Saturday, August 9, 2008

From the comments: more on Magic

One of the reasons why I love doing this blog is that smart people disagree with me and send me emails.

And I am not wedded to any position. I change my mind.

Here from the comments is a comment that is accurate enough as per Magic now:

John...Thanks for your thoughts on Magic. We too were short the stock for some of its fall but have now gone long in significant size. Yes they underwrote a lot of crap, but the premium deficiency reserve which assumed a51% loss rate compensated for that. Now the remaining bulk RIF is only $3.5 billion per page 13 of the recent supplement. Total reserves are $4 billion or $34,000 per delinquent loan at June 30. If the cure rate is 50% (which is way below the historic number) then the reserve per real delinquent loan is more like $68,000. You are right to mention how Magic is cash flow neutral and thats important. We see Magic as generating $1.5 billion in pre provision pre tax earnings per year. Just take revenues minus operating expenses. That is alot of cash at $1.5 billion a year plus $4 billion of reserves to pay future claims. Recent book value was just below $23 per share and based on expected losses over next 6 quarters this should not get below $18 per share at year end 2009. At this point the real earnings power of Magic will shine through remember $1.5 billion pre provision pre tax earnings divided by 150 million shares = $10.00 per share. I guess you could say that makes us believe in Magic.

The Anon Guy is right in one key respect. The business is now cash flow neutral. It is however running very substantially statutory capital negative. They will run out of stat capital if the new business shows any substantial losses.

I do not believe that the deficiency reserve is adequate – but the level to which it is inadequate is not large enough to make me want to be short the stock. It exacerbates the stat capital problem but it is not lethal.

The question is whether you believe that the business they wrote in 2007 and early 2008 is sensible.

If the new business is sensible you believe in Magic. I am afraid that I do not believe but my data for that view is thin.

The trend on losses for mortgages originated in 2007 is not good. Indeed it is positively sick. The trend on Fannie Mae and Freddie Mac insured mortgages is looking not good.

In other words the core business is looking worse. However if it is only a little bit worse then my friend above is correct – and you should be be long Magic. I need the core business to deteriorate markedly to get paid on this short.

I think that happens – but any help in modelling would be much appreciated. Dear reders – send me your emails.

John


Postscript: My explanation of statutory capital requirements for Magic is slightly faulty. I have blogged about that here.

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