A Tempting Bet on Housing Recovery

01/12/2011 12:32 pm EST

Focus: STOCKS

George Putnam

Editor, The Turnaround Letter

After surviving the real estate crash, private mortgage insurer MGIC is poised to profit from the demise of several competitors, writes George Putnam III in The Turnaround Letter.

MGIC Investment Corp. (NYSE: MTG) is the leading US private mortgage insurer; in fact, the company claims to have founded the mortgage insurance industry in 1957. After many years of relatively steady earnings, MGIC was forced to sharply increase its reserves beginning in 2007 as more homeowners began defaulting on their mortgages.

As a result, the company posted large losses in each of the last three years, which reduced its capital to a precarious level. Almost all of the other mortgage insurers suffered similar fates, with several competitors being forced out of business.

MGIC raised new capital in March 2008 and again in April 2010, and it now appears well situated to lead the mortgage insurance industry out of its depression. While the housing sector has yet to show any signs of sustained recovery, MGIC’s numbers are improving. The company has been actively working to reduce losses by seeking rescission of mortgages that were issued as a result of fraud. It is also benefiting as more troubled mortgages are modified. As a result, the inventory of delinquent loans has declined every month since July.

Best House on a Sketchy Block
In addition to reducing losses, MGIC is beginning to re-grow revenues. New business written has increased every month since April. With many competitors still struggling, the company appears well positioned to capture market share. Moreover, the new business is likely to be very profitable because the company has tightened its underwriting standards to avoid future losses even if the housing sector remains weak.

The government appears to be signaling that it wants to encourage the recovery of the private mortgage insurance industry. During the depths of the financial meltdown, the industry lost significant market share to the Federal Housing Administration (FHA). Now the FHA itself appears undercapitalized, and it is raising its rates, thereby making private insurance more competitive again. Recent regulations also provide a role for private insurance in federal mortgage programs.

Dramatic Profit Upside
When the housing industry finally does begin to recover, the effect on MGIC’s profits could be dramatic. Rising house prices would help to reduce losses in the legacy portfolio, and new home sales will lead to increased sales of new insurance.

There are still risks in MGIC. Like any insurance business, the company has very large potential insurance liabilities supported by a relatively small capital base. As a result, if losses started to build again, the stock would be hit hard. However, we believe that the trends will continue to go in the right direction, and we recommend buying MGIC stock up to $17. [Shares traded modestly above $11 Tuesday after a 39% surge over the prior six weeks. Putnam’s last pick, housing materials supplier Owens Corning (NYSE: OC), is up 11% in the month since that excerpt ran—Editor.]  

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