How Kyle Bass is Playing the Housing Recovery

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Last November, Kyle Bass’s hedge fund, Hayman Capital Management, filed a 13G disclosing its 4.9% stake in Milwaukee-based private mortgage insurer MGIC Investment Corp (NYSE: MTG) (read more on the announcement). His investment was predicated on the belief that the housing market was near or already at its bottom. This may have been prescient given that the S&P/Case-Shiller index fell 3.5% in February, the smallest 12-month drop since February 2011. The data was interpreted by some investors as a possible trough. In the subsequent months after the announcement, MTG shares shot to over $5—the stock closed at $3.56 on Friday.

MTG operates in the mortgage insurance industry, offering lenders protection against homeowners that put down a down payment that amounts to less than 20% of the home price when purchasing a home. In the early 2000s, MTG and fellow insurers, Radian Group (NYSE: RDN), Genworth (NYSE: GNW), and American International Group (NYSE: AIG) insured millions of mortgages at low premiums. This led to massive losses in the aftermath of the financial crisis when mortgage insurers had to pay up, forcing a number of competitors to go out of business and leaving those that survived in precarious financial situations.

Fast forward to this past Monday when MTG reported Q1 earnings. The losses remain with the quarter being the seventh straight quarterly loss. The reported loss was $19.6 million but realized gains rose to $77.6 million, up significantly from $5.8 million a year ago. Earnings were only slightly weaker than expected and due to the company’s increase of reserves (from $26.0k per delinquent loan to $26.2k per delinquent loan). We actually view this move toward conservatism in a positive light. We also see other positives. MTG reported its lowest rate of new defaults in five quarters and a 20% decline in new notices of default, which indicates how many newly insured mortgages became delinquent in the quarter. Net paid claims were down as well. In spite of the loss, the risk-to-capital ratio stayed at 20.3:1 though will likely increase if unprofitability lingers.

The second half of the year will be crucial in instilling confidence in the company. Unfortunately, due to seasonality, trends in the summertime tend to lean toward higher delinquency rates and higher incurred losses, which would put downward pressure on book value and the stock itself. There are concerns that recent trends suggest new notices will remain high enough to continue the erosion in capital, keeping the pressure on capital and limiting operating flexibility. No doubt, investors will be scrutinizing how the company manages these trends.

Now let’s take a look at the other major players in the industry. RDN reports its Q1 results on May 1. Its March data was consistent with seasonality and like the broader industry, saw improvement in credit quality. Defaults were down y-o-y and new insurance written was up $0.3 billion. RDN also entered into a quota share reinsurance agreement through which it will be able to offload $1.3 billion to $1.6 billion of risk. GNW has not faired well, taking a hit recently after making a bad bet on the Australian real estate market. GNW’s shares were down 24% on April 18 alone after the company reported heavy losses in Australia, postponing the regions’ planned IPO until 2013. GNW had announced last November plans for the carve-out IPO, but given the poor performance and reevaluation of the unit’s credit rating by Moody’s, we think 2013 may be optimistic. GNW is a major insurance conglomerate but strictly speaking from the mortgage insurance business point of view, we would stay away from the company.

MTG’s recent underperformance—shares were down 27.7% in the two and a half weeks leading up to Q1 earnings—accelerated post-earnings but has come back up. The initial sell-off had us questioning if Bass had missed something. Were the underlying industry trends and company specific metrics that much worse than investors expected? Certainly another quarterly loss is disappointing but not totally unexpected. The losses were modest and MTG was up ~5% on Thursday and mostly flat on Friday, erasing losses from prior days. Bass (read his December Letter to Investors) commented that he thinks “they’ll be one of the last ones standing” and that his fund is “in it for the long haul.” We agree with Bass, though expect to see additional volatility. We would buy a couple tranches if shares dip below $3.30. 


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