Monday, March 19, 2007

Tip toe through the 10K--MTG's

Today I spent a little time looking at MGIC Investment Company's (MGIC MTG) 10-K for the year ended 2006. I want to excerpt a few things for you to give you a flavor for some of the issues facing these insurers AND these same issues face any organization that has shaky mortgage exposure--also there are some comments on how the interest rate environment affects these folks. My "what this means to me" comments are bracketed [ ]. I certainly invite you to look at the 10K, nothing herein is meant to be an analysis, but rather some things for you to consider.

  • "NIW for bulk transactions decreased from $21.4 billion in 2005 to $18.9 billion in 2006 due primarily to narrow credit spreads and increased competition from both the marketplace (reflecting greater appetite for higher risk tranches by investors including hedge funds, and CDOs), and other mortgage insurers." [Everyone jumped into this pool!]
  • "Our direct pool risk in force was $3.1 billion, $2.9 billion and $3.0 billion at December 31, 2006, 2005 and 2004, respectively. These risk amounts represent pools of loans with contractual aggregate loss limits and those without such limits. For pools of loans without such limits, risk is estimated based on the amount that would credit enhance the loans in the pool to a `AA' level based on a rating agency model. "[I don't know about you but when I read "credit enhance" in the same sentence stating "without such limits", red flags go off. But perhaps it is my ignorance]
  • "Net premiums written and earned during 2006 decreased, compared to 2005, due to lower average premium rates, offset by a slight increase in the average insurance in force. Assuming no significant decline in interest rates from their level at the end of February 2007, we expect the average insurance in force during 2007 to be higher than in 2006 because insurance in force at December 31, 2006 was at the highest level of any quarter-end in 2006 and our expectation, discussed under "NIW" above, that private mortgage insurance will be used on a greater percentage of mortgage originations in 2007. [Due to competition we didn't charge enough premium for the risk taken on and given that things are so bad in the mortgage market, there will be a greater demand for mortgage insurance].
  • "As discussed in "Critical Accounting Policies," consistent with industry practices, loss reserves for future claims are established only for loans that are currently delinquent." [Here's my problem with this...and I've seen this type of qualifying/hedging language in all of reports that I've read. . . I think that they are really saying, we think that these loan losses will be higher but we are going to do things the way we've done them in the past. I say...look out ahead for big loan losses as the 2006 tranche of loans start to turn ugly.]
  • "Loss reserves are established by management's estimation of the number of loans in our inventory of delinquent loans that will not cure their delinquency and thus result in a claim (historically, a substantial majority of delinquent loans have cured)." [More hedging language--but to their credit, loss reserves is part art and part science. My guess is that the "art" that they refer to is "black" art (like black magic). I will read every report they issue this year. If I'm wrong, I'll be graceful about it. If I'm right I will bray like a donkey].
  • "The increase in estimated severity is primarily the result of the default inventory containing higher loan exposures with expected higher average claim payments as well as a decrease in our ability to mitigate losses through the sale of properties in some geographical areas." [This is why the economic outlook is so critical.]
  • "In the fourth quarter of 2006 California and Florida began to experience less favorable housing markets, which will likely increase the actual claim rates and severity in those areas." [We think something is looming, but we are not going to do anything about it for reasons that we told you about before.]
  • Discussion of purchase of Fieldstone: "At September 30, 2006, Fieldstone owned and managed a portfolio of over $5.7 billion of non-conforming mortgage loans originated primarily by a Fieldstone subsidiary. These mortgage loans are financed through securitizations that are structured as debt with the result that both the mortgage loans and the related debt appear on Fieldstone's balance sheet. The closing of the acquisition will not change this balance sheet treatment. At September 30, 2006, according to information filed by Fieldstone with the Securities and Exchange Commission, Fieldstone's assets were $6.4 billion; its liabilities were $6.0 billion; and its shareholder's equity was $424 million. [Not a terribly robust spread given the amount of loan losses that are likely--MTG's loan losses on drecht debt is 14%--not much coverage which is why they are giving up the ghost.]
  • "The transaction supports C-BASS's fundamental business premise of using servicing provided through Litton to increase the returns on mortgage assets owned by C-BASS. The acquisition of Fieldstone will also provide C-BASS with mortgage origination capability. Subprime Market: Significant dislocation occurred in the subprime mortgage market during February 2007. Spreads on non-investment grade and non-rated subprime mortgage securities, which are the bulk of C-BASS's mortgage securities portfolio, increased dramatically through February 23, 2007, when our Management's Discussion and Analysis was finalized. Unless spreads return to their level at the end of January 2007, C-BASS will experience expense from negative mark-to-market revaluations of these assets." [These credit spreads are what are going to hit in waves and cause mark to markets--NO ONE who is knowledgeable is really quantifying this! I'm not knowledgeable, please let me know if you see analysis.]
  • "As noted under "Our income from joint ventures could be adversely affected by credit losses, insufficient liquidity or competition affecting those businesses--C-BASS" inItem 1A. of this Annual Report on Form 10-K, t he substantial majority of C-BASS's on-balance sheet financing for its mortgage and securities portfolio is dependent on the value of the collateral that secures this debt. When spreads increase, additional cash (margin) must be provided to the lenders to offset the related decline in collateral value. C-BASS has maintained substantial cash resources against the risk of spreads increasing by amounts that are substantially greater than have been experienced in February 2007 through February 23, 2007. Hence, we do not believe the spread increases experienced in February 2007 through February 23, 2007 have materially impaired C-BASS's liquidity. C-BASS also maintains substantial liquidity to cover additional margin that may be required when C-BASS's interest rate risk hedging instruments decline in value as a result of short-term interest rate declines. "[No matter which way interest rates go, somebody is going to suffer.]

5 comments:

Gemma Star said...

This is significant, important information. Thank you for digging it out.

It's not pretty and it's also challenging to understand and grasp, which is why your comments are so helpful in terms of trying to interpret it.

I'm not competent to dig into this. Anyone else out there able to comment??

joey said...

ah, MaGIC...I myself spent several hours reading a 10K last August; and was slack jawed in amazement at the risk management/business practices which they reported...like you, I thought it worth highlighting that loss reserves are set up after the loans are delinquent...and, as we well know, delinquency isn't identified until well after the fact...it's a very good practice to lock the barn door after the horse is out... I took so many notes about troublesome flags that I got writer's cramp...
I haven't returned for a reread and haven't checked my notes - and I stand to be corrected - but I believe that the mortgage insurance is added to the loan (hence prepaid); but, the reality is that in yesteryear, very few of those loans would have been carried to term - that was evident from MaGIC's tables and charts - because in an environment of rapidly rising house prices, the mortgagors were refinancing to take out their equity or selling their houses to buy a better house. So, with the front end load of the insurance, MaGIC was getting disproportionately higher premium...such a tragic pity that times have changed...
anyway, what I did was buy some jan08 puts; and in the successive interval 'til recently have been amazed - and in the red - as MaGIC has levitated...
what sleight of hand...

holding FNM puts was not a rewarding trade last year either.

I appreciate your musings...keep muttering...

Leisa said...

I'd also recommend looking a Fidelity Guaranty Insurance Company's website (FGIC.com). You can pick up the Moody's, Fitch's and S&P rating reports to include Moody's industry outlook. There's lots of interesting stuff about risk in the market, the increasing risks that these firms have taken on and the narrowing of risk to capital ratios.

joey said...

thanks Leisa.
I'll check that out.
I also have some July Countrywide puts - up about 150%;
and, Jan08 HSBC puts
With the MTG and HSBC LEAPS, I hate to cash out precipitously, as there is so much premium paid...
just learning here...options are new quivers...

~ Nona said...

Joey,

Re: Leisa's musings (which you enjoy) and your exhortation (that she keep muttering), I say....

HEAR! HEAR!