Bloomberg News

PMI Swaps Signal Mortgage Insurer May Default: Corporate Finance

June 29, 2011

June 29 (Bloomberg) -- PMI Group Inc., the third-largest guarantor of U.S. home loans, may be headed toward default following four years of losses, trading in credit derivatives shows.

Credit-default swaps on PMI at about a 16-month high imply an 85 percent probability of default within five years, according to data-provider CMA. The Walnut Creek, California- based company’s ability to write new business may be frozen if it fails to meet regulatory capital requirements by the end of September, according to CreditSights Inc.

PMI, which pays lenders when homeowners default and foreclosures fail to recoup all of the mortgages, has posted 15 straight quarterly losses amid the worst slump in U.S. housing prices since the Great Depression. Home prices decreased in the year ended in April by the most in 17 months, according to the S&P/Case-Shiller index of property values in 20 cities.

“Eventually this company has to go bankrupt. I just don’t see this company ultimately surviving, but it can survive a long time,” said Jonathan Carmel, founder and money manager at Carmel Asset Management LLC in New York. “People are nervous. They’ll squeak past it for the time being.”

Insurers need to show U.S. regulators they have sufficient capital to back policies, and many states require a risk- capital ratio of less than 25-to-1. The company repatriated $14.5 million from a European business in April to bolster U.S. unit PMI Mortgage Insurance Co., or MIC. MIC’s risk-to-capital ratio was 24.4-to-1 for the first quarter, up from 8.3-to-1 in the comparable period of 2007.

‘Out of Compliance’

“As a result of continuing losses, we expect that MIC will be out of compliance with applicable regulatory requirements in the second quarter of 2011,” and may be prohibited from issuing new policies in 16 states, PMI said in its May 5 earnings statement. PMI said it has received or requested waivers where applicable in the states in which it fails to meet requirements.

Its principal overseer in Arizona, where MIC is domiciled, told the company in March it isn’t required to obtain a waiver to continue writing business if it fails to meet requirements. The insurer may try to sell coverage from a different subsidiary if MIC is prohibited from selling new policies.

Kosta Karmaniolas, a spokesman for the company, declined to comment.

A regulatory seizure of MIC would trigger a cross-default, according to a June 8 CreditSights Inc. note. The cost to protect against a default by PMI, which has been publicly traded since 1995, has held at about a 16-month high, with five-year credit-default swaps tied to the company’s debt diverging from the other so-called monoline mortgage insurers, MGIC Investment Corp. and Radian Group Inc., by the most on record.

PMI Swaps

Contracts on PMI’s debt climbed to 37.7 percent upfront yesterday, according to CMA. That’s more than six times their level on Dec. 31, and means investors would pay $3.77 million initially and $500,000 annually to protect $10 million of the insurer’s obligations.

Radian’s risk-to-capital ratio was 20.3-to-1 as of March 31, according to its latest quarterly filing, and MGIC’s, excluding combined insurance operations, was 19.7-to-1, its filing shows. PMI is running out of options if its risk levels, already the highest of the three, deteriorate, according to Matthew Howlett, an analyst at Macquarie Group Ltd.

“They’ve already asked for and received waivers from states to continue running their business. At some point, if the capital levels keep eroding, there are not a lot of other things they can do,” he said. “What the market is saying is, how much further will regulators bend the rules for this company that’s honestly in a very weak operating position?”

Default Probability

Howlett, who has a “neutral” rating on the company’s stock, does not expect a default this year.

The swap contract’s implied probability of default is up from 44 percent on Dec. 31, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

PMI is rated Caa2 with a positive outlook by Moody’s Investors Service and CCC- by Standard & Poor’s. S&P lowered PMI’s counterparty credit and senior debt ratings from CCC+ on June 14, and said it may cut the rankings further, citing “expectations of continued elevated losses in 2011 and 2012” relative to its capital.

‘Significant Pressure’

“Losses in line with or in excess of the current industry trends -- without additional capital contributions or substantial internal capital generating initiatives -- could put significant pressure on PMI’s statutory capital by year-end 2012,” S&P analysts led by Miles Kaschalk wrote in the note.

“Even with various capital raises, we’ve seen PMI statutory capital dwindle over the past couple of years,” New York-based Kaschalk said in an interview. “As losses emerge, the capital continues to decline, so based on our forecast, we’re seeing the statutory capital decreasing to a significantly low level, a point where you start to have concerns about the regulators cutting off new business writings.”

High-yield insurers bonds have lost 3.46 percent this month, while overall junk debt dropped 1.68 percent, according to Bank of America Merrill Lynch index data.

Mortgage insurers are resolving “very problematic legacy portfolios” while facing relatively low demand on better- quality new business, said Guy LeBas, chief fixed-income strategist and economist at Janney Montgomery Scott LLC.

Triad Guaranty

“I suspect that will someday change, and given the administration’s proposals for mortgage market reform, there’s good long-term potential for the industry,” Philadelphia-based LeBas said in an e-mail. “But the light on the horizon is many years off, whereas the problems are very much immediate.”

Triad Guaranty Inc. was forced to stop selling mortgage insurance in June 2008 when government-backed Freddie Mac disqualified it as a guarantor of new home loans.

PMI’s $250 million of 6 percent notes due in September 2016 plummeted to 59.5 cents on the dollar with a yield of 18.3 percent yesterday from as high as 81 cents with a 10.6 percent yield in February, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The notes were issued in September 2006 to yield 6.01 percent, or 1.25 percentage points more than similar-maturity Treasuries, Bloomberg data show. At the time, the mortgage insurer was graded A by S&P and its senior unsecured debt was assigned an A1, a step higher, by Moody’s. The current spread is 16.74 percentage points, Trace data show.

Spreads Widen

Average spreads on PMI’s debt have expanded to 1,475 basis points, or 14.75 percentage points, as of June 27 from 726 basis points at the start of the year, Bank of America Merrill Lynch index data show.

PMI ended at $1.15, down 1 cent, in New York Stock Exchange composite trading yesterday. The shares have fallen 65 percent in the past 12 months as the housing market remains an obstacle for the U.S. recovery. MGIC has declined 26 percent and no. 2 Radian has fallen 53 percent.

“In an industry that’s still trying to turn itself around, PMI has the lowest cushion and lowest margin of error among the three monoline mortgage insurers, and that’s weighing on the stock and bond prices,” said New York-based Howlett. “If losses do accelerate in the mortgage insurance industry, they’re clearly in the worst position.”

‘Positive Catalyst’

PMI agreed to sell its Australian and Asian units to QBE Insurance Group Ltd. for about $896 million in August 2008. Assuming full payout, the parent company will get about $208 million in September and MIC received $25 million from QBE, adding 94 cents per share, the company said in a May 5 earnings call.

“That may be a positive catalyst for the CDS and the bonds,” Jeff Peskind, founder of Phoenix Investment Adviser LLC, which oversees $300 million in New York, including some PMI debt. “That’s really kind of a short-term issue. What really needs to happen is the homebuilding cycle needs to gain a little traction.”

PMI will use those proceeds to pay off a $48 million short- term lending facility maturing in October, Macquarie’s Howlett said. After that payment, the company’s next major debt maturity is in 2016 with the $250 million of 6 percent notes, Bloomberg data show.

Housing Falls

The S&P/Case-Shiller index fell 4 percent from April 2010, the biggest drop since November 2009, a report yesterday showed. Robert Shiller, an economist who created the index with Karl Case, told a conference in New York this month that a further decline in property values of 10 percent to 25 percent in the next five years “wouldn’t surprise me at all.”

“There’s no precedent for this statistically, so no way to predict,” Shiller said June 9 at the conference hosted by S&P.

PMI’s new business writings have been “limited” over the past two years by competition from the Federal Housing Administration, and this year by “lower than expected residential mortgage originations,” according to its latest quarterly filing.

“This one is not for the faint of heart but we think there’s decent liquidity and a decent chance for the company to have enough time for the market to recover,” Peskind said. “If this thing turns, people will make a lot of money in this space.”

--With assistance from Noah Buhayar, Andrew Frye, and Shannon D. Harrington in New York. Editors: Mitchell Martin, Alan Goldstein

To contact the reporters on this story: Mary Childs in New York at mchilds5@bloomberg.net; Sapna Maheshwari in New York at sapnam@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net


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