Why You Should Consider Mortgage Finance

Nathaniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

While the economy is finally starting to show signs of a recovery, opportunity within the finance sector can possibly still be found within an unconventional, niche industry. The majority of the financial sector, everything from the credit to the small regionals, have performed exceptionally well of late.

Why?

Rising interest rates, improving credit quality, and a recovering housing market have created a near-perfect storm for this industry. Financial companies, which have taken themselves to the highest level of operating efficiency, are now ready to benefit from this environment. The institutions can afford to lend greater amounts due to improving credit quality at higher interest rates, thus leaving the potential for great growth in net interest income. 

A niche industry you may have never heard of, mortgage insurance, may benefit greatly during this time of recovery. Companies within this sector write insurance policies that protect mortgage lenders or title holders in the event that the borrower defaults on payments, dies, or is otherwise unable to to pay mortgage. I would like to highlight three stocks positioned to benefit from the major tailwind that I just mentioned.

Paulson's picks

First up, Radian Group (NYSE: RDN), a favorite of none other than John Paulson. If you remember, it was Paulson who famously called the collapse of the financial markets and profited by taking large short positions in high risk mortgages. Well, the tides have turned, Paulson is now bullish on the housing and real estate recovery. Recently, he took a bullish position in Radian as the company is set to benefit from decreasing risk associated with its insurance portfolio.

Radian provides investors direct exposure to the mortgage insurance industry through its subsidiaries. Over the last few months, the company has witnessed its delinquency rates fall 7%, a bullish indicator of momentum to come. Analysts are expecting just over $1.00 per share in earnings next year, giving the company a forward earnings multiple of 13 times, which is not bad considering the housing recovery is just getting underway. 

Next Up, MGIC Investment (NYSE: MTG), another favorite of the hedge fund legend Paulson. While shares have moved up by over 100% this year, some believe the run is far from over. The company itself has predicted quarterly losses for the foreseeable quarters, however, analysts covering the company have taken a slightly more bullish stance on it of late.

By 2014, the Street believes the company will register a small, $0.19 per share profit for the fiscal year. More recently, the company has improved its profitability situation with help from the recovering economy. A combination of new issuance and declining delinquencies has helped it over the last few months. Delinquency loans dropped 6% while new issuance rose 17%. Looking forward, I would expect to see delinquency rates remain stable around these levels, improving credit quality, and declining debit balances have put people in a great position financially. For example, delinquency rates on credit cards for the largest issuers sit at roughly half of the typical levels. 

Diversified exposure

When writing about companies with high risks, I always like to include an alternative investment vehicle for the more risk adverse investor. In this case, I want to highlight an exchanged traded fund, the SPDR S&P Mortgage Finance ETF (NYSEMKT: KME) provides investors diversified exposure within the broader mortgage finance industry. Below, I have created a chart showing the current breakdown of the fund.

Investors will receive diversification and exposure to both the housing recovery and insurance sectors. The housing recovery portion of this portfolio will benefit from greater housing demand and credit quality as mentioned previously. Additionally, the insurance portion of this portfolio will benefit from increasing interest rates as these firms can generate higher return on the lumps of cash they currently have parked in low yielding products. 

Summary

The mortgage finance industry stands to benefit from a number of tailwinds, including higher credit quality, lower delinquencies, and rising interest rates. Investors might consider the options above to benefit from these drivers.

With the American markets reaching new highs, investors and pundits alike are skeptical about future growth. They shouldn't be. Many global regions are still stuck in neutral, and their resurgence could result in windfall profits for select companies. A recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!


Nathaniel Matherson has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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