The housing market will probably cool a bit after a sizzling summer of sales. But even as it settles, its fuel should persist. Mortgage rates aren’t expected to increase sharply over the next year, staying near 3%. Jobs and wages are rising. And there’s plenty of pent-up demand from first-time buyers and others aiming to take advantage of historically low rates.
Much of the housing sector is already pricing in these trends, but one pocket still looks cheap: mortgage insurance companies.
Barron’s found three stocks that look appealing: NMI Holdings (NMIH), Essent Group (ESNT), and MGIC Investment (MTG). The stocks look inexpensive, trading at single-digit price/earnings and low price-to-book ratios. They’re solidly profitable, with net income expected to increase more than 10% over the next year. The longer-term outlook hinges on rates and the pace of mortgage defaults. But the industry seems to have learned its lesson from the last housing collapse—building more capital buffers, offloading risk to reinsurers, and benefitting from tighter lending standards.
“We had a substantial cushion heading into this crisis, and that’s been a real positive,” says Claudia Merkle, CEO of NMI Holdings. “We see a really strong market in 2021 and probably beyond.”
Mortgage insurance protects lenders if a loan defaults and eventually heads into foreclosure. Borrowers with good credit and a 20% down payment aren’t required to buy mortgage insurance, which is usually tacked on to monthly payments. The Federal Housing Administration provides mortgage insurance to low-credit borrowers, generally with scores below 620. That still leaves a vast market of first-time buyers and others who need private mortgage insurance to qualify for a loan. But private insurance for higher-credit borrowers remains a vast market; 16% of mortgages will be privately insured this year, amounting to $544 billion of new policies, down from $600 billion last year but still near record levels, according to Deutsche Bank Securities analyst Phil Stefano.
High housing prices, while tough on affordability, could expand the insurance pool. More borrowers tend to buy insurance as house prices climb (since a 20% down payment becomes a taller hurdle); refinancing also picks up as borrowers aim to lock in lower rates, even if they don’t yet meet a home-equity threshold to avoid insurance. First-time buyers, who can put as little as 3% down on a loan with insurance, make up half of the mortgage insurance market. Rising prices may also delay foreclosures since banks and borrowers have more wiggle room to sell a property or make a loan modification.
The industry has come a long way from the financial crisis. Lending standards have tightened as Fannie Mae (FNMA) and Freddie Mac (FMCC) imposed tougher requirements for loans eligible for securitization (buying the vast majority). Insurers are now required to hold more capital against losses. Companies are also using reinsurance to further backstop losses, including funding through insurance-linked notes.
Insurance pricing has become more sophisticated, too, with companies using “black box” formulas to price quotes on multiple criteria, including credit scores, debt-to-income ratios, and geographic market data. “There are so many ways you can price now with granularity,” says Merkle. “It allows us to make sure we’re carving out the right risks and credit mix.”
Two big headwinds could knock down the stocks. One is a federal moratorium on foreclosures, imposed during the pandemic. Borrowers in the program get a hiatus of up to 18 months on payments. About 4% of mortgages were in forbearance at the end of May, according to the Mortgage Bankers Association. The rate is coming down, but a day of reckoning is coming: The program expires at the end of June, and lenders can start initiating foreclosures in October, potentially saddling insurers with claims.
The housing market may also be peaking, coming off a pandemic-fueled surge in sales and prices. If bond yields and mortgage rates start to increase, potentially in 2022 or 2023, it could dampen demand and loan volume, pressuring insurers’ stocks.
The dynamic wouldn’t be entirely negative; insurers would earn higher yields on their underlying bond portfolios and would probably hold on to insured loans for longer as fewer people refinance and drop coverage (which is automatic when a borrower’s home equity hits 22%). Nonetheless, the end of the boom wouldn’t be positive, even if it is a soft landing. “You have two cycles playing out: losses from delinquencies as forbearance ends, and uncertainty over when the Fed will squash the market,” says RBC Capital Markets analyst Mark Dwelle.
The stocks aren’t pricing in much optimism, though, trading at low valuations. A catalyst for price gains would be more mortgages “curing” from forbearance as borrowers come out of the program and make back-payments—freeing up insurers’ loss reserves and lifting their returns on equity. “If forbearances work out successfully, that could fuel earnings growth well into 2022,” says Dwelle.
Launched in 2011, NMI Holdings is the smallest major insurer, but it’s growing rapidly. The company issued $26.4 billion worth of policies in the first quarter, up 33% from the fourth quarter of 2020 and up 134% from a year earlier. Its insurance in force hit $124 billion, up 26% year over year, and its default rate has been heading down, falling to 2.04% in May from 3.6% at the end of September.
NMI’s return on equity, or ROE, a key profit measure, was 15.4% in its last quarter, down from 24.5% a year earlier. An increase in loss reserves lowered its ROE, mainly because mortgages went into forbearance. Merkle says many of those mortgages are likely to cure. “We expect the vast majority of defaults won’t roll to claims,” she says.
NMI trades at 1.4 times book value, above the industry average. It looks more reasonable on 2022 estimates at 1.1 times book. BTIG analyst Ryan Gilbert calls it his top pick. “They write the highest-quality insurance, and they have a structural growth story that others don’t have,” he says, expecting the stock to trade at two times book, supporting a price of $33.
Essent also trades at a premium, of 1.2 times book, reflecting a few key strengths. One is industry-leading operating margins of 69%. The company launched in 2008 and didn’t start underwriting until 2010, avoiding the default drag from the housing bust. Founder and CEO Mark Casale, who took Essent public in 2013, runs a conservative book with $197 billion of insurance in force and 7.7% debt-to-capital, less than a third the industry’s average leverage. Essent also has a solid backstop against losses of $2.1 billion in reinsurance, against $4 billion in equity. Its credit ratings lead the industry.
“There’s a lot less volatility around our returns than even five years ago,” says Casale, who incorporated the company in Bermuda, keeping its tax rate down. Essent is pricing insurance with more-sophisticated tools, recently launching a new pricing engine that incorporates 400 factors and uses artificial intelligence to squeeze out the highest premiums at the lowest risk.
Essent’s conservatism may have cost it some market share, as pricing pressures heated up lately. Its market share fell to 13% in the first quarter from 18% in 2020. Casale expects it to get back to its historical average around 16%. A key driver will be insurance in force, which he expects to increase as mortgage rates rise. “We won’t have as much churn” as refinancing slows, he says. And unless rates jump sharply, purchase volumes should stay intact while yields on insurance-premiums improve.
Deutsche Bank analyst Phil Stefano calls Essent a “best in class” operator, expecting the stock to reach $61. BTIG’s Gilbert also rates it a Buy, with a target of $58. Even at that price, the stock would trade just under 10 times the consensus estimate for earnings of $6.07 share in 2022.
MGIC is more of a value play at one times book. The discount arises due to its portfolio of legacy mortgages that it insured around the 2008 housing collapse, constituting less than 10% of its $252 billion of insurance in force. Defaults on those legacy mortgages continue to pressure the company’s ROE. But CEO Tim Mattke says the legacy loans aren’t going delinquent at disproportionate rates anymore, compared to policies written recently. “They’re performing similar to or better than we expected,” he says.
MGIC had $2.3 billion in excess capital at the end of March, or 141% of regulatory requirements. Delinquencies are falling steadily, down to 4.7% of its portfolio in the first quarter. If they keep dropping, the company could free up some loss reserves, potentially boosting ROE.
Mattke says the outlook for 2022 looks strong. While refinancing is likely to decline as rates increase, it could keep more insurance in place, supporting earnings. As millennials enter their peak home-buying years, demand for house purchases should stay strong, he says. “We think there’s a good cohort of first-time buyers coming into the market,” he says.
Gilbert expects the stock to reach $17, up from recent prices around $14, lifted by positive default trends through 2022. At $17, he estimates, the stock would trade at 1.2 times book value of $13.95 a share. Investors would be hard-pressed to find a cheaper play on a housing recovery.
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