revenue bonds will likely remain unaffected by any emergency manager debt haircut initiatives or bankruptcy filing.
Of course, Orr's attempt to reduce debt service may be inspired by public relations more than bona fide expense reduction. OPEB liabilities are generally written in graphite, not ink, even before considering the special powers vested in the emergency manager. Detroit's $6B liability can go as low as Orr needs it to go, but attacking malicious Wall Streeters will give him and his supporters cover to take actions with less legal hurdles.
Imposing losses on debt holders and insurers will take a bankruptcy filing, and even then, only limited tax general obligation bonds would be in serious danger. These LT GOs are an emperor with no clothes: while they are called general obligations, they are not the unlimited tax GOs that are the pinnacle of legal security in muniland. The LT GOs must be paid for out of available sources in the general fund, and as such their credit has more in common with traditional Certificates of Participation and lease revenue bonds than ULT GOs. COPs and lease revs traditionally are secured by a leased asset while LT GOs are basically just an unsecured credit of the general fund. Based solely on the pledge behind the bond, Detroit LT GOs could fair worse than Vallejo's golf course COPs. Lobbying by the cult of GOs would be the best hope for these bonds should a Ch. 9 filing occur. Detroit has uninsured and Ambac-insured LT GOs outstanding.
Pension Obligation bonds traditionally have LT GO pledges, but Detroit bucks the trend here too. The city's Pension Ob structure is technically a lease revenue, but has all the strength of an unlimited tax general obligation. More specifically, the credit has all the strength of vested benefits of a pension plan including an unlimited taxing authority should the city miss a payment, legally transferred to it with that transfer receiving the blessing of a court. Detroit's Pension Obligation Certificates are insured by FGIC and Syncora. NPFG/MBIA and Assured Guaranty insure some true ULT GOs.
Like Vallejo, Detroit's essential service revenue bonds will likely remain unaffected by any emergency manager debt haircut initiatives or bankruptcy filing.
Sunday, June 9, 2013
JeffCo Addendum for Syncora
Within the Plan Support Agreements alone, Syncora looks to be taking a loss of $60M-90M for a net reserve release of $40M-$70M based on our read of the deal. This seems like a reasonable settlement as it would be better than the terms of Syncora's 2010 commutation of JeffCo exposure, and rightfully so since this agreement releases J.P. Morgan from all related litigation.
Still there is an outside chance of there being an agreement outside of the PSAs, but we don't think so. On the upside this would mean further compensation for releasing JPM from litigation. On the downside it would mean having recently commuted exposure for a substantial sum prior to this deal.
Indeed, we had previously thought that the April commutation contained Jefferson County exposure as commutation payments are typically the sum of net unearned premiums and loss reserves. About $10M of the $91.5M April payment is unearned premiums and only Jeff Co reserves could account for that type of payment. It now seems to us more likely that this $80M excess over unearned premiums was in compensation for some insured or underlying asset. This means most of the bump to surplus from this deal is coming from contingency reserves. Contingency reserves would be considered cookie jar accounting shenanigans under GAAP, so the April commutation appears to us to be a non-event.
So there it is. The deal leads to $40M-$70M reserve release unless we are wrong on there being an additional agreement.
Fun Facts on the JeffCo Agreeement
While less interesting than the Red Wedding, there is plenty of entertaining tidbits in the 336 page finale to the Jefferson County debacle. Here is what stood out to us:
1) Insurers will essentially pay no further claims. Assured will be compensated for all payments it makes and the vast majority of all other insured warrant holders must commute their exposure, or else there is no deal. With $2.4B of warrant holders contractually obligated to support the deal, the commutations will or should happen. We don't know if the plan will force all non-Assured warrants to commute though it seems that it will. Ambac did force a commutation settlement of all its Las Vegas Monorail exposure several years ago. It is also possible that all FGIC ($1.4B) and Syncora ($700M) wrapped paper is embedded in that $2.4B. But for other warrant holders, the commutation election is independent of voting for the plan of reorganization.
2) The 20% haircut to warrant holders is well within the opportunity and legal costs of duking it out with the county, so this does not diminish the standing of the rate covenant or net revenue pledge. Most warrant holders are earning only two times LIBOR on a junk credit, the 20% they are losing out on can be earned back elsewhere in four or five years.
3) The $165M payment to insurers is not enough to make them whole in settlement of $335M of certain warrants that they own (non-2013 warrants). Pay close attention: the payment is made to the insurers collectively and not simply 49% of each warrant. It makes the most sense for this payment to be divvied up not based on the warrants owned, but for the losses on these warrants to be in proportion to each insurers total exposure. This would fit intuitively with industry commutation practices. For example, if each insurer took a 5% loss on total exposure that would work out to losses on direct exposure of: Assured - $10M; Syncora: $50M; FGIC - $75M. Golly, it looks like the losses were just north of 5%, and in exchange the insurers will no longer incur significant legal costs. This is well within even FGIC's reserves, which we believe are the lowest (for example, lower dollars reserved than Syncora despite having more net exposure.)
4) The language in the agreement does not seem to absolutely disallow additional outside agreements between the parties, but this is our lowest confidence read. An outside agreement would allow councilmen to campaign on having made all of Wall St. bend the knee when perhaps all the payments are ultimately coming from JP Morgan's pocket.
1) Insurers will essentially pay no further claims. Assured will be compensated for all payments it makes and the vast majority of all other insured warrant holders must commute their exposure, or else there is no deal. With $2.4B of warrant holders contractually obligated to support the deal, the commutations will or should happen. We don't know if the plan will force all non-Assured warrants to commute though it seems that it will. Ambac did force a commutation settlement of all its Las Vegas Monorail exposure several years ago. It is also possible that all FGIC ($1.4B) and Syncora ($700M) wrapped paper is embedded in that $2.4B. But for other warrant holders, the commutation election is independent of voting for the plan of reorganization.
2) The 20% haircut to warrant holders is well within the opportunity and legal costs of duking it out with the county, so this does not diminish the standing of the rate covenant or net revenue pledge. Most warrant holders are earning only two times LIBOR on a junk credit, the 20% they are losing out on can be earned back elsewhere in four or five years.
3) The $165M payment to insurers is not enough to make them whole in settlement of $335M of certain warrants that they own (non-2013 warrants). Pay close attention: the payment is made to the insurers collectively and not simply 49% of each warrant. It makes the most sense for this payment to be divvied up not based on the warrants owned, but for the losses on these warrants to be in proportion to each insurers total exposure. This would fit intuitively with industry commutation practices. For example, if each insurer took a 5% loss on total exposure that would work out to losses on direct exposure of: Assured - $10M; Syncora: $50M; FGIC - $75M. Golly, it looks like the losses were just north of 5%, and in exchange the insurers will no longer incur significant legal costs. This is well within even FGIC's reserves, which we believe are the lowest (for example, lower dollars reserved than Syncora despite having more net exposure.)
4) The language in the agreement does not seem to absolutely disallow additional outside agreements between the parties, but this is our lowest confidence read. An outside agreement would allow councilmen to campaign on having made all of Wall St. bend the knee when perhaps all the payments are ultimately coming from JP Morgan's pocket.
Saturday, April 27, 2013
Old Republic Read Through - MI Profits on the Way
Old Republic's earnings announcement on Thursday showed that the company's mortgage insurance business was essentially break even in the first quarter despite having been in run-off since August 31, 2011. It's safe to say that should the company have continued writing business at a decent clip, the unit would have been profitable. Likewise, extrapolating the results to Radian and Genworth shows that those companies should be profitable in the first quarter, while MGIC could be close. Radian and Genworth have the most new (post-2008) profitable business and strongest reserves, respectively.
Reserves per default are set to spike at all of the MI companies. Our darling, Radian is set to see the primary reserve per default increase by as much as $2m to $3m depending on the level of provisioning. That will bring the total above $30m.
The level of profits at these companies will not result in P/E levels that justify the current stock price. But that's not what this earnings season is all about. This season should be when the industry's financial trajectory becomes clear to the guru watchers and serious "home gamers" rather than just the obsessed industry-following clowns.
More and more capital is recognizing that the fix is in financially (Post 11/6/12 rebuttal to Barron's). There is plenty of room to run on that path as normalized profits begin in 2015 with record profits possible for some shortly thereafter. After that, the next leg of the run would come from housing finance reform, but that's a whole other story.
Reserves per default are set to spike at all of the MI companies. Our darling, Radian is set to see the primary reserve per default increase by as much as $2m to $3m depending on the level of provisioning. That will bring the total above $30m.
The level of profits at these companies will not result in P/E levels that justify the current stock price. But that's not what this earnings season is all about. This season should be when the industry's financial trajectory becomes clear to the guru watchers and serious "home gamers" rather than just the obsessed industry-following clowns.
More and more capital is recognizing that the fix is in financially (Post 11/6/12 rebuttal to Barron's). There is plenty of room to run on that path as normalized profits begin in 2015 with record profits possible for some shortly thereafter. After that, the next leg of the run would come from housing finance reform, but that's a whole other story.
Tuesday, February 19, 2013
Reasons to Expect a Larger Share for PMI Industry
The role of private mortgage insurance (PMI) is set to grow. Independent initiatives by Congress, the administration, FHA, FHFA, and other government agencies have created and/or seek to create a housing finance system that would expand the role of PMI. Meanwhile, the return to normal household formation levels and pent up demand bode well for home purchase volumes. Money has flowed back into the industry: market insider Old Republic bought a minority stake in MGIC, Arch Capital bought the MI operating assets of bankrupt PMI Group Inc., and market leader Radian Group broke above $1B in market capitalization for the first time in two years. The following articles highlight major opportunities for market participants.
http://www.corelogic.com/downloadable-docs/MarketPulse_2013-February.pdf
CoreLogic's recent Market Pulse newsletter said that rather than the 20% down payment baseline under the 2011 QRM proposal, "it is anticipated that the QRM rule, to be released by the end of Q2 2013, will impose a minimum down payment restriction of 10 percent." The study also shows the size of a 5% or lower down payments segment of the market, but not the 20% or lower segment. "Meanwhile, a bipartisan group of senators who drafted the language requiring the QRM rule in the 2010 Dodd-Frank Act wrote a letter to regulators yesterday urging them to drop a strict down-payment requirement."
http://www.bloomberg.com/news/2013-02-13/housing-industry-pins-hopes-on-obama-to-soften-down-payment-rule.html
This article sites broad-based support from the administration to Congress for aligning QRM with QM. Interestingly the article concludes with this: "Not everyone in the housing industry favors merging the two rules. Private mortgage insurers, which protect lenders against defaults on loans with down payments below 20 percent, stand to gain if the QRM rule allows its down-payment limit to be waived in some cases when the borrowers buy their coverage." Out loud, the PMI industry has been crying loudest for a reduction in the down payment requirement, becoming the only low down payment means of complying with the rules would create a boon the industry has never seen before.
http://financialservices.house.gov/calendar/?EventTypeID=309
House Financial Services two early February hearings on FHA and Mortgage Insurance garnered broad, if not unanimous, bipartisan committee support for further curtailment of FHA and expansion of private mortgage insurance. In the hearing focusing primarily on FHA's health, Carol J. Galante, Commissioner and Assistant Secretary for Housing at FHA, testified that FHA is currently working to reduce it's underwriting share of the mortgage insurance market. Talk has grown around the idea of FHA-PMI risk sharing arrangements may create a new opportunity for PMI companies.
http://www.fhfa.gov/Default.aspx?Page=30
In his latest speech on December 8, 2012 Edward DeMarco, Acting Director of the FHFA, overseer of Fannie and Freddie, said "Also part of any transition are steps that FHFA is taking to contract the Enterprises’ operations – whether it is increasing guarantee fees or pursuing risk sharing alternatives. These initiatives have the potential to transfer some credit risk to the private sector, a goal that most policymakers seem to agree with." This followed comments on November 28th "As we seek to reduce the Enterprises’ long-term risk exposure and place them in a more stable financial condition, we are examining various methods of risk sharing, including the expanded use of mortgage insurance and securities structures that allow for private sharing of risk."
http://www.corelogic.com/downloadable-docs/MarketPulse_2013-February.pdf
CoreLogic's recent Market Pulse newsletter said that rather than the 20% down payment baseline under the 2011 QRM proposal, "it is anticipated that the QRM rule, to be released by the end of Q2 2013, will impose a minimum down payment restriction of 10 percent." The study also shows the size of a 5% or lower down payments segment of the market, but not the 20% or lower segment. "Meanwhile, a bipartisan group of senators who drafted the language requiring the QRM rule in the 2010 Dodd-Frank Act wrote a letter to regulators yesterday urging them to drop a strict down-payment requirement."
http://www.bloomberg.com/news/2013-02-13/housing-industry-pins-hopes-on-obama-to-soften-down-payment-rule.html
This article sites broad-based support from the administration to Congress for aligning QRM with QM. Interestingly the article concludes with this: "Not everyone in the housing industry favors merging the two rules. Private mortgage insurers, which protect lenders against defaults on loans with down payments below 20 percent, stand to gain if the QRM rule allows its down-payment limit to be waived in some cases when the borrowers buy their coverage." Out loud, the PMI industry has been crying loudest for a reduction in the down payment requirement, becoming the only low down payment means of complying with the rules would create a boon the industry has never seen before.
http://financialservices.house.gov/calendar/?EventTypeID=309
House Financial Services two early February hearings on FHA and Mortgage Insurance garnered broad, if not unanimous, bipartisan committee support for further curtailment of FHA and expansion of private mortgage insurance. In the hearing focusing primarily on FHA's health, Carol J. Galante, Commissioner and Assistant Secretary for Housing at FHA, testified that FHA is currently working to reduce it's underwriting share of the mortgage insurance market. Talk has grown around the idea of FHA-PMI risk sharing arrangements may create a new opportunity for PMI companies.
http://www.fhfa.gov/Default.aspx?Page=30
In his latest speech on December 8, 2012 Edward DeMarco, Acting Director of the FHFA, overseer of Fannie and Freddie, said "Also part of any transition are steps that FHFA is taking to contract the Enterprises’ operations – whether it is increasing guarantee fees or pursuing risk sharing alternatives. These initiatives have the potential to transfer some credit risk to the private sector, a goal that most policymakers seem to agree with." This followed comments on November 28th "As we seek to reduce the Enterprises’ long-term risk exposure and place them in a more stable financial condition, we are examining various methods of risk sharing, including the expanded use of mortgage insurance and securities structures that allow for private sharing of risk."
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.
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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