Category: Equity

Genworth MI (TSX: MIC) reported 2nd quarter earnings yesterday. The results were smashingly positive for the company and show that the state of credit stability in the Canadian mortgage market is very high.

My calculated tangible book value for share, diluted, is $34.11 compared to the current market price today of approximately $39.70 per share (a 16% premium over book value). Booked income was $1.02 per share, noting the mild accounting change regarding how deferred policy acquisition costs are processed. This also would have been even higher if one backs out the extingushment of debt expense that occurred during their bond refinancing (offset by backing away the one-time capital gains from their portfolio).

In general, the trend for the company has been very positive with declining loss ratios and delinquencies in their mortgage insurance portfolio. This quarter has proven to be an exception in that the ratio has gone even further lower than the prevailing trend:

Loss Ratio
Q1-2013: 31%
Q2-2013: 25%
Q3-2013: 22%
Q4-2013: 22%
Q1-2014: 20%
Q2-2014: 12%

Suffice to say, this is incredibly low – indeed, a record low since the company went public. The existing stability in the Canadian mortgage insurance market is leading to the top dogs (mainly CMHC and Genworth MI) to book a lot of revenues as people continue to amortize their mortgages (and thus reduce the risk even further of mortgage defaults occurring).

On the top line, premiums written was also better than last year’s Q2 (160 million vs. 137 million), but not quite as good as 2012 (which had 176 million). This amount bodes fairly well for revenue stabilization (which is lagged behind the actual premiums written as most of this gets amortized in the subsequent 5+ years of the life of the mortgage).

In terms of their portfolio, it continues to be relatively unexciting, consisting of the usual staples of bonds and a small smattering of equity – yield is 3.6%, duration 3.7 years.

The other significant piece of news is the establishment of a new amount of internal minimum capital required to operate the business:

The Insurance Subsidiary is regulated by OSFI. Under the MCT, an insurer calculates a ratio of capital available to capital required in a prescribed manner. Mortgage insurers are required to maintain a minimum ratio of core capital (capital available as defined for MCT purposes, but excluding subordinated debt) to required capital of 100%.

Under PRMHIA and the Insurance Companies Act (Canada) (“ICA”), the minimum MCT ratio for the Insurance Subsidiary is 175%. In
conjunction with this requirement, the Insurance Subsidiary has set its internal MCT target capital ratio to 185%. The Company manages its capital base to maintain a balance between capital strength, efficiency and flexibility. As at June 30, 2014, the Insurance Subsidiary’s MCT ratio was approximately 230%, or 45 percentage points higher than the Company’s internal target of 185%. The Company regularly reviews its capital levels, and after reviewing stress testing results and after consulting with OSFI, the Company established an operating MCT holding target of 220% pending the development by OSFI of a new regulatory test for mortgage insurers which is targeted for implementation in 2017. While our internal capital target of 185% MCT is calibrated to cover the various risks that the business would face in a severe recession, the holding target of 220% MCT is designed to provide a capital buffer to allow management time to take the necessary actions should capital levels be pressured by deteriorating macroeconomic conditions. Under this framework, capital in excess of the operating holding target may be redeployed.

Currently the company’s MCT is at 230%, while the new minimum will be 220%.

The implication of this is fairly obvious – there will be a reduced amount of capital available to give out a special dividend and/or share buybacks. There is an excess of about $150 million over the 220% minimum required. The company declared a 35 cent dividend this quarter (which translates into roughly a $33 million distribution) and will likely increase the dividend to 38 cents in the next quarter with the potential of a special dividend of a dollar to bleed the excess capital away. Since the company is booking income of about $1 a quarter, this should not be a problem for them.

Since the Canadian mortgage insurance unit is so profitable at the moment, it will not be surprising if there was attempted encroachment in the market by competition, and I wonder if we are going to see price competition that deviates away from the CMHC payment schedule. If this happens, shares in Genworth would start to decrease.

Right now the market is pricing in perfection in the Canadian mortgage insurance scheme. This continues to worry me that the fundamental picture for Genworth MI cannot get much better than it is at present, especially with their 12% loss ratio.

I continue to remain long in Genworth MI as I generally see it being a reasonably good store of capital at the moment. I did sell some when it was trading in the upper 30’s and lower 40’s earlier this year, but this was to reduce concentration in what is otherwise a company that is firing on all cylinders.

Since their quarterly report at the end of April 29, Genworth MI is trading at all-time highs. I haven’t had a chance yet to listen to the conference call, but I would expect management signaled that the foreseeable future is relatively stable and that their loss ratio estimates are on the conservative side.

The question is – how much better can things get? No defaults at all in the Canadian mortgage market?

Assuming all things are equal to today, one would expect Genworth to earn about $3.80/share this year and next year this would be slightly higher due to mortgage insurance premium increases. The mortgage premium increase will attribute for a $35 million increase in written premiums in 2014 and $70 million in 2015. This will effectively equalize their current differential between written and earned premiums; earned premiums have been higher than written premiums for the last five years.

Doing some math would lead an equity investor to expect approximately a 10% total return, minus market valuations (P/E, P/B expansion) and other external events (competition, real estate volumes, etc.).

Considering your typical bond investor is going to be lucky to make a decent 5% yield with a A- to BBB risk profile (your typical US$ BBB-rated 5-year bond yield is currently at 5.8%), and Genworth MI’s rating is A-, there is a healthy equity premium associated with the company that would still justify holding the shares. Genworth MI itself just issued 10-year debentures at about 4.25% for 10 years recently. However, the company has long since passed the point where it is bargain territory.

Genworth MI itself is a glorified bond fund, with about $5 billion in assets invested with an average yield of 3.6% and duration of 3.7 years. This, along with the liabilities associated with the mortgage insurance business, is valued at $3.7 billion presently. Given the “if all things are equal” projection, it does make financial sense for the company to still invest in its own equity since there is a good yield spread of about 5% still to be harvested. If you give a “natural” equity premium of 3% then there is 2% left to run – i.e. around $44/share.

I hope momentum and yield investors (speaking of which, is about 3.6% at current prices) actually does that. If and when they do, I will take that opportunity to unload shares.

What is keeping back the market from bidding up the share price are all the obvious factors concerning the general perceptions of over-valuation in the Canadian real estate market and macroeconomic factors, including the Fairfax doomsday scenario. If the commodity sector starts to sneeze and prices decline, then it will have an impact on employment, which will subsequently have an impact on the overall health of the mortgage credit market.

Right now Genworth MI is priced for some fairly rosy days ahead of itself and this bodes well for the general Canadian economy. Are investors right? How long will this last? I don’t know.

Genworth MI, on account of its appreciation over the past 20 months, is still a significant component in my portfolio.

Genworth MI has posted its quarterly report. The company continues to fire on all cylinders – specifically the loss ratio, at 20%, is lower than it has been in a very, very long time. This is a function of record low mortgage delinquency rates (0.12%).

Everything appears to be humming along and the company continues to be a cash generation machine.

Tangible book value is $33.36 per share (which includes other accumulated comprehensive income, but excludes deferred acquisition costs) which is up since the previous quarter.

Written premiums are level from the quarter in the previous year. The revenues are expected to increase 15% due to the increase in pricing of mortgage insurance.

The company’s reinsurance bet on a property market crash not happening in Australia over the next three years seems to be a $6 million dollar bet with a maximum risk of AUD$30 million – they recognized $510,000 in this quarter, I am making a straight line estimate of their premium recognition curve.

There is really not much else to report other than the rather pleasant state of the Canadian real estate loan market. Looking ahead I would expect the company to increase its dividend in the third quarter and perhaps give off a one-time special dividend once the regulatory requirements for minimum capital are set in stone later this year. It remains a mystery whether management will buy back its own shares at current levels (approximately 12% premium to tangible book value), but we will see.

I am long Genworth MI equity from significantly lower costs, but have trimmed the position recently due to portfolio concentration. The business is doing well and it is priced that it will continue to do well.

The OSFI has released draft guidelines (B-21) on residential mortgage insurance companies. There is a comment period up to May 23, 2014. Considering that CMHC and Genworth form substantially the entire market, I do not anticipate much comment.

Despite what the media is reporting (that it would involve a marginal tightening of the mortgage insurance market), upon reading the draft guidelines I do not see this conclusion, which is little change.

Specifically for investors, the only change that will be visible will be a slightly higher amount of disclosure than what is currently provided to the public. This includes (and the bold-print is what I believe will be new):

A breakdown of mortgage loans insured during the previous 12 months as well as the total stock of insured mortgage loans, with further separation by mortgage insurance type (i.e., transactional- vs. portfolio-insured loans), for the following categories:

* Volume: The number and outstanding balance of insured mortgage loans;
* Loan-to-Value: A breakdown according to LTV buckets of 5% increments (both estimated current and LTV at origination);
* Amortization: Amortization period ranges (e.g., 15 – 19.9 years, 20 – 24.9 years, ≥ 25 years, etc.) at origination and remaining amortization;
* Geography: Geographic breakdown by province and territory; and
* Delinquencies: Breakdown of the level of insured mortgage loan delinquencies.

FRMIs should also provide a discussion of the potential impact on insured residential mortgage loans in the event of an economic downturn.

Genworth MI is down less than a percent in today’s trading, which may or may not be caused by the above pronouncement by the OSFI. It continues to be my largest holding despite being trimmed at higher price levels.