The PMI Group, Inc. Q3 2008 (Qtr End 9/30/08) Earnings Call Transcript

The PMI Group, Inc. (PMI)

Q3 2008 Earnings Call

November 3, 2008 12:00 pm ET

Executives

Bill Horning - Vice President, Investor Relations

L. Stephen Smith - Chairman, Chief Executive Officer

Donald P. Lofe, Jr. - Executive Vice President and Chief Financial Officer

David Kacko - President and Chief Operating Officer, PMI Mortgage Insurance Company

Analysts

David Katz - J.P. Morgan

Mike Grondahl - Key Colony

Donna Halverstadt - Goldman Sachs

Joseph Marino - Piper Jaffray

Howard Shapiro - Fox-Pitt Kelton

[Maria Hangenupen] - New York Life

[Bryan Monteleone] - Barclays Capital

[Bob Scottsman] - First Manhattan

[Steve Sun - Four Research]

[Steve Selmack] - FBR Capital Markets

Presentation

Operator

Hello and welcome to the third quarter 2008 earnings call for The PMI Group. (Operator Instructions)

And now I will turn the meeting over to Bill Horning, Vice President Investor Relations. Sir, you may begin.

Bill Horning

Thanks, [Angie]. Good morning and welcome to The PMI Group's third quarter 2008 conference call.

Today's call will begin with comments from Steve Smith, PMI's Chairman, and Chief Executive Officer. Mr. Smith will discuss PMI's overall financial results and business highlights for the third quarter. Don Lofe, PMI's Executive Vice President and Chief Financial Officer, will then address various other financial and capital matters. We also have with us today David Kacko, President, and Chief Operating Officer of PMI Mortgage Insurance Company who, along with Steve and Don, will be available to answer your questions following today's prepared remarks.

Also on today's call we'll be referencing non-generally accepted accounting principle measures such as net operating income which, under SEC Regulation G, we're required to reconcile to GAAP. The reconciliation of these measures with GAAP financial measures are available on our website.

Before we begin I would like to review the company's safe harbor statement under the Private Securities Litigation Reform Act of 1995. During the call we may be making forward-looking statements. Actual results may differ materially from the statements made during this call. The company's business depends on investment considerations which are highlighted in our Securities and Exchange Commission filings, including our most recent Form 10-K and Form 10-Q. Forward-looking statements are made as of today, November 3, 2008, and we undertake no obligation to update such statements except as may be required by law.

With that I'll turn the call over to PMI's Chairman and Chief Executive Officer, Steve Smith.

L. Stephen Smith

Thanks, Bill, and good afternoon, everyone, and thank you for joining today's call.

As you've seen in our financial results released this morning, The PMI Group had a net loss from continuing operations in the third quarter of $149.3 million or a loss of $1.83 per share.

As of September 30, PMI Australia, PMI Asia, and PMI Guarantee were characterized as discontinued operations.

Now the third quarter saw a continuation of the many challenges we've seen in the nation's economy and housing market and that was evident in our financial results for the quarter. That said, we continued to execute on our five-point plan and on that front we continue to make progress.

First, as we announced on October 22, we completed the sale of PMI Australia to QBE Insurance Group. With the closing of the transaction we received 80% of the selling price or $746 million in cash. The significant cash proceeds from this sale will help PMI Mortgage Insurance liquidity and claims paying resources.

Additionally, we and the buyer continue to work to complete the sale of PMI Asia in November. Of course there can be no assurance that the sale of PMI Asia will be completed on the terms announced or at all. The PMI Asia sale is structured similarly to the PMI Australia and if closed on the announced terms will bring in approximately $45 million to The PMI Group, increasing our liquidity and financial flexibility at the holding company.

Moving to other aspects of our international operations, in the third quarter we made significant progress on the closure of our Canadian operations and expect to repatriate between $40 and $50 million of capital to PMI Mortgage Insurance Company in the fourth quarter, subject, of course, to final regulatory approval.

In Europe we're moving forward with a reconfiguration of our operations with the closure of country offices and corresponding reduction in headcount, resulting in an aggregate pre-tax charge of approximately $7.6 million.

In our Financial Guaranty segment in the third quarter we paid approximately $152 million of excess capital from PMI Guaranty to the holding company. Now, approximately $144 million of this repatriated capital was then contributed to PMI's U.S. mortgage insurance operations.

Shifting to the U.S. market, on a macroeconomic basis we're encouraged by the resources the government, as well as bank servicers and other mortgage market participants are devoting to help find solutions to the nation's housing problem. PMI's actively involved in this process and I'll describe PMI's specific programs in a moment.

Now let's get into the details of our third quarter results:

In our core U.S. mortgage insurance operations we again had a quarter of high-quality new business writings. In the third quarter of 2008 we booked $6.2 billion of new insurance written, bringing our year-to-date total to $16.9 billion. While both numbers are down from production levels a year ago, the quality of what we are booking is very high. For example, our new insurance written in the third quarter of 2008 consisted of 99% fixed-rate loans; 44% of the loans had FICOs of 740 and above. Our average FICO was 731. The average loan-to-value was 91%. And 70% of our new insurance written had loan-to-values at or below 90%.

Our portfolio trends seen during the third quarter included the following:

The persistency rate in our primary portfolio improved to approximately 81%, up from 73% from one year ago.

Our insurance in force was $123.1 billion and risk in force was $30.4 billion at quarter's end, both up slightly from a year ago.

Our new premiums written and net premiums earned were both down marginally in the third quarter, primarily as a result of lower new insurance written and premium refunds related to the rescissions of insurance previously written.

In the third quarter of 2008 our U.S. mortgage insurance operations paid claims of $200 million, bringing our nine-month total paid claims to $555 million. Both of these dollar amounts were reduced by the $25.8 million recovered from the trusts of terminated captive agreements during the third quarter.

With the paid claim results we've experienced for the first nine months of the year, we're revising our expectation for our full year paid claims downward to $850 to $900 million from our previously announced range of $900 to $975 million.

In the third quarter net incurred losses were $348.1 million, comprised of the aforementioned paid claims of $200 million, loss adjustment expenses of $10.2 million, and net addition to our reserve for losses and LAE of approximately $138 million.

Our reinsurance recoverables also increased in the third quarter by approximately $79 million, primarily representing ceded losses [break in audio] reinsurance agreements. [As a result] our quarter-end reserves for losses and LAE increased to $2.35 billion, an increase of $217 million from the second quarter.

Our reserve additions in the third quarter were primarily driven by the increase in the number of loans in default from 80,895 in the second quarter in 2008 to [93,067] at September 30, 2008. While there was an increase in defaults in loans, we did see positive loss development trends that partially counteracted the increase in NODs. These included stabilization of the claim rate for the delinquent loans we received in 2007 - what we called the 2007 report year - stabilization of the average claim sizes, and stabilization of NODs reported from California and Florida.

As you may recall, a rapid acceleration we saw in these and other credit variables in the first two quarters of 2008 resulted in a billion dollar increase in our reserve relative to where we ended 2007. The abatement of those upward trends during the third quarter resulted in a lower addition to reserves.

Additionally, we're also seeing an increasing benefit from our loss mitigation efforts and the home ownership preservation initiatives of ourselves and others as well. In total, for the first nine months of 2008 our various home ownership preservation initiatives have enabled over 10,200 PMIinsured loans to homeowners to remain in their homes. At the current pace, for the full year we would expect approximately 16,000 loans insured by PMI to benefit from these programs.

Now moving to expense management, throughout the company we continue to focus on driving down our cost of doing business. As I mentioned earlier, we have undertaken a reconfiguration or our European operations and incurred a restructuring charge in the third quarter. And throughout the company we have implemented an early retirement program, restructurings and severance programs that resulted in charges totaling approximately $6.3 million net of taxes in the third quarter.

All of these initiatives better align our organization with our business going forward and will result in significantly lower operating costs in future periods. There will be additional effects in the fourth quarter that we'll report on a year end.

Finally, as Don will cover in more detail in his section, we remain focused on maintaining adequate capital and liquidity. The completion of the sale of PMI Australia and our pending sale of PMI Asia will add significant financial flexibility to our U.S. mortgage insurance company and holding company, respectively. And as I just mentioned, we're continuing to reduce the operating costs of our business through restructurings, early retirement programs and other expense management initiatives, all of which will help to maintain our liquidity and preserve our capital.

Now let me turn the call over to Don to cover the financial aspects of these announcements as well as other capital matters for the third quarter. Don?

Donald P. Lofe, Jr.

Thanks, Steve, and good afternoon. Let me first cover certain financial and liquidity matters for the third quarter and then provide some detail on the sale of our Australian operation and the calculation of our operating results for the third quarter.

Let me start with our captive reinsurance agreements. As Steve mentioned, in the third quarter we had an increase of $79 million in our reinsurance recoverables. This brought our total ceded losses or reinsurance recoverable balances to $393 million. These receivables are supported by captive trust balances of $824.5 million at the end of September 2008.

We now expect the total benefits received from our captive reinsurance agreements to be approximately $500 million in 2008, inclusive of approximately $26 million received in the third quarter due to terminated captives which Steve previously mentioned. Further, we expect total benefits from captives in 2009 to be between $250 and $300 million in 2009.

In our European operations this quarter we had two noteworthy items in the income statement. First, we recognized the loss of $9.9 million from our credit default swaps. This was primarily driven by the unrecognized loss due to the widening of spreads in our credit default swaps, partially offset by gains from normal accretion. We also had an increase in our reserves for losses and LAE in Europe for the third quarter. This was primarily driven by a reserve increase of approximately $30 million for various reinsurance transactions.

Now moving to our capital plan, we continue to work with our financial advisors towards the execution of our various capital initiatives. PMI Mortgage Insurance Company's claim-paying resources remain strong, with a highly rated investment portfolio and cash totaling $1.8 billion.

On a statutory basis, PMI Insurance Company ended the quarter with statutory risk in force of approximately $25 billion and policyholder surplus of $425 million and contingency reserves of approximately $1.2 billion, resulting in a risk-to-capital ratio of 15.75 to 1 as of September 30, 2008.

And at the holding company level we ended the third quarter with liquid assets consisting of cash, cash equivalents, and investments of $232.3 million.

Now with respect to the Australian sale, we have provided a detailed summary of the PMI Australia and Asia sale transactions on our website. As shown in the summary, on October 22 we received approximately $746 million in cash. This dollar amount was locked in at the time we negotiated the sale back in July at a U.S. dollar to Australian dollar exchange rates of 0.95. Since that time the rate moved significantly downward to 0.79 as of September 30, 2008.

Moving down the summary page, the bottom line effect of the sale of PMI Australia and the expected sale of PMI Asia was a loss of $80.5 million in the third quarter. This loss is primarily driven by the accounting treatment of the $184.7 million promissory note for Australia and the projected $11.1 million promissory note for Asia.

Due to the contingent nature of these notes, under GAAP their values could not be recognized at the time of sale. Rather, their value is to be recognized at their maturity in 2011 or if the notes are sold before that time. I should also mention that, in accordance with the terms of our revolving credit agreement, with the completion of the sale of PMI Australia, the aggregate commitment of our facility was reduced by $50 million and now it stands at $250 million. At the end of the third quarter we continued to have bonds of $200 million outstanding under this facility.

As you may recall from our conference call last quarter, in January we adopted SAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," including an amendment of FASB Statement No. 115. The adoption of this guidance requires the difference between the carrying value before the election of the fair value option and the fair value be recorded as an adjustment to beginning retained earnings in the period of adoption. The instrument for which the fair value was elected was The PMI Group's $400 million of senior notes. As a result of adopting this new guidance, we recognized a net income benefit of approximately $66 million in the third quarter.

And finally I would like to direct those interested in a reconciliation of our consolidated net loss to our consolidated net operating loss to review disclosure material posted on our website.

With regard to PMI Europe, we have treated our CDS marked-to-market adjustments as nonoperating only to the extent any adjustments are deemed to relate to increases in credit spreads only. And we have treated the fair value adjustment for SFAS 159 restructuring and other costs for PMI Europe and PMI Canada, net realized investment losses, and losses from discontinued operations as nonoperating. Therefore, as presented in the reconciliation, our consolidated net operational loss in the third quarter of 2008 was $129.8 million or $1.59 loss per common share.

Now let me turn the call back to Steve for some closing remarks before we open up the call for questions. Steve?

L. Stephen Smith

Thanks, Don. I wanted to leave you with some closing thoughts before we begin our question-and-answer session.

First, we're continuing to execute on our five-point plan for progress and we've made significant progress in the third quarter, highlighted by the sale of PMI Australia. In our core mortgage insurance business, we're very pleased with the high credit quality of the new business that we've written. And as we discussed on last quarter's conference call, effective October 1 we implemented our new borrower-paid MI risk-based pricing.

We're continuing to manage our expenses as we've discussed and as evidenced by our 16.1% expense ratio in our U.S. mortgage insurance operations. We've enhanced our liquidity from the sale of PMI Australia, the expected sale of PMI Asia, the repatriation of capital from PMI Guaranty, and the planned repatriation of capital from PMI [break in audio].

And finally, I'm pleased to announce that we'll be hosting an investor presentation in New York on Thursday, December 4. This event will be webcast and available on our website so all investors can participate in the conference. We look forward to sharing more with you at this event in early December.

Now with that let's open up the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from David Katz - JPMorgan.

David Katz - JPMorgan

I had a couple of questions. First, I was hoping you could talk about if you anticipate any access to TARP?

L. Stephen Smith

Obviously there's been a lot written in the press over the last several weeks about that potential, and you probably know that our industry trade association filed a response, an RFI, that was due to the Treasury on October 28. So I think there is potential for that and probably a good basis for that, but there's no certainty that would come to pass.

David Katz - JPMorgan

And then with the actions that some banks are taking we were curious if a loan has its principal reduced, what is the impact to PMI? Does PMI suffer a loss or instead is that entirely borne by the mortgage servicer?

David Kacko

At this point the way our policy reads - and we don't really anticipate a change in this regard  is if the loan is written down, the coverage is applied to the new loan amount and we do not suffer that loss. It is absorbed by the investor.

David Katz - JPMorgan

Just for clarification, if the loan were for - well, if the loan were written down 20% and then defaulted, would your coverage amount be 20% less or would you still be liable for their original coverage amount?

David Kacko

No, it would really be your former explanation. Let's use a simple example. Let's assume that we had a $100,000 note balance. It was written down to $80,000. We had 20% coverage initially. It'd still be the same 20% on the $80,000 now.

David Katz - JPMorgan

Okay, so it would take your liability to $16,000?

David Kacko

That's right.

David Katz - JPMorgan

And then what was the risk-to-capital ratio after the sale of PMI Australia?

Donald P. Lofe, Jr.

We haven't given that number after the sale, but as of 9/30 that was 15.75 to 1.

David Katz - JPMorgan

And you're not going to release a number after the sale or even a pro forma?

Donald P. Lofe, Jr.

Well, the 9/30 balance in essence incorporates respect to the sale because of the discontinued operations treatment. In essence, you have the number.

David Katz - JPMorgan

And then finally the delinquencies - and you talked about this a little before with the claims, but I was hoping you go into a little more detail - the delinquency rate went up a fair amount quarter-over-quarter, yet claims were relatively flat. Is that due to a delay in payment?

Donald P. Lofe, Jr.

No, we've heard that there's been some discussion about whether payment delays are changing our paid claims. We don't see that at this time. A couple of things are going on.

One, we believe we've gotten some significant traction in our home ownership preservation initiatives, so we've been able to, as Steve mentioned in his comments, work cooperatively with our servicers to help get loans reperforming through a variety of different kind of repayment plans, loan modifications, etc. So that's number one.

Number two, I think overall we're seeing a slowing in our NOD development. We saw that in the third quarter in a couple of key states, Florida and California being two primary examples. So I think that's why we're seeing lower claims paid.

The last point - and we've talked about this on previous calls - the 2007 book in particular had a very high rate of fraud. As you know, as we've said repeatedly, we'll pay every single claim that is due to our insured, but not in the case of fraudulent loans. And we did see an increase in fraud-related rescissions in the third quarter.

But I think those factors helped moderate our paid claims in the third quarter of '08.

L. Stephen Smith

Let me just amplify on the home ownership preservation initiatives. As I mentioned in my opening remarks, we had about 10,000 loans that were worked on that allowed homeowners to stay in their homes for the first three quarters of the year and we estimate about 16,000 for 2008. So you can see that's approximately another 6,000 in the fourth quarter that we're projecting. So that is definitely gaining traction and accelerating quite nicely.

David Kacko

I want to come back to a comment on a question you asked about the arithmetic on writedowns and notes. I need to clarify that the way that would work is that the $100,000 that I mentioned with the 20% coverage, that same amount of coverage would apply but it would be on a lower principal amount, the $80,000? So when you said $16,000, I said yes. That's not correct. Follow me on that?

David Katz - JPMorgan

No. You had me until the $16,000.

David Kacko

Yes. What you had said - would you apply the 20% on the $80,000 for a $16,000 exposure. It's the 20% on the original $100,000 - $20,000 - but now applied to a lower principal amount if it later defaults.

L. Stephen Smith

Right.

Operator

Your next question comes from Mike Grondahl - Key Colony.

Mike Grondahl - Key Colony

On the risk-to-capital at 15.8 to 1, where do you project that that's going to be over the next couple of quarters? And at what level do you have to look at some alternatives - reinsurance or taking some capital?

And then secondly, you said that I think fraud recessions increased in the third quarter. Can you give us a comparison, maybe, to the second quarter or the first quarter?

And then lastly, have you done anything with the Bank of America/Countrywide and what they're talking about modifying, potentially up to 400,000 loans? How many of those are sitting in your portfolio or even the latest announcement from JPMorgan? Can you give us any color on what your exposure is there and how that might be beneficial for you?

Donald P. Lofe, Jr.

Why don't I start with the first question and then I'll turn it over to my colleagues, Steve and David, with respect to the second two questions.

With respect to forecasting, obviously we don't do that relative to this particular metric, but let me put some parameters with respect to that. We've been forthright, obviously, on previous calls in our various disclosures concerning our covenant of 20 to 1 for our revolving credit facility, so obviously we pay very close attention to that.

And as we've indicated - and Steve said in his remarks with respect to our five-point plan - the capital initiatives are a significant component of that plan. And as we've done, we've continued to execute upon that for the disposition of our consolidated and unconsolidated subsidiaries potentially. And raising capital in the marketplace has always been part of that plan.

And, as Steve and I've indicated, it hasn't been the primary focus to date because of the other initiatives that we've been executing upon. But clearly that's going to become more of a focus as we move forward in that that will be a component we need to consider relative to raising capital to not only just meet the particularly regulatory and other financial covenant's metrics, but also for opportunities that the industry, we believe, will have available to itself for writing some new business.

So we don't forecast that number, but it's something we pay very close attention to. We look at it very routinely and it's obviously considered up against the various metrics that we have to deal with on our various regulatory aspects and credit facility.

L. Stephen Smith

Mike, let me take the second part relative to the recessions. As we said on prior calls, the 2006 and 2007 books had higher percentages of fraud or guideline violations than prior books of business. It takes time to investigate those, etc. So what we're finding is that, as the quarters have gone on throughout the year, the percent as well as the dollar amount of recessions have increased. We haven't quoted those numbers or percentages, but they have accelerated and the pipelines of loans under investigation have also increased.

David, you want to take the B of A and JPMorgan question?

David Kacko

Sure. Mike, at the present time we haven't finalized a data swap with Countrywide on the loans that we believe we have in our portfolio that may be subject to the agreement, but I think we can make a general statement that, as best we can map over the product types - which, as you know, are various forms of subprime, hybrid ARMs, payment option ARMs, and then just straight up subprime loans - it is about 4% to 5% of our current delinquencies.

As you also know, the JPMorgan announcement really was released on Saturday, so it's a little early to talk about how that might map over to our portfolio. As best as we can tell, however, the JPMorgan announcement probably related to their acquisition of Wamu and the payment option ARM exposure at Wamu. As you probably know from the data we've put out, we have a very small exposure to payment option ARMs generally. I don't know to what degree we'll see our mapping of our default inventory over to Chase. My guess is it will be less than what we'll see with Countrywide, as I described earlier.

L. Stephen Smith

And let me add, Mike, when I gave you the number of 16,000 modifications or workouts with borrowers for the calendar year and implying about 6,000 in the fourth quarter that would not be including any expectation of acceleration of activity from B of A, JPMorgan Chase, or other lenders.

Mike Grondahl - Key Colony

And then just one clarification. David, the 4% to 5% of delinquencies, I would apply that to the ballpark 93,000 - 94,000 in delinquencies, right?

David Kacko

That's correct.

Operator

Your next question comes from Donna Halverstadt - Goldman Sachs.

Donna Halverstadt - Goldman Sachs

Most of my questions have been asked. I had two things left that I wanted to ask about; one was the increase in the loss reserves in PMI Europe. I was wondering if you could give us a little bit more color, whether that was any particular countries or any particular insurance structures and just a little bit more about what was going on there.

Donald P. Lofe, Jr.

We've indicated this before. This is a continuation of certain reinsurance transactions that we have. It's U.S. subprime exposure and that is the continuation of the reserve build in Europe. And so those transactions are approaching - at least the ones we've been provisioning for - their limits. Again, that's again a similar [inaudible].

Donna Halverstadt - Goldman Sachs

And the other thing I wanted to ask about, you gave us the amount of cash and liquid investments at the hold co. Can you just update us on what the run rate of hold co expenses is in two different buckets, one bucket being interest expense on debt hybrids in the facility and the other bucket being anything else that's paid by the hold co?

Donald P. Lofe, Jr.

Sure. With respect to the holding company - let me get those numbers exactly for you - for interest for - generally an annualized rate for interest and financing costs are approximately $50 million, and the holding company expenses and related other items are approximately $30 million on a run rate basis. But again, obviously, some of those costs will fluctuate depending on where we are with particular initiatives. Steve indicated about some of the various initiatives that we're working on.

Dividends obviously now are quite small relative to a $0.01 rate, approximately $800,000. And then, as you might remember, we have $45 million of repayment of debt coming due actually this month on the 15th.

So those are the largest items. You obviously are going to have investment income, but that's a relatively small amount because of the amount that we have present for overall cash and investment balance in the holding company.

So those are the main components, and obviously we looked at that. We forecast that by quarter and look at that out several years.

Operator

Your next question comes from Joseph Marino - Piper Jaffray.

Joseph Marino - Piper Jaffray

What is your assumption for unemployment and then what does that have to go to in order to result in a material change in your outlook for losses?

L. Stephen Smith

Joseph, our core outlook is similar to Moody's Economy.com, but we're looking for in 2009 somewhere in the 7.5% range, possibly up to 8%. But the core forecast is around 7.5%.

Obviously unemployment negatively affects results, but it's not a simple equation because it depends upon where the unemployment is, where your mix of business is, what the product types are, what the seasoning is, and a whole host of factors. But clearly, movements in unemployment upward aren't favorable.

Joseph Marino - Piper Jaffray

In your lowering of your paid loss guidance, does any of that have to do with unemployment expectations?

L. Stephen Smith

Yes, Joseph. We factor that in in our core assumptions in terms of how we expect that to migrate from an incurred to a paid claim.

Joseph Marino - Piper Jaffray

How would you characterize the performance of the 2008 vintage so far relative to 2007?

L. Stephen Smith

We see, as I mentioned in my opening comments, the quality of the 2008 book of business, particularly in the second and third quarters and our expectation for the fourth, is very high-quality business and we expect that to be a profitable book of business. Obviously, that's contingent upon macroeconomic factors, but if you look at the credit quality of the book of business itself relative to '07 - '06, from our internal scoring as well as external models that we use, it's very high-quality business.

Joseph Marino - Piper Jaffray

And what about the first quarter of 2008?

L. Stephen Smith

That was basically a mix between new business under new guideline criteria as well as the transition from commitments that actually wrote in the first quarter of the year. So the quality of that business was higher than 2007, significantly so, but not as high as the second and third quarters. All in all, the quality of the book year-to-date is quite high for the company.

Joseph Marino - Piper Jaffray

Do you feel like California and Florida are starting to stabilize a little bit in terms of delinquencies?

L. Stephen Smith

On the opening comments, Joseph, I talked about the stabilization of the number of NODs actually coming from California and Florida, and we did see that stabilization in the third quarter. Obviously, we'll need to see what happens in the fourth, but that was an encouraging sign and trend that we saw in the third quarter.

Joseph Marino - Piper Jaffray

And you had not seen this last quarter yet?

L. Stephen Smith

No.

Operator

(Operator Instructions) Your next question comes from Howard Shapiro - Fox-Pitt Kelton.

Howard Shapiro - Fox-Pitt Kelton

I just wanted to ask a question on accounting policy as some of the various modification programs gain traction - the B of A one, the JPMorgan one, maybe the one that the Treasury does under TARP. Will you or can you account for reserve differently as you find out that loans are in the modification process?

Donald P. Lofe, Jr.

Bottom line is you've got to look at what we expect the loss to be, and I know you know that and that's obviously the triggering point, when an NOD occurs. So relative to these programs, what ultimately comes forward, similar to what Steve and David articulated, we're just going to have to look at the specific aspects of each individual program or combination of the programs and then see how the accounting would ultimately follow that.

But what it'll be, the clearly driving event will be what do we expect the loss to be? What will we have on the books today and then what affect those programs would have on our current inventory and then what do we think about that as we look at various projection scenarios.

Howard Shapiro - Fox-Pitt Kelton

And just so I'm clear, on the risk-to-capital ratio, the current 15.8, or 15.7 to 1, that does incorporate the proceeds from Australia?

Donald P. Lofe, Jr.

Yes, it does. It shows the discontinued ops - and I know this is somewhat of a complicated quarter  but that does incorporate the effects of PMI Australia, the anticipated effects from PMI Asia - and, again, that's what we know today - and then also PMI Guaranty. So that's clearly the discontinued ops section.

Howard Shapiro - Fox-Pitt Kelton

On California/Florida, I know it's only one quarter's worth of data. What would you have us be looking at to see if these positive trends are occurring into the fourth quarter? What can we be looking at?

David Kacko

I think we should all watch absorption of the existing home inventory. I think you've seen statements in the general press that estimate roughly 45% to 50% of all existing home sales in California were for foreclosures. While that's unfortunate for the individuals involved and we recognize that, it's actually healthy for the market to absorb excess inventory. Keep watching that statistic as we will in the fourth quarter and that could be an early indication that things are starting to stabilize in California.

Donald P. Lofe, Jr.

Just a clarification. PMI Asia - I just was referring to the discontinued ops presentation - but, as you know, that's at the holding company, so that would not be in that ratio.

L. Stephen Smith

I think the other thing, Howard, would be the success of, I'm sure, B of A, JPMorgan Chase and ourselves and other lenders who will continue to report on the success of their home ownership preservation initiatives. So combined with what David said and the reports that people that are forthcoming on HPI initiatives would be, I think, two things to watch for sure.

Operator

Your next question comes from [Maria Hangenupen] - New York Life.

Maria Hangenupen - New York Life

Just two questions; the first is on the bank line. Could you talk about any other covenants there, whether it might be leverage or net worth that you're subject to?

Donald P. Lofe, Jr.

Two covenants that we've spoken about before besides the risk-to-capital ratio, but if you didn't hear that on the previous question, my response, the risk-to-capital ratio's 20 to 1; the debt to total capitalization is 35% and that's based upon a GAAP calculation so it'd be fair market value is the metric that's utilized. And then the net worth covenant is a covenant of $1.505 billion and, with respect to that, we can add back the marked-to-market affect [FJIG], [RAMRE] as well as PMI Europe, and we also do not include other comprehensive income in that.

There are various other covenants, such as eligibility with respect to the GSEs and various other regulatory matters, but those are the substantive covenants.

Maria Hangenupen - New York Life

Now based on that $1.505 calculation, where are you currently?

Donald P. Lofe, Jr.

We are in excess of that. We're approximately adjusted net worth of about $2 billion. And what you have to do is start with the consolidated shareholders' equity; you add back the various components that I indicated. We also are committed to add back the GAAP loss to this calculation for PMI Australia, which, again, gets you to the approximately $2 billion of a calculated adjusted net worth.

Maria Hangenupen - New York Life

And just the next question would be on just any comments you might be able to make with regards to your relationship with the GSEs.

David Kacko

As we've shared with the investment community on previous calls, we are in regular communication with both Fannie Mae and Freddie Mac on our remediation plan. We were most recently at a meeting with both organizations at the National Mortgage Banking Conference, which was two weeks ago today.

And as they have said - so I don't want to speak for them - but they have publicly said that we remain within good standing with them and are eligible to ensure product on their behalf. And at this point I don't anticipate that changing.

Operator

Your next question comes from Donna Halverstadt - Goldman Sachs.

Donna Halverstadt - Goldman Sachs

I just had a follow up on the question on paid claims. Is some of that reduction due to the timing of paids just being pushed out because servicers are so overwhelmed with foreclosures and whatnot?

David Kacko

I have heard that discussed in the marketplace and I think if we were having this conversation a year ago we would have answered the question affirmatively and said yes because servicers were having a difficult time ramping up. We do not see that in our data today. We don't anticipate that we'll be backending this some time into 2009.

Donna Halverstadt - Goldman Sachs

And apologies if I missed this, but have you said when you're going to start giving '09 paid claims guidance?

David Kacko

We have not said that.

Donald P. Lofe, Jr.

We have not.

Donna Halverstadt - Goldman Sachs

When do you think you will be?

L. Stephen Smith

Well, Donna, it will either be December 4 or when we do our earnings call for the - 2009, for the calendar year end, and we haven't decided that at this point.

Operator

Your next question comes from [Bryan Monteleone] - Barclays Capital.

Bryan Monteleone - Barclays Capital

Do the recessions during the quarter include the 5,500 loans at Indy Mac that are being commuted by the FDIC?

And then two, can you please quantify what benefit the recessions had in terms of loss reserves during the quarter?

Donald P. Lofe, Jr.

Let me take the first part of your question and I'm just going to talk about it from a high level accounting perspective.

Yes, it does include some effect related to that particular transaction you referred to. We have to consider the nature of the situation, so it hasn't been, if you will, the reserve effect hasn't been totally removed from the financial results. We have to consider certain other aspects of that relative to premium and so on. So that's somewhat of a different approach, if you will, because of the nature of that particular transaction.

With respect to recessions overall, if you just take - I will call that a normal-type recession and I'm just going to use a monthly type perspective - when that occurs, the written and earned premium, the way that's treated from an accounting perspective, it's treated as if it never existed. So the refund effect, if you will, goes through those two line items and then, if there's NODs relative to that particular recession, those are removed from reserves. High level, that's the accounting effect of that particular transaction type as well as, then, this unique one.

David, did you have any of the other matters?

David Kacko

No, I don't think so, no.

Bryan Monteleone - Barclays Capital

Can you quantify what benefit that would have been to loss reserves during the quarter?

Donald P. Lofe, Jr.

We haven't quantified that publicly and at this point in time we are not going to do that.

Operator

Your next question comes from [Bob Scottsman] - First Manhattan.

Bob Scottsman - First Manhattan

I just would like to get a sense of the state of the mortgage insurance industry today, your competitors and you. And if you can talk about the - first talk about your cure rates today and opportunities with what we read in the newspaper about what the government is proposing and just the overall environment.

And also, importantly, just from the point of view of is there a real business going forward and do you have adequate capital in terms of having a real business going forward? Because again, looking at the stock prices, one might draw a very negative conclusion.

L. Stephen Smith

I really obviously can't comment on my competitors and their capital positions, but let me just talk about some general views regarding the industry. I think we have a very strong value proposition in the marketplace. Clearly, we're a key part of the housing finance system, the safety and soundness of the system. We're the largest counterparty to the GSEs. In order to provide the liquidity that's necessary for the market in '08 and '09, we will play a key role in that regard.

Obviously, many of our competitors and ourselves are working on a broad-based range of maintaining our financial strength through things that indicated - that Don had indicated earlier in terms of all of the initiatives we have regarding the partial or full sale of some of our assets, reinsurance, the potential for accessing the capital markets, etc. We will obviously use all those programs prudently.

But I think from a value proposition the industry is quite strong and is recognized so by many public pronouncements of lenders and other parties in the marketplace. So I feel very good about the value proposition, the franchise value.

Obviously, it's paramount that we, as well as our trade association, continue to talk about that, and I can assure you that's a priority as we go into an uncertain regulatory and legislative environment in 2009. But I think our value proposition is quite strong.

I think you know, Bob, we have an office in D.C. that has very regular interactions with not only the GSEs but also public policymakers to properly portray our industry. So again, I think the value proposition is strong.

In terms of cure rates and those kinds of things, I think I would go back to what we said earlier in the conversation relative to our own initiatives in terms of loss mitigation but also the home ownership preservation initiatives and highlight the fourth quarter [inaudible] versus the year-to-date. And that’s prior to the success, which I anticipate, from the announcements that lenders have made, like B of A and JPMorgan Chase.

I think the infrastructure is there. David Kacko mentioned earlier in the call that the infrastructure of the lenders has improved dramatically from where they were a year ago. So I think all of these efforts are poised to help facilitate and increase home ownership, help people stay in homes, and stabilize communities, and we're certainly working in that regard.

Obviously, everything I've seen is - in terms of the future and the role that people in the finance system play, they talk about capital but they also talk about sustainability home ownership. Clearly, when a consumer loses, an MI company loses. We have highly rated capital that is meant to be focused on sustainable home ownership and strengthening communities, and I think we play a vital role in that regard.

Bob Scottsman - First Manhattan

Could you be a little more specific about cure rates in the third quarter versus, say, cure rates in the first quarter or the fourth quarter of last year?

David Kacko

We don't actually publish that at the PMI level. I would direct you to the [MICA] statistics that are put out publicly. I'd be happy to get those to you.

I will tell you, while we do not plan for recession data, as Don mentioned earlier, we absolutely plan for cure. I'm not going to give you the number, but I will tell you that we're tracking above our own internal projections on cures and I think that really reinforces what Steve and I and Don have talked about, which is we've invested tremendously in our home ownership preservation. We absolutely think we're getting real and notable pickup.

Bob Scottsman - First Manhattan

And again, on the U.S. mortgage insurance business, the loss ratio in the third quarter dropped significantly from what it had been in the prior four quarters and I just wanted to ask you, is this an aberration or do you see loss ratio - where is the direction of loss ratio going?

Donald P. Lofe, Jr.

We can't, if you will, give a forecast for the fourth quarter and subsequent quarters, but David and I have both talked about this and Steve, in his remarks. We saw, if you will, the effects of report year '07 really driving a good deal of that effect and similar report year '08. As we go forward into the quarter, we'll comment upon some of those items.

You might have noticed in the supplement, actually, on the loss reserve table where we show approximately a $45 million reduction and that's driven by principally the report year 2007. So we are seeing some effects for that. Obviously, as some of the callers have talked about before, the economic environment and the other aspects that we constantly consider will have to be taken into consideration as we evaluate our provision relative to each particular month and quarter.

And we're just not in a position to comment on that. And as Steve indicated, we'll evaluate on December 4 or the fourth quarter conference call as to what guidance we'll give.

Bob Scottsman - First Manhattan

I understand your hesitancy. I just want to understand; again, going back the last four quarters, you were well above, give or take, 250%. This quarter you were 193.7%. So, again, maybe just go over the key points that brought your loss ratio down significantly from what it was in the past four quarters.

L. Stephen Smith

Let me start, Bob, and it will really be what we said earlier in the call. The 2007 report year is showing improving trends in terms of claim rates as well as stabilization of claim sizes, and the 2008 report year, although it's too early to say it's stabilized, it is within or potentially lower than our expectation for claim rates or claims sizes.

The stabilization of NODs coming from Florida and California are other key factors in the trends that we saw in the third quarter.

Bob Scottsman - First Manhattan

Just one last thing and that is have you disclosed what you think the taxes that you'll pay on the sale of the Australian business are?

Donald P. Lofe, Jr.

Yes, we've given an estimated effect for that, Bob. It's on the detailed summary page.

Bob Scottsman - First Manhattan

I'm sorry I missed it.

Donald P. Lofe, Jr.

That's okay. It's an estimate of $38.5 million for Australia. PMI Asia's approximately $2.3 million. And that's generally driven by the basis difference in the original value of the investment at our ownership date and also relative to the disposition date.

Bob Scottsman - First Manhattan

I'm sorry. That's what your tax payment will be on the gain?

Donald P. Lofe, Jr.

That's what the estimated GAAP effects are for those two particular transactions.

Bob Scottsman - First Manhattan

I'm asking for tax. Are you giving me GAAP or tax?

Donald P. Lofe, Jr.

I'm giving you GAAP tax $38.5 million for Australia and $2.3 million is the estimate for PMI Asia.

Bob Scottsman - First Manhattan

And just one last thing - I'm sorry - risk-to-capital ratio of 15.8 to 1. Did you say that that includes a pro forma for the sale of - that's in the U.S. mortgage insurance business? Does that include the proceeds that you received from your sale of Australia?

Donald P. Lofe, Jr.

Yes, it does, Bob, and also the PMI Guaranty effect is considered in that. And then PMI Asia is at the holding company, so that would not be included in that calculation.

Bob Scottsman - First Manhattan

So again, for somebody who can't do the math really quickly, what is the capital in that computation?

Donald P. Lofe, Jr.

Well, let me just give you what the ultimate proceeds were that came into the organization and Steve has talked about it. The estimated book value at September 30, 2008 - and this is all in this detailed summary, so we'd be happy to go through this over in more detail if you'd like - is $816 million. Okay? Then we have to obviously remove certain effects related to discontinued ops and, again, show those effects.

But ultimately the effect that will come into was the loss on discontinued ops for Australia and Asia, and that's $67.7 million and for Asia it's $12.8 million. So after consideration of the proceeds, as Steve mentioned in his remarks, you have to show the effects of this particular loss for Australia. So when you work through that calculation and the effects of this particular transaction that results in the risk-to-capital of 15.75 to 1.

Bob Scottsman - First Manhattan

Okay, thanks. And what page is that on?

Donald P. Lofe, Jr.

It's on a detail page, Bob, that we included on the website. And Bill and I'd be happy to go through that in more detail with you if you'd like, which lays out both Asia and Australia and shows the minor effect from PMI Guaranty.

Operator

Your next question comes from [Steve Sun - Four Research].

Steve Sun - Four Research

This is just a clarification regarding the [inaudible] modification. Did you guys say this is a 4% or 5% of the 94,000 [inaudible]?

L. Stephen Smith

Relative to B of A in terms of our delinquencies and the percent of delinquencies that we think are in the B of A program. Although David mentioned we're still working with them to further align that data, it appears to be about 4% to 5%, that's correct.

Steve Sun - Four Research

So 4% or 5% on 94,000, which means it's around 4,000?

L. Stephen Smith

That's correct.

Steve Sun - Four Research

One of your competitors mentioned they identified almost 50,000 loans related to this modification and 14,000 of them are in default, so why such a big difference between you guys and your competitor?

David Kacko

The simplest answer I can give you - and I really can't speak for that competitor - is that they're considerably larger than us. I don't think it's anymore complicated than that.

Bill Horning

Operator, I think we have time for one more question.

Donald P. Lofe, Jr.

Operator, just to clarify one of my responses. That came from Donna regarding Europe, as I mentioned. Her question concerning the reserve development in Europe was significant quarter-over-quarter and that was driven by the various reinsurance agreements that I spoke about, of U.S. subprime risk. We'll indicate in our Q that we do expect that losses will continue to accrete in Europe because of other contracts, but not at the similar rate that we saw quarter-over-quarter. So I wanted to add that commentary for the participants on the call.

Operator

Your last question comes from [Steve Selmack] - FBR Capital Markets.

Steve Selmack - FBR Capital Markets

Just real quick on the loan modification question, it's been my understanding that the industry, the MI industry, has actually paid out claims on loan modifications despite not actually legally having to pay out claims, the MI industry seeing the payout on the modification as encouraging modification activity and the modification being the lesser of two evils. First, is that statement correct? And then secondly, if it's true, is that an activity you guys expect to continue in the wake of the announcements with Bank of America and JPMorgan?

L. Stephen Smith

What you're referring to is what we used to call our Sharp Program that was implemented in the oil patch crisis in the '80s, and that is still a tool that we use, that we monitor on a loanbyloan basis. It is not part of a mass program because you have to look at it loan-by-loan. We still use that tool, but it is a very minor [break in audio] we do.

David Kacko

In addition to what Steve has mentioned on Sharp, you know, we're very active in our loss mitigation group in terms of mitigation strategy [break in audio] related to pre-sales, to deedandlose, to payment plans, working with Fannie Mae on their home saver option. We've got about half a dozen different tools at our disposal that Gene Campion and his team are using to help modify loans for the betterment of the borrower and ultimately to the insured.

So that could be what you're hearing about in the marketplace. Every MI has participated in that as far as I know.

Steve Selmack - FBR Capital Markets

I guess the questions I receive are, you know, question of severity versus frequency. With modification, obviously, your severity is down but the fear is it increases frequency. So I guess I can go on the assumption that that should not be the case in the wake of Bank of America and JPMorgan?

L. Stephen Smith

If you look at a 35-plus year history, Steve, for PMI, of all the modifications we've ever done, our estimate is about 85% of the time those resulted in preventing a foreclosure occurrence.

Now in this environment, with the level of modifications that are being expected, now that percentage is likely to slip. But nevertheless, it will still be a positive for housing.

Operator

And at this time I'll turn it back over to the speaker for closing remarks.

Bill Horning

Thanks, Operator. This concludes our third quarter conference call. Thank you for joining us on today's call and, as always, if you have any further questions, please feel free to give us a call and thank you for your ownership and interest in The PMI Group.

L. Stephen Smith

Thank you very much.

Donald P. Lofe, Jr.

Thank you.

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