By: Erick Bergquist

March 15 , 2001, The American Banker

Despite posting solid earnings and credit losses near record lows last year, the publicly-traded mortgage insurers Mortgage Guaranty Insurance Corp., Radian Group, and PMI Group are sorely undervalued relative to the rest of the stock market, several observers said.

So undervalued, in fact, that a leading analyst and a Wall Street investment banker say the companies are ripe for takeover.

We believe these companies are extremely attractive acquisition candidates, said Jonathan E. Gray, an analyst with Sanford C. Bernstein & Co. It seems plausible that at some point, management frustration with valuation may lead to acquisitions in this sector.

The investment banker, who requested anonymity, said that the companies are incredibly cheap, more profitable than Countrywide, and have less volatility in their earnings, and that their financial characteristics are such that they appear to be an attractive way to participate in the housing credit market.

The mortgage insurers primary business is providing credit insurance on loans purchased by Fannie Mae and Freddie Mac that carry a down payment of less than 20%. With only eight or so players, the sector is a thinly populated, highly specialized industry.

Over the past 10 years the companies have posted average gains much larger than many S&P 500 companies, several observers said. According to Mr. Gray, for instance, earnings at Milwaukee-based MGIC s grew an average of 26% a year over the past decade, while the S&P 500 averaged only 12%.

Nonetheless, Mr. Gray said, the companies shares are trading at just nine times next year s estimated earnings -- the most common standard used by equity analysts to measure a company s valuation -- while the S&P 500 stocks have been trading at 20 times their price/earnings ratio.

The insurers have experienced several jolts that have had a big impact on investor psychology. In July 1998 Congress passed legislation requiring mortgage insurance to be automatically cancelled after borrowers reach 22% equity in their homes. That law spooked many investors.

Three months later Freddie Mac, one of the insurers main customers, tried to gain congressional approval to get into the mortgage insurance business. Though Congress rebuffed the move, both Freddie and Fannie Mae have continually tried to encroach on the sector by offering borrowers insurance products payable up-front to the government-sponsored enterprises in lieu of traditional mortgage insurance.

David Graifman, an analyst with Keefe, Bruyette & Woods Inc., said that as a result of the GSEs efforts, the insurers lost as much as 30% of their stock value in only one day.

Further, credit losses increased for all the mortgage insurers during the California real estate crisis in the early 1990s, when the bottom fell out of the housing market.

Though analysts agreed that Fannie and Freddie s threat to mortgage insurers has evaporated, investors may not be listening. Mr. Gray said the industry s valuation has never recovered from the GSE trauma.

Leon Kendall, a professor of finance at Northwestern University s J.L. Kellogg School of Management and a former MGIC executive, said the industry s vulnerability to credit losses in economic catastrophes would discourage any company from picking up a mortgage insurance company -- especially now that the low credit loss rates can only go up.

Despite the historical financial performance, analysts say the GSE threats, combined with the eccentricity of the business and the credit loss issue, are the insurers Achilles heel.

Their business model is too much of a question for outsiders who don t know the business, said Chad Yonker, an analyst with Fox-Pitt, Kelton Inc.

Gary Gordon, an analyst with UBS Warburg, said that in 1998 and 1999, the insurers shares were trading at half their value today, yet no company made a move to acquire them.