Category: Equity

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:

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!

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.

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.