Description

Radian (RDN) is being valued like a company that faces the risks inherent in consumer credit and housing, which, for obvious reasons, does not make for a popular long in the current environment. We believe this perspective provides a terrific opportunity to buy a catalyst-driven, inherently inexpensive business which will impose significant opportunity costs on those who choose to wait for economic clarity due to impactful and accelerating capital returns. 

As importantly, the countdown has started on a very significant and quantifiable catalyst that few, including most of the analysts and many current RDN shareholders understand. Starting in 2023, but massively accelerating in 2024, Radian is in line to start releasing “contingent reserves” that effectively harken back to the GFC (explained further below). These reserves can be dividended up from the insurance subsidiary to the holding company without the need to get clearance from regulators. The scheduled releases equate to 115% of RDN’s current market cap. This is free and clear capital management can deploy (read: return) without turning to regulators to ask permission. Note that this is incremental capital above and beyond the ~$600mm per year we expect the company to generate from operations. As the timing of this major catalyst nears, we believe investors and analysts will start to focus on it and the contention that this capital generating and returning machine should continue to trade at a significant discount to TBV is severely compromised.  

In net, we view RDN as the most attractive liquid stock we have found from the perspective of risk/reward asymmetry. At 86% of tangible book, could the stock, on the basis of market beta, trade down to 80% of TBV? Sure. But that scenario implies a +1% total return over the next 12 months including dividends and a conservative view of what the company will earn and further assumes book value is NOT accelerating ahead of what earnings would imply as management buys stock below book (all very conservative assumptions). However, if over the next 12-months, when it dawns on investors and analysts that we are just two quarters away from a dramatic increase in free and clear capital generation, the stock climbs to just book value (again, I’m using book value assuming no book value-accretive, below-book buybacks, which is very unlikely) the 12-month return implies 34%.  

Is there upside to that? Yes. Given the large and prolonged acceleration in capital return ($425-560 million every year for at least eight consecutive years; see the table below), it is reasonable investors may be willing to pay 12-month-out book. This would imply a 45-50%+ total return over where the stock can be bought today.

And one more thing…While investors and analysts have not paid close attention to upcoming contingent reserve releases and their impact on the ability to return capital, one can be certain the situation is not lost on potential acquirers. PE firm Apollo and its insurance arms (Athene, Aspen et al)  have likely done the math on how quickly they could payback the purchase price (or the debt raised to make a purchase) of RDN given the capital that will start to become available in 18 months. As a policy, we never make acquisition a pillar of an investment thesis as there are always too many unknowns; both timing and otherwise. However, we did notice that almost exactly a year ago Apollo’s Aspen hired a very senior executive from the MI subsidiary of Arch (ACGL)  to lead its mortgage business, which is curious as Aspen is not in the mortgage insurance business… at least not yet.

https://www.artemis.bm/news/aspen-hires-rippert-from-arch-as-evp-head-of-mortgage/

The details around Contingent Reserve releases.

Since most insurance focused investors are not familiar with the mechanics of why RDN has such a large contingent reserve and why they are getting close to being able to access it, we present the relevant disclosure from the 2021 10K below. Note that since the 10k was filed, the company has updated its projections and now expects the “unassigned surplus” to turn positive in 2023 based on Q1 results and its current outlook for profitability the remainder of 2022 and 2023. 

(Bolding is mine)

 “At December 31, 2021, Radian Guaranty had a negative unassigned surplus balance of $562.8 million, primarily due to the need for mortgage guaranty insurers to establish and maintain contingency reserves, as further discussed below.

 For statutory reporting, mortgage insurance companies are required annually to set aside contingency reserves in an amount equal to 50% of earned premiums. The contingency reserve, which is designed to be a reserve against catastrophic losses, essentially restricts dividends and other ordinary distributions by mortgage insurance companies as such amounts cannot be released into surplus for a period of 10 years, except when loss ratios exceed 35%, in which case the amount above 35% can be released under certain circumstances.

In light of Radian Guaranty’s negative unassigned surplus and the ongoing need to set aside contingency reserves, we do not anticipate that Radian Guaranty will be permitted under applicable insurance laws to pay ordinary dividends to Radian Group for the next several years.”

 130 pages later:

 Based on the typical 10 -year holding requirement, Radian Guaranty is scheduled to release contingency reserves to unassigned surplus beginning in 2024. See “—Statutory Dividend Restrictions” below for additional information.

 Footnote:

 Assuming the continuation of the current positive trends in our mortgage insurance business, we currently expect this transition from negative to positive unassigned funds to occur for Radian Guaranty in 2024. While all proposed dividends and distributions to stockholders must be filed with the Pennsylvania Insurance Department prior to payment, if a Pennsylvania domiciled insurer has positive unassigned funds, such insurer can pay dividends or other distributions out of such funds during any 12-month period in an aggregate amount less than or equal to the greater of: (i) 10% of the preceding year-end statutory policyholders’ surplus or (ii) the preceding year’s statutory net income, in each case without the prior approval of the Pennsylvania Insurance Department.

Risks:

Finally, let me hit on the pushback one gets when discussing RDN, specifically its exposure to a slowing housing market. While the prospects of decreasing housing prices are not a net positive, the current situation facing mortgage insurers is very unique. Most of the risk RDN faces was added before the massive run-up in home values we’ve experienced over the last several years. As such, the value of the collateral securing most of the mortgages RDN has insured has appreciated far above the mortgage balance. Further, rising rates will slow the pace at which homeowner with mortgage insurance will be able to refinance their mortgage and rid themselves of the cost of the insurance. This will increase RDN’s persistency (how long insurance stays in force) which is an important KPI for profitability. 

Perhaps home purchases will slow and RDN’s growth will be impacted. That’s fair and something I might worry about when RDN is trading at 115% of book and there is an inherent expectation of growth in the valuation. With significant and accelerating excess capital and an  86% of tangible book valuation I don’t worry so much. Slower growth just means more capital availability. We will worry about growth when the stock is significantly higher.  

To summarize:

1. RDN is an inherently inexpensive company.
2. There is a catalyst-driven glidepath to significant upside under very pedestrian assumptions,
3. Downside risk is limited.
4. Capital return is significant and for specific reasons is poised to materially accelerate.
5. The potential for an acquisition is real and logical.
6. Credit risk is benign.

Catalyst

Contingent reserve releases.

Accelerated buybacks.

Acquisition