Mortgage Insurers Have Another Leg Down to Go

Includes: MTG, ORI, PMIR, RDN
by: Adam Gefvert, CFA

From doing extensive due diligence in the industry, I have come to the conclusion that we will see another leg down in the private mortgage insurance industry. And it will be another big drop as well. Since there's a lot to discuss, this is going to be a two part analysis.

I think MTG, RDN, PMI, and ORI are great investments for the long term since I believe they will dominate the mortgage insurance market, as they are almost entirely pure plays in that sector. New mortgages are very safe, but for now, investing in them would be a value trap. Because they are going through pretty much the worst period mortgage insurers have ever gone through.

Although I wouldn't short these stocks at current levels because the stocks have continually retested lows, I wouldn't buy them either. If I had to make a choice between buying or shorting, I would short. I believe it's very likely they'll drop another 25-35%, and at that point I believe the bottom will have been reached. I think this because the next two quarters will almost certainly be very bad for the mortgage insurance sector.

If these companies have another bad quarter and possibly another bad quarter after that, the risk of a capital raise will cause the stocks to plummet. ORI and PMI are especially in bad spots right now as their risk to capital ratios are over 25 to 1 as confirmed here. This is the maximum many states require a mortgage insurance company to have in order to continue writing business. RDN and MTG are at about 21 to 1. Regulators are giving PMI and ORI some leeway and to continue writing business to stay afloat despite the high ratio. However, it is inevitable that they will have to raise more capital in the near future. This will dilute the stock and push the share price down. MTG and RDN may have to raise capital as well, although they are in better shape than the other two.

The following are a couple reasons I see that show bad news for mortgage insurers ahead.

Banks Are Dealing With Homeowners Who Are Gaming the System.

When dealing with delinquent homeowners, the banks have a strategic goal of getting as much money as possible out of them and giving them the least amount of concessions. The banks' worst enemy are troubled homeowners with their own strategic goal: Part with the least amount of money possible and get the most value out of their home while they're doing it.

It's much easier for a bank to deal with a troubled homeowner who is oblivious to the game or feels it's their moral obligation to pay their mortgage. The bank can more easily persuade and negotiate with them to continue paying their mortgage. After awhile, homeowners begin to learn to game the system out of necessity for extra money or learn about doing it from others.

I heard about this woman named Wanda who recently moved to California from Florida. She had purchased a house in Florida for $289k in 2005 and it is now worth $120k. She stopped making her mortgage payments in July, 2010 because she lost her job and couldn't afford it. After a few months of not paying her mortgage, the bank negotiated with her to do a loan modification.

After a couple months, she decided that she didn't want to keep the house, and decided to forget the loan mod and do a short sale. In March, she left the house and moved to California. As the house was going through the short sale process (a slow process as Florida is really backed up) she thought of a plan to rent the house out while it's sitting vacant. She found someone who will move in starting August, 2011. Wanda hired a real estate attorney who is very experienced with the Florida real estate foreclosure process and knows all the tactics to stall it.

One tactic is to oscillate between a loan mod and a short sale. Right before Wanda is required to sign the deed in lieu of foreclosure, she will decide later that she doesn't want a short sale anymore, and wants to do a loan mod again, which the bank will graciously accept. Then after several months of going through the system, the loan mod program gets going, and she pays for maybe one or two months just to look like she's serious.

Then she'll stop paying her mortgage for a few months and "change her mind again", and go back to the short sale. Then she'll go back to the loan mod eventually. The attorney said he could continue this tactic and others for the next three years and Wanda will continue to collect free rent on her house.

Wanda is an extreme example of ruthlessly gaming the system, but this kind of thing is going on throughout the country. Most people start out honest making an effort to pay their mortgage, but then quit paying because it's too high. Then other people hear about it happening, and they try to stay in their homes as long as possible without paying their mortgage. It gets to be a joke. This article from last year illustrates this attitude that's accepted in certain areas of the country.

These homeowners are making things more expensive for the lenders because the process takes longer and requires more expenses to get them out of the house. The mortgage insurers end up reimbursing the lenders. Since 2009 was the year the economy got hit for the worst and real estate took the biggest dive, that is the year that most delinquencies happened, as shown in this chart from Ritholz' Big Picture Blog:

click on images to enlarge

Right now, two years later, a huge part of the uncureable delinquencies from 2009 are being pushed through the foreclosure process.

This table is from the MGIC Investment Corp (NYSE:MTG) Q2 2011 results news release.

New notices are when the mortgage insurer is made known of a missed mortgage payment by the homeowner. Cures are when a homeowner that previously missed a payment is now caught up, and this includes through loan modifications. A big reason for the selloff of MGIC, is because the new notices have now surpassed the cures in Q2 2011. How many homeowners are wishy washy like Wanda and their cures turn out to be false? I'm not sure but I think it's important to take that into account.

Total claims paid increased last quarter to 13,553, for a total amount of net paid claims of $818 million. Contrast this to Q1 2011 total paid claims of 13,466 and net paid claims of $687 million, a dollar amount jump of 19%. This is the biggest percentage jump in net paid claims dollar amount for at least the past year and a half. The question to ask is will it get even worse next quarter? I think it will. For a mortgage insurer to pay a claim, the house needs to be sold, and the insurer will reimburse the lender for the total dollars lost. As real estate continues to fall, this increases the mortgage insurer's cost per claim.

Real Estate Will Continue to Fall

Real estate's double dip is all around bad news for mortgage insurers. It not only increases the cost per claim, it also decreases the number of cures. When real estate is on a downward trend, homeowners are more willing to walk away from their mortgage. At the moment, real estate prices are in a downward spiral. Cures rose briefly between Q4 2010 and Q1 2011, from 43,191 to 45,639. Then it dropped in Q2 2011 to 35,832. So, a quarter over quarter rise of 5.4% and then a decline of 21.5%.

This yo-yoing of cures reflects the rise and fall of real estate. During 2010, many thought real estate had reached the bottom. In September of last year, legendary investor John Paulson indulgently recommended the purchase of real estate. He said:

If you don’t own a home buy one, if you own one home, buy another one, and if you own two homes buy a third and lend your relatives the money to buy a home.

Now, Paulson is no longer positive about real estate, as stated here.

The bold line in the above chart shows the percent change in real estate prices from a year ago in the United States. The dotted line shows the average dollar value of a US home. It shows that real estate values rose in 2010, but then dropped to new lows in 2011 - back to mid 2002 levels. It was a fake rally that tricked even the great John Paulson.

The double dip in real estate is the reason for MGIC's double dip in cures from Q1 2011 to Q2 2011 as shown in the above table. As homeowners noticed their homes rising in value in 2010, they were more willing to get current on their payments. This resulted in an increase in cures from Q4 2010 to Q1 2011. Once people found out how much their houses lost value in Q1 2011, they were less likely to want to keep their home, which resulted in a huge dip in cures in Q2 2011.

With the higher pace of foreclosure selling, which is punishing the mortgage insurers, and no immediate QE3, in my opinion it's fairly obvious that real estate is going to continue to plummet for the next year at least, probably for the next two years. I would recommend not investing in any stocks related to real estate right now, unless it's a niche business or it is extremely undervalued.

In the next segment I'll talk about how the government will not be helping private mortgage insurers, and I'll do a valuation of one of them.

Disclosure: I am short MTG. I'm short an MTG call.