Radian operates in the following businesses:
Mortgage insurance business provides credit protection for mortgage lenders and other financial services companies on residential mortgage assets through traditional mortgage insurance as well as other mortgage-backed structured products.
Financial guaranty business insures and reinsures credit-based risks and provides synthetic credit protection on various asset classes through credit default swaps.
Financial services business consists mainly of our ownership interests in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”)—a mortgage investment and servicing firm specializing in credit-sensitive, residential mortgage assets and residential mortgage-backed securities—and in Sherman Financial Services Group LLC (“Sherman”)—a consumer asset and servicing firm specializing in credit card and bankruptcy-plan consumer assets.
In 2006, MI provided 49% of revenue, Financial Guarantee 23% and Financial Services 28% of revenue respectively.
Following the collapse of the subprime market and the scandal with rating subprime debt a lot of the banks and insurers have taken a huge hit to their balance sheets. In this analysis, we look to see if Radian has a future and is an investment at these prices.
In the quarter ending June 30th, each of the above segments contributed to income as follows:
Mortgage Insurance: -28.2 million
Financial Guarantee: 22 million
Financial Services: 27.3 million
The company reported a profit overall despite a negative mortgage insurance segment.
Interestingly enough, MTG also reported a profit in this quarter. But MTG reported a loss in Q3 and issued the following guidance regarding FY08.
MTG is providing the following guidance for the remainder of 2007 and the full year 2008:
•2007 Fourth Quarter paid losses approximating $270 to $290 million
• 2008 paid losses approximating $1.2 to $1.5 billion
This is the worst case loss of 1.8 billion with a shareholders equity of 4 billion for MTG.
Let us now look at Radian Q3. In the business call on 9/5/07, management offered the following scenarios for book value from 2007 through 2010. Book value of $46.9 in 07, $49 in 08, $54 in 09 and $59 in 10.
The Q3 book value came in less than what management predicted at $42.86.
From Q3 onwards, the company will only have two lines of business, mortgage insurance and financial services. In both these sectors, the company took a loss by valuing the derivatives to the mark to market criteria. Excluding this, the loss in the MI division was about 200 million. Financial Services had a slight profit. The company booked a large loss in Q3 and wrote off all of CBass investment. The company also thinks it can pay off the mortgage liability from the reserves and has adequate capitalization.
The stock holder equity was 2.2 billion in the MI division and 1.3 billion in financial services division.
Now let us look at two scenarios. The first one is the normal case as outlined by the company. This involves about 10% loss in the bubble states such as California and Texas. This is also the worst case envisioned by some other independent groups as well. The stress case involves taking 20% loss in these states and the company should do fine in this case. The reduction in book value in Q3 came in as management had expected except for the mark to market of derivatives. In the worst case, one can expect the book value to go to $30 in this scenario.
In the second scenario, we can expect the losses to continue till end of 2008 and mid 2009 at the current rate and another write off of 1 billion from the book value. This should still leave 2.1 billion in book value about 3 times the current market price for the stock. Even writing off the entire mortgage insurance business off still leaves a value of around ~$19/share in Radian.
The great risk for the company is downgrading of its credit from AA to a lower grade by SP and Moody's. In this case, the business may be harmed beyond repair. In the conference call, management was confident that it will be able to maintain its rating.
This stock has high uncertainty and low risk built in. A patient investor may be rewarded handsomely for holding on to this asset.