Mortgage Market’s Misunderstanding Creates Significant Opportunity

The Market’s Misunderstanding
During the COVID-19 inspired sell-off a confluence of factors have combined to hammer the stock prices of the pure-play Private Mortgage Insurers (PMIs), collectively MGIC Investment Corp. (MTG), Radian Group (RDN), Essent Group (ESNT), and NMI Holdings (NMIH). While there are some distinguishing considerations between these four firms, their business models are very similar and their stock prices are highly correlated. I believe that a combination of factors, including their being small caps and underfollowed, scars from the housing bust of ’08, and confusion over their relatively more difficult to understand industry, has resulted in a significant discount to their fair value.

It will be helpful to provide an overview of the residential mortgage market in general and how PMIs fit in. Whenever an individual purchases a home and gets a loan from an originating bank, the vast majority of those banks will then in turn sell the home buyer’s residential mortgage on to an investment bank that then securitizes pools of mortgages and in turn sells these securities on to investors. To give these investors added comfort surrounding default risk, and in turn allowing would be home owners to obtain more affordable interest rates with lower required down payments, Fannie Mae, Freddie Mac, and Ginnie Mae (the Government Sponsored Entities (GSEs)), guarantee to back-stop these loans in the event of default. The GSEs stipulate that they will only guarantee mortgages that are deemed to be “conforming”. One qualification for a loan to be conforming is that if the down payment on the house is less than 20% (and the loan-to-value is consequently above 80%), then the borrower is required to purchase mortgage insurance as an added form of protection for the GSEs. If a borrower stops paying their mortgage and their home is ultimately foreclosed on, the mortgage insurer would pay for the lender’s losses. This would be the remaining principal amount after the home is sold (foreclosed homes can see heavy discounts in a sale) as well as any other legal fees, taxes, transaction costs, etc. The Federal Housing Administration (FHA), Department of Veterans Affairs (VA), and other private portfolios also compete with the GSEs and fill this role, however they do not utilize PMI. The FHA and VA typically lend to borrowers with lower credit scores.

The housing crisis and recession of 2008 brought the PMIs to their knees (MTG and RDN were the only two of our four that existed at the time) and nearly put the companies out of business, as nationwide the average home price declined by 30% with some markets declining more than 50% and unemployment peaking at 10% by October 2009.

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