Buy MGIC, Or Are Investors Right That You Could Lose Your House? (NYSE:MTG)

I keep pounding on my Buy call on MGIC (NYSE:MTG) and its peer mortgage insurers Radian (RDN), NMI Holdings (NMIH) and Essent (ESNT). I usually update the Buy call when they report earnings, or new big picture housing data is reported. My last article was only a little less than a month ago. Back already, this time drilling down to MGIC’s average customer, who may be a lot like you.

Investors currently assume, as I will show you, that you homeowners out there have a material chance of losing your home over the next few years. I disagree. If you don’t lose your house, MGIC and its peers are excellent investments right now. Let’s see if you agree with me when you’ve finished reading this article (you will finish it, right?)

The housing disaster that MGIC’s current valuation implies

As I write this, MGIC is selling at $12.50 per share. Let’s see how that compares to its key valuation measures:

• Net cash. As an insurer, MGIC holds investments as reserves against potential insurance claims. The large part of its investments are medium-term corporate bonds. Net of debt, these investments equal about $16.80 per share, after marking Q1 data down for the subsequent bond market mess. MGIC’s stock price is valued at only 75% of its cash value! And MGIC is currently earning about $2.50 in cash per share per year. Investors therefore assume that MGIC will be making very large claims made on defaulted loans going forward.
• Book value. At March 31, MGIC’s book value per share was $14.75. Since then, declines in the value of MGIC’s bond portfolio have reduced book to maybe $14.25 per share. Assuming that MGIC earns its expected $1.50 EPS for the rest of this year (Seeking Alpha), and assuming that MGIC uses all of those earnings to buy back stock at the current price (very likely), MGIC’s book value will be $15.75 by year-end. MGIC is selling at 80% of year-end book. Which again means that mortgage defaults will have to be so high going forward that the company’s $277 billion of insurance in force will generate losses for many years.

• EPS. Seeking Alpha’s analyst survey expects MGIC to earn $2.14 per share this year and $2.15 next year. That puts MGIC’s P/E ratio at 5.8. MGIC is selling at only 35% of the S&P 500 multiple. More graphic, the 5.8 P/E means a 17% earnings yield. Using actual cash earnings, MGIC is selling at a 20% yield. Check my math, but that beats the 10-year Treasury yield by a very, very wide margin. Again, MGIC’s P/E forecasts a housing disaster.

How big a housing disaster does the market forecast?

We can roughly back into this number. Assume that:

• MGIC should trade at a 10 P/E in normal times. I’d argue for higher, but let’s leave it there.
• Trading at $12.50, then, Mr. Market assumes that MGIC will earn about $1.25 for many years ahead. That $0.90 per share shortfall from current forecasts is $350 million a year in higher claims payments. Not just for one year, but for many years; let’s assume five years. MGIC therefore has $1.75 billion of extra claims payments coming its way.
• During Q1, MGIC’s average claims payment was $28,000, down from $37,000 a year ago. Let’s assume a $40,000 average going forward. The math says that MGIC will have to pay 44,000 extra claims over the next five years. MGIC insures 1.16 million of loans at present. That means 4% of its policyholders will lose their homes.

Who are these families at risk of default?

Today’s average MGIC insured:

• Clearly is working, with the country’s measly 3.6% unemployment rate and with over 11 million jobs currently unfilled.
• Has a 750 FICO score. That is well above the U.S. average of 714 (Experian). And the Millennials, probably the biggest cohort of first-time homebuyers today, have an average 686 FICO, according to Experian.
• Bought their home for $265,000. MGIC doesn’t insure mansions, it insures middle-class housing.
• Bought their home two years ago. Since then, their home has appreciated by an astounding 35%. Even homes bought a year ago are up 20% in value. So, their original $20,000 in equity in their homes is now over $100,000.
• Has a 3.5% mortgage rate. Throw in the mortgage insurance premium, and the rate is still under 3.75%. Those mortgages are clearly gold today. Who will willingly give them up?

What kind of disaster has to happen for MGIC’s average customer to default? A nasty recession that throws loads of people with a history of paying their bills out of work and pushes home prices down by at least 20%. If you expect that, stop reading this article immediately and own nothing but T-bills.

But MGIC even has protections against that nasty recession. It has reinsured a lot of the risk on 95% of its insurance book. That ratio was below 50% going into the Great Recession.

And keep in mind that people like owning their own homes, a lot

From a CNBC story:

“Nearly three-quarters (74%) of American adults still view homeownership as a top hallmark of achieving the so-called American Dream, beating out the ability to retire (66%), a successful career (60%) and having children (40%)…Among the non-homeowners, nearly two-thirds said affordability was the main reason they hadn’t yet purchased a home. Gen Zers largely said their income wasn’t high enough yet, while millennials primarily blamed rising home prices.”

MGIC’s customers will work really hard to keep their homes. Which supports MGIC’s earnings. And makes its stock awfully cheap.