Call it the canary in the coal mine, but the decision by US-based mortgage insurer Genworth to pull the planned float of its Australian business is a resounding indication of what investors think of the Australian housing bubble. A Fortune 500 company based out of Virginia, Genworth is one of the two leading mortgage insurers in Australia (the other being QBE) and had been planning to partially exit its Australian business “as part of its business portfolio management strategies”.
In announcing the withdrawal, Genworth told investors that it will now “seek to complete the IPO in 2013” and noted:
“For the 2012 first quarter, the company expects to report elevated loss experience in Australia as lenders accelerated the processing of later-stage delinquencies from prior years through to foreclosure and claim at a higher rate and severity than expected, particularly in coastal areas of Queensland that experienced natural catastrophes and regional economic slowdowns and among certain groups of small business owners and self-employed borrowers. First quarter experience is anticipated to result in a modest first quarter loss in the Australian MI business.” (emphasis added)
As the Daily Reckoning’s Greg Canavan observed, in the past two years Genworth has generated a profit of about $50 million a quarter from its Australian business — now it expects to make a loss for the March 2012 quarter, largely due to increasing loan delinquencies. That is a very significant turnaround.
As this column noted previously (in relation to QBE’s mortgage insurance business, mortgage insurers will be the first casualty of the housing bubble — the reason is simple, they take the largest slice of risk in lending for a home purchase. Australian banks require home buyers to take out mortgage insurance where they aren’t able to scrape together a deposit for more than 20% of the purchase price.
Banks, however, will happily lend up to 95% of the purchase price (or even more) where the purchaser gets their riskiest sliver of equity insured by a company such as Genworth of QBE. That transfers the risk of any fall in value from the bank to the insurer (assuming the insurer can cover the losses). In a rising market, this isn’t a problem. In the event that the purchaser can’t keep up with repayments, the property is sold for more than its purchase price and everyone (other than the evicted home owner) is happy.
Of course, in a falling market, things aren’t so dandy.
Mortgage insurers take a double-barrelled risk, First, they insure the riskiest part of the purchase — they are required to pay out should the property be foreclosed for less than the purchase price and the vendor is unable to make up the difference (this is happening already given Genworth’s first quarter loss). Second, purchasers needing insurance in the first place are also more likely default — so Genworth was lending on a high-risk product to high-risk borrowers. (With the possible exception of investors seeking to maximise their tax deductions, there would be no reason for a home buyer to not contribute 20% of the equity for their purchase unless they don’t have the money).
Now that the froth has come off the Australian housing market (which is down around 6% from its peak, but more in some areas), delinquencies are rising. It would be especially concerning for Genworth (and QBE) that even though prices haven’t fallen to an especially great extent (yet), Genworth’s Australian business went from making $200 million a year to reporting a loss this quarter. Even worse, unemployment in Australia is at cyclical lows — if it returns to long-term trend, it would be highly feasible that Australian house prices will follow their US counterparts. The result for the insurers (and possibly the banks) would be catastrophic.
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A good analogy can be drawn between mortgage insurance and those who wrote CDS ‘insurance” on bonds, shares and even property prices before the GFC. A CDS (or credit default swap) is basically an insurance product on a financial asset that can be customised to the requirements of the purchaser. While commonly used to insure against default on bonds, one of the more infamous uses of CDSs was by hedge fund investor John Paulson, who used CDSs to effectively bet on the US housing collapse.
A CDS requires the person seeking protection (or speculation) to place what is effectively a small insurance premium up front — if the conditions of the CDS are met, the CDS holder is paid out a far larger sum. Paulson was able to make $US5 billion after the US housing collapse largely through the use of CDSs with minimal money down (one of which was the infamous Abacus transaction, which led to Goldman Sachs paying $US550 million to settle an SEC claim).
Companies (such as AIG) and various banks effectively wrote CDS insurance policies to earn slightly higher returns during the boom. This allowed them to report higher profits to shareholders (and allowed its executives receive fat bonuses). The problem is, as would only later be revealed, the banks and insurers were taking almighty risks for what was only quite a small additional return.
It appears Genworth has fallen into the same trap. While the US-based insurer was able to earn larger-than-normal returns by insuring Australian property, those profits will quickly be overcome by losses on delinquencies. It appears that investors realise this, which is why Genworth hastily pulled its Australian float.
Don’t expect to see it again any time soon.