Friday, August 8, 2008

Do you believe in Magic? [Fannie Mae part IA.]

This post has a couple of purposes. Firstly it is interesting in its own right – but more importantly it is key to understanding Fannie Mae’s credit profile. Consider it as Fannie Mae Part IA to go with my Fannie Mae Part I.

Mortgage Guarantee Insurance Corporation (MGIC or NYSE:MTG) is a mortgage insurance company. It was the mortgage company I hated most. I despised it. MGIC was always known as Magic – and almost whatever they said I didn’t believe. I would rather believe in witches and other black magic than almost anything the CEO of this company said.

You need a little background to know why I hated this company so much.

The changing role of mortgage insurance

There is a traditional role for mortgage insurance. The GSEs (Fannie and Freddie) were not allowed to underwrite mortgages with a loan to valuation ratio of greater than 80% without secondary mortgage insurance.

However realistically most first home buyers have never been able to put 20% down. So secondary mortgage insurance was required. This would bring the loan within Fannie Mae criteria. The traditional book of mortgage insurance companies was thus enormous piles of loans originated with 80-95 percent loan to valuation ratio – almost all loans to young couples for their first home where the total mortgage was somewhere between 100K and 200K. These loans were diversified by geography and time of origination – but not much else. They were also pretty safe.

Then a few things happened. By far the most important was that banks and the securitisation market started offering closed end seconds (CES). The idea was that you took a standard Fannie or Freddie mortgage (ie a GSE qualifying mortgage) and a second mortgage (or even two second mortgages) above that. This was the so called 80-10 product meaning an 80% GSE mortgage and a 10% second above that. There was also 80-20 product and 80-10-10 product describing different sizes of secondary mortgage.

The result was banks undercut mortgage insurers and the core product of the mortgage insurers looked obsolete. The mortgage insurers looked in a quandary – and several of the mortgage insurers had a hard time growing in the domestic market. According to the mortgage insurers association (MICA) the total mortgage insurance in force was 668 billion in December 2006 and 619 billion in December 03. That is not much growth in the most wild-ass mortgage market in the history of the USA. During that period premium rates actually fell – so revenue went nowhere to backwards.

The mortgage insurers compensated by doing other things – mostly riskier things – and that blew them apart.

  • PMI went to Australia and purchased a stake in FGIC. FGIC is a bond guarantor that has been smashed.
  • Radian funded a bond guarantor (Radian Guarantee – formerly Enhance Re) and blew up on it. They also invested in a fraudulent securitisation company (CBASS) I blogged about here.
  • General Electric just decided it wanted to exit the space and wrapped its mortgage insurer in Genworth Financial and spun some out and sold the rest.
  • Magic went subprime – and owned a stake in CBASS.

What Magic did

Magic went deep and scummy subprime. It started guaranteeing mortgages in the pools produced by the most dodgy of producers – it was particularly big into Novastar and ResCap (the GMAC mortgage business). Novastar were about as questionable as subprime mortgage providers got (and the money they owe Wachovia is a case-in-point about questionable exposures at Wachovia). ResCap by comparison were Vestal Virgins (and we know how f—ked about ResCap is). Herb Greenberg wrote more-or-less continuously about Novastar. He got a lot of flack – but he was right.

Anyway – insuring mortgages written by Novastar was a pretty quick way to the poorhouse if you asked me. Novastar also got PMI to ensure mortgages but quite quickly PMI realised what Novastar was it stopped doing business with them. Herb Greenberg also wrote about that.

Anyway Magic were the ugliest of the ugly in subprime securitisation. They insured pure crap. I couldn’t imagine how they would wind up solvent.

They then pretended it was OK by using the most absurd definition of subprime, Alt-A and prime I have ever seen. I blogged about that here. Their definition of subprime was so weak that it was possible to not be considered subprime if you had:

  • A 95 percent loan to valuation in a low-end housing estate
  • Where the valuation was taken by a broker-friendly appraiser at the third cash-out refinance
  • Where there was no evidence that the person was able to repay principal and – to the contrary where they needed to refinance their mortgage every few years to make it current, and
  • Where the customer had in the past seven years defaulted on a credit card costing the issuer money

And that was the guts of the reason why I hated Magic. It was the company with the most subprime book – but they pretended it was mostly not subprime by defining subprime in such a way that only serial credit card fraudsters seemed to meet the definition.

They also owned half of CBASS – which owned a very nasty loan servicing business (Litton). You can find out just how nasty Litton is here. I blogged about it here.

Magic were the scum of the mortgage boom.

And if you had asked me if there was any realistic proposition of magic surviving a proper crisis I would have answered no. I always said it was a $5 stock – which was just so I didn’t sound nutty saying it was a zip. [I was considered a hyper-bear in those days…]

Anyway I was wrong. Magic is sort of surviving. It is not an easy situation – but it is not completely diabolical. And sometimes I am stunned when institutions with OK management (Fifth Third) or really rich institutions (Natixis) get into trouble. But this stuns me the other way – these guys are haven’t filed the Chapter 11 they so richly deserve.

Do I have to add that they compounded these errors by repurchasing billions of dollars worth of their shares at absurd prices? No – I can thank them for it – their repurchases provided a counterparty to my short sales!

So where is Magic today?

Well – obviously they have given up doing the real dumb business. CBASS has been written off and the company has retreated to doing the traditional business of first home buyers…

I doubt I can say it any better than the Management discussion in the last annual report:

Premium Deficiency

Historically a significant portion of the mortgage insurance we provided through the bulk channel was used as a credit enhancement for mortgage loans included in home equity (or “private label”) securitizations, which are the terms the market uses to refer to securitizations sponsored by firms besides the GSEs or Ginnie Mae, such as Wall Street investment banks. We refer to the portfolios of loans we insured through the bulk channel that we knew would serve as collateral in a home equity securitization as “Wall Street bulk transactions”. During the fourth quarter of 2007, the performance of loans included in Wall Street bulk transactions deteriorated materially and this deterioration was materially worse than we experienced for loans insured through the flow channel or loans insured through the remainder of our bulk channel. Therefore, during the fourth quarter, we decided to stop writing insurance on Wall Street bulk transactions. In general, loans included in Wall Street bulk transactions had lower average FICO scores and a higher percentage of ARMs, compared to our remaining business.

In the fourth quarter of 2007, we recorded premium deficiency reserves of $1,211 million relating to Wall Street bulk transactions remaining in our insurance in force. This amount is the present value of expected future losses and expenses that exceeded the present value of expected future premium and already established loss reserves on these bulk transactions. See further discussion under “— Results of Operations —Losses— Premium Deficiency.”

C-BASS Impairment

C-BASS, a limited liability company, is an unconsolidated, less than 50%-owned joint venture investment of ours that is not controlled by us. Historically, C-BASS was principally engaged in the business of investing in the credit risk of subprime single-family residential mortgages. Beginning in February 2007 and continuing through approximately the end of March 2007, the subprime mortgage market experienced significant turmoil. After a period of relative stability that persisted during April, May and through approximately late June, market dislocations recurred and then accelerated to unprecedented levels beginning in approximately mid-July 2007. As a result of margin calls from lenders that C-BASS was unable to meet, C-BASS’s purchases of mortgages and mortgage securities and its securitization activities ceased. On July 30, 2007, we announced that we had concluded that the value of our investment in C-BASS had been materially impaired and that the amount of the impairment could be our entire investment.

In connection with the determination of our results of operations for the quarter ended September 30, 2007, we wrote down our entire equity investment in C-BASS through an impairment charge of $466 million. This impairment charge is reflected in our results of operations for 2007. For additional information about this impairment charge, see Note 8 to our consolidated financial statements. In mid-July 2007 we lent C-BASS $50 million under an unsecured credit facility. At September 30, 2007 this note was carried at face value on our consolidated balance sheet. During the fourth quarter of 2007 C-BASS incurred additional losses that caused us to reduce the carrying value of the note to zero under equity method accounting. The equity method reduction in carrying value is not necessarily indicative of a change in our view of collectability.

Well apart from not disclosing just how scummy C-BASS was all along this seems a fair disclosure. But here are the critical things for the future:

  • That the excess of future claims over revenue (a premium deficiency reserve) was a bit over a billion dollars.
  • That the flow business – the traditional first home business – was not showing undesirable credit characteristics as of year end.

Now, as you imagine, I never thought this company had much credibility (they continued to lie about the nature of C-BASS) and they were as close to scum as anyone I have come across in this industry. (Surprisingly the CEO has not changed.) But if the losses on the closed block of business are larger than this or the traditional business of first home buyers goes pear shaped then there is not going to be much left.

So here is the sticky question: do you believe in Magic?

The company gave us one marker that I guess you could use to test whether you believe… that marker is that they predicted paid losses this year to be just under two billion dollars.

And if you want a bull case – the margins are very much improved

Premium revenue is going up massively and they are no longer having to write business for Novastar to get that premium. Net premium written in the second quarter were 372 million compared to 321 million last year – and the total par insured has fallen from 19 billion to 14 billion.

372 million for accepting credit risk on 14 billion of mortgages is still not stunning business – it is still less than 3 percent. But it is an awful lot better than it was. However with this premium the company is still going to get into diabolical trouble if the conventional first-home owner/Fannie insured mortgage market goes pear shaped.

But current margins are not the story – the back-book and the quality of the new business is

Magic gave us a criteria by which we can judge - they told us that premium income was going to be rising and claims paid would be under 2 billion dollars this year. Surprisingly they are beating this by a very comfortable margin.

The claims paid are running at 385 million for the last quarter – about what the written premium is. The company is barely bleeding cash at all. If you had asked me whether it was possible that this – the most scuzzy of mortgage companies – could be essentially cash-flow neutral this far into a mortgage crisis this big I would have laughed and not answered. But they are essentially cash flow neutral (with a caveat that I will explain below about statutory capital). Still it is pretty hard for a company that is not bleeding cash to go insolvent. It is not impossible – but on these numbers you would have to say that you do believe in magic.

The problem with this analysis is that there is a bad reason claims paid are running below projections. It is just that the courts are jammed up, the servicers of the mortgages totally swamped and foreclosure is running much slower than anticipated.

You can see that. The delinquency on their super-scummy subprime loans is over 36 percent and rising very fast. This is serious delinquency – the company does not bother reporting 30 day delinquency (probably because its servicers do not tell it).

The company’s reserves smell very light if you adjust for this problem. They have insurance over 34 billion of bulk loans in force and they have serious delinquency on the bulk loans of is over 25 percent. They are coming in at a few billion of losses – not just the billion or so in the reserve kitty. This company looks and smells under-reserved still. And given that I probably wouldn’t buy insurance from it. Whether it is solvent or not – that is another question.

But people do buy insurance from it and in quantity – and if that insurance doesn’t blow up in their face then the company will be just fine.

Is the new business any good?

This whole thing is contingent on the new business being OK. This is a company keeping up with old losses by writing lots of new business – and to date it is working.

The new business is mostly flow business being written for Fannie Mae and Freddie Mac. It may be good business (the jury is out). But it is pretty clear why Fannie and Freddie want to support Magic. It is in the interest of Fannie and Freddie to keep this company alive. If it dies then Fannie and Freddie are on the hock for the insured business. And if Fannie and Freddie stop trusting it for insurance then the company will die.

This is a bad dynamic. Magic gets to write lots of business at today’s much improved margins at terms which might keep it alive – and it gets to do it because Fannie and Freddie refuse to face reality.

But here I think the magic is very black indeed.

Look at the delinquency rate on the flow business. It has doubled and it is running I the table above just over 6 percent. That number has me really puzzled. Indeed I needed a good lie down and think.

Why is six percent so high? Well Fannie Mae publishes the delinquency on its credit enhanced book every month – you can find it in the monthly statistics. It’s a pretty good indication of the average of the mortgage insurance industry. You can find the table in the bottom right corner of the second page of this pdf.

The Fannie Mae number is running at 3.56 percent. The Magic number is almost twice as high. Come to think of it – the Magic number is almost twice as high as the delinquencies on the 100 odd billion of Alt-A stuff at Freddie Mac which makes everyone sure that Freddie is going to fold.

This suggests to me that Magic is doing something considerably riskier than the Fannie Mae average to get the higher delinquency.

We are meant to believe that this is good business – but it doesn’t look like America. Fannie Mae’ average delinquency of under 1.5 percent looks like America. I do not get it and I have fast come to the conclusion that Magic are just unreformed and unrepentant river-boat gamblers who still operate in the risky end of what is left of the mortgage market.

It might be just the general trend that I have blogged about – that 2007 business just looks sick (see here and here). But if it is the oncoming train of 2007 business then I wouldn’t want to stand in front of it.

So in summary: I do not believe in Magic. I have covered my short – unfortunately several dollars higher than this. But something remains not quite right here.


Postscript: Can you go bust whilst being cash flow positive?

I asserted in my post that it was pretty difficult for Magic to go bust whilst being cash flow positive. That assertion was a gross simplification.

Magic is a holding company with considerable debt holding a regulated insurance company. When the insurance company writes premium it needs to make reserves (the so-called contingency reserve). These reserves reduce distributable capital. The losses also reserve distributable capital. The cash flow and the ability to distribute from the regulated insurance company to the holding company are not correlated.

The holding company needs to receive distribution as it has debt – and if it fails to pay that debt it will fold.

In other words it is possible for the holding company to go bust whilst the whole entity is cash flow positive. [Holders of Conseco once found that out.]

I would love it if someone has modelled the statutory accounts of this company – or could help me with that task.


Note: I put my MTG:NYSE short back on "last night". This is unusual for me - I originally shorted this stock above 50 and covered at 20 and 12. I put it back on below 8. For those that don't know I am in Australia - so it really was last night.


Anonymous said...

I'm curious that given how much the value of the company has fallen they are still paying out dividends?

John Hempton said...

Stock is down from about 60 to about 7.

It has done a dilutive capital raise (like many others).

It pays a token dividend of 2.5c per quarter.

The company used to buy back huge quantities of stock. Obviously that has stopped.


Unknown said...

Their definition of subprime was so weak that it was possible to not be considered subprime.
More Cleavage

Anonymous said...

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.

John Haskell said...

is it possible to be CF positive and still go bust? I don't know, but Jimmy Cayne might be able to tell you.

Anonymous said...

MTG, PMI, RDN and even ORI and GNW are all buys.

the best way to think about MI conceptually is as a bridge loan. if home prices collapse or the borrower loses a job in the first 3 yrs, the loan goes bad. otherwise, it's a solid investment.

the critical question to getting these stocks right is the level of cumulative defaults on 06/07 flow business. 05 is bad, but not catastrophic. the bulk business has already been written off. therefore, the only lingering uncertainty is what the level of defaults on 06/07 will be.

here is how to answer the question. MGIC's total claims paying resources (investments + collateralized reinsurance recoverable + the present value of installment premiums) is roughly $13B. that is 24% of the total risk in force. the subprime debacle (for which you were right to short the stock) will end up costing them about 8% of risk in force on a cash basis. that leaves 16% of risk in force (roughly $9B) available to satisfy claims on 06/07 business.

that leaves roughly 2/3rds of the claims paying ability ($9B) available to satisfy losses on flow business. the problems are concentrated in 06/07. the total risk in force on 06/07 is roughly $20B (may be high). so in order for MGIC to go bust, roughly 4/10 06/07 vintage loans must go belly up.

so how likely is that? well, if you obtain copies of MI annual statements, you can recreate loss triangles by accident year. they will show you that, over time, the cumulative default rate on a flow book is around 2%. it also demonstrates that by year 3, somewhere between 30 and 50% of lifetime defaults have been recognized.

you can use the loss triangles and historical seasoning curves to develop a rough model of what lifetime defaults will be on the 06/07 books, given the experience to date. they suggest cum defaults in the range of 10-15%. now, 06/07 only accounts for 40% of the flow book, so the total contribution to loss frequencies will probably by somewhere in the 4-6% range.

this analysis suggests that, far from being insolvent, there is actually tremendous value here that has been unrecognized by the market. the stocks are 10-20 baggers over a 5 year time frame.

that being said, i think all parts of the capital structure of these companies are interesting. for those who are intrigued by the analysis, but scared to own the equities, i'd point to RDN and PMI holding company debt. you are getting 13-25% YTM (face value 55-80% of par) for a senior interest in the holding company that owns the regulated MI subsidiary.

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