Description

Short: Genworth MI Canada Inc. (TSX: MIC)

Intro

Given the recent HCG CN write-up here, I thought I’d describe another way to play the bubble if you are so inclined.

Thesis

Genworth MI Canada, the largest private residential mortgage insurer in Canada, has risk in force of 230x its excess capital1, leaving it exceedingly vulnerable to the Canadian housing bubble, which has grown larger than the recent US bubble. Despite MIC’s paltry capital level, 65% of its insurance book consists of high LTV borrowers that have average LTVs at origination of 92-94%. Although these borrowers are mostly prime, a prime loan in Canada requires less documentation than it does in the US2. Furthermore, the business of mortgage insurance inherently misaligns incentives as the lender originates the loans but bears no risk as to how they perform thereafter. If prime foreclosures in Canada reach levels seen in the US, MIC will breach minimum capital requirements.

Housing Bubble

Business

In Canada, mortgage insurance, which is mandated for federally regulated lenders on mortgages with LTVs >80%, covers 100% of the mortgage (plus additional costs) unlike in the US (so Canadian insurers are in first and full loss positions). The lender purchases mortgages insurance, pays the insurer up-front, and charges the borrower over the length of the mortgage3. The largest insurer is the government-owned CMHC that insures almost half of all outstanding mortgages in Canada. The fact that MIC competes with a government entity (governments are almost never rational economic parties) explains why it has a lower ROE than the chartered banks yet still takes on much more risk. Unbelievably, MIC pays a fee to the government to reinsure MIC’s insurance in the event of MIC’s dissolution so that lenders aren’t hit with an unfavorable risk weighting for holding MIC insured loans.

Issues and Potential Losses

Beyond MIC’s capital inadequacy and high LTV borrowers, there are further concerns with the business. In Canada, mortgage rates usually reset every five years. This exposes borrowers to the risk of higher payments. Despite this, MIC is insuring borrowers at the same total debt service ratio it was in 2007 when rates were much higher. Additionally, in H1’13, 12% of MIC’s insurance was comprised of the frothiest part of the Canadian housing market: condos. A mortgage broker I spoke with explained that MIC is the most lenient of the three insurers and that he has overruled underwriters on more than one occasion. Data confirms that as MIC lends at slightly lower credit scores than CMHC4. Lastly, MIC has material risk from non-prime borrowers who provide negligible proof of income.

When speaking with an underwriter at one Canadian lender, she mentioned that she will spend much less time underwriting an insured loan than an uninsured loan. This is an example of the moral hazard discussed above. This problem extends to servicing as well, which leads to increased loss severities for MIC. Loss severities are already over 30%, and a decline in housing prices coupled with foreclosing in a weak market suggest loss severities potentially doubling in a housing downturn. 50-60% loss severity combined with 4% foreclosures as seen in the US prime market5 is enough to eliminate MIC’s excess capital.

MIC’s recent stronger push into Alberta should also give investors pause given the obvious energy dynamics hampering that region. At the beginning of 2014, Alberta accounted for 16% of MIC’s s insurance in force. However, through the first nine months of 2014, Alberta accounted for 27% of new insurance written.

Given the above, it makes sense that Brian Hurley, the former CEO and current Chairman who is only in his mid-50s, decided to step down as CEO earlier this year. It makes one wonder about his claim on the Q2’14 earnings call: “Predominantly made up of first-time homebuyers, our insured borrowers are buying homes that they can afford and afford to stay in even in times of potential stress.”

Why does this Mispricing Exist?

This mispricing exists due to a Canadian housing bubble perpetuated by massive intervention from CMHC. As stated above, CMHC insures almost half of all outstanding mortgages in Canada. Its initial mandate was to provide assistance to first-time homebuyers but has since morphed into a behemoth. Late in 2013, former Finance Minister Jim Flaherty stated: “regrettably, CMHC became something rather more grand I think than it was intended to be.” CMHC has effectively been subsidizing home purchases in Canada, which has led to increased demand, which has resulted in an unsustainable boom in housing.

Risks

• The Canadian housing market treads water or manages a soft landing

Appendix

Catalyst

Decline in Canadian housing prices