Genworth no riskier than major banks despite Queensland exposure

They are two of Australia’s biggest, yet less understood, companies: the lenders mortgage loss insurers, or “LMIs”: Genworth and QBE LMI. 

Both have estimated market values well in excess of $1 billion. Collectively they insure half a trillion dollars’ worth of Aussie home loans. And the recently deferred IPO of Genworth has suddenly brought the industry into focus. In particular, correspondents overseas have argued that this could be the “canary in the coal mine” for the Aussie housing market. 

But it is an odd time to be getting negative on this admittedly oblique industry. Australian Property Monitors reports today that Australian house prices rose by 0.9% in the first quarter of 2012 following the RBA’s two rate cuts in November and December. Unemployment is sitting at a historically low 5.2% and shows no signs of rising. And with the RBA all but certain to cut its cash rate by 50 basis points, which should deliver a net reduction in borrowing rates of about 75 basis points since November, conditions in the housing and mortgage markets are likely to improve further. Declining interest rates, low unemployment, and steady house prices are surely sanguine conditions for LMIs. 

Genworth Australia’s parent was planning on selling (only) 40% of the local business via an ASX listing in 2012. It was slated to be one of the biggest IPOs of the year. The explanation of the deferral of the IPO was tied to the expectation that there would be a “modest loss” reported by the Australian business in the first quarter of 2012. 

Yet it is not clear whether this decision was motivated by the modest loss, or just as much by the desire of the ailing US parent company to keep repatriating valuable dividends delivered by its Australian jewel. I’d suggest the latter is a very real possibility. 

In 2011 alone, the Australian business paid the parent $166 million in dividends. Since that time, there has been a material increase in premiums earned from the sale of insurance in Australia. 

The Australian business also has enormous excess capital. Standard & Poor’s assesses that Genworth Australia’s total assessed capital before debt funding and reinsurance contracts, which further mitigate risk, is $3.3 billion. This is impressive because APRA’s minimum capital requirement for Genworth Australia is just $1.5 billion. The business’s formal Tier 1 capital is $2.3 billion, or over 1.5 times the minimum APRA wants. As the chart from S&P below shows, Genworth’s capital ratios are substantially better than its main competitor, QBE LMI.

What is more remarkable is that the Australian business has basically no debt at all. S&P assesses total leverage to equal just 4.1%, with a single Lower Tier 2 loan of $140 million outstanding. 

This contrasts strikingly with the AA- rated major banks, which are heavily leveraged with substantial senior-secured (covered bonds), senior unsecured, subordinated and hybrid debt. The typical leverage ratio for the major banks is 15 to 18 times shareholder equity. Here S&P notes that Genworth’s leverage (or lack thereof) is of “AAA” quality: 

“As of Dec. 31, 2011, GFMI's capitalization metrics continue to be very strong, with an S&P capital model score maintained at 'AA,' and APRA MCR multiple of 1.55x. The company's leverage also remains well within our 'AAA' rating tolerance, with the A$140m 10NC5 subordinated debt issue representing 4.1% of total assessed capital.” 

Following the deferral of the IPO, S&P issued no ratings action. Moody’s, on the other hand, put Genworth Australia’s rating “under review”. 

While S&P assumes when giving the Australian business its “AA-“ rating that (1) the IPO doesn’t occur, (2) any reinsurance provided by the US parent, which is a declining minority of the Australian business’s total reinsurance, has zero value, and (3) that the housing market continues to remain “soft” with, importantly, no further interest rate relief, Moody’s has, relatively speaking, had a more negative view on the major banks, the LMIs, and the Australian housing market more generally. 

Notwithstanding their significance to the national economy, the business models of the two LMIs are not well understood. They are nevertheless quite simple. 

In short, Genworth and QBE LMI insure the risk of default on Aussie home loans. Collectively, they cover about $500 billion. Since there is a total of $1.23 trillion of home loans outstanding, the major banks, in effect, self-insure most of the default risk on the remaining $723 billion. The major banks are, therefore, mortgage loss insurers in addition to being deposit-taking and lending institutions. 

The LMIs do make interesting comparisons to the major banks. Unlike the major banks, they have basically no debt. They face no risk of a run on retail deposits, or the refusal of wholesale funders to refinance their debts. They have no exposures to the riskier corporate, personal, or commercial real estate lending markets (as judged by both default rates and APRA). And they have no non-core businesses that can introduce catastrophic risks (e.g., Asian expansion strategies). 

But what does a worst-case scenario for the LMIs look like? Tapping the parent’s US filings, we can look at Genworth’s total loans insured, the share of “bad” loans, and then compare these to the rest of the Australian home loan market. The next chart summarises the first part of this analysis.

At the end of December 2011, Genworth’s 90-day delinquency rate across its 1.4 million loans was only 0.55%. This represents a fall from 0.59% in the September quarter and 0.56% in the June quarter. Importantly, this delinquency rate is actually below the industry-wide level assessed by the RBA, which was 0.6% at the end of December. 

Genworth’s low delinquency rate is a little surprising given that LMI is assumed to normally only apply to high loan-to-value ratio (LVR) loans of 80% or more. In fact, Genworth also does a lot of portfolio-wide insurance. 

In December 2011, Genworth reported that the weighted-average LVR across its book of 1.4 million loans was 62%. Its geographic distribution of loans is also what you would expect, and in line with the major banks, as the third chart below shows. Only 22% of its loans were originated in Queensland, which is consistent with the state’s share of the overall mortgage market.

While Genworth’s Australian business has performed consistently well (e.g., during the GFC) and realised a strong increase in new net premium revenue over 2010 and 2011 (see next chart), its “loss ratio”, which reflects claims and provisions relative to premiums earned, had increased slightly over 2011. This is not a total surprise given the RBA’s decision to hike rates in late 2010, and the flat-lining of employment growth thereafter.

The explanation for the “modest loss” that is expected to be reported in the March quarter reiterates messages Genworth had communicated months earlier to the rating agencies. For example, S&P commented prior to the deferral of the IPO that: 

“GFMI's operating performance has remained steady and in line with our expectations, with Dec. 31, 2011, results showing good year-on-year gross written premium growth of 8.6%. However, this was offset by a loss ratio of 49.5%, up from 43.3% a year earlier due to continued pressure from southeastern Queensland, and certain lenders accelerating the claims process to address aged arrears.” 

What does a realistic worst-case scenario look like? Despite the strong geographic diversification and relatively low LVRs in its portfolio, you could, in such a scenario, boost its delinquency rate seven times to, say, 3%, which is in line with the peak in the UK during the GFC. 

You could then assume that half these loans go bad, which would be about right. So there are full mortgage loss insurance claims on 1.5% of all loans insured. Today the average claim per loan is about $65,000. Let’s hike this to $100,000 per loan. 

Total claims in this scenario would then sum to about $2.2 billion, which is well below Genworth’s current capital of $3.3 billion. Thus without any new funding at all, it could cover this realistic catastrophe. It would, of course, need to raise about $400 million of new capital to meet its minimum APRA requirements. Yet since these claims would be strung out over a period of two to three years, this seems like a straightforward task. 

The LMIs’ business models have risk — but no more than a major bank.

Dr Elvis Jarnecic is a senior lecturer at the University of Sydney.