Genworth MI reports Q4-2016

Genworth MI (TSX: MIC) reported their fourth quarter a couple weeks ago. This post is a little late in the game (and irritatingly, a conference call transcript has not been made available and I have had to suffer the indignity of actually listening to the conference call). By virtue of the Canadian housing market not imploding over the quarter, the company likely exceeded market expectations, which registered a 10% price spike since their announcement.

Here are some of my takeaways:

* Loss ratio is exceptionally low, at 18% for the quarter. Management projects 25-35% for 2017 as they identified that Fort McMurray and Quebec were abnormally low in Q4-2016 and that a more normalized loss ratio is to be expected in BC and Ontario (which have been quite dormant in terms of mortgage defaults).

* Book value is up a little bit to $39.28, which is $2.46 more than the previous year. The market value continues to converge to book.

* Premiums written, Q4-2015 to Q4-2016, was down about 20%. Portfolio insurance is down as expected per the rule changes, and transactional insurance is down due to the changes in the mortgage rules. The new capital requirements and new premium changes will kick in at the end of March which will offset reduced volume with price increases.

* Investment portfolio continues to be managed in line with previous quarters, in addition to the losses incurred by the preferred share portfolio seemingly normalizing (and if rates continue to rise, discounted rate-reset shares should fare quite well in that environment).

* Regulatory ceiling for private mortgage insurance was raised from $300 billion to $350 billion, which makes this a non-factor for the next while (a low risk that did not materialize).

* New capital requirements result in a “recalibration” of the minimum capital test ratio. The company is internally targeting 160-165%, and each percentage point is about $25 million in capital. Once they head over 165% then the surplus will likely be distributed via buybacks or dividends – it does not look like anything special is going to happen on this front in 2017 as they will be using retained earnings in order to buffer the capital levels. The new OFSI regulations have grandfathering components with respect to the capital requirements which should mathematically ease in the new capital requirements (especially with the evaluation and testing of the mortgage books acquired 2016 and earlier), but the MCT ratio is not likely to materially climb higher to the point where one can start thinking of extra dividends or buybacks.

* Insiders have exercised options and dumped stock after the earnings release, which is a negative signal.

I will warn readers that I have also lightened my own position in Genworth MI in the days ahead (i.e. after they announced) of the earnings announcement, my first sale since the second half of 2015. The last quarter was undoubtedly a good one for the company. I still have a large position in the stock, but I was reducing my position strictly for reasons that it had gotten too concentrated and I want to reduce my overall portfolio leverage. There is still a lot of runway for Genworth MI to run up to the low 40’s as they have everything going correct for them fundamentally and are generating a lot of cash in a semi-protected business environment. The whole country has been so bearish on Canadian housing that they forget to realize there are considerable pockets of profitability and Genworth MI is one of the spaces where there is money that continues to be made – I am guessing that the short sellers have gotten killed on this one.

CMHC increasing mortgage insurance premiums

CMHC announced this morning they will be increasing mortgage insurance premiums on March 17, 2017.

The changes are significant for those interested in mortgages with a 10-20% down-payment:

Loan-to-Value Ratio Standard Premium (Current) Standard Premium (Effective March 17, 2017)
Up to and including 65% 0.60% 0.60%
Up to and including 75% 0.75% 1.70%
Up to and including 80% 1.25% 2.40%
Up to and including 85% 1.80% 2.80%
Up to and including 90% 2.40% 3.10%
Up to and including 95% 3.60% 4.00%
90.01% to 95% – Non-Traditional Down Payment 3.85% 4.50%

The changes were a result of the OFSI changing the capital holding requirements of mortgage insurance institutions in Canada (affecting CMHC, Genworth MI and Canada Guaranty) and I have telegraphed this well in advance in my previous analyses of Genworth MI.

It is quite probable that Genworth MI will follow suit and this will result in a substantial increase in premiums written for the company in the 2nd to 4th quarter of 2017. The market has not picked up on this at all.

Details of Genworth Financial merger

There are lots of juicy details of the merger proposal with Genworth Financial in their preliminary proxy filing. In particular there are some hints that Genworth MI in Canada will get sold off whether this merger is successful or not.

Despite all short-sellers and naysayers believing that the Canadian housing market is going to crap, Genworth MI continues to appreciate post-Trump and is still trading 10% below their book value. They’ll continue to be mystified when the stock will break through its all-time highs it reached back in November 2014:

Not coincidentally, that’s when I last sold shares. I will note the price has been adjusted multiple times due to their rather large dividend (currently $1.76/share), and whether the Genworth Financial merger is successful or not, it is quite probable that Genworth MI Canada will be sold for as much as can be sought for it, because doing so before the Canadian housing market collapses is the only smart thing to do.

In terms of valuation, one can make a good claim for over CAD$40/share.

The market is also not appreciating at all the notion that mortgage insurance rates will be headed higher in early 2017 due to capital changes. The last time mortgage insurance rates went higher, the stock went up about 10%.

They are also somewhat buoyed by the “good politics, bad policy” decision by the BC government to extend a 5-year interest-free loan, matching dollar-for-dollar on the first 5% of a downpayment (for an insured mortgage). It would be a poor decision for a prospective buyer in BC to not take advantage of this, but they would need to pay mortgage insurance to do so.

Genworth MI reports Q3-2016

Genworth MI (TSX: MIC) reported their Q3-2016 report. This was a very “steady as she goes” type report fundamentally, with little hidden surprises. Some highlights:

* Stated book value per share is $39.01 (means the company is trading 29% below book value, which is a huge discount – I will also point out there is about $2.48/share of goodwill, intangibles and the deferred policy acquisition costs, so the most absolute conservative valuation of tangible book value is roughly $36.50/share diluted).

* Loss ratio goes to 25%, up from 20% in the previous quarter mainly due to oil-producing (Alberta, Sask) delinquencies and defaults. Delinquency rate is still at 0.10%.

* Investment portfolio is up another $200 million in invested assets (3.2% average yield).

* Transactional written insurance premiums down 15% from quarter of previous year; portfolio insurance up 7%, which was somewhat surprising given the rule changes after Q2-2016 (quarter-to-quarter comparisons here are not that useful due to seasonality).

* Minimum capital test under soon-to-be-replaced OSFI rules went up to 236% from 233% in previous quarter.

* Dividend raised from 42 to 44 cents (I was expecting a 3 cent raise, but this is probably to ensure they keep raising capital levels for the new rule changes – market may not like this although in strict financial theory they’d do best to scrap the dividend and repurchase shares at current prices).

* Credit score increases of client averaging 752 from 744, gross debt service level is 24% (would lead one to suspect that absent of catastrophe, clients would continue to pay mortgages above all else)

* They seemed to figure out how to stop losing money on buying Canadian preferred shares. They really should just outsource this to James Hymas, who I am sure will be able to provide superior risk/reward on these investments.

The big question is the looming impact of regulatory changes, an issue previously discussed on this site. Some snippets:

* On the issue of OSFI capital calculation changes, the “new” target is 150% (from 220%), and in the new framework, they are at 155-158%, the previous June 30, 2016 quarter had it at 153-156%.

* Impact of BC announcement of 15% property transfer tax on foreign buyers in Vancouver area:

As of August 2, 2016, foreign individuals and corporations will be subject to an additional 15% land transfer tax on the purchase of residential property in Metro Vancouver. The Company does not expect these changes to have a material impact on its business, as foreign borrowers are typically not eligible for high loan-to-value mortgage insurance.

* Impact of the mortgage changes and applicability of transactional and portfolio insurance on various mortgage properties:

After the Company’s review of the mortgage insurance eligibility rule changes announced October 3, 2016, it expects that the transactional market size and its transactional new insurance written in 2017 may decline by approximately 15% to 25% reflecting expected changes to borrower home buying patterns, including the purchase of lower priced properties and higher downpayments.

As the result of clarifications provided by the Department of Finance after the October 3, 2016 public announcement, the Company now expects that portfolio new insurance written in 2017 may decline by approximately 25% to 35% as compared to the normalized run rate after the July 1, 2016 regulatory changes for portfolio insurance. The new mortgage rules prohibit insuring low loan-to-value refinances and most investor mortgages originated by lenders on or after October 17, 2016.

Notes: I had anticipated transactional insurance would drop by 1/6th (so this is within the 15-25% estimate), and I thought portfolio insurance would get completely shot up (which is going to be the case).

Basic calculations would suggest that if transaction insurance gets dropped 20%, the annual run-rate is about CAD$521/year, plus whatever insurance premium increases that will happen in 2017 as a result of heightened capital requirements. I had originally given some conjecture that this number would be CAD$570 in the end – which is still a pretty good number even if the combined ratio goes up to 60% or so – you’re looking at a very, very, very profitable entity.

Portfolio insurance will taper down and contribute about $60 million/year in written premiums.

Going forward, Genworth MI should produce about $570-580 million/year in written premiums, without increases in mortgage insurance premiums.

Cash-wise, at a 50% combined ratio (30% loss and 20% expense) and a 26% tax rate, shareholders are looking at $210-215M/year or about $2.32/share in operating net income. A $6.2 billion investment portfolio at 3.2% blended yield gives $1.60/share, taxed at 26%. Combined, the entity would still pull in cash at $3.92/share – considering the $27.86 share price currently, this is trading at a P/E of 7, at a book value of 30% below par… needless to say, an attractive valuation.

I generally do not care about the top-line revenue number as this just represents an amortization formula of the unearned premium reserve. However, analysts and uninformed members of the public do tend to care about this since revenues translate into bottom-line results, and this number will continue to rise over the next year above the $162 million they booked this year. The only thing that will change this is a change in claim experience and time – for any given insurance policy, more of it gets booked in the earlier stages of the policy than the later ones. The increasing revenue number will result in higher amounts of higher reported net income, and higher EPS.

Questions for conference call:
– Impact of Genworth Financial’s acquisition on Genworth MI – what restrictions would there be on equity repurchases – and asking about the out-right sale of the MIC subsidiary (which, at current values, has to be put on the table);
– Ability/willingness for Genworth MI to repurchase shares at extremely discounted book value per share prices;
– Regulatory impact of private mortgage insurance $300 billion cap (currently at $275 billion for all private entities, MIC at $221 billion);
– What the MCT internal target will be with the new OSFI capital regime.

Final thoughts: Right now, repurchasing shares of Genworth MI is such a no-brainer shareholder-enhancing decision. I hope management can snap on it. The common shares are trading on the basis of Canadian real estate fear and not in any regard to the underlying financial reality which show an entity that is generating a massive amount of cash.

Genworth Financial bought out

Imagine my initial surprise when I saw a news feed that Genworth had been bought out. Unfortunately for me, it was Genworth Financial (NYSE: GNW) and not Genworth MI (TSX: MIC).

Genworth Financial is being taken over by China Oceanwide Holdings, chaired by Lu Zhiqiang, who apparently has a networth of $5 billion.

In the press release, there are scant details. They mentioned the buyout price and the intention of the purchaser to inject $1.1 billion of capital into Genworth to offset an upcoming 2018 bond maturity and shore up the life insurance subsidiary, but the release also explicitly stated a key point:

China Oceanwide has no current intention or future obligation to contribute additional capital to support Genworth’s legacy LTC business.

The LTC (long-term care) insurance business is what got Genworth into trouble in the first place, and its valuation is the primary reason why the company’s stated book value is substantially higher than its market value.

The press release also declared that this is primarily a financial acquisition rather than a strategic one, with management and operations being intact.

One wonders how long this will last.

Since Genworth Financial controls 57% of Genworth MI, it leads to the question of what the implications for the mortgage insurance industry will be – and it is not entirely clear to me up-front what these implications may be. Will the government of Canada be comfortable of 1/3rd of their country’s mortgage insurance being operated by a Chinese-owned entity? What is the financial incentive for China Oceanwide’s dealings with the mortgage insurance arms of Genworth Financial (noting they also own a majority stake in Australia’s mortgage insurance division)?

One thought that immediately comes to mind is that if Genworth Financial is not capital-starved, they will no longer be looking at ways to milking their subsidiaries for capital. In particular, if Genworth MI decides to do a share repurchase, they might opt to concentrate on buying back the public float (currently trading at a huge discount to book value) instead of proportionately allocating 57% of their buyback to their own shares (in effect, giving the parent company a dividend). This would be an incremental plus for Genworth MI.

Finally, one wonders what risks may lie in the acquisition closing – while it is scheduled for mid-2017, this is not a slam dunk by any means. Genworth Financial announced significant charges relating to the modelling of the actual expense profile of their LTC business and it is not surprising that they decided to sell out at the relatively meager price they did – there’s probably worse to come in the future.

However, as far as Genworth MI is concerned, right now it is business as usual. There hasn’t been anything posted to the SEC yet that will give me any more colour, but I am eager to read it.

(Update, early Monday morning: Genworth 8-K with fine-print of agreement)

Yes, I’ve read the document. Am I the only person on the planet that reads this type of stuff at 4:00am in the morning with my french-press coffee? Also, do they purposefully design these legal documents to be as inconveniently formatted as possible, i.e. no carriage returns or tabs at all?

A lot of standard clauses here, but some pertaining to subsidiary companies (including Genworth MI), including:

(page 47): Section 6.1,

the Company will not and will not permit its Subsidiaries (subject to the terms of the provisos in the definition of “Subsidiary” in Article X) to:

(viii) reclassify, split, combine, subdivide or redeem, purchase or otherwise acquire, directly or indirectly, any of its capital stock or securities convertible or exchangeable into or exercisable for any shares of its capital stock (other than

(A) the withholding of shares to satisfy withholding Tax obligations

(1) in respect of Company Equity Awards outstanding as of the date of this Agreement in accordance with their terms and, as applicable, the Stock Plans, in each case in effect on the date of this Agreement or
(2) in respect of equity awards issued by, or stock-based employee benefit plans of, the Specified Entities in their respective Ordinary Course of Business and

(B) the repurchase of shares of capital stock of Genworth Australia or Genworth Canada by Genworth Australia or Genworth Canada, as applicable, pursuant to share repurchase programs in effect as of the date hereof (or renewals thereof on substantially similar terms) with respect to such entities in accordance with their terms);

(note: Genworth MI’s NCIB expires on May 4, 2017)

(page 53): (e) During the period from the date hereof to the Effective Time or earlier termination of this Agreement, except as set forth on Section 6.1(e) of the Company Disclosure Letter, or as required by applicable Law or the rules of any stock exchange, the Company shall not, and shall cause any of its Subsidiaries that are record or beneficial owners of any capital stock of or equity interest in Genworth Canada or any of its Subsidiaries not to, without Parent’s prior written consent (which consent, in the case of clauses (ii)(B) and (iii) below (and, to the extent applicable to either clause (ii)(B) or clause (iii) below, clause (iv) below) shall not be unreasonably withheld, conditioned or delayed):

or (z) any share repurchases that would not decrease the percentage of the outstanding voting stock of Genworth Canada owned by the Company and its Subsidiaries as of the date hereof)

(note: Hmmm… this does open the door for repurchases).

I’m still unsure of the final implication on Genworth MI other than the fact that if this merger proceeds that the parent company is going to lean less on their subsidiaries for capital.

Genworth MI: Opposing arguments

Interesting article posted by David Desjardins on Seeking Alpha – he has purchased deep out-of-the-money put options (January 2018 puts with a strike of 18) and is clearly anticipating a drop further in the stock price.

His arguments can be summed up as follows:

1. Vancouver housing prices are ridiculously high, inventories are climbing, and prices are dropping;
2. Alberta unemployment is at relative highs and their delinquency rates should spike to 2010 levels;
3. Ontario housing prices have ascended and when they taper, delinquency rates should rise to averages;
4. Higher delinquencies will result in higher claims, and these claims will have a serious negative impact on the corporation;
5. Increased capital requirements, both as a result of claims but government regulatory changes, will require MIC to issue shares.

My comments:

1. My own overall thesis is that we will see a tapering of pricing demand in the urban real estate markets, but not a crash. The housing targeted to foreign interests will depreciate considerably (my own on-the-ground research has shown this has had a 10-15% impact on asking prices in BC), but these markets have not been eligible for mortgage insurance since July 7, 2012. The spill-over is what happens to the townhouses and condominiums in the Vancouver marketplace – there will be undoubtedly be price compression due to decreased demand as a result of decreased credit availability.

I do agree, however, that BC’s delinquency ratio (currently 0.07%) is abnormally low. Ontario’s (0.04%) is also abnormally low, but the company’s loss ratio guidance has always been above the expectations of what delinquency numbers would imply – original 2016 guidance was 25%-40%, but it is fairly obvious that it is going to be well under 40%, and they decreased the upper band for loss guidance to 35%.

2. If we see the delinquency rates as he suggests in his article (1% in BC, 0.7% in Ontario), then Genworth MI and CMHC will be in very rough shape. You would see a significantly lower stock price and you will be seeing huge political ripples about the whole Canadian housing market going from boom to bust in short order. Genworth MI’s peak delinquency rate was 0.3% in June 30, 2009 during the 2008/2009 global economic meltdown, and their loss ratio was 46%. It is not a stretch that a delinquency ratio larger than that would be the result of another meltdown in equal size, something I do not believe in the offering.

If the author’s worst case scenario of 1.5% delinquency rates occur in the insured mortgage space then you will be seeing crisis headlines that would ripple well beyond the financial state of the mortgage insurance industry.

It is also important to note that lending practices in the USA during 2008-2009 had significant differences than lending practices in Canada today.

3. Genworth MI, in general, has a healthier mortgage insurance portfolio than CMHC (I will leave speculation why out of this discussion). In Q2-2016, Genworth MI’s delinquency rate was 0.1%, CMHC was 0.32%. Any changes in regulatory burdens will impact CMHC’s profitability more so than Genworth MI; while this doesn’t directly impact whether there will be a spike in delinquencies, the federal government clearly does not want to knee-cap its own crown corporation in the process (one that generated about $550 million in net income to the Crown in the first half of this year).

4. Housing prices are the primary driver of claim severity, while unemployment is the primary driver of claims. Insured mortgages in Canada are full-recourse, which means the metric to watch for is unemployment and not housing prices. An unemployment rate of 7% nationally is not concerning for housing.

5. In Alberta, unemployment is anti-correlated with increases in energy prices and has probably peaked around 9%. Housing prices have decreased by 5-10% in the province, and delinquencies have climbed from 0.09% (Q2-2015) to 0.17% (Q2-2016), but this has been well-anticipated by management. Delinquencies peaked in Alberta at 0.62% for Genworth MI in Q4-2010 (the primary after-effect of oil going down to US$33 at the beginning of 2009). My estimate for delinquencies in Alberta should taper off around 0.25-0.3%.

6. The author appears to be misunderstanding the minimum capital test. The new regulations by OSFI introduce a new regime for minimum capital required to retain insured mortgages. While the statutory minimum is 100%, the supervisory target is 150%, and the company typically keeps an internal buffer higher than the supervisory target to ensure that month-to-month operations do not bring the ratio under 150% – the pro-forma at Q2-2016 was 153-156% of the new MCT, while I suspect the internal target will be somewhat higher. Genworth MI will book another $100 million of after-tax income for the second half of the year (after dividends) and this will push it to the 160% level. They do not need to raise capital – they just need to slow down issuing insurance and continue amortize their current book.

In addition, there are transitional arrangements to the new capital levels that will only “kick-in” after they are lower than the old capital test levels. That said, the old and the new capital test levels include a 20% buffer for “operational risk”, and since the new capital test levels are higher, this will also increase the capital required for operational risk (which in the new rules, is the operating capital minus the supplementary capital required for insuring mortgages in “hot” markets). This increase in required capital is transitioned in over a 3 year period.

The effect of these changes, however, will definitely increase capital required for mortgages, especially for lower ratio mortgages:

mct

These changes affect MIC and also CMHC. CMHC is relatively less affected as in Q2-2016, its MCT level was 366%.

As a result of these changes, I expect transactional mortgage insurance origination to decrease significantly (guessing around 20%). As I said before, if Genworth MI stopped writing insurance, their share price would still increase as their liability book would shrink and capital is released for asset distribution.

7. 92% of MIC’s mortgage business is written on loans under $550,000. 8% would be between $550k to $1M. In relation to income capacity of borrowers, this does appear to be reasonable (especially considering the average gross debt service ratio of borrowers is a reasonable-sounding 24% on Q2-2016).

8. Even if home values drop below mortgage values, the option to strategically default in Canada is much, much more expensive due to full recourse rules on insured mortgages. As long as people are employed, they will continue paying their mortgages (albeit be a bit bitter about paying down a debt on a property that is valued less than the debt).

While the author’s “what-if” estimates in the event of a spike in delinquencies is an excellent stress test, they appear to stem from a scenario that is the result of something worse than what happened in 2008-2009. If the 2008-2009 scenario happened, there are far better short sales out there than Genworth MI (candidates that come to mind include HCG, EQB, FN, etc.).

Recall that Genworth MI went public in 2009 at CAD$19/share (the first window of opportunity after the financial crisis) and this was a forced IPO because Genworth Financial desperately needed to raise capital. CAD$19 back then was a fire-sale price and the entity today is larger and more profitable than it was back then (and also noting that they had 117.1 million shares outstanding after IPO, compared to 91.9 million today) – and they IPOed at 10% under book value, compared to 25% under book today!

Mortgage changes and Genworth MI valuation

By now the whole nation has heard of the proposed changes to mortgage financing and insurance requirements for Canadian mortgages.

Genworth MI (TSX: MIC) evaluated the impact of these changes and the payload of this was in the following paragraphs in their press release issued 4 minutes after the market opened yesterday:

Based on year-to-date 2016 data, we estimate that a little over one third of transactionally insured mortgages, predominantly for first time homebuyers, would have difficulty meeting the required debt service ratios and homebuyers would need to consider buying a lower priced property or increase the size of their down payment.

Furthermore, approximately 50% to 55% of our total portfolio new insurance written would no longer be eligible for mortgage insurance under the new Low Ratio mortgage insurance requirements.

The market proceeded to take MIC down from about $34 to $30 in short order, presumably on the basis that a third of their mortgage insurance market is going to get knee-capped due to customer income requirements.

mic

It is important for the reader to understand the difference between transaction insurance (which the typical retail investor is familiar with) and portfolio insurance (which is where a financial institution purchases insurance on its own behalf for the purpose of assembling mortgages and securitizing them for selling in the secondary marketplace).

I am generally of the belief that despite these regulatory changes, Genworth MI is very much undervalued at present pricing. There are quite a few variables at play in this space, which I will go over as follows:

1. On the basis of premiums written, portfolio insurance was 13% of Genworth MI’s business in 2015. There was a regulatory change (dealing with mortgage substitutions and time limitations for portfolio insurance) that is effective July 1, 2016 which caused a one-time spike in portfolio insurance demand in Q2-2016. The portfolio insurance market was already effectively squelched by regulatory change and this further change will dampen it further.

Because portfolio insurance is written on low-leverage mortgages, they are akin to selling significantly out of the money put options on mortgages. In Q2-2016, Genworth MI insured $26 billion in mortgages via portfolio insurance, but this only generated $78 million (0.3%) in premiums (the median loan-to-value was 65-70%).

I would anticipate that portfolio insurance will be a very small part of the future mortgage insurance market – I’d be surprised to see more than $10 million in premiums each quarter going forward.

2. Transactional insurance is the bread and butter of the business. The question is how much of consumer demand for insurance will be eliminated because consumers failed to pass the affordability test (due to using the Bank of Canada posted rates) versus these consumers simply choosing to downsize their financing requirements to fit with the new mortgage insurance parameters.

My initial estimate would be that transaction insurance would slow down by about 1/6th of ambient levels instead of the 1/3rd backward-looking estimate given in the release. The past four quarters had $686 million in transactional premiums written. Going forward, I’d expect this to decline to around $570-ish.

3. Clearly these changes are going to result in less premiums written for Genworth MI (and also CMHC). However, this will not impact the existing mortgage insurance portfolio. If Genworth MI decided to stop underwriting all business and decided to run off its mortgage book, shareholders would still be looking at north of their Q2-2016 book value of $38.23/share as the company recognizes revenues. In a relatively normal environment, the company’s projected combined ratio should be around 45-50% (which is above what it has typically been) and the unearned premiums (currently of $2.08 billion) would likely amortize to another billion in pre-tax income if the book were to be run off.

The terminal value of the operation, with the assumption they decide to shut everything down, would be very well north of the existing book value, and most of this capital would be freed up completely after 5 years (customers would have their mortgages amortized to a point where mortgage losses would virtually be impossible).

There are various ways to value companies, but they all generally depend on a function of income expectation and how much cash can be liquidated from the balance sheet if operations were to cease. In Genworth’s case, there is a huge margin of error between current market value, current book value, and a reasonable expectation of performance in future years.

Simply put, the market is valuing Genworth MI as if it is going to lose money in the future. I do not believe this is a reasonable assumption even though this Canadian government appears hell-bent on pushing us into a tax-induced recession.

4. OFSI has released a draft proposal concerning the capital requirements of mortgage insurance companies, and in general this will require Genworth MI to retain more capital for its existing mortgage insurance portfolio. The reason is that the new capital requirements introduce a supplemental capital requirement for housing markets that are “hot”, which is determined by a price to income ratio. It is likely that mortgage insurers are going to raise premiums in 2017.

Genworth MI’s policy has been to keep its capital base above a certain level above its internal minimum (in the new proposal, the fraction will be above 150% of the revised minimum capital test) and distribute the rest of it in buybacks and dividends. Although the future rate of premium collection will be less, the company will be in a position to repurchase shares at a considerable discount to book value.

5. These changes in capital requirements force mortgage insurance companies to heavily err on the side of conservatism, both in terms of balance sheet strength and insuring customers that are quite strong (via the posted rate interest test).

6. The parent company (Genworth Financial) has stabilized considerably since last year and I still believe a low probability scenario is for them to exit the Canadian mortgage insurance market through a sale of the entity. They could certainly fetch more than CAD$30/share, but the question would be who the buyer would be – there are not a lot of obvious well-capitalized candidates, but I would think of Fairfax or even the CPPIB or a Canadian pension fund doing so.

7. It didn’t take a rocket scientist to realize that the government announcement of October 3, 2016 would be negative for transactional and portfolio insurance volumes, yet the market only reacted when Genworth announced the retrospective impact of the changes. Yes, I should have been there on the morning of October 4th and pounded the bid, but I was asleep at the switch and I would have expected the negative market reaction to be on October 3 and not a day after!

8. In relation to the rest of the financial entities trading on the TSX, Genworth MI is very much undervalued and the market has over-applied the negative effects of the regulatory change on the company by weighting its impact on future premiums written too heavily. Genworth MI could easily give its shareholders a boost by announcing a wind-down of operation and a release of capital as mortgage insurance policies amortize, but they will not do this simply because Canadian mortgage insurance is still too profitable. In the first half of 2016, they make approximately a 60% profit of every dollar of premium they recognize. Why give this up?

Where should Genworth MI be trading? Higher than what the market is currently valuing it. This is a fairly strong buy on my radar, despite the fact that it has been a long-term core holding since 2012 when I first invested.

Genworth MI – Despite housing slowdown, still undervalued

mic

Genworth MI (TSX: MIC) has gone nowhere in the past three months, despite the corporation lowering losses from insurance claims and the housing market being relatively stable to date. The company trades at a 10% discount to book value, and also at a P/E of 9 (realizing that these two metrics are not the only ones that insurance companies should be valued by, but suffice to say, unless if the insurance written is completely bad, it is difficult to lose money when buying something under book and under a P/E of 10).

There are a few cautionary flags – the reduction of their portfolio insurance business (which allows third-party financing firms to securitize and sell their lower loan-to-value mortgages with portfolio insurance) and also the slowdown in housing sale volumes, combined with the attempts by the BC Government to quell foreign ownership with a 15% transfer tax for non-permanent residents or citizens.

In particular, the transfer tax has caused quite a quenching of the roaring housing fire that was occurring in the southwestern BC housing market. This in turn has spooked the various markets linked to residential real estate. However, it is my assessment that as it relates to mortgage insurance, the market has continually over-estimated the impact of the short-term gyrations in Canadian real estate.

What would cause issues is mortgage serviceability and this is a function of employment, not housing prices. Although there is correlation between housing prices and construction-related employment, if there is not mass unemployment it is difficult to see how somewhat lower housing prices would cause difficulties in the mortgage insurance space. Indeed, the $300 billion ceiling for private insurance in Canada seems to be more of a daunting barrier than the state of the actual insurance market.

It is worthy to note that during the depths of the 2008-2009 financial crisis that the loss ratio peaked out at 46% (June 30, 2009) and this still resulted in a profitable book for the firm. The subsequent combined ratio peaked at 62%, which means that for every dollar of revenue booked that the firm recorded a gross profit of 38 cents.

Also, the corporate has increased its quarterly dividend every year for the past 5 years – it is currently 42 cents and if prior patterns continue they will likely raise it to 45 cents per share. Although the yield is not important (cash generation is), there are various market participants out there that only care about yield and this would serve to boost the stock price.

Genworth MI Q2-2016 results review

Genworth MI (TSX: MIC) reported their 2nd quarter earnings results.

The results are reasonably positive for investors and a shade higher than what the market expectation would be.

Diluted book value per share goes to $38.23, up a dollar from the previous quarter (higher than net income minus dividends due to portfolio fluctuations).

Premiums written were $249 million, up significantly from $205 million in the Q2-2015, but this number was artificially higher due to the closing of the July 1, 2016 regulatory window for the issuance of portfolio insurance (i.e. future portfolio insurance issuances are likely to be significantly lower). Portfolio insurance written has been averaging about $24 million for the previous four quarters, but this quarter was $78 million. Transactional insurance (the type of insurance most people associate with mortgage insurance) was down 7% to $170 million.

Portfolio insurance has been quite profitable as the constituents of the loans are low loan-to-value ratio material – although the premiums received by the company are relatively low to the loans insured, these premiums are basically free money exchanged to entities so those other entities can free up the capital to make other loans. The government announced they were going to put a halt to this activity in the 2013 Budget as entities (e.g. HCG, EQB, etc.) were basically using government guarantees to increase their ability to perform higher amounts of mortgage lending. Now the lenders will have to take higher risk, which would potentially dampen the credit market for residential housing.

Other items of note include the following (quotations are from their MD&A):

The Company has reviewed the proposed methodology for calculating SCRIs and observed that Calgary, Edmonton, Toronto, Vancouver and Victoria would breach their respective prescribed SCRI thresholds at the end of the first quarter of 2016. These metropolitan areas represent approximately 35% to 40% of transactional new insurance written in the first six months of 2016.

Calgary, Edmonton and Vancouver would have been in breach of the prescribed SCRI thresholds since 2010 or earlier and are currently more than 15% above the respective SCRI threshold. The anticipated changes from the proposed new capital framework, including the proposed supplementary capital requirement may impact the regulatory capital requirements for the Company however the final impact will not be known until OSFI publishes the supplementary capital requirements. The Company expects that transactional and portfolio insurance premium rates may have to be increased for affected metropolitan areas as a result of the implementation of the new capital framework in 2017.

If the regulatory framework continues to tighten (i.e. more capital required for “hotter” markets), this would result in increased mortgage insurance rates and hence higher premiums written for future transactions – or perhaps premium surcharges for “hot” metropolitan areas. Not surprisingly, Vancouver is the epicentre of this.

During the quarter the Company entered into a $100 million senior unsecured revolving credit facility, which matures on May 20, 2019.

This was very mysterious. Genworth is solvent, their nearest debt maturity is not until June 15, 2020 ($275 million) and they have plenty of capital that they are using as a buffer until federal regulations are finalized. So why go through the bother to open up a credit facility? Odd.

(Update, August 3, 2016: Remarks were made in the conference call:

CFO: “It’s not earmarked at this time for any specific activity. It’s more in light of build-in financial flexibility to ensure that we’re nimble and whether this is core business opportunities in the MI business, for example, you saw the levels of bulk insurance as we did last quarter. If in the future other opportunities were to present themselves in our core business, and it require incremental capital, we certainly have long-term plans to fund that capital. We may use the facility for short-term need but it’s clearly not intended for a long-term portion of our capital structure.”)

The loss range for 2016 has been revised to 25% to 35%.

The company’s initial projections for losses were 25-40% for the year, but the upward range of this was lowered to 35%. For the first two quarters of the year the loss ratio averaged 22%. This is obviously a good sign for investors.

In order to help improve housing affordability, on July 25, 2016 the B.C. government introduced a four-pronged plan that includes an additional land transfer tax on foreign buyers. As of August 2nd, foreign individuals and corporations will be subject to an additional 15% land transfer tax on the purchase of residential property in Metro Vancouver. The company does not expect these changes to have a material impact on its business, as foreign borrowers are typically not eligible for high loan-to-value mortgage insurance.

I will parenthetically add that foreign buyers typically do not take out mortgages for properties either – these are cash payments as the real estate title is the vessel for storing cash offshore. Foreign investors would not have a requirement for mortgage insurance.

Also, delinquency rates have lowered from quarter-to-quarter. While Alberta and Saskatchewan have higher delinquencies, they have lowered significantly in Quebec. I would also estimate that the severity of the real estate market decrease in Alberta was less pronounced than projected.

Not everything is rosy, however. There are a couple other storm clouds worth noting:

1. The company has lost a considerable amount of money on its preferred shares. They have $49 million in unrealized losses as of the end of June on their preferred shares, which is down from $51 million at the end of March, but this is very sloppy pickings by their asset managers.

2. Private mortgage insurers are approaching a $300 billion cap:

The maximum outstanding insured exposure for all private insured mortgages permitted by the PRMHIA is $300 billion. The Company estimates, that as of March 31, 2016, the outstanding principal amount of insured mortgages under PRMHIA was $197 billion for Genworth-insured mortgages and $241 billion for all privately insured mortgages. While the federal government has increased the cap to ensure that the private sector can continue to compete with CMHC in the past as the total of the outstanding principal mortgage amounts has approached the legislative cap, there is no guarantee that this will continue. The Company estimates that the private sector will remain below the cap for the remainder of 2016 and the first half of 2017 based on the current market share of the private mortgage insurers and the forecasted size of the mortgage originations market.

The inability to capture more of the mortgage insurance market beyond $300 billion, needless to say, would be a negative – the company would have to run off the book and only acquire insurance at the rate that it expires. I am also not sure how Genworth would coordinate with the other private insurance company (Canada Guaranty) to collectively stay under the $300 billion mark. This is a line item that would need to be addressed in legislation, specifically the 2017 Budget, and I would not view the current government to be supportive of private industry in mortgage insurance markets.

Finally, I will observe that the company is unlikely to buy back shares or declare special dividends until such a point that the regulatory framework for capital holdings is solidified.

Overall, my conclusion still remains unchanged that Genworth MI appears to be somewhat undervalued at present (trading at 89% of book value, with a strong balance sheet and low loss ratios). The market is clearly pricing them lowly due to the increasing speculation of over-valuation of real estate pricing in Canada, in addition to the balance sheet issues faced by their parent company. Genworth MI appears to be very aware of the Canadian real estate issues at hand. As I have been long-since speculating, given the issues that are going on in the parent company (Genworth Financial), Genworth MI is a likely candidate to be taken over if Genworth Financial finds the correct (and willing) purchaser. The take-out price would most certainly be higher than the current market price.

Genworth MI update

I did not write an update to Genworth MI’s first quarter as it was relatively routine (albeit a slightly negative quarter in terms of premiums written). This decrease was due to the corporation being more conscious of what they were underwriting, in addition to slowdowns in oil-producing regions. Financially they continue to be wildly profitable, with a combined ratio of 42% and continuing to build book value (sitting at $37.23, about a 10% discount to market).

The company’s stock price has not gone anywhere over the past couple months:

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I look at peer companies, both in the financing and REIT domains and see nothing catastrophic occurring there.

There are a few interesting undercurrents that Genworth MI is facing, including:

1. Issues at the Genworth Financial parent company (this may result in financial pressure on their holdings – indeed, one scenario for Genworth MI is that they will be liquidated, hopefully at book or a premium to book value!);
2. The new Liberal government elected in Canada may introduce some curbs or regulatory burdens (via OFSI) which would encumber the insurance operation and/or empower CMHC;
3. Impact of oil prices and on the Alberta/Saskatchewan housing markets, although delinquencies have not risen beyond expectations to date;
4. The general insanity that can be found in the Vancouver/Toronto housing markets;
5. Provincial governments enacting curbs on transaction volumes and generally suppressing volumes that would otherwise stimulate the mortgage insurance market.

In addition, there are known regulatory changes concerning portfolio insurance transactions that were effective July 1, 2016 which would serve to decrease premiums received in what would be a fairly low-risk insurance market (such loans have loan-to-values ratios of less than 80%). Fortunately, these transactions have typically only been 10-20% of the premiums written in any single quarter.

About CMHC, they continue to deliver worse results than Genworth MI (quarterly reports for CMHC here) and their fraction of insurance covered in the Canadian market continues to decrease – a question remains whether they will attempt to take more market share, which would serve to deflate Genworth MI’s future premiums written.

With their present insurance book, as long as there is no general property market crash, they will continue to book revenues as mortgages are amortized and converge to at least book value. They also will be generating an excess of capital which management can decide to repurchase shares or declare a special dividend (which they typically do in the second half of the year). At present prices both are acceptable options although I really thought they should have bought back shares in January and February.

Genworth MI is still valued cheaply, but of course was not the screaming bargain it was when it was below $25 earlier this year. There is still capital appreciation yet to be had. In the meantime, shareholders are paid to wait.