Tag: MIC

Genworth MI – Capital Adequacy Guidelines from OSFI

Genworth MI (TSX: MIC) commented on the new OSFI Capital Adequacy Guidelines for Mortgage Insurers.

I’ve gone through the technical document, which is always an interesting read. If you can go through this document and be able to comfortably recite Section 3.1.1 and subsections underneath, you will know all there is to know about capital requirements for Canadian mortgage insurers (i.e. you’d know a serious component of what it takes to properly analyze Genworth MI or CMHC).

This is a consolidation document which incorporates some differences between the previous advisory guideline which was effective at the beginning of 2017.

Notably, the requirement for a mortgage insurer to update the required capital as a result in a credit change of the loaner has been removed in exchange for a flat 5% increase. They probably figured out that obtaining credit scores of your clients every year isn’t a sustainable operating practice.

This will require Genworth MI to retain more capital for the same amount of book liability, which has the effect of reducing return on equity.

There is a possibility that CMHC will increase mortgage insurance premiums as a result of this and Genworth MI would match it.

Here are some tidbits for those housing bears that think a crashing Canadian housing market will take down Genworth MI:

1. Loan-to-value is defined as follows:

For mortgages originated after December 31, 2015, the LTV input is calculated by dividing the outstanding loan balance on the reporting date by the property value on the origination date or the date of the most recent appraisal, provided that the appraisal was commissioned by an independent third party entity other than an insurer.

… and …

Note that if the value of LTV determined in this subsection is greater than 100% then an LTV input of 100% should be used in the formulas in subsections 3.1.1.2 and 3.1.1.3.

So in a crisis scenario, if people are suddenly underwater on their mortgages, it doesn’t matter to what degree they are underwater – the capital retention requirement only uses a maximum LTV of 100% (i.e. zero equity, not negative equity) in the calculation for how much capital they are to retain.

2. Wondering how much your credit score (at mortgage origination) affects how much capital your mortgage insurer has to retain? The “m-value” below is the factor that capital retained is affected.

Credit Score Impact on Mortgage Insurance Capital Required

Credit Scorem
< 6003.00
[600,620)2.05
[620,640)1.80
[640,660)1.60
[660,680)1.35
[680,700)1.10
[700,720)0.90
[720,740)0.65
[740,760)0.55
[760,780)0.45
≥ 7800.40

What’s interesting is that I do not see the phrase “credit score” defined anywhere in the document. Must be super-secret!

Genworth MI Q2-2018: Steady as it goes

Genworth MI (TSX: MIC) reported second quarter earnings yesterday. This quarterly report could be classified as “more of the same” as the previous quarters, exhibiting low loss ratios (14%, with the company decreasing guidance to the 10-20% range), with a slight increase in delinquencies and losses on claims.

Here are some other notables:

* The number of units of transactional insurance written was down 7% from the same quarter in the previous year, but the amount of premiums written remained steady due to price increases (OSFI regulations for capital requirements changed, hence the price increases).

* There was a large increase in Quebec transactions in Q2, about 25% – this was seasonally seen in the previous year’s quarter as well, at 22%. But this is the highest I have seen in some time for Quebec.

* The amount of the portfolio above a 80% loan-to-value ratio remains steady at 42%. The bear case scenario would have this number rise (primarily due to assessed home values declining faster than the proportionate mortgage principal declining).

* Delinquency rate is 0.19%, up from 0.18%, but this is small enough that I would consider this statistical fluctuations rather than anything resembling a trend. Alberta and Ontario were the primary reason for the very mild increase.

* Their investment portfolio is relatively unchanged – about half a percent more invested in preferred shares. Their interest rate swap continues to pay off (fair value of $135 million) on $3.5 billion notional value. I commended the CFO for entering in this transaction on earlier posts. As short term rates rise, this interest rate swap should continue to pay off further – I suspect another percent or so and they’ll close it.

* Book value goes to $44.40 on diluted shares outstanding, the current market price is at a premium to book (which is not common for MIC). The minimum capital test ratio remains at 170% – this ratio will increase with retained earnings, but will increase/decrease if mortgages exhibit decreased/increased LTVs due to property appreciation/deprecation (which is the much stronger factor here for bull/bear cases). The company is likely to raise the dividend next quarter to 50 cents/share as they are tracking at the lower end of their payout ratio.

* Finally, they have a June 15, 2020 bond (5.68%) that is now under 2 years to maturity. The credit markets currently are quite favourable and it would not surprise me if they floated another bond offering with a 10-year term. They should be able to shave off at least a hundred basis points on the transaction.

To conclude, there is not much evidence at present for a bear case. Things are going as well as they can financially for Genworth MI. Not surprisingly, this is why the stock is at the highest point it has ever been. Will it continue? I don’t know. Readers on this site will know I very recently sold all my shares in Genworth MI, but I have no extraordinary knowledge that would suggest that the stock will go down anytime soon.

Exited my Genworth MI position

The trading in Genworth MI (TSX: MIC) feels like it is in the middle of unwinding a short sale position in Genworth MI. Short investors (2,276,672 shares as of July 13, 2018) are obviously losing money. The quarterly reports have usually been positive news events for the company as they report record low loss ratios and insanely high profit margins. Everything is as rosy as it can get – high profit margins, low unemployment, low default rates, and people paying their mortgages. The stock is trading above tangible book value for the first time, ever.

Sounds like a good time to sell.

I’ve sold the last of my position today. The last block of shares went off at $46.06. This has been my longest held position, initiated in 2012, and partially sold and partially added on at opportunistic prices. For a considerable length of time between 2012 to 2016, it was my largest position.

I will still continue tracking the stock as my accumulated research (I have written more about Genworth MI than any other person on the entire internet) will come in handy if the price range descends into a more opportunistic range.

There’s probably a bit of upside remaining in the stock (in a good case could go to $50), especially if the short sentiment decides to cover up in a hurry. But I’m not one to play these types of guessing games and getting out at a 5% premium to book is sufficient for my investment purposes.

The cash will be parked – I still don’t see much compelling opportunity out there.

Canadian Dollar, Genworth MI and Residential REITs

This will be a rambling post in no particular order.

1. The Canadian dollar has tumbled with Donald Trump beating the war drums on the trade portfolio:

This will keep going lower and lower until the Government of Canada realizes that a lower currency doesn’t mean you’re more competitive when you’ve basically killed your own industry. Normally there is correlation between oil prices and the Canadian dollar but this linkage has now been considerably more muted because of WTIC to Alberta oil differentials. Investment has been flowing away from Alberta/SK oil and everything is on maintenance mode.

This will clear the way, however, for the Bank of Canada to raise interest rates another quarter point.

Domestically, this is going to be a disaster for general Canadian standards of living. It seems to be that our largest urban export is continuing to be real estate.

2. Speaking of real estate, bearish market participants in Genworth MI are going to face a short squeeze:

I’m not sure why anybody would want to use Genworth MI as a proxy for Canadian housing when there are so many more other investment vehicles to express this sentiment, ones that are trading well above book value and are making nowhere close to as much money as Genworth MI is on their insurance portfolio.

I’ll send a “hat tip” to Tyler, who writes infrequently at Canadian Value Stocks, for the brief mention of my continuing analysis of Genworth MI. The best analogy I can give is “picking up hundred dollar bills in front of a steamroller” instead of the usual cliche of “picking up nickels”. Genworth MI is claimed to be poised to have a giant collapse, but the variables required to make that happen seem distant at this point in time. Hint: Pay attention to China.

3. Speaking of real estate, the most hyped investment seems to be mortgage REITs and also residential REITs. The cap rates received by purchasers are incredibly low. Example press release linked here, key quotation in the first paragraph:

Northview Apartment Real Estate Investment Trust (“Northview”) (TSX:NVU.UN) today announced that it has agreed to acquire a 623 unit portfolio of six apartment properties (the “Acquisition Properties” or the “Acquisition”) from affiliates of Starlight Group Property Holdings Inc. (“Starlight”). The aggregate purchase price of the Acquisition Properties is $151.8 million (excluding closing costs), representing a weighted average capitalization rate of 4.5%.

A 4.5% cap rate? Do I even need to open a spreadsheet to know that the purchasing side of the transaction is wholly reliant on capital appreciation of the underlying properties for this to make financial sense?

The big favourite in this market is Canadian Apartment Properties (TSX: CAR.UN) and they probably can’t even believe how much their equity has traded up over the past year. They did a secondary at $35.15/unit and probably feel like idiots since just three months later they’re trading at $43/unit.

We drill down into their financials and see that from the last quarter, extended to 12 months, their normalized funds flow through operations (recall that accounting rules will add gross amounts of volatility in REITs due to mark-to-market rules when properties are re-appraised and this difference will be added or subtracted from income, making standard income statement comparisons incomprehensible without going through mental gymnastics) results in a net yield of about 4.3%.

An investment in CAR, therefore will expect to receive 4.3% plus the variable components of changes of rental amounts, property values, financing and operating expenses, and vacancy rates. Will these variable components be enough to give a rational equity investor a higher rate of return as surely nobody would want to take equity risk for a measly 4.3% gain?

The case to short Genworth MI

I very much like reading the short sale cases of anything I hold. It forces you to check your own analysis and compare conclusions. I remember dissecting a post back in October 2016 that was posted on Seeking Alpha (David Desjardins said he bought January 2018 put options at a strike price of 18 – if held to maturity they would have expired out of the money).

The newest case I’ve read is from Tim Bergin, who wrote extensively about it on his website and even won the runner-up status in an investment idea contest (something to be fairly proud about considering the quality of presentations that go into these sorts of things – there is a large amount of raw financial brainpower that want to be noticed by hedge fund managers).

I agree with some of Tim Bergin’s analysis of Genworth MI (TSX: MIC), but there are some missing elements of the analysis. This post may appear to be a bit critical and if Tim – you’re reading this – please note I appreciate your work much more than what this post is letting on!

Items I agree with

* I generally agree that the maximum upside (as a short-seller this would be downside), in the short-term time horizon, is about 20-30%.

* I also agree that if the facts in his thesis materialize (specifically: 5-15% mortgage default rates, 20-40% housing price declines) that the price of Genworth MI will drop 60-100%. I believe that his projections are actually conservative if this occurs (i.e. the numbers he presented will be worse).

* B-20 will impact housing prices. What this will typically result in, however, is that would-be buyers would shop for lower valued properties that can fit the financing parameters.

* The correlated risks in the investment portfolio (e.g. debt/preferred share investments in financials that would presumably be linked to real estate credit markets).

* Using LTV and amortization is not a sound way of pricing an insurance product, but this is due to consumer simplicity and also just matching whatever CMHC charges – in any event, if the market was actually competitive, based on loss ratios, mortgage insurance premiums would be much lower.

Items I disagree with

* The analysis seems heavy on severity and not frequency. The trigger point for frequency is not debt ratios, but rather employment (something not discussed in the presentation).

* The most fatal flaw in the presentation: The “soft-landing” scenario (slide 26). Reading the slides, I don’t get the impression the author is differentiating between revenue recognition and premiums written. Cash intake (premiums written) in FY2017 was $663 million. Even if the company only recognized revenues on a 10-year basis (this modelling is also flawed), in a “soft landing” scenario, the revenue recognition would normalize to the rate that premiums were being written. There is no explanation for why premiums written would drop by 60%.

* The conversion to “actual loan-to-value (LTV)” (slide 19) is a very creative way to bloat the ratio and implies the liability book is larger than it may seem, but ultimately it doesn’t mean anything – the fact that it takes money to dispose of delinquent properties is known and banks also incur the same risks, or in any industry where there is collateral backing loans.

* The 10-year revenue recognition suggestion doesn’t make sense. Looking at FY2017 year end, the average transactional mortgage insurance LTV is 62% – each and every year after the mortgage loan is amortized even further, reducing risk. So even in the event that housing prices drop 25% universally, the LTV still is 83% – defaults that occur will not be severe, unless if the defaults are part of a (my terminology) “cascade selling” where selling of defaulted properties causes further price drops. What would the accounting basis be for delaying recognition of revenues that has an incredibly high probability of never incurring further cost? It’s pretty self-evident that the further the LTV drops (whether it is due to appreciation of property or amortization of debt) the less risky the insurance written is. Of course in a declining housing price environment, LTVs may go above 90% and then it becomes reliant on the mortgage holder to continue paying down the mortgage and amortizing debt instead of having the safety valve of just selling the property (which would explain how Home Capital Group and others got away with sloppy underwriting).

* In relation to US mortgages (strategic defaults), recourse in Canada is quite powerful.

* That MIC’s insurance portfolio is weaker because of the reduced (90%) government backstopping. Performance data between CMHC and MIC (loss ratios) would suggest otherwise. I agree I don’t know why this is the case, but it would suggest that MIC does have better screening techniques.

Items that should be in the analysis but isn’t mentioned

* That as long as CMHC profits from mortgage insurance that Genworth MI will as well and any “crash” scenario will also greatly affect the government (with even more political consequences than financial ones), thus the federal government has a high incentive to preventing a crash scenario from occurring.

* If mortgage insurance was such a crappy deal for MIC (and by extension CMHC), would they not have a justification to raise insurance rates even further, just like how they did when the OSFI raised mortgage insurance capital requirements?

* MIC’s data from the 2008-2009 economic crisis seemed to suggest that even in a sour economy that they can still make money.

* Genworth Financial’s 57% ownership in MIC is a big question mark considering the China Oceanwide merger process (that has been going on for over a year).

* What if MIC just said the following tomorrow: “We’ve stopped writing mortgage insurance. We will be letting our existing insurance book run to expiry and distribute the remaining free equity to shareholders.” – what is the terminal value of MIC in this case?

Closing Thoughts

I’ll be happy to let Tim Bergin borrow my shares of MIC if he wishes to short it. The market currently asks 2.4% for a borrow, plus 4.7% carrying costs for quarterly dividends.