Friday, August 29, 2008

From the comments - believing in Magic

Bondinvestor (whoever they may be) left a reasoned piece in the comments. It disagreed with my position on Magic outlined in this post.

I like people that disagree with me and I would love BondInvestor to get in contact...
bondinvestor 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.

My objections to this are that I am not sure that the bulk book is fully written off, nor am I sure that the book in 2007 will look anything like any previous year - as the last refinance of my rolling loans was onto Magic's book.

My further objection is that statutory capital deficiency happens way earlier than this - and stat capital deficiency will close the business as per TGIC.

But I remain to be convinced otherwise - and I have had a go at reconstructing Magic's loss triangles (with help from a reader) and we got not very far (probably because we gave up early).

If Bond Investor would like to share with me I would much appreciate it.



1 comment:

Anonymous said...

I assume these "loss triangles" plot the annual inflow of losses by loan book year on the y-axis and the # of years post-origination on the X-axis.

I guess the logical next step is sum up the loss triangles to get a plot of annual cash outflow due to losses?

My concern with this model is that something may have fundamentally changed with recent losses. The worse case scenario is that lifetime default rates are higher than historicals, and these losses are coming in much earlier. Even if the MIs can cover the long-term losses, I am not sure they can survive the short-term cash-flow squeeze.
It is also questionable whether the re-insurers can pay up when capital is needed, since everybody else will be collecting too.

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