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.

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.