Source: Yahoo Finance
While the recent rally was gratifying, I believe the MI stocks are still in the early innings of a much larger rally. My reasoning starts with the fact that the stocks remain dirt cheap:
Sources: Yahoo Finance, company reports
The low valuations tell us that Mister Market’s story about the MIs is their EPS is certain to head down materially in the not-to-distant future. The reasoning has to be that a weak housing market will lead to materially rising mortgage default claims. After all, we are ten years into an economic expansion, and lenders have always done stupid things by then. And the last time they did something stupid with mortgage lending, they outdid themselves with a spectacular blow-up. So we investors should be shaking in our boots about the MIs, right?
Wrong. The real story is that the MIs today have many very real defenses against rising defaults, and that shareholders should start benefitting in a major way from the good defensive work.
The MIs’ tight defense – an argument in five pictures.
My prior MI posts presented lots of data supporting the safety of mortgage credit overall, and of the MIs’ insured mortgage portfolios in particular. Here’s a couple of pictures that update the data or add new angles.
I start with the home mortgage delinquency rate:
Source: New York Federal Reserve
They are low, and still falling. That’s good. But how about the critical leading indicator to mortgage delinquencies, namely loan underwriting quality? It’s such an important indicator for the mortgage insurers that I’ll show you two sources. First, from my second favorite regional federal reserve board, namely New York:
Source: New York Federal Reserve
Loans to weak borrowers fell off in 2009 and have stayed low ever since. Once again, good news. My other outside source for loan underwriting quality is the Urban Institute. Their index measures mortgage credit risk generated both by the borrower and by loan terms (debt levels, documentation, etc.):
Source: The Urban Institute
Mortgage credit standards clearly remains tight, and even tightened last quarter. But the media is hot on the idea that a housing bubble is now bursting. The last bubble was caused mostly by psychotic lending, but also by overbuilding. So let’s check out housing vacancies:
Source: Census Bureau
Not only is housing not in excess in the U.S., we have a growing shortage. That makes sense when you combine the recent news of healthy job growth and soft home construction. Prices of any product don’t decline when there is a shortage of it.
So there is plenty of evidence that the mortgage credit quality big picture is in great shape. Is that showing up in the mortgage insurers’ results? You bet it is - actual claims paid declined sharply last year:
Sources: Company reports
MGIC and Radian are seeing losses plummet from their insurance they issued during the housing bubble. Essent and NMI, who both started up after the bubble, have essentially no claims payments. Not exactly signs of imminent danger. So why worry? Ignore Mister Market.
The MIs’ improving offense – returns to shareholders.
Mortgage insurers are simply not growth stocks, and never will be:
· Their underlying product, mortgage debt, is not a growth product. Mortgage debt growth is quite sluggish, at less than 3% annually over the past three years. Mortgage debt should grow no faster than household incomes over the long term, which is about at a 3-4% pace.
· The MIs have no natural product extensions. They all offer some mortgage origination services to their mortgage banking customers, but these extras will always represent less than 10% of profits.
· I can’t see the MIs diversifying. They will not build out 5G networks. They won’t produce original content for streaming companies. They will not sell artisanal toothbrushes online. They are far more likely to be acquired to help diversify some other company. Listening, Warren Buffet?
No, we will have to be satisfied with bond-like returns with a modest growth kicker. That isn’t so bad when, as I showed above, the bonds are earning 12% returns. But one problem – the MIs are more like zero coupon bonds today. They haven’t been paying much at all to investors, either through dividends or share buybacks.
But that’s about to change.I expect that 2019 will be the year these zero-coupon bonds will start paying big dollars to shareholders. My confidence on this score is because (A) the MIs now have excess capital, and (B) the MIs are generating substantial amounts of capital in excess of their regulatory requirements. Check out these numbers:
Sources: Company reports
The MIs’ recently introduced capital requirements have the acronym PMIERS. All of them have a healthy cushion to their requirements, and are expected to earn material sums in 2019. Note also that the pre-2009 legacy insurance held by MGIC and Radian require a lot of capital versus their new competitors Essent and NMI, so as their legacy books pay down, MGIC and Radian will free up a lot of capital. Further, the MIs are have selling off some of their credit risk through various reinsurance arrangements, which frees up more capital.
I therefore conclude that:
· MGICwill aggressively buy back stock this year; my guess is at least 5% of its outstanding shares. And it should institute a dividend.
· Radian should buy back 3%+ and could raise its currently token dividend.
· Essent should be in the position to announce a buyback program and/or dividend.
· NMI could fund its still-rapid insurance in force growth without another dilutive share offering.
And 2020? The cash flow offensive should increase further. Get ready to reap your cash rewards, MI investors. I believe the MI stocks still have a comfortable 50% upside over the next few years.
Disclosure: I am/we are long NMIH. 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.