Much of the housing sector is already capturing these trends, but one pocket still looks cheap: mortgage insurance companies.
Barron’s found three stocks that look attractive:
(MTG). The stock looks inexpensive, trades at single digits price / earnings, and has a low price-to-book value ratio. They are consistently profitable and their bottom line is expected to grow more than 10% next year. The long-term outlook depends on the rates and rate of default on the mortgage. But the industry seems to have learned a lesson from the latest housing collapse – building additional capital buffers, shifting risks onto reinsurers, and reaping the benefits of tightening lending standards.
“We had a significant airbag on our way to this crisis and that was a really positive development,” says Claudia Merkle, CEO of NMI Holdings. “We see a really strong market in 2021 and probably beyond.”
Mortgage insurance protects lenders in the event of default on the loan and, ultimately, foreclosure. Borrowers with good credit history and a 20% down payment are not required to purchase mortgage insurance, which is usually included in monthly payments. The Federal Housing Administration provides mortgage insurance to borrowers with low creditworthiness, typically with a rating below 620. This still leaves a vast market for new buyers and others who require private mortgage insurance to obtain a loan. But private insurance for borrowers with a higher credit history remains a vast market; Phil Stefano, an analyst at Deutsche Bank Securities, said 16% of mortgages will be privately insured this year, representing $ 544 billion in new policies, up from $ 600 billion last year, but still close to record levels.
High house prices, while limiting affordability, can expand the insurance pool. More borrowers tend to buy insurance as home prices rise (as 20% down payment becomes a higher hurdle); refinancing is also increasing as borrowers seek to lock in lower rates even if they have not yet reached the home equity threshold to avoid insurance. Half of the mortgage insurance market is made up of first-time buyers who can shell out as little as 3% on an insured loan. Rising prices could also delay the transfer of foreclosures, as banks and borrowers have more room to maneuver to sell property or make changes to a loan.
The industry has come a long way from the financial crisis. Lending standards have tightened as
as well as
established stricter requirements for loans subject to securitization (purchase of the overwhelming majority). Insurers must now hold more capital in case of losses. Companies also use reinsurance to further prevent losses, including financing through insurance-linked bills.
Insurance pricing has also become more complex, with companies using black box formulas to determine quotes based on a variety of criteria, including credit rating, debt-to-income ratio, and geographic market data. “There are so many ways you can now set a granular price,” says Merkle. “This allows us to make sure we are cutting out the right risk and credit structure.”
Two large headwinds can knock stocks down. One of them is the federal moratorium on property alienation, introduced during the pandemic. Borrowers participating in the program receive a repayment break of up to 18 months. According to the Association of Mortgage Bankers, at the end of May, about 4% of mortgage loans were on hold. The rate drops, but the payback is coming: the program expires at the end of June, and lenders could begin foreclosures in October, potentially burdening insurers with claims.
The housing market may also peak, moving away from pandemic-triggered sales and price increases… If bond yields and mortgage rates begin to rise, potentially in 2022 or 2023, this could reduce demand and loan volume, putting pressure on insurer stocks.
The dynamics would not be completely negative; insurers will receive higher returns on their underlying bond portfolios and are likely to hold insured loans for longer as fewer people refinance and discontinue insurance (which happens automatically when the borrower’s equity reaches 22%). However, the end of the boom will not be positive, even if it is a soft landing. “You have two cycles playing out: late payment losses as the grace period ends, and uncertainty about when the Fed will crush the market,” said Mark Dwelle, an analyst at RBC Capital Markets.
However, stock prices are not particularly encouraging as they are trading at undervalued prices. The catalyst for rising prices could be more mortgages that “recover” from leniency as borrowers exit the program and pay back – freeing insurers’ reserves and increasing their return on equity. “If leniency works well, it could boost revenues in 2022,” says Dwelle.
NMI Holdings, founded in 2011, is the smallest major insurance company, but is growing rapidly. In the first quarter, the company issued policies worth $ 26.4 billion, up 33% from the fourth quarter of 2020 and 134% more than a year earlier. The incumbent insurer reached $ 124 billion, up 26% from last year, and the default rate is declining, dropping to 2.04% in May from 3.6% at the end of September.
NMI’s return on equity, or ROE, a key indicator of earnings, was 15.4% in the last quarter, up from 24.5% a year earlier. The increase in provisions for possible losses has reduced the return on equity, mainly due to the fact that mortgage loans have ceased to function. Merkle says many of these mortgages can be cured. “We expect that the vast majority of defaults will not escalate into lawsuits,” she says.
NMIs are traded with a book value 1.4 times the industry average. This looks more reasonable with a 2022 estimate of 1.1 times the size of the book. BTIG analyst Ryan Gilbert calls this his top pick. “They make up high quality insurance, and they have a history of structural growth that others don’t,” he says, expecting the stock to trade at double its book value, supporting the $ 33 price tag.
Essent also trades at a premium of 1.2 times its book value, reflecting several key strengths. One is the industry-leading operating margin of 69%. The company began operations in 2008 and did not begin underwriting until 2010, avoiding the default resistance of the housing recession. Founder and CEO Marc Casale, who listed Essent in 2013, runs a conservative company with $ 197 billion in insurance and 7.7% debt to equity, less than a third of the industry average. Essent also has robust $ 2.1 billion loss protection in reinsurance versus $ 4 billion in equity. Its credit ratings are industry leading.
“The volatility of our earnings is much less than even five years ago,” says Casale, who has incorporated a company in Bermuda while maintaining a low tax rate. Essent sets insurance prices using more sophisticated tools, recently launching a new 400-factor pricing system that uses artificial intelligence to generate the highest premiums with the lowest risk.
Essent’s conservatism may have cost him some market share as price pressures have increased recently. Its market share fell to 13% in the first quarter from 18% in 2020. Casale expects it to return to its historical average of around 16%. The key factor will be existing insurance, which he expects to grow as mortgage rates rise. “We won’t have that much churn,” as refinancing will slow down, he says. And if rates do not rise sharply, purchase volumes will remain unchanged, and the profitability of insurance premiums will rise.
Deutsche Bank analyst Phil Stefano calls Essent a “best-in-class” operator, expecting its shares to rise to $ 61. BTIG’s Gilbert also rates it a “Buy” with a target price of $ 58. Even at that price, the stock will trade just under 10x the consensus forecast for earnings of $ 6.07 a share in 2022.
MGIC is more of a game of value in one go. The discount comes from his portfolio of legacy mortgages he insured during the 2008 home collapse, which is less than 10% of the $ 252 billion in current insurance. Failure to meet obligations on previous mortgages continues to put pressure on the company’s return on equity. But CEO Tim Mattke says legacy loans will no longer be delinquent at disproportionate rates, compared to recent policymakers. “They are performing as well or better than we expected,” he says.
At the end of March, MGIC had a surplus capital of $ 2.3 billion, or 141% of regulatory requirements. Delinquencies have been steadily declining, to 4.7% of the portfolio in the first quarter. If they continue to fall, the company could free up some loss reserves, potentially increasing its return on equity.
Mattke thinks the outlook for 2022 looks good. While refinancing is likely to decline as rates rise, it could keep more insurance while maintaining profits. As millennials enter their peak home buying, he said, demand for home purchases should remain strong. “We think there is a good cohort of first-time buyers coming to the market,” he says.
Gilbert expects the stock to rise to $ 17 from recent prices of around $ 14, driven by a positive trend towards default through 2022. At $ 17, he estimates the share will be worth 1.2 times the book value of $ 13.95 per share. Investors will find it difficult to find a cheaper game in rebuilding the housing stock.
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