This is probably my most profitable trade ever. In 2011 and early 2012 Mortgage Insurers (MIs) were significantly underperforming after PMI filed for bankruptcy on November 22nd, 2011 after being seized by the Arizona regulator. MGIC Investment Corporation (MTG) and Radian (RDN) credit (actually the whole capital structure) sold off substantially. On July 30th, 2012, after releasing poor monthly operating statistics, it was very evident that MTG would not be able to maintain a sub 25:1 statutory risk-to-capital ratio at the op-co, which included MTGs statutory surplus and its contingency reserve, and therefore was at risk of being seized by the Wisconsin regulator. Additionally, it was widely speculated that MTG would defer the coupon payment on their converts as it had done during the financial crisis, and the converts subsequently fell to around 18 flat. The stock was trading at ~60 cents. CDS (referencing the holdco) settled in with 5YR around 40pts, 2YR around 20pts and recovery at 40 (roughly). From the 10-Q:

At June 30, 2012, MGIC’s preliminary risk-to-capital ratio was 27.8 to 1, exceeding the maximum allowed by many jurisdictions, and its preliminary policyholder position was $211 million below the required MPP of $1.3 billion. We expect MGIC’s risk-to-capital ratio to grow and to continue to exceed 25 to 1. At June 30, 2012, the preliminary risk-to-capital ratio of our combined insurance operations (which includes reinsurance affiliates) was 30.0 to 1. A higher risk-to-capital ratio on a combined basis may indicate that, in order for MGIC to continue to utilize reinsurance arrangements with its subsidiaries or subsidiaries of our holding company, additional capital contributions to the reinsurance affiliates could be needed. These reinsurance arrangements permit MGIC to write insurance with a higher coverage percentage than it could on its own under certain state-specific requirements.

Although we do not meet the Capital Requirements of Wisconsin, the Office of the Commissioner of Insurance of the State of Wisconsin (“OCI”) has waived them until December 31, 2013. In place of the Capital Requirements, the OCI Order containing the waiver of Capital Requirements (the “OCI Order”) provides that MGIC can write new business as long as it maintains regulatory capital that the OCI determines is reasonably in excess of a level that would constitute a financially hazardous condition.

This read as very bullish in my opinion. The Wisconsin Regulator was not going to immediately seize MTGs reinsurance subsidiaries and therefore cause MTG to file for bankruptcy. MTG had generated $238MM in premium fees in the 3 months ending June 30th, 2012 and had a paid-in-capital balance of $1.2BN. It seemed that either two scenarios could occur:

  1. MTG would be forced to file for bankruptcy within 1.5years
  2. Housing prices would tick up and losses incurred would improve (eventually becoming lower than premium fees), allowing MTG to raise outside capital.

MIs are very levered by nature, and you therefore want to own the lowest part of the capital structure if you believe there will be an up-trade. In 2012, the overall market was in the midst of a recovery, rates were low and the Fed was jawboning the yield curve flatter, and consumer credit was starting to be extended. I wanted to find a trade where I would be able to participate in the up-trade should MTG losses incurred improve, but protect myself in the short term should the company file for bankruptcy.

The original trade idea was the buy the converts, buy 2yr CDS, and buy recovery for a total cost of 78 pts +500, or 88pts over the two year period. This created the following risk profile:

  1. If there was a filing before two years, I would make between 22 and 12pts depending on the date.
  2. If MTG became profitable again, raised capital or sentiment changed, I would lose 20+ running on 2yr, the recovery might go up slightly but the probability of default would go down so it wouldn’t matter – maybe a loss of a point [1], and the converts could rally tremendously, if the coupon was turned back on there was a scenario where they could be back at par or higher. Also, MTG would have a credit event after 10 years if the convert coupon was not paid back in full. If MTG was to remain as a going concern the company would have to turn the coupon on at some point.
  3. The main risk would be if MTG filed after two years or the curve steepened tremendously, but I felt like in the market environment at the time it would be hard for 5yr CDS to stay at 40 forever - MTG would either file quickly or the fundamentals would improve.

It ended up being a bit harder to buy recovery than I anticipated, and I ended up not being able to buy much. I purchased sub converts between 16 and 19 flat and owned a quarter as much 5yr recovery and 2yr cds. I put the 2yr cds + recovery package on at about 70 and owned 4x as many converts. In the event of a filing I would lose ~13pts on the total converts position while retaining most of the upside if fundamentals improved.

Fast forward 10 months, RDN and MTG were able to raise capital, losses incurred improved as the housing market recovered and as I write this article the converts and trading at 123 with the 9% coupon turned back on. Not a bad trade.

Update as of June 2016 - MTG 9% Sub Converts Chart:

mtg

[1] underlying vs recovery trades are a great way to retain upside while hedging against downside risk. Anytime you can buy a package of matched low dollar bond vs recovery for under par you should do it. The idea is that if there is a filing you recover par, and if the asset rallies, the PV of your recovery swap will approach zero because the probability of default is going lower.