FUNDAMENTAL FEATURE - PMI Group, Inc. (PMI)

Is PMI Out of Dangerous Waters or Will the US Mortgage Market Keep on Biting?

On Thursday, PMI Group, Inc. (PMI) announced that they are selling their Australian mortgage insurance subsidiary to QBE Insurance Group (QBE) for approximately $920 million. Steve Smith, Chairman & CEO, stated, “PMI Australia’s customers will benefit from the financial strength, expertise, and operational excellence of QBE, and PMI Australia’s employees will gain the scale and resources QBE will bring them to expand and grow their business in Australia.” Ok, it does make sense for a U.S.-based company with an Australian subsidiary to sell to an Australian-based company, but it’s important to know why they are selling and if the sale would benefit PMI.

The deal is being structured as 80% cash at closing and 20% in an interest-bearing note issued by QBE. According to PMI’s press release: “The promissory note matures and is payable in September 2011, and the actual amount payable on the note could be reduced to the extent that the performance of PMI Australia's existing insurance portfolio as of June 30, 2008 does not achieve specified targets”.

Although this amount is variable depending on the loan loss ratio over a three year period, currently based on my analysis, PMI stands to make approximately $200 million.

In addition, PMI will fund $46.5 million in premiums to cover reinsurance losses for PMI Australia. And not only that, they’ve agreed to sell PMI Asia, based in Hong Kong, with net tangible assets amounting to $55 million. Although there is no solid deal yet, this capital will be used to help shore up the balance sheet, according to management.

However, let’s not forget that PMI came out on May 12 to affirm its guidance on paid claims, which came out to be between $825 million - $975 million. That’s a lot of money. They also reported a Q2 loss of $246.3 million, $3.03 per share. $225.9 million of the total net loss figure amounted to increases in paid claims and loss adjustment expenses (LAEs) in addition to adding to the reserve for U.S. Mortgage Insurance Operations.

More updates (according to Q2 results):

• PMI Canada will cease operations and expects to transfer approximately $60 million in capital to the struggling U.S. Mortgage Insurance Operations.
• PMI Guaranty Co. paid approximately $144 million to PMI. PMI expects to reinvest 80% of its capital into U.S. Mortgage Insurance Operations.
• Reserves for losses and LAE (loss adjustment expenses) for U.S. Mortgage Insurance Operations totaled $2.1 billion by June 30, 2008. (Since there is usually a one year lag time, expect payouts in claims to begin in 2009)
• Payout claims increased from $72.3 million in Q2 2007 to $192.7 million for the Q2 2008.
• PMI Australia, PMI Europe, and PMI Asia have all recorded a net profit ($24 million, $5.8 million, and $2.5 million, respectively).

It’s pretty clear: As long as the housing, mortgage, and credit markets continue to deteriorate in the U.S., PMI will continue to struggle directly from high payouts resulting from the high level of mortgage defaults and wave of foreclosures. However, combining the favorable terms of sale (pending successful closings) and with $2.1 billion already in loss reserves, PMI will be in a much greater capital position going forward into 2009. Management has taken a proactive step toward eliminating risks related to Australia’s deteriorating mortgage market. They show that they are flexible enough to sell off or close down even profitable international subsidiaries to focus on domestic operations and to provide much needed liquidity to stabilize PMI’s capital position during this difficult time.

How difficult? The stock nearly lost over 95% of its value throughout the past 12 months before participating in the S&P financials rally. On Thursday, PMI gapped up and closed 49.46% higher on 18.64 million shares traded, or 6x the daily average volume. The announcement also helped lift PMI’s peers: MGIC Investment Corp. (MTG) surged 9.7% to $7.80, Radian Group, Inc. (RDN) lifted 13.4% to $3.65, LandAmerica Financial Group (LFG) climbed to 14.4% to $15.81, Ambac Financial Group, Inc. (ABK) jumped 15.7% to $4.56, and MBIA, Inc. (MBI) spiked 17.9% to $10.32.

Technically, PMI looks good. The most promising bullish move for PMI is the continuation gap on the highest daily volume, ever, for this year. The only downside is that PMI meets significant resistance from this year’s previous lows.

Full Disclosure: The author does not hold any positions in PMI, MTG, RDN, LFG, ABK, or MBI.