All about converts

MTG deferred coupon trade – August 2010

Trade Summary

• September 2010: Long MTG 9% convertible bonds and long October 6 strike put options.
• MTG began deferring coupons on the MTG 9% convertible bonds beginning with the April 1, 2009 coupon. According to the indenture, MTG had the right to defer the coupons for up to 10 years. However, the coupons are cumulative and compound at 9% annually, thus making this convertible bond the highest cost of capital security in the capital structure.
• Once the coupon has been deferred, MTG can only use proceeds from the issuance of common stock within the previous six month period to pay the deferred coupons. MTG issued $1B in common equity in April 2010, which meant the company only had until October 2010 to use the capital raised to apply the proceeds to the deferred coupons ($74m).
• Based on our analysis of the indenture, the company’s cost of capital, and conversations with management and analysts, we determined that there was a 75% chance that MTG would reinstate the coupons beginning with the October 1, 2010 payment.
• We believed the MTG 9% converts did not price in a high probability of a coupon reinstatement. We initiated a long convert position at 107 versus $8.64 for the stock and long Oct 6 strike options at 20.7c to protect the downside.
• In first scenario where MTG reinstates the coupon, the converts would pay out 19 points of accrued interest with the position falling to 100 versus 8.64 (supported by a 9% yield) for a 12 point gain.
• In second scenario where MTG does not reinstate the coupon and the stock drops to $7.30, we believed the converts would lose 4 points in value, offset by a gain of 1.2 points on the options for a net loss of 2.8 points.
• Given our probability weighted scenarios, we felt the risk/reward of the trade was favorable.
• In October, MTG reinstated the coupon and the position was up 12 points.

Trade Details

Summary

MTG has deferred coupons on its 9% convertible sub bonds beginning with the April 1, 2009 coupon. These coupons compound at a 9% annual rate. By October 1, 2010, MTG will owe 19.22 points. I looked at the cost of capital for MTG 9% converts and concluded that it is very expensive capital (15.71%) if the company continues to defer the coupons. Even if they reinstate the coupons, the 9% converts are still expensive capital (12.77%), so a flush is also a possibility. I think the company can pay between 36.67 and 41.72 points in a flush (similar to MF 9%, which offered 48 points). The one thing that can hold the company back from reinstatement is if the business environment deteriorates or potential government regulations cause uncertainty. While this is certainly possible, MTG has until September 15 to decide what to do, so that is a short amount of time for things to change. The company just reported a very good quarter in July.

Based on my conversations with MTG IR and sell-side analysts, the earnings conference call, and my calculations of the company’s cost of capital, I believe that is about 75% chance that we see a reinstatement or flush by October 2010.

Facts about the converts

9% convertible junior subordinate debentures due 2063 ($389m)

1)      The converts pay coupons semi-annually on April 1 and October 1 of each year starting with October 1, 2008. Starting with the April 1, 2009 payment, MTG deferred the coupon. By October 1, 2010, MTG would have missed 4 coupon payments. These coupon payments compound at 9%, which would give a value of 19.22 points as of October 1, 2010. (total of $74m)

2)      Once the coupon is deferred, MTG can only use proceeds from the issuance of common stock within the previous 6 month period to pay the deferred coupon. For example, MTG issued common stock in April 2010. It has until October 2010 to apply those proceeds to the deferred coupons ($74m).

3)      MTG must give notice of a coupon deferral at least 15 days prior to the interest payment date. This means MTG must decide on the next coupon deferral by September 15, 2010.

4)      MTG has the right to defer coupons for a total of 10 years. However, after 5 years, the company must use its best efforts to issue common stock or preferred stock and use the proceeds to pay the missed coupons. During the deferral period, MTG cannot pay common dividends or buy back common stock. (page 91)

5)      The converts can be redeemed at par on or after April 6, 2013 if the common stock exceeds $17.55 for 20 out of 30 business days. (page 98)

6)      The converts can be redeemed at par plus make-whole prior to April 6, 2013 if there is a “tax event” or a “ratings agency event”. The make-whole is the present value of the present value of the principal payment on April 6, 2063 and coupon payments from redemption date to April 6, 2063 at a discount rate equal to treasury rate  + 50 bps. (page 98)

7)      The convertible bonds are dividend protected from 0c and take-out protected with a make-whole matrix.

MTG Capital Structure

Holdco debt:

5.625% senior debt due 9/2011 = $78.4m

5.375% senior debt due 11/2015 = $300m

5% converts due 2017 = $345m

9% converts due 2063 = $389m

Market value of equity = 1.816B

Cost of Capital

The above tables show that the 9% convertible bonds have a very high cost of capital, almost as much as the equity. This cost of capital of the convertibles would be even higher if MTG continues to defer coupons and if the company cannot shield the 9% coupon from taxes (very likely given that MTG is not profitable and has significant Net Operating Loss Carry Forwards).

Since the deferred coupons compound at a 9% rate, continued deferral increases the cost of the convert to 14.39% from 12.77% in 2010. If MTG were to defer again, the cost of the convert rises to 15.71% in 2011.

Given, the cost of capital calculations, I believe it makes sense for MTG to reinstate the coupon because the cost of the convert will be higher than the cost of equity by 2011 without getting the benefit of getting full equity credit.

Furthermore, if MTG cannot take advantage of the 9% interest tax shield, the cost of the convert will be even greater at 17.1% for 2010 and 18.42% for 2011.

Potential for a flush

Since the cost of the convert is very high even if MTG were to reinstate the dividend, it makes sense for the company to flush the converts at the right price. I think it makes economic sense for the company to pay between 36.67 and 41.72 points for a flush.

The 36.67 points are based on the 19.22 points of deferred coupons plus the present value of future coupons for the next 2.5 years discounted back at the 15.55% cost of equity. This makes sense if the company were to issue equity to pay for the flush.

On the high end, MTG could decided to pay as much as 41.72 points based on the 19.22 points of deferred coupons plus undiscounted future coupons if it makes the argument that it makes sense to pay for the flush with excess cash on the balance sheet that is earning close to 0% interest.

Obviously, the potential for a flush increases as MTG stock increases since the company would likely have to pay fewer points to get holders to accept.

This situation is very similar to MF 9% converts, where MF offered to tender for the converts at 44.5 points but most holders did not tender even at that offer. MF converts are also 9% coupon with 2.89 years left.

Holding company cash

In April 2010, MTG issues $700m of equity and $345m converts. Of the capital raised, only $200m was downstreamed to the operating company, leaving the remaining $845m at the holding company. This cash at the holding company gives the company flexibility to use that cash to reinstate the dividend and/or flush the converts.

Why is October 2010 the right time to reinstate the dividend?

MTG just raised $1.045B of new capital in April 2010. Under terms of the indenture they must use new equity capital (issued within 6 months) to pay deferred coupons. October 2010 will be the first opportunity that MTG has to reinstate the coupons since the capital raise. The company is purposefully keeping cash at the holding company to give themselves flexibility to do something with the cash.

MTG also reported a good quarter in July, their first profitable quarter in over two years. Their stock is high enough where they can raise new equity. With their 5 year CDS at 485, they could probably issued 5 year bonds at about 8%. It makes sense to either reinstate the coupons or to flush the converts.

Conversation with MTG

I spoke to Mike Zimmerman, IR of MTG 414-347-6596.

He said the company has not made any decision about paying the deferred coupons but they have to decide by September 15, 2010 on the next coupon. The proceeds from the April 2010 common stock offering can only be used to cover deferred coupons for 6 months after issuance. So if they were to defer again in October, the company would have to raise new common equity.

The disadvantages for continuing to defer is that the 9% converts are the high cost of capital that MTG has due to the 9% coupon and compounding effect.

The advantage of continuing to defer is that the extra conserved cash gives the company more flexibility.

The company’s decision will be based on how they see the business going on 9/15, specifically credit trends of their portfolio but also the outlook for the mortgage insurance business.

He has received several calls from holders with some of them suggesting that MTG flush the bonds. They will consider all options when the time comes.

Conference call comments

John Evans – – Analyst

You raised about $1.1 billion in capital. Can you talk a little bit about uses of that capital? Do you think you will bring back the interest on the convert? And you were very aggressive in buying back some of your debt early at very favorable prices. Can you talk a little bit about that?

Mike Lauer – MGIC Investment Corp. – CFO and EVP

We have got — as I mentioned, or Curt mentioned early in the call — we did put $200 million down to MGIC, and use that for supporting the core Company. We don’t anticipate putting any additional capital down the balance of the year relative to risk to capital levels. There is about $1 billion at the holding Company. Relative to the repurchase of the debt, at that time, it was trading at a significant discount. And now it is trading at par. So there isn’t much opportunity there, and then relative to the reinstatement of the interest on the convert, we have not made a decision on that as of this date.

John Evans – – Analyst

And can you just tell me what — is that a Board decision? Or what will trigger that because it is in arrears, right?

Mike Lauer – MGIC Investment Corp. – CFO and EVP

That’s correct. The next payment is due, I believe, October something. So if in fact we’re going to do that, we’ll decide between now and that date.

Curt Culver – MGIC Investment Corp. – Chairman & CEO

With the Board.

Mike Lauer – MGIC Investment Corp. – CFO and EVP

With the Board, yes.

John Evans – – Analyst

Okay. Great. Thank you so much.

Michael Levine – – Analyst

Hello. Thanks. I just have a follow-up to the question on the 9% convert. Is there any penalty to not going current on that? Or is it simply — it’s just in arrears?

Mike Lauer – MGIC Investment Corp. – CFO and EVP

The interest continues to compound on all the deferrals. I guess that would be the penalty. Nothing additional to that.

Conversation with GS credit analyst

Donna Halverstadt thinks whether MTG reinstate the convert coupons will depend on management’s outlook on the future business by the time September 15 comes. If business conditions stay as they are or improve, MTG will likely reinstate the coupon. If business conditions turn down, MTG may decide to defer the coupons again. But economically, given the high cost of capital for the converts with the compounding, it makes sense to reinstate the coupons.

Rating agency treatment of junior sub debt

I have to follow up on this but there has been talk that trust preferred securities may not get as much equity treatment in the future. I’m not sure what this means for junior sub debt with deferrable coupons. If these securities get less equity credit in the future, they become very expensive capital and would be one more reason to flush the securities.

Background on MTG business

Mortgage insurance is typically taken by buyers of homes who want to have their mortgages to be GSE eligible. GSEs will only accept mortgages with a greater than 80% Loan to value. Therefore, buyers take out mortgage insurance to cover the other 20% in case of a default. About 75% of MTG’s insurance comes from GSE eligible loans.

For example, a house costs $200,000

In order to be GSE eligible, the mortgage can be at most $160,000 (80%)

However, if the buyer does not want to put down $40,000, he can borrow the additional $40,000 but buy mortgage insurance to cover that amount. For the mortgage insurer, this amounts to insurance in force of $200,000 and risk in force of $40,000. The maximum loss that the mortgage insurer is responsible for is $40,000.

Annual premium = 2% ($800)

Run off value (MTG)

Below we look at the run-off value of MTG’s existing portfolio using GS estimates. This gets us to a discounted stock price of $10.32. Keep in mind that this price is very sensitive to assumptions. Realistically, the stock can worth $0 or $20 in 2 years.

Risk in force = 55,700

Premiums = 3,825

Cash = 9,035

Money coming in = $12,860

Losses = 10,013

Debt = 768

Money owed = 10,781

Excess = 2,079

Shares = 125

$/share = 16.62

PV = 10.32

Key issues

1)      HAMP modifications that reduce payments for certain homeowners started last year. Depending on who you talk to, this program has been a success or a failure. The program has helped MTG because it has slowed foreclosures but many consider the program a failure because it has not helped as many people as expected.

2)      A new HAMP program is expected to start in the Fall of 2010 where principal will be reduced. The government would pay a 21% subsidy to the banks. If the principal gets reduced, the mortgage insurers do not have to make payments.

3)      Rescissions – In 20% of defaults, MTG has not paid claims due to misleading information about the loan. Rescissions have gone up and have helped MTG.

4)      Future of FRE, FNM – This is a big wild card because the reason for mortgage insurance to exist is to get mortgages to be GSE eligible. The future of the GSEs will have a big impact on mortgage insurance.

5)      Credit improvement – Delinquency trends have improved in the recent months. Some analysts think this is a seasonal improvement that will reverse in the fall. Other think the improvement will continue. It is hard to know what happens.

6)      Fin Regulation – It is unclear how the financial regulation reform impacts mortgage insurers because the rules are still unclear. There is a 5% retention rule which forces banks to hold 5% of the residual of securitizations. Does this put mortgage insurers at a disadvantage  because the FHA and VA are exempt? Or are mortgage insurers also exempt?