Radian Group, Inc. (RDN) is a mortgage insurer that survived the meltdown in the housing market and has positioned itself for a meaningful recovery.  Although RDN’s stock price has recovered from the depths of the recession, I believe RDN’s recovery is still obscured by legacy issues, obtuse accounting and recent weakness in mortgage originations as well as continued uncertainty regarding Washington’s approach to housing finance and the mortgage insurance industry.  Radian appears to have reached a tipping point in terms of financial performance and offers a compelling investment opportunity for the next several years.

Background

Radian operates two business segments – Mortgage Insurance (MI) and Financial Guarantee (FG).  The mortgage insurance business provides private mortgage insurance (PMI) for borrowers who generally have less than a 20% down payment.  The Financial Guarantee segment guaranteed a wide range of financial instruments including bonds issued by governmental entities and structured instruments such as CDOs, CLOs, CMBS and RMBS.   Both segments expanded rapidly until 2008.

When the financial meltdown occurred, Radian went into triage mode, discontinuing issuance of new Financial Guarantee business, and substantially paring back the MI business. Radian also raised a significant amount of capital through equity and convertible debt offerings. 

Between June 2008 and December 2013, RDN reduced the net par outstanding under its Financial Guarantee business from $115 Billion to $24 Billion.  This business has been in run-off mode since 2008, and exposure should be cut in half over the next 4 years.

In 2013, Radian raised $689 million by issuing $400 million of convertible debt and selling 39.1 million shares at $8.00.  Radian also exchanged $195 million of its 5 3/8% notes that were due in 2015 for 9% notes due in 2017. These transactions put the balance sheet on a solid footing. Radian now has over $600 million of cash at the holding company level.

The Mortgage Insurance business has seen a dramatic turnaround, with high quality underwriting since 2009.  Over 60% of RDN’s primary risk in force is represented by policies issued in 2009 or later, which are well underwritten and very profitable. (An additional 11% of loans have been modified under the HARP program, which lowers interest rates for performing borrowers, and decreases the likelihood of defaults.) In contrast, 98% of both reserves and claims paid in 2013 relate to the pre-2009 vintages.

Why is there an opportunity?

When you look at Radian, you see a combination of legacy MI performance, legacy financial guarantee performance, new MI results and a whole host of policy termination and other charges related to the transition from the “bad” businesses to the good.  In addition, the company has two issues of convertible debt that generate phantom interest expense and exposure to derivatives that generate a lot of “noise” in the financial statements.

Mortgage originations in the first quarter were down sharply from 2013.  Higher interest rates have severely reduced the number of re-financings and new home purchases.  New insurance written by Radian in the past three months has been significantly below last year’s levels. ($6.8 billion in the first quarter of 2014 versus $10.9 billion last year.)

While the lower number of new policies written hurts Radian’s originations, Radian benefits from the higher persistency of existing business.  Each 100 basis point increase in persistency is equal to approximately $1.6 billion of new insurance written.

Radian’s accounting also makes it difficult to understand actual performance.  Radian amortizes the imputed discount on two large convertible debt issues into interest expense, resulting in much higher book interest expense than the actual cash interest paid.  Another example is executive compensation.  Radian granted management cash settled performance stock units in 2011 and 201.  Because the units are cash settled, Radian’s G&A expense was increased by $66 million in 2013 due to the strong performance of its stock. 

There is also a fair amount of uncertainty regarding the future of the GSEs and regulation of the mortgage industry.  While various proposals have been made, I do not expect this issue to be resolved before the elections.

Mortgage Insurance

The mortgage insurance segment enables borrowers with less than a 20% down payment to get a mortgage that is typically resold to one of the GSEs. For example, a borrower with a 720 FICO score and a 10% down payment would pay a 44 basis point premium on a single-family first mortgage. Radian has significantly upgraded the quality of its insureds. Average FICO scores for policies originated since 2009 are in the 760 range versus lower than 700 for policies originated before 2007.

The results are apparent from the tables below.  Note that these tables reflect Radian’s primary insurance and exclude the small amount of pool insurance written by Radian.

Primary defaults have fallen further in 2014.  At the end of March, Radian had 53,119 primary policies in default.  Radian paid 6,049 claims in Q1.  Cures exceeded defaults in the quarter, which is a normal seasonal trend.

Note that the payments and defaults in 2013 reflect a settlement with Freddie Mac that removed 9,756 claims.

Two things are happening here.  First, the losses from legacy (pre 2009) vintages are becoming less of a factor, and are about to reach break even.  At the same time, policies

written in the past four years are generating solid profits, and growing at a healthy pace.  The combination of these two factors provides a powerful tailwind for the MI business.

                                    Earned Premiums less Incurred Losses

                                                            $Millions

The Mortgage Guarantee business has turned the corner on profitability.  While near term originations may be weak based on a slower housing market, there are two long term trends which should help this business.  First, the FHA, which stepped into the mortgage insurance business in a big way during the financial crisis, has begun to step back.  The FHA’s market share of MI, which peaked at 80% in 2009 and 2010, dropped to 50% in 2013. (It was in the low 20s prior to the financial crisis.) Second, there is a large backlog of potential new household formations, and new homebuyers.  Many of these new homebuyers will have less than a 20% down payment, and will be prime targets for MI.

Financial Guaranty

Between June 2008 and December 2013, RDN reduced the net par outstanding under its Financial Guarantee business from $115 Billion to $24 Billion.  This business has been in run-off since 2008, and management expects half of the remaining exposure to run off over the next 4 years.  The financial guarantee exposure is mostly to investment grade entities.  RDN’s internal credit ratings are as follows:

                                                                             $Billions

            AAA                                                                 9.2

            AA                                                                   1.1

            A                                                                     3.1

            BBB                                                                 8.3

            Below Investment Grade                                  2.2

                  Total                                                        23.9   

The current book of business consists of the following:

                                                                   $Billions

            Reinsurance                                          4.9

            Direct Public Guarantees                        8.1               

            Structured Finance                              10.9

                        Total                                       23.9

Reinsurance consists of $4.4 billion related to public finance obligations, and $500 million related to structured products. Radian’s exposures in the public finance space include Puerto Rico ($400m), Spain ($49m), Italy ($25m), Hungary ($22m), and Detroit ($8m).

The $10.9 billion of par exposure in the structured finance area include TruPs, Corporate CDOs, RMBS and CMBS securities. $450 million of this exposure was commuted in January.  An additional $450 million is scheduled to go away later this year.

Radian has reserved $21 million for its expected losses in the Financial Guaranty book, and carries an additional $264 million of contingency reserves.  There is approximately $1.2 billion of surplus in the Financial Guaranty business, that will eventually be up-streamed to the mortgage guarantee business assuming no adverse development in the FG book.  The FG business paid dividends to the MI business of $36 million in 2012 and $54 million in 2013.  Radian expects to pay an additional $32 million in 2014.   

Valuation

Radian has two series of convertible debt outstanding.  Since they are convertible at prices that would be in the money in a bull case scenario, I assume conversion, which results in an additional 76 million shares.  The $250 million of debt shown in the table below excludes the convertible debt.

The MI business has turned the corner, and should be solidly profitable in 2014.   I believe this business is capable of generating $350 million of normalized EBIT, based on $810 million of premium income, $50 million of investment income, $300 million of claims, and $210 million of operating expenses.   Note that actual results will undoubtedly be a lot messier than my model.  I have excluded temporary gains/losses from investments and derivatives.

The FG business, while profitable, is in run-off.  Its value to RDN largely depends on how quickly its capital can be up-streamed.  RDN currently expects to dividend $32 million from the FG business in 2014.   The pace of dividends could expand as exposures run off. The downside case reflects dividends at the current rate discounted at 12%.  The upside case reflects RDN’s surplus invested in the FG business.

Radian has a $1.022 Billion deferred tax asset.  I have discounted this by 50%.  Management expects to reverse the DTA in 2015.  If Radian achieves the profitability I am anticipating, the bulk of the DTA should be realized over the next 5 years.

The profitability in the MI business should become apparent over the balance of 2014.

The deferred tax asset should reverse in 2015, which will add $5.81 per share to book value and send a positive message about RDN’s financial strength.

Further reductions in the FG portfolio from commutations or other terminations may allow increased capital returns from the FG business.