PMI, MGIC Investment: Subprime Trouble for Mortgage Insurance Companies

The problems faced by subprime lenders like New Century (NEW) and Novastar (NFI) continue to take center stage as these stocks were down 68% and 41% respectively yesterday. This new wave of selling started after New Century announced that it was in default with several lenders and that federal regulators have begun an investigation. A Merrill Lynch analyst added that due to the defaults and the new investigation, bankruptcy for New Century was a much stronger possibility than originally anticipated.

Although we expect additional problems related to subprime loans, most of the subprime related companies have already had large percentage declines. However, mortgage insurance companies that may have significant exposure to subprime loans have declined slightly, but these companies have been relatively stable compared to the subprime loan originators. We expect the mortgage insurers to see increased mortgage insurance related losses due to an increased number of claims created by an increasing number of mortgages in default.

While a recent Standard & Poors article took the position that mortgage insurers may have limited exposure to subprime loans, we think that the S&P author may have underestimated the exposure companies like PMI Group (PMI) and MGIC Investment Corp. (MTG) have to subprime loans. The article cited smaller average loan prices and limited exposure to ARMs in an argument that mortgage insurers should not be sold off in sympathy to problems in the subprime market. The article also mentioned that lenders are increasingly turning to mortgage insurers when trying to sell their loans to Fannie Mae (FNM) and Freddie Mac (FRE). These government sponsored entities require mortgage insurance when the borrower has less than 20% equity in the value of the property. S&P argued that between 2003 and 2005 this requirement was often satisfied by packaging second and third liens with the primary loan, but rising interest rates have made mortgage insurance more cost effective than multiple loan originations. However, the S&P article failed to make the connection that because of this 80/20 rule and the trend away from second and third liens, mortgage insurers may have ended up with more exposure to subprime loans. On average borrowers who cannot afford to put 20% down on a purchase are at a higher risk of default. Although many of these borrowers may still have good credit ratings and are therefore not categorized as subprime, they are still more likely to default than borrowers who put at least 20% down.

The deterioration of the broad real estate market also spells trouble for mortgage insurers. The bull market in real estate was a boon to mortgage insurers and allowed companies like PMI and MGIC to consistently increase revenues and profits. This growth in revenues and profits has already started to decline as PMI’s profits dropped 7% in the forth quarter compared to the year ago period. MGIC has had a decline in profits for three straight quarters.

Although shares in the PMI Group have lost some value since the deterioration of the subprime market started, PMI is still trading within 10% of a 52 week high. Additionally, PMI shares are still about 8% higher than they were in late November before the troubles with the subprimes started.

Shares of MGIC Investment Corp. have dropped slightly more than PMI recently, but MGIC is still trading above its recent low in August before the subprime lenders started experiencing problems.

We believe that PMI and MTG are both promising short sell trades at this point due to exposure to subprime mortgages and a deteriorating environment for the growth of mortgage insurance due to the underlying weakness in real estate markets throughout the US. If the fallout from the subprime market hits another related industry, mortgage insurance companies appear to be in danger of substantial near term selling.

Suggested trades:

* SHORT SELL PMI near $45.50
* SHORT SELL MTG near $58.70

PMI 1-yr chart


MTG 1-yr chart