Hi CB, Maybe this company can finance my Christmas present more willingly than FNM ...
Chugs, Jay
grantsinvestor.com
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RISKY BUSINESS
by Mary Levai
Robert Tracy 07:00 AM 07|06|2001
As Radian Group gets ever chummier with subprime borrowers and higher loan-to-value credits, the potential rewards seem way too skimpy to balance the risks, particularly in a deteriorating economic atmosphere.
If you love risk taking, you can indulge yourself in a number of ways. Why not grease some pitons and go rappelling in the rain? Or skateboard blindfolded in city traffic? Or, you might decide to do what Radian Group does: write mortgage insurance for banks that loan nearly the full purchase price of a home to subprime applicants. Such exhilaratingly risky behavior is more and more becoming the lucrative bread and butter for RDN, a mortgage insurer based in Philadelphia. Risk is not without its rewards, of course, and Radian's earnings have risen steadily over the past eight years as mortgage bankers, commercial banks and savings-and-loan institutions bought lots of policies to protect against default by borrowers. The downside is that defaults have been increasing.
But why should Radian fret? It's got a trusty talisman, its trademarked Prophet ScoreÒ , to ward off the demons of mass default while it rakes in the premiums that risk commands. According to Radian, the Prophet can "accurately measure the impact that future losses may have on [a lending institution's] profits." Maybe so, but Grant's Investor prefers another sort of tool. It's called old-fashioned financial analysis. And when we examine Radian's increasing exposure to risk through subprime loans and high loan-to-value credits, our magic eight ball says, "Beware."
In today's lending landscape, mortgage insurance has become something of a fixture, protecting lenders against default by borrowers who put down less than 20% toward the purchase of a house. Radian covers policyholders for either 25% or 30% of the purchase price of a house, that is, the first 25% or 30% of loss incurred by a lender. In general, it writes 30% coverage on mortgage loans-to-value (LTVs) of 90% to 95%, and 25% coverage on LTVs of 85% to 90%. An onslaught of would-be homeowners able to put down no more than 20% is driving demand for mortgage insurance nationwide. In fact, 23% of home buyers deposit only 10% or less on a house today, according to the U.S. Federal Housing Finance Board, more than double the share of mortgagees who made such small down payments in decades past.
Little wonder that the business of insuring the mortgage providers has been brisk, lifting Radian's earnings to $0.96 a share in this year's first quarter from $0.77 in the year-earlier period. And with RDN currently trading at a split-adjusted $39, investors pay a seemingly cheap 11 times trailing 12-month earnings and about 1.7 times book value for a piece of the profitability. What is more, Radian expects to both diversify and strengthen its revenue growth with the recent purchase of Enhance Financial Services, a reinsurer of municipal and asset-backed debt obligations. If all goes well, the company will earn about $3.75 per split-adjusted share this year and $4.25 next year, according to the experts.
But smooth sailing is not exactly baked in the cake. For one thing, there is the growing risk associated with insuring higher LTVs. In the company's annual report, management says, "One of the most important determinants of claim incidence is the relative amount of borrower's equity (down payment) in the home. The expectation of claim incidence on 95s (loan-to-value ratios of 95%) is approximately two times the expected claim incidence on the 90s." Nevertheless, from 1999 to 2000, Radian increased its exposure to higher-risk LTVs (95%-plus) to 6.7% of its total portfolio from 4.8%, while decreasing its lower-risk LTVs (85.01% to 90.00%) to 41.4% from 43.9%.
Compounding the risk is Radian's soaring exposure to subprime borrowers. During the first quarter, new underwriting of subprime mortgages accounted for 31.5% of the company's primary (vs. pool) insurance, up from 16.8% a year before. (Primary insurance, which makes up 95% of Radian's business, is written on individual loans, whereas pool insurance is written on a group of loans. The latter is offered to state housing finance agencies on the collateral for their bond issues and for the mortgages included in mortgage-backed securities.) Radian's growing appetite for insuring subprime business has not gone unnoticed by its peers. Darryl W. Thompson, president and CEO of Triad Guarantee, a mortgage insurer with a more conservative outlook, acknowledges "a trend [toward] getting involved with more A-minus paper, and, to some extent, maybe subprime. But Radian," he says, "has probably done more of that than most." ("A-minus" ranks just above "subprime" on the FICO scale, which is used by mortgage lenders nationwide.)
Given that Radian has nearly doubled its subprime business, shareholders must ask whether the premiums generated are worth the risk. If history is any guide, the answer is no. Already, the company is grappling with a steadily rising default rate on its subprime primary loans. Defaults in this segment have risen from 3.6% in 1999 to 4.1% in 2000 to 4.4% in the first quarter of this year. Viewed from another perspective, the loss provision for defaults (excluding Enhance Financial), expressed as a percentage of premiums earned on the policies, rose to 32.1% in this year's first quarter from 30.5% a year before. And as the company concedes, "Although higher premium rates and surcharges are charged in order to compensate for the additional risk [of non-prime loans], these products are relatively new and have never been insured in an adverse economic situation, so there is no assurance that the premium rates are adequate, or the loss performance will be at or close to expected levels."
So, Radian admits that it is sailing its non-prime loans into the uncharted waters of an economic downturn, and cannot possibly determine adequate loss reserves. (That is so like a prophet to be mute when needed most.) And thanks to a quirk in GAAP, Radian investors have also been denied a transparent profit-and-loss statement. Radian, it seems, recognizes revenues from higher-risk premiums in the period they're earned, but under GAAP rules, it does not have to reserve for default-related losses from these policies until default actually occurs. This makes for a very handy way to "front end" earnings and thus produce a more pleasing profit picture, provided Radian continues to grow its underwriting revenues at breakneck pace. In short, investors whose heads have been turned by Radian's revenue stream may be getting a less-than-panoramic image of the risk the company has taken on to generate those revenues.
But if the P&L statement lacks clarity, other information sounds the alarm loud and clear: Radian is already experiencing margin pressure in its mortgage insurance business. In the first quarter, its net earnings margin on premiums earned dropped to 57.4% from 59.1% a year ago as costs rose for both loss provision and policy acquisition costs. The provision for losses as a percentage of premiums (again excluding Enhance Financial) rose to 32.1% from 30.5%. And in Radian's world, "provision for losses" means the estimated costs of settling claims on loans that are currently in default.
The coup de grace is that even if Radian had not increased its exposure to higher LTVs or subprime applicants, its risk as an underwriter of mortgage insurance would still be hypertrophic because of an accurate "timetable" for default that Radian itself identifies in its latest 10-Q: "Relatively few claims are received during the first two years following issuance of the policy. Historically, claim activity has reached its highest level in the third through fifth years after the year of loan origination. Approximately 69.1% of Radian's primary risk in force, and almost all of Radian's pool risk in force at March 31, 2001, had not yet reached its anticipated highest claim frequency." Or, to paraphrase John Paul Jones, "They have not yet begun to default."
The case against Radian may reside in the specifics of its weakening financial picture, but it is brought into sharper relief by troubles in the economy at large. Under a page-one banner headline, "More Falling Behind on Mortgage Payments," The New York Times recently observed that "the number of Americans who are behind on their mortgage payments has increased sharply in the last year. The increase is particularly worrisome, housing analysts say, because it suggests that many of the new homeowners, who were part of a surge in house-buying during the last decade, may not be able to afford their current mortgages during slow economic times. 'This is the first time these loans have been tested,' said Mark Zandi, an economist at Economy.com, a forecasting firm in West Chester, Pa. 'The pace at which things have eroded reveals severe stress.'"
What's more, mortgage lenders of all stripes have been courting subprime borrowers with high LTVs, the kind that Radian insures. Brian Nottage, the senior economist at Economy.com, told Grant's Investor, "There has been a concerted effort across the agencies, including the directives from Freddie and Fannie, to dramatically increase home ownership and home ownership opportunities in urban areas and among previously left-out groups. We're likely to see more deterioration across the board, but also with the FHA certainly." To wit, FHA delinquency rates have been on the rise, as the graph above makes clear. Triad Guarantee's Darryl Thompson observes a similar phenomenon among conventional mortgage lenders. "There's a trend today to get more involved with borrowers that have marginal credit. And I'd have to say that some of those aren't going to perform as well," he says flatly.
As if the specter of widespread mortgage default weren't enough to raise beads of perspiration on a Radian shareholder's brow, new business is falling off as well. Data provided by Mortgage Insurance Cos. of America, an industry trade group, indicate that the volume of new, insured mortgages declined 12% from March to April. Furthermore, International Strategy & Investment Group, a firm that specializes in economic research, recently noted that the downtrend extends to mortgage refinancing applications, too. Of course, delinquent mortgage payments and declining numbers of mortgage applicants go hand in glove with the atrophying creditworthiness of the American consumer. Apparently, most people have a hard time passing up offers of easy money from the Capital Ones of the world. According to the Federal Reserve, the U.S. household debt service burden from mortage debt reached 6.46% of disposable income as of the end of 2000. In addition, personal bankruptcies reached a near-record 356,836 in the first three months of the year, the American Bankruptcy Institute reports.
And when the crescendo in "D" begins to build, declining property values may heighten Radian's pain. In a recent New York Times piece, Floyd Norris noted that after the 1987 stock market crash, real estate did not enter a bear market until the early 1990s. Were this pattern to hold true in the current economic slowdown, Radian would find itself having to pay the greatest number of claims just as the properties of defaulting homeowners were sinking in value. Thus, foreclosure sales, from which Radian could take its share of the pie, would be that much less lucrative. Remember, it insures against the first 25% to 30% of loss.
Further clouding the Radian picture is the February purchase of Enhance Financial Services for $540 million in stock and assumed debt. Though Enhance diversifies Radian's revenue stream, it may increase the company's risk in other ways. For the nine months ended last September 30, Enhance reported a year-over-year increase in premiums earned (the revenue recognized on the income statement) while new premiums written during the period actually decreased. In fact, net premiums written fell an alarming 22% for the three months ending last September 30. Stated another way, Enhance recognized more premiums than were generated by fresh underwriting. For example, a municipality might pay its 15-year-loan premium in full, but Enhance will not recognize the full amount upon receipt. Some portion of the premium earned will be accreted into the income statement over time. To make a bad situation worse, rising claims are eroding profit margins. The net margin on Enhance's insurance underwriting has plummeted from 41.29% in fiscal 1998 to 18.21% in fiscal 1999 to 15.03% in the nine months ended September 2000. All things considered, it appears that Radian Group may have bought itself a pricey lemon.
At the end of the day (and this article), after weighing the merits of Radian, our prophet scorer says, "More risk than reward."
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