MGIC and Radian – the reward/risk tradeoff doesn’t get much better. Thanks, nervous investors.

Oct 29, 2018 by Gary Gordon


My last post discussed “investor PTSD”, which is when investors experience a traumatic event and take many years to overcome their irrational fear that it is going to imminently recur.  I cited the housing market as an example of investor PTSD.  Yes, very bad things happened to housing a decade ago.  But I argued that another housing bust is highly unlikely to recur today.

My influence on the markets is clearly infinitesimal.  Hard to believe, my loyal and worshipful readers, but true.  Since October 17, when MGIC, one of my favorite housing-related stocks, reported strong earnings, its stock price fell by 10%.  So did its peer Radian.  This puts MGIC’s earnings yield (2018 expected earnings per share divided by stock price) at 13%, and Radian’s at 14%.  Yes, the whole market sold off – you may have noticed that too – but seriously…

Let me repeat: MGIC’s earnings yield is 13% and Radian’s is 14%.  That is about double the stock market average and more than double the yield on a junk bond.  If their earnings never grow again, you get a 13%+ per year return on your money.  If we could earn 13% a year on our total investments, we would become very rich indeed.  You could end world hunger.  I could buy the Mets some relief pitchers.  (Don’t you question my priorities!)  So the investment analysis for MGIC and Radian is pretty easy; to show that they are cheap stocks I just have to show that they are unlikely to blow up. 

Private mortgage insurers, you may recall, take the risk of default on low downpayment mortgages (<20% of the home’s value) in exchange for an insurance premium.  As such, the great bulk of their earnings over the next few years is already on their books in the form of multi-year insurance policies.  My analysis of MGIC and Radian can therefore narrow even further to the current state of health of existing home mortgage debt.  The following check-up hopefully will convince you that the existing home mortgage debt is as healthy as a horse (what a bizarre idiom).  Here goes.

Mortgage credit standards are excellent.

I’ll repeat two pictures I’ve previously shown.  The first is a history of mortgage lending standards:

 

Source: The Urban Institute

Nearly all of the existing home mortgages outstanding in the US have been written with stringent credit quality.  But how about the mortgage insurers specifically?  Let’s compare Radian’s credit standards for its insurance books at the peak of the housing bubble and today:

 

Source: Company reports

Radian’s credit quality difference is dramatic; literally night and day.  MGIC and the whole industry are similar.

The housing market is in balance

Again I pull out a chart from last week, because it is so important.  Namely, a chart showing the amount of excess housing units in the good old USA, assuming a normal 3.5% vacancy rate:

 

Source:  Census Bureau

Then?  A record 2 million excess homes.  Today?  A housing shortage.  A growing housing shortageFYI, Pulte Homes management said on their recent Q3 earnings conference call that at the current level of job growth the US is underbuilding by 200,000 homes a year.

The mortgage debt burden.

A hot topic today is housing affordability.  Yes, it is a challenge for many would-be buyers in some markets.  But what about the homeowners whose insurance policies are already on the books of the mortgage insurers?  Let’s check out a history of US mortgage payments as a percent of household income:

 

Source: Federal Reserve

The lowest in at least 40 years!  Those crazy-low mortgage rates of the last 10 years have made the bulk of American homeowners very comfortable with their mortgage payments, which is awesome for the mortgage insurers’ credit outlook for the foreseeable future.

But what about the big run-up in home prices over the last few years?  Isn’t that a sure sign of a mortgage debt bubble that will have to burst?  Sorry, but once again the data is on my side:

 

Sources:  Federal Reserve, Bureau of Economic Analysis

The big run-up in US homeowners’ equity from 1998 to 2006 was certainly fueled by debt growth.  But the boom since 2012 clearly was not.  Rather, I argue, home price increases were a good old function of rising demand from job growth meeting a weak supply of new housing.  Nothing unwholesome about that at all.

The proof is in the pudding.  Er, the earnings.

Another weird idiom.  But I digress.  I noted above MGIC’s strong third quarter earnings report.  Highlights from its third quarter versus a year ago were:

  • Revenue growth of 7%.  Not bad for a company that investors expect so little of.
  • Net paid mortgage default claims of $87 million, down from $113 million.  And 72% of newly delinquent loans came from the pre-2008 insurance policies.  The credit quality since has been impeccable.
  • Book value grew by 14%.
  • Cash flow data is not yet available for Q3, but during the first half of 2018 it more than doubled from the year-ago period.

Expect similar results from MGIC’s peers when National Mortgage (stock symbol NMIH) reports Q3 earnings tomorrow (Tuesday), Radian reports on Halloween morning (treat, not trick!), and when Essent (ESNT) reports on November 9th

Wrapping up…

I strongly believe the prevalent housing worry is misplaced.  If so, MGIC and Radian have outstanding risk/reward outlooks.  Let’s take ourselves two years out from today, to October 29, 2020.  The world will be obsessing about our next Presidential election, but I will also be peeking at MGIC’s stock.  By then, MGIC’s numbers should look something like this:

  • Book value of $12.90.
  • Earnings per share (EPS) of $1.75 or more.
  • 10-15% fewer shares outstanding than today, which will add 10-15% to MGIC’s long-term per-share earnings power.

With these numbers, could MGIC’s stock really be lower in two years than its current $11.65 price?  Or is $20 a lot more realistic by then?  Little chance of a decline (the risk) and a reasonable chance of up 70% (the reward).  For Radian, I believe the upside is more like 100%.  I like those odds.  You may also.