Goldman Sachs Gives MIs a Neutral Rating

NEW YORK-Goldman Sachs has initiated coverage of the mortgage insurance industry, having a "neutral" view, noting, "We believe mortgage insurance has a necessary place in the U.S. economy.

"Thus, our neutral coverage view reflects the capital level of the companies - not a negative view on the viability of the industry," said the report.

The purpose of its report, Goldman Sachs said, is not to take a view on the future of the mortgage insurance industry, especially in light of the future of Fannie Mae and Freddie Mac.

The analysts at Goldman Sachs believe the mortgage insurers will have elevated losses over the next two years as defaults on prime-grade mortgage loans peak and the companies have to increase their reserves for loans already delinquent. The issue, the report said, is "the ultimate economic book value for the legacy books of business is still uncertain and debated within the investor community.

"However, our analysis suggests pockets of opportunity remain within the space, as we believe the market has painted each firm with a similar brush despite different economic values."

Besides dealing with elevated losses over the next two years, other headwinds identified include severities remaining high as more than 20 months' supply of housing inventory affects the market and pressure on MI revenue as mortgage debt outstanding continues to contract. However, the report said, "Market share could mitigate some of this headwind as the insurers marginally loosen underwriting standards."

Goldman Sachs rates the three companies whose primary business is mortgage insurance: MGIC, Radian and PMI.

MGIC has been given a "buy" rating, as Goldman Sachs claims it is in "the best capital position to weather its capital issues."

This implies, the report continued, that MGIC should be able to continue to write new business.

There is risk, as Goldman Sachs sees at least one more year of operating losses at MGIC.

"Thus, 2010 and 2011 are expected to be a bumpy ride, but investors are likely to be rewarded with a book value well in excess of the current stock price," the report declared.

At the other end of the spectrum is PMI, which Goldman Sachs has given a "sell" rating. "We believe the market has correctly valued the fundamentals of PMI, where we believe the most likely scenario - absent significant prime mortgage modifications - is a situation where the company breaches the risk-to-capital levels required by many states."

Goldman Sachs believes PMI will break the 25-to-1 risk-to-capital ratio barrier a number of states require sometime in the second quarter of this year.

"Breaching a risk threshold, while negative from a new business perspective, does not in itself change the economics of the residual value (given we assume a run-off of premiums in our base case analysis). However, we note that the earlier a company breaches its 25-to-1 risk-to-capital threshold, the less incoming premium it can generate to help build up capital support to protect against future losses," the report said.