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Shares of private mortgage insurer (PMI) MGIC Investment Corp. (MTG - Analyst Report) fell 9.5%, following the release of a draft regarding new capital requirements by the Federal Housing Finance Agency (FHFA). The draft – Private Mortgage Insurer Eligibility Requirements (PMIERS) – proposes new capital requirements that private mortgage insurers are required to meet in order to carry on business with the government-sponsored enterprises Fannie Mae and Freddie Mac.

The proposed rules will allow a two-year transition period to the insurers to equip themselves with the desired capital.

The PMIER will be open for public comment till Sep 8, 2014.  After this, the FHFA is expected to review and consider input before publishing the final requirements.  PMIERs in its full force will become effective 180 days after the final publication.  Approved insurers will be given an extended transition period, of up to two years from the final publication date, to comply with the financial requirements.

This regulation, which was in the making for a long time, pulled back shares of all the players in the mortgage insurance industry. In Friday’s trading, shares of Radian Inc. (RDN - Snapshot Report) fell 5.4%, Essent Group Ltd. (ESNT - Snapshot Report) was down 2.4% and Genworth Financial, Inc. (GNW - Analyst Report) lost 2.6%.

While the regulations would prove arduous for all the companies, MGIC is the worst sufferer. It will be an uphill task for the company to fortify its capital as it backs more riskier delinquent and older loans compared to its ilk.  Moreover, its debt obligations, materially exceeding cash and investments, will make it difficult for the company to gather new capital.

Role of Private Mortgage Insurers

PMI is a critical component of the housing finance industry, providing it with necessary lubrication. Fannie and Freddie require borrowers who put down less than 20% for private mortgage insurance.

For most homebuyers, the biggest hurdle to owning a home is the down payment of 20% without which even lenders’ hands are tied. Mortgage insurers here play a critical role of stepping in to provide financial guarantee to lenders, should a loan go into foreclosure. It is this guaranty that allows many lenders to sidestep the 20% down payment. The biggest benefit of PMI to the housing finance industry is that it increases the buying power.

Why Such Stringent Regulations?

These rules are intended to resurrect and protect the housing industry which suffered tremendously when the housing bubble burst.  During the financial crisis in 2008, mortgage insurance companies were left unable to pay for insurance obligations as claims on bad loans chipped away at capital reserves. A default by these mortgage insurers led to huge losses for Fannie Mae and Freddie Mac since these had relied on mortgage insurers to pay the former in case the borrower defaulted on loan.

A number of players were forced to exit the market after they were left with insufficient capital to pay for claim payments. PMI Group filed for bankruptcy protection in Nov 2011 after the Arizona Department of Insurance took over the main unit as claims on soured mortgages drained capital. Triad Guaranty Inc. also had to stop selling new policies when capital ran short, and Old Republic International Corp. (ORI) also cut down its mortgage insurance business after suffering huge losses.

The new regulation is a measure sought by the government to build the inherent strength of mortgage insurers to better manage and avoid the kind of loss and failure faced during the 2008 financial crisis. Government is also trying to shore up the market share of private mortgage insurance by limiting the role of its insurer, the FHA.

Will MGIC Investment be Able to Comply with PMIERs?

According to MGIC Investment, its Available Assets would be materially less than the Minimum Required Assets at both the projected effective date and two years thereafter.

We believe that raising capital could prove challenging for MGIC Investment which carries older, riskier insurance and has a high debt on its balance sheet.

Capital Position

The draft PMIERs requires MGIC Investment to carry required minimum assets of $5.9 billion as of Dec 31, 2014, but the company estimates $5.3 billion in assets by then, resulting in shortage of $600 million. MGIC Investment expects to cover $300 million of shortage from its ongoing operations over the two-year transition period.

But the company has a considerable amount of debt to redeem during this period. At Mar 31, 2014, it had approximately $542 million in cash and investments and debt obligations of $1,297 million, out of which $407 million has to be paid back by 2017. MGIC also incurs $66 million annually as interest on debt. With a substantial amount of debt to service it will be a herculean task for MGIC to gather the required capital.  

Though MGIC expects to utilize other options including external reinsurance and issuance of debt capital, it will only lead to increased financial leverage in the company’s capital structure.

Mix of Business

MGIC is exposed to a portion of business that carries higher probabilities of claims even when housing values are stable or rising. These characteristics include loans with loan-to-value ratios over 95%, FICO credit scores below 620, limited underwriting, including limited borrower documentation, or higher total debt-to-income ratios.

As of Mar 31, 2014, approximately 21.6% of the company’s primary risk in force consisted of loans with loan-to-value ratios greater than 95%, 6.5% had FICO credit scores below 620, and 6.7% had limited underwriting, including limited borrower documentation. Going forward, there is a huge possibility of these loans getting soured and resulting in operating loss.  

Of the other players, Radian needs $850 million to cover the shortfall now and Genworth Financial needs $550 million by Jun 30, 2015, to maintain the capital standards.  

Increased Activity Among Players

In order to arrange capital under the new regulation we expect players to resort to various measures such as external reinsurance which reduces capital that needs to be set aside as reserves; spinning out non-core business units and assets; raising of debt and also bringing out locked-up cash.  

We also expect to see aggressive lobbying from the industry group to make the regulations easier. Players are of the opinion that rather than strengthening the industry, the new regulations would restrict access to credit and increase the cost of homeownership thus driving away creditworthy borrowers. This would also increase the share of FHA in the mortgage market and drain out the share of private mortgage insurance.

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