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.]
  

Sub Prime .....Tick, Tick, Tick

I'm making it a point to educate myself in understanding the sub-prime mortgage ticking time bomb. My hypothesis is this: Sub-prime is a symptom of something much larger. It represents a vast ocean of money in search of yield. To meet the demand for yield, a preponderance of structured debt obligations were created. It represents the shifting of risks from the traditional holders to a broader base of holders who may be holding instruments in which all of the opportunity has been wrung out in terms of fees for all of the specialized handlers but none of the risk has been mitigated or perhaps even fairly reflected in the yield.

As I share this information with you, I will ascribe credit to the sources that I use, and as always, qualify my opinion on (as well as my ability to research) such matters as being woefully constrained by my general ignorance in how these sophisticated instruments work. What is becoming apparent to me, and I have no wish to disparage any party, is that this environment has been a very fee rich environment where the rewards are great and the risks (except to the ultimate purchasers of these obligations) are small. I'm willing to bet that the re-packaging of this risk and distributing it downstream eliminated the traditional safety valves that would have curtailed continued lending. In this fee rich/risk free environment, ordinary prudence was hit over the head and wrapped in a rug. Well, there are quite a few of these ordinary prudence corpses strewn about, and the air will begin to fill with the stench of them. I think we got our first whiff this past week. I'll also add...this stuff makes my head hurt.

Now, there are lots of people in the food chain of the structured debt obligations. My goal is not to provide an exhaustive detailing of that, but rather I'll provide you with links to resources along the way. My first recommendation is that you read Wikipedia's entry for collaterized debt obligations and mortgage backed securities. If you are balking at reading Wiki's entry, let me remind you that this knowledge is part of your continued erudition AND you will be the center of attention at your next cocktail party as you explain to others about the potential problems involved. Seriously folks, I believe that this will be as troublesome as the junk bond fiasco. So as a citizen, take 20 minutes to educate yourself. Yen carry trade--laugh at it. I don't think it is anything compared to the possible unwinding of these structured debt obligations. My greatest hope? That I'm wrong.

My first bit of research is to provide you with the following table. It is only slightly amended from the original table which you can find referenced within the table. While there are other types of asset back securities, I chose to limit the table to mortgage-related issues. This table shows the people who have insured the securities. in addition to sizing the total market for 2005 and 2006. As you can see (and presuming my understanding is correct) less than 5% of the total amount issued has been insured. You may also find it interesting to note that FGIC (Fidelity Guaranty Insurance Company is owned partially by Blackstone).

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Median Price/Earnings

Okay, you saw it here first. I decided to do some nosing around, and I think that I have done something reasonably credible. I did it on a national basis. I'm pretty confident that you would find much wilder swings. I'm not a statistician, nor do I play on on TV, but I think this supports my point.

Bottom Line: To maintain the same median income to median home price in 2006 from 2000, the median household income would have to be ~40% higher. The household would have to be earning $67K v. $48K.
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P. S: 4.49 p.m. The actual median price of a home discussed in the news is about ~230K. I'm not sure why there is a difference between how I calculated and/or applied the index. Suffice, to say, though, the point still sticks if not more conservatively stated here.