Mortgage Insurers on the Rise

Mention the words "mortgage" and "investment" in the same sentence and you're likely to not only raise eyebrows, but you might also have your sanity questioned. After all, rates have been rising, mortgage production is down, housing is tanking and...well, you know the rest. Generally speaking, anything that depends on the mortgage market makes investors run for the hills these days. But there is a related area that is doing quite well. In fact, you might even say that their prospects are getting better all the time.

Mortgage insurers, the companies that provide lenders and their secondary market investors with a hefty degree of comfort on low-down-payment loans, are coming out of trying times. Contrary to the cycle that generated the greatest housing and mortgage boom we have ever seen, mortgage insurers such as  MGIC Investments (MTG),  PMI Group ,  Radian Group (RDN), and  Triad Guaranty (TGIC) actually experienced some tricky times over the past few years. When mortgage originations exploded by 33% in 2003, primary insurance in-force, the mainstay of the mortgage insurance industry, decreased by 7.4% while the number of new applications remained flat. Translated into terms we can all understand, refinances of mortgages with mortgage insurance were not replaced as often with new mortgage insurance.

Mortgage Insurers in Our Coverage Universe
Company	Morningstar Rating	Moat	Risk	Market Cap
MGIC (MTG)		Narrow	Average	$5.15 billion
PMI Group		Narrow	Above Average	$3.80 billion
Radian (RDN)		Narrow	Above Average	$4.87 billion
Triad Guaranty (TGIC)		Narrow	Average	$0.76 billion
* Data as of 09-25-06

One of the main culprits behind the divergence was the proliferation of piggyback loans being pushed by lenders. In periods of low interest rates, the spread between first and second mortgage interest rates diminishes to a point where it is actually cheaper for a borrower with less equity to have a first and a second mortgage as opposed to the standard first with mortgage insurance. Since lenders make more money with the piggyback loan, they tend to encourage customers to take a first and a second mortgage over the more traditional mortgage insurance approach.

Another factor that hampered the mortgage insurance industry had to do the rapid appreciation in home values which allowed a number of borrowers to cancel mortgage insurance once they reached their lender's loan/value target. Mortgage insurance is required when the loan/value target exceeds 80% and borrowers can petition to cancel the insurance, and the monthly fee, when the increased equity satisfies the lender's requirements.

There were other factors that affected the mortgage insurance industry, such as growth in mortgage-backed securities, more private lender portfolios, less GSE ( Fannie Mae (FNM) and  Freddie Mac (FRE)) involvement and, to a lesser extent, FHA/VA lending. However, what is most important is that the mortgage insurance industry faced some extremely difficult times, and the market is now shifting in their favor. Higher rates mean fewer piggyback loans. Declining home values at a time when borrowers are turning in their adjustable mortgages expands their market. Higher rates mean less refinancing, which keeps the existing book of business from running off.

Mortgage insurers have gone international with a fair degree of initial success. Australia has written mortgage insurance for the past few years, and it appears that the concept is gaining acceptance in Western Europe and Hong Kong. This year has seen three mortgage insurers file to set up operations in Canada, a country already familiar with the concept. Expanding markets present new sources of revenue to the industry.

Two mortgage insurers, Radian and PMI, now have interests in financial guaranty companies. Financial guarantors have historically insured payment on municipal bonds, but they have branched out into many other credit enhancement products, including mortgages. Strategically, this allows them to develop longer-tail businesses, i.e., business that generates more stable and lasting premiums, since financial guaranty policies remain on the books producing premiums far longer than mortgage insurance. It also allows them to use a new channel with different risk parameters and opens the door to reinsurance for large mortgage-backed securities. However, the financial guaranty business is one that we believe is more perilous, which is why we rate these two insurers as having above-average risk as opposed to the average risk rating assigned to MGIC and Triad.

Mortgage insurance is evolving in other ways that give these companies more flexibility on price and risk assessment. The companies have written pool insurance on blocks of mortgages sold to investors in the secondary market for years, and this market has decent expansion possibilities. Pool insurance is especially important in insuring large books of subprime loans. What's so appealing about this is that the companies can set deductibles and loss limits, which has not been the case in their standard primary-flow business in which lenders dictate terms.

A couple of other bonus points to think about: There is pending legislation that would allow mortgage insurance to be tax deductible, which will help in marketing. This has come close to passing into law a couple of times, and the industry believes that it will finally make it through Congress this year. And here's one that puts the icing on the cake: There are pools of mortgages that become insured to secondary-market investors that already have mortgage insurance on the original loan. That's right, double insurance premium on the same risk! The first premium is paid by the borrower upon origination and the second by the entity seeking further credit enhancement for investors.

Of course, there is a downside to the industry: claims. The risk is that a severe downturn in the economy will lead to loan defaults. Furthermore, if housing prices were to collapse, a certain percentage of borrowers with low equity could decide to just walk away from their mortgages if the home is worth less than the outstanding debt. Mortgage insurers got burned pretty badly in the 1980s, but, to their credit, they survived in relatively good shape. While we have forecast increasing claims due to defaults, we also believe that such an increase is manageable and well-covered by existing reserves.

Morningstar directly covers four mortgage insurers--MGIC, PMI Group, Radian, and Triad. Three others, Genworth, AIG, and Republic are subsidiaries of other companies. MGIC, Radian and PMI are the three largest in the industry, and Triad is a smaller company with strong growth. All four companies have Morningstar Ratings for stocks of 4 stars.