(Editor's Note: There is much greater volume on the TSX under the ticker MIC).
People tend to underestimate the risk of events that have not occurred in a while. After individuals become overextended in borrowing to finance speculative investments, they start realizing that something is likely to go wrong. Welcome in Vancouver.
The low delinquency rate and the historically low provision for credit losses are not indications of credit quality. They are only consequences of surging home prices.
Before going any further, I want to mention that I own January 2018 puts on Genworth MI Canada (OTC:GMICF) with a strike price of $18. I paid $1.30 per contract. I initiated my position when the stock was trading at around $34 per share. This is not a recommendation to buy or sell any stock. I am an undergraduate student, not a financial advisor. Because the stocks mentioned in this article are trading in Toronto, all figures are in Canadian dollars unless otherwise stated.
This article will be focused on Genworth. However, I am worried about the mortgage industry in general. Equitable Group (OTC:EQGPF) provides mortgage loans to a wide range of customers including self-employed borrowers and newcomers to Canada.
Let Equitable Bank's ''customer first'' approach help you achieve your aspirations of home ownership - whether you're self-employed, a new immigrant to Canada with a limited or no credit history, a credit-challenged individual or an investor.
Despite holding the risk of $9 billion of uninsured mortgages on its balance sheet, Equitable Group took only $105,000 of provision for credit losses during the last quarter. It represents around 10% of the average selling price for a detached home in Toronto. Remember that Equitable provides loans to credit-challenged individuals. This example illustrates the current stage of the housing market in Toronto and Vancouver.
With $800 million of uninsured residential mortgages in Alberta, I strongly believe that the provisions taken by Equitable in the past quarters are largely insufficient to cover the future losses. The exposure in Alberta represents almost 100% of the shareholders' equity. The reserves are almost non-existent, the unemployment rate is close to 9% and the number of bankruptcies is spiking in Alberta. Let's put it simply: I am extremely skeptical on Equitable.
I want to mention it again. The firm has $800 million of uninsured mortgages in Alberta and took provision for credit losses of $105,000 on its whole portfolio during the second quarter. This is despite the fact that the unemployment rate is at a 20-year high in Alberta.
Shareholders of Equitable Group must understand the risk related to these numbers. I am worried about the ridiculous level of allowance for credit losses considering the risk present in the housing market in Alberta and British Columbia. I think the management should issue shares at the current price level. Otherwise, the firm will be forced to issue shares at a much lower price in the coming months. Again, this is only my own and personal opinion. Different opinions are needed to create a market and I respect them.
Equitable Group looks pretty bad. However, the situation of Genworth MI Canada is even worst. When the prices are climbing by 30% in a year, the mortgage insurance business is wonderful. This golden age is now in the rearview mirror.
What is the worst case-scenario for a borrower when the prices are climbing by 30% in a year? The borrower who is not able to afford his mortgage just has to sell back his house on the market and enjoy his capital gain of $300,000 on a home of $1,000,000. This was possible until now.
The median selling price for a detached home in Vancouver West reached its peak in April 2016 at $3,688,000. As of September 2016, the price is now of $2,990,000. It represents a decrease of around 23%. I agree that Vancouver West is not representative of the Greater Vancouver Area because it represents the high-end market. So, let's look at some anecdotal evidence.
The residence located at 3639 Oxford Street (Vancouver East, V5K-1P4) was initially listed for $2,288,000 on August 10, 2016. The asking price 54 days later was $1,588,000. It represents a drop of $700,000 or 31% in less than two months. Is it an indication of a failing market?
I agree that it might be an exception and that it might not be representative of the whole market. Let's look at a second example.
The residence located at 2754 Dundas Street (Vancouver East, V5K-1R2) was listed for $1,888,000 on August 9, 2016. The asking price dropped to $1,588,000 as of September 28, 2016. It is a decrease of $300,000 or 16%.
Let's look at a third one just for entertaining purpose.
The residence located at 3451 West 6th Avenue was listed for $2,798,000. The asking price is now of $2,288,000. It is a decrease of $500,000 of 18%.
It looks like the sellers are trying to get prices that buyers are no longer willing to pay. The following quote of Paul Krugman published in 2005 is perfectly relevant to the Vancouver housing market in my opinion.
So the news that the U.S. housing bubble is over won't come in the form of plunging prices; it will come in the form of falling sales and rising inventory, as sellers try to get prices that buyers are no longer willing to pay.
Paul Krugman said falling sales? The total detached number of sales was equal to 1,272 in September 2015. According to the last data published by the Real Estate Board Of Greater Vancouver, this metric was equal to 666 in September 2016. It is a decrease of 47.6%.
Considering the decline in sales and the increasing number of new listings, I think it is reasonable to say that the inventory is probably rising in Vancouver. Naturally, I believe the inventory buildup is more important in the high-end market like Vancouver West or Vancouver East for example.
What is the impact of these data on Genworth MI Canada? According to the financial statements of the company, the exposure in British Columbia represents 15% of its mortgage portfolio. Because British Columbia is not equal to Vancouver, I used the population proportion as a proxy for the proportion of mortgage directly in Vancouver. The British Columbia population is around 4.6 million and the population of the Greater Vancouver area is approximately of 2.4 million. So, the exposure of Genworth in Vancouver should be close to 8%.
According to my estimation, the exposure in Vancouver is 10 times greater than the shareholders' equity and the exposure in Alberta is 20 times bigger. This is why Genworth is the best vehicle to go against the Canadian housing market. The firm is highly levered and any deterioration in the credit quality would send the stock to the floor.
The firm insures $71 billion of mortgage in Alberta where the unemployment rate is at a 20-year high. However, the loss reserves are ridiculously low exactly like Equitable Group. Considering that Genworth insures $443 billion of mortgages, the loss reserves of $143 million are pretty miserable. With the weakening housing market in Vancouver, I would not be surprised to see the default rate spiking in this province. The loss reserves are non-existent.
What kind of event could force Genworth to fill for bankruptcy protection? Sadly, it can occur pretty easily and quickly in my mind. I believe this risk is not priced in by the market.
During the second quarter of 2016, Genworth paid $29 million in claims. This amount was divided between 425 different claims. So, the claim per unit was around $68,000. With an average loan size of $225,000, it is possible to estimate the loss given default (LGD) at around 30%. This is consistent with the past few quarters. Logically, the loss given default will jump if the housing prices decline. Because the shortfall will be bigger for the lender, the claim per unit will increase causing the loss given default to spike.
When a borrower defaults on his mortgage, Genworth is losing around 30% of the loan size. However, what is the probability of default? Indeed, a delinquent mortgage does not equal at all to a defaulted mortgage.
At the beginning of the second quarter, Genworth had 2,034 delinquent loans, which are characterized by an arrear rate of 30 days or more. During the quarter, the firm paid 425 claims. If there are five delinquent loans, it will have to pay just one claim (5:1). With this number in mind and the number of insured loans by provinces, it is possible to estimate the number of claims Genworth will have to pay as a function of the delinquency rate. Again, the housing market has never been as strong as today. I believe the proportion of claims to delinquent loan could spike if the housing market deteriorates.
The mortgage delinquency rate in Ontario is currently at 0.14%. It is the lowest level since April 1990. This is not surprising considering the surging home prices in the province. Instead of defaulting, you just have to sell back your home on the market. The average mortgage delinquency rate since 1990 is equal to 0.37%.
When the average price went from $255,020 to $214,971, the delinquency rate went from 0.11% to 0.66%. In other words, when the price declined by 16%, the delinquency rate increased by 500%. It is perfectly possible that the delinquency rate goes back to its 26 years' average of 0.37%. Just a little blip would be required to send the delinquency rate through the roof.
Considering the number of insolvencies and the unemployment rate in Alberta, I think it is realistic to assume that the delinquency rate will jump to a minimum of 1%. When the unemployment rate was around 7% in 2009, the delinquency rate jumped to 0.8%. As of September 2016, the unemployment rate is 8.5%. It could easily justify a delinquency rate of 1%.
The unemployment rate is at a 20-year high and the delinquency rate is under its average since 1990. This is not sustainable and the delinquency rate will spike abruptly. If we combine this fact with the bubble in Vancouver, Genworth is in big trouble.
In the case of British Columbia, I think the delinquency rate will surge because of the declining home prices. I use Zolo to track the Vancouver housing market closely. According to the MLS statistics, the average price is down 19.8% on a quarterly basis. It corroborates the numbers that I used on Vancouver earlier in my article.
What is the implication for Genworth? If the delinquency rate reaches 0.7% in Ontario and 1% in British Columbia, Genworth will have to issue a significant amount of shares to respect the minimum regulatory MCT ratio of 175%.
It is important to understand that it is not a ''bubble bursting'' scenario. The delinquency rate in Vancouver reached 0.7% in 2000 without any drop in price. I believe that a drop of 10% to 15% across the board in Vancouver would be sufficient to send the delinquency rate above 1%.
I also assumed that the delinquency ratio will peak at 1% in Alberta. This metric reached 0.8% when the unemployment rate was at 7%. The unemployment rate is currently at around 8.5%.
I assumed that the delinquency ratio will peak at 0.7% in Ontario. This metric reached 0.7% in 1990 without any drop in price. In my mind, my scenario assumes only a weakening housing market in Toronto and Vancouver. We are not talking at all about a collapse or a crash. In my opinion, it is probable to see a collapse in Vancouver, but it is not wise to make investment decisions based on extreme scenarios. The following tables illustrate the variables used for 2017, 2018 and 2019.
Considering these variables, I build a model to estimate the losses and the capital required to comply with the minimum MCT ratio of 175%.
With around $2.1 billion in capital available at the end of 2019 and a required capital of $1.6 billion, the MCT ratio would be equal to 130% which is way below the minimum. If this soft lending occurs, Genworth will have to issue approximately $700 million of new shares just to comply with the minimum of 175%. Genworth would be in the obligation to issue $1.1 billion worth of new shares to increase its MCT to 200%. If the stock collapse to 20$ per share, a share issuance of $1.1 billion would represents around 60% of the market capitalization.
I also want to point out that if the delinquency ratio jump to 1.5% in Ontario and British Columbia, Genworth is simply bankrupt. Ironically, a delinquency rate of 1.5% is not impossible at all in my mind.
I did not talk about the new regulation imposed by the government last week. However, the impact will be important for Genworth. The new premiums written which is the main source of income will decrease meaningfully in the coming quarters in my mind. Furthermore, the claims paid by Genworth could reduce its investment portfolio. It will affect the investment income negatively, which is the second source of income.
Indeed, all insured homebuyers will be forced to use an interest rate approximately equal to 4.6% (Bank of Canada's conventional five-year fixed posted rate) to qualify for mortgage insurance. According to Genworth, the impact will be important.
Based on year-to-date 2016 data, we estimate that a little over one third of transitionally insured mortgages, predominantly for first time homebuyers, would have difficulty meeting the required debt service ratios.
Furthermore, approximately 50% to 55% of our total portfolio new insurance written would no longer be eligible for mortgage insurance under the new Low Ratio mortgage insurance requirements.
Following this news, the stock collapsed by 10% which is the biggest intraday drop since August 2009. In my mind, Genworth will continue to experience a lot of selling pressure in the coming days. For more information, please refer to the official press release issued by Genworth on October 4, 2016.
In conclusion, Genworth is the most leveraged vehicle to bet against the Canadian housing market. Moreover, the loss reserves are negligible because the management probably believes that the current conditions will continue indefinitely. A little blip in the housing market in Toronto and Vancouver would send the stock to the floor. The delinquency rate in Alberta will jump in the next quarters and Genworth will be hit pretty badly in my opinion.
Genworth MI Canada could be forced to issue a significant amount to stay in compliance with the minimal capital requirement. A delinquency rate of 1.5% in Toronto would crush Genworth under billion of dollars in claims. Issuing share at the current price looks like a wonderful idea. Otherwise, the firm will probably wait to do so at a much lower price and the dilution for the existing shareholders will be significant causing the stock to decline further. I see Genworth trading below $10 before the end of 2017.
Disclaimer: This article reflects my opinion only. I am not a financial advisor. Please do your own due diligence and consult your financial advisor before taking any decision. I am not a financial advisor. The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone acts upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: I am/we are short GMICF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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