When MGIC (MTG) announced that Freddie Mac (FMCC.OB) was threatening to block one of their insurance writing subsidiaries (MIC) from writing coverage unless a dispute between MGIC and Freddie was settled, the stock price of MGIC collapsed. With the stock price well under a dollar, a price that assumed a disastrous outcome, I bought and then added to my position. It seemed to me that the worst case outcome was no sure thing.
We are at a point now where the stock price has recovered significantly from those distressed levels. Any future increase is going to be determined by future developments in the dispute with Freddie.
I have written about this dispute previously in some detail in a post about what I worried about with the mortgage insurers (here). At the time, my analysis was limited to the SEC filings from MGIC and a few articles that I found that had referenced the court proceedings. I did not have access to any of the court documentation first hand.
Earlier this week, I was fortunate enough to find a link to the original court document of MGIC's Complaint for Declaratory Relief against Freddie Mac. It was posted on MGIC's Yahoo board.
The document describes the pool insurance dispute between the two companies and the case presented by MGIC.
Having read through the document a couple of times, my takeaway is that MGIC has a decent case against Freddie Mac and that, all things being fair, the evidence suggests good odds of them winning. What remains at issue is that all things are not fair. In particular, I believe the primary impediment to their success, and the primary uncertainty in the stock, is simply the leverage that Freddie Mac can inflict upon them.
Let's get into the issue at stake.
What's at issue
The disagreement revolves around 11 pool insurance policies. Each of these policies contains a number of pools of loans that MGIC had agreed to insure for Freddie Mac beginning in 1996. The insurance was designed to be in force up to a limit defined by a percentage of the principle balance of each pool.
To get an idea of how these policies work, let's put it in terms of a simple example. Let's assume we have one policy and it contains two pools of loans. Each pool contains loans worth a total of $1 million. Let's also assume that the policy is structured such that MGIC has agreed to insure a maximum of 1% of the principle balance of the pools within it. MGIC therefore has an aggregate loss limit (meaning the maximum amount that they could potentially be on the hook to pay if a lot of the loans in the pool started to go sour) with respect to the policy of $20,000.
The disagreement between Freddie and MGIC stems from what happens once insurance on one of the pools expires. Going back to our example, let's assume one pool was added to the policy in 2000, and the other was added in 2003. Both of the pools have insured agreements for 10 years. Time passes and 2010 rolls around and insurance on the first pool reaches its expiration.
According to Freddie's interpretation of the policy agreement, MGIC is still responsible for $20,000 of losses (less what had been incurred up to 2010) because Freddie believes that the aggregate loss limit of the policy is based on the total principle balance of all loans ever included under the policy.
Under MGIC's interpretation, the aggregate loss limit is determined by the total principle balance of loans currently insured under the policy, so when the first loan pool runs off, it is no longer included in the calculation. Under MGIC's interpretation, the aggregate loss limit would drop to $10,000.
In this example, the difference between the two interpretations is $10,000; that is the amount of insurance that MGIC may have to pay on defaults in the remaining pool for 3 years. In the actual contract between MGIC and Freddie, the difference between the two interpretations is $550 million of potential losses. $550 million, being a tidy sum of money, could be the difference between life and death for MGIC.
Points raised by the declaration
As I said, there were a number of points raised in the declaration that made me think that MGIC has a fairly strong case. These points were:
- The premium paid by Freddie for the policy insurance was consistent with the interpretation of the agreement by MGIC. Freddie paid premiums that were consistent with the 10-20 year periods that each pool was to be insured. Freddie did not pay anything extra that could be construed to reflect the extra insurance coverage that Freddie's interpretation results in.
- It was only in 2008 that Freddie began to reinterpret the agreement. Prior to that time, Freddie acted as though they agreed with the MGIC interpretation. Specifically, Freddie created additional policies with MGIC after 2007. These policies were used to insure new pools. This coincided with when the existing policies began to wind down. If Freddie had believed at the time that the insurance in force was not dependent on whether the existing policies were winding down, they would have just added new pools to the existing policies.
- Before 2000, the 11 policies existed separate from one another. In 2000, Freddie and MGIC changed the agreement so that the 11 separate policies were combined into a "mega" policy whereby the losses to all policies would be aggregated and a single loss limit would be applied to the "mega" pool. When this change was made, the language of the change specifically referred to the loss limit being determined by "loans insured" and "loans that become insured". MGIC's position is that the language is clear that once a loan is no longer covered by the insurance, it should be removed from the aggregated volume. I would say this sounds in line with the language.
- With respect to the mega pool, Freddie Mac's reading of the contract would have resulted in an increase in the regulatory capital requirements of MGIC when the agreement to combine policies into a mega pool was made. This is in conflict with one of the objectives of both Freddie and MGIC for creating the mega pool. The mega pool idea was conceived to reduce capital requirements for MGIC so they could write more pool insurance for Freddie in the future. MGIC argues that it makes no sense to accept Freddie's interpretation, which would have meant that Freddie was constructing an agreement that would accomplish the opposite of that.
- There is an element of incompetence on the part of MGIC implicit in the Freddie interpretation. There are these policies outstanding. MGIC is allowing Freddie to continue to add pools of loans to these policies. These pools of loans, because they are new, are extending out the life of the policy and increasing the total UPB that has been added to the policy. So with Freddie's interpretation that the limit of the insurance is independent of whether older pools have expired, those newer pools are effectively having higher and higher loss limits. This would be a ridiculous business decision on the part of MGIC.
- In 2007, the individual pools within the mega pool began to wind down. Under MGIC's interpretation, this would have meant a corresponding reduction in aggregate coverage of the pool. Under Freddie's interpretation, the coverage would have remained the same. Yet Freddie, beginning in 2007, created new policies with MGIC that were not part of the mega pool. Naturally the inference is that they did so because they would receive better coverage from a new policy than from the existing policies that were winding down, which means that at that time, they understood the nature of the agreement as being consistent with the MGIC interpretation.
- During 2008, there was an email communication between MGIC and Freddie where the two parties discussed how MGIC could reduce exposure on the some of the policies. In that exchange, Freddie noted that most of the risk in these policies would be unwinding due to their natural expiration dates during the remainder of 2008 and throughout 2009." With the interpretation of the agreement Freddie has, this would not have been the case and the risk would be continuing for a number of years hence.
I imagine that the reason that MGIC decided to go to court is because they felt confident that the court would settle in their favor. Conversely, the reason that Freddie is putting the screws to MGIC to settle out of court is, in my opinion, because they see the same result.
Unfortunately, Freddie has a lot to leverage on MGIC. In particular, Freddie has the ability to approve or not approve the use of the insurance subsidiary MIC.
MGIC created MIC to write insurance in states where the existing MGIC insurance subs could not. MGIC has been pushing up against the risk to capital ratio of 25:1 and some states have as a hard limit whereby you cannot write insurance once a sub is above that ratio. In the second quarter, MGIC finally exceeded the 25:1. To get around this, and keep writing insurance in all states, MGIC created a new, capitalized, subsidiary. Enter MIC.
But for MIC to write insurance, it needs the approval of the GSE's for that insurance to be approved to go into their securities. And while Fannie has agreed, Freddie has balked.
What brought the dispute to a head was when Freddie sent this letter to MGIC stating that they wanted the dispute resolved, along with a few other requests, before they would designate MIC approved insurer of Freddie Mac loans.
What is somewhat unclear to me is what happens if MGIC does not have approval to write insurance through MIC for Freddie. There are a couple of aspects of this that remain gray areas:
- While MIC would not be able to write insurance on loans that are subsequently sold to Freddie, they would be able to do so for Fannie. The problem here is that most loans are originated without a particular end-party in mind. However, whether this can be worked around or whether it is an impediment to writing any new business is a question I have not seen addressed
- There are 16 states that have hard limits on risk to capital. Of those, MGIC has already received waivers from 6. Of the remaining 10, 3 have denied waivers and MGIC is waiting for responses on the other 7. While the inability to write insurance in 3-10 states would crimp overall volumes and is obviously not preferable, it would still leave upwards of 40 states that MGIC would be able to write new business in.
Whether an outright rejection of Freddie's demands is an alternative for MGIC or not is not clear. But what is clear is that it would be preferable to settle.
What I'm doing
With MGIC back to $1.20, it is at a level that no longer prices in imminent bankruptcy. But, I would argue, it also does not price in any of the upside of a positive settlement with Freddie. I have been debating taking some of my position off at this level, and reducing the size back down. I still may do that, but given that MGIC does appear to have a decent case against Freddie Mac, I would be reluctant to eliminate my position completely. I want to keep some skin in the game because a reasonable settlement to the court case with Freddie would likely result in a move in the stock price back to $2 and beyond. If I could be more certain that the case would resolve on its merits, and not on the leverage of Freddie Mac, I would be tempted to buy more. But unfortunately, the power of Freddie Mac, along with the uncertainty about their actions, remains too great to take too much of a chance on the stock until more clarity can be gained.
Disclosure: I am long MTG.