Those who know me know that I love the private mortgage insurance stocks (MIs) more than my family. Only kidding. But sometimes not really. Actually, my family hasn’t much minded my callous view this year since my seriously over-weighted position in them has benefited us all. In fact, since I wrote “Mortgage Insurance Stocks – It’s Go Time” last December 11, the stocks are up an average of 40%.
The MIs all beat Q1 EPS estimates by a couple of cents a share.
A meager few cents a share? Why get worked into a lather over that? Because MI earnings components move like snails. About 97% of each quarter’s revenues derive from insurance and investment assets that were there the prior quarter. Operating expense increases are quite stable. Only their loss provisions have much theoretical quarterly volatility, but housing trends are multi-year, not quarterly. So surprising Wall Street is pretty darn good. And I’ll bet – wait, I have bet – my bottom dollar that the MIs have at least a few more cents per share upside this year.
Significant distributions of excess capital have begun.
I confess that I had big hopes for capital distributions – dividend announcements and share repurchases – from the MIs this quarter. After all, their regulatory capital requirements were finally set as of January 1, they all have plenty of extra capital and they are all earning big bucks. I didn’t get nearly all that I expected, but I did get some positive signs.
The best news by far came from Radian. First, a quick background. The MIs are structured as holding companies that own insurance subsidiaries. To get cash to shareholders, the MIs need regulatory approval for the insurance subs to transfer cash to the holding company. Radian was allowed to ship a hefty $825 million to its holding company over the past six months. By April 26, Radian had used $122 million of that haul to buy back 3% of its stock. That’s a 3% permanent boost to EPS. Super.
But MGIC, while authorizing a $200-million buyback recently, bought back nary a share. And Essent, which I had hopes for, did nothing. Only National Mortgage gets off the hook because it still is growing fast enough to need to retain capital.
But the MIs still have their excess capital, and MGIC, Radian and increasingly Essent need less than half of their earnings to fund insurance portfolio growth. I promise – more buybacks, and soon dividends, will soon be coming your way.
The MIs’ competitive environment remains stable.
This point was summarized nicely in National Mortgage’s Q1 conference call:
J.P. Morgan: “…From a competitive…[are you] seeing any distortions there that we should be thinking about in terms of pricing…?”
Claudia Merkle (National Mortgage CEO): “…We believe the market is generally very stable…For us, most importantly, for NMI, we continue achieve pricing that supports our strong mid-teens return objectives.”
Well put, Ms. Merkle.
Claims payments will almost certainly remain below average for the next five years.
MI earnings are all about their loss ratios. How much of the premiums they earn must be set aside to cover current and expected future claims payments on defaulted mortgage loans? Here’s what Radian said:
“Radian’s stochastic modeling indicates an approximate 20% through-the-cycle loss ratio on newly originated MI business.” (Radian Q1 ’19 presentation slide)
“Stochastic modeling” estimates a variety of possible outcomes and averages them. The 20% loss ratio figure is an average of Radian’s estimated mortgage default losses under many economic scenarios. Thanks for the work, Radian, but stochastic modeling doesn’t help investors much. The fact is that only one scenario will actually occur over our investment timeframe, and it’s that scenario that will drive stock prices. Our job as investors is to identify which loss ratio outcome is most likely.
At present, loss ratios for the MIs are far below 20%:
Sources: Company reports
Note that MGIC’s and Radian’s ratios are higher than for Essent and National Mortgage because they till bear losses from loan originated during the mid-'00s housing bubble.
What is the most likely loss rate scenario over the next five years? I believe it is sub-10%, well below Radian’s 20% expected average. Here’re my three key pieces of evidence. First, MI loss rates will rise if home prices decline, but home prices don’t decline very often:
Source: Federal Housing Finance Board
So something unusual has to happen to drive them down. Basic economics says that prices go down when supply exceeds demand. Is that the case today? Far from it. In fact, housing is actually in modest under-supply in the U.S. today:
Source: U.S. Census Bureau
Note that the period of significant over-supply coincided with the U.S.’s only sustained national home price declines since WWll.
The other key driver of MI losses is bad underwriting. But third, MI underwriting standards are excellent today, as shown by this comparison of Radian today versus the bad old days of 2006:
Source: Company data
Literally night and day. And again, the ’06 dumb lending standards coincided with that single era of home price declines.
Conclusion – MI loss rates will stay well below average for a long time.
The MI stocks remain seriously unloved.
Here are two quick quotes from Wall Street stock analysts commenting on Radian’s Q1:
“While [Radian] is producing strong underwriting results and improving its capital position, we see the current multiple as largely reflecting the company’s excellent operating results.” (RBC, May 1, 2019)
“BTIG analyst…boosts his price target for Radian Group to $29 from $26…”
The first is satisfied with Radian’s current 8 P/E ratio, while the second is now willing to go to 10. But both valuations are way below the stock market’s current 17.6 P/E. I’m not only comfortable that the MIs’ EPS will be steadily growing, but that their P/E ratios will narrow the gap with the overall market. That makes for nicely rising stock prices. I believe all four MIs have 50% upsides over the next few years based on the above. So join me and dig in for a profitable long term.
Disclosure: I am/we are long MTG ESNT RDN 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.