Reserve Worries Put MGIC Behind the Eight-Ball
By Peter Eavis
Senior Columnist
01/10/2003 07:18 AM EST
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It must've been magic that caused the 7% pop in MGIC Investment (MTG:NYSE - news - commentary - research - analysis) shares Thursday, because the company's earnings were far from spellbinding.
Indeed, the mortgage insurer's fourth-quarter earnings, released before the start of regular trading, showed deteriorating credit quality, continued skimping on bad loan reserves and heavy use of a low-quality revenue source. And, oh yes, the Milwaukee-based company took its 2003 earnings guidance down -- to a range of $5.85 to $6.10 per share, from $6.05 to $6.20.
Detox last took a close look at MGIC in September, after a previous reduction in earnings estimates. Because of nervousness over credit quality, MGIC's stock trades nearly 40% below its 52-week high. However, some investors are betting that the company is poised to do well if the economy recovers because mortgage defaults will decline.
But there are two big weaknesses in that approach. MGIC's insurance book has grown strongly in the past few years, and nasty surprises often follow a binge -- even in a favorable economic environment. Second, MGIC appears to have substantially under-reserved during the expansion of its book, and that seems to be catching up with the company. Indeed, skeptics say the main problem with MGIC's business model is that it allows for the front-loading of earnings. Reserves for losses are built well after the insurance business is written.
MGIC didn't reply to an email asking for comment.
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Thursday, the company was keen to point to a big increase in reserves in its fourth quarter, but a key ratio for measuring the adequacy of the reserves remained more or less flat compared with the prior quarter and well below recent historical levels. Reserves per loan in default were $9,955 in the fourth quarter vs. $9,941 in the preceding period. But these numbers look skimpy next to $11,228 at the end of 2001 and $16,228 at the end of 2000.
What's hard to explain is how this reserve ratio has fallen when defaults are rising. The default rate for the entire portfolio was 4.45% in the fourth quarter, substantially higher than in the year-ago period and up on the prior quarter. The default rate on mortgages to people with impaired credit, or subprime borrowers, jumped to 12.68% in the fourth quarter from 11.68% in the year-earlier period. Recent housing statistics show much stress in the subprime mortgage sector.
Clearly, a good case can be made for adding more reserves. But if the company had done so, earnings could've suffered. And there is other evidence in the income statement that MGIC had to stretch to hit numbers. The "other revenue" line was $45 million in the fourth quarter, substantially higher than in any of the previous three quarters. Other revenue contains income from C-BASS, a part-owned entity that takes impaired loans and sells them. Income from sales is booked upfront, and is considered lower quality by most investors because a company's assumptions can turn out to be too rosy. But that $45 million was nearly a fourth of pretax income in the fourth quarter.
MGIC stock may be ramping, but don't fall under its spell. |
