New IPO Essent Group Brings Mortgage Biz Fresh Start
When the housing bubble burst several years ago, mortgage insurers were prime casualties.
Lenders for years had thrown money at anyone who could ink his initials, knowing they could then package mortgages of dubious quality into securities that yield-hungry investors would eagerly buy.
For the insurers, it meant a nightmarish roster of defaulting loans. Most mortgage insurers bled red ink for years. Several were forced to stop writing new business.
But that only created opportunity for a new, well-capitalized insurer that was not weighed down with bad legacy loans. A group of investors -- includingGoldman Sachs ( GS ) andJPMorgan Chase ( JPM ) -- saw a chance to establish an insurance upstart that could wrest new business from struggling rivals.
EnterEssent Group ( ESNT ), newly capitalized in 2008 with $600 million from Goldman, JPMorgan and other investors. Organized as a limited liability corporation, and domiciled in Bermuda to lighten its tax obligations, Essent wrote its first policy in the spring of 2010.
As rivals continued to struggle, Essent captured new business swiftly. By June of last year, it had over 12% of the private mortgage insurance market. Last October, it raised more than $300 million in an IPO.
Observers with a moralistic bent may fret and fume that two banking behemoths that have agreed to pay huge fines for their roles in packaging and selling sour mortgages should now profit in the bubble aftermath. Even after selling some of its shares in the Essent IPO, Goldman still owns nearly 7% of Essent. JPMorgan holds just over 5.4%.
"They're opportunistic investors," said Compass Point Research & Trading analyst Jason Stewart.
That's one way to look at it. Private mortgage insurance now promises opportunity in an important niche.
On mortgages where borrowers contribute down payments of less than 20%,Fannie Mae ( FNMA ) andFreddie Mac ( FMCC ) will not guarantee the full mortgage. A buyer, for example, may commit to purchase a $200,000 home with a down payment of just $10,000. Fannie Mae and Freddie Mac might insure against the first $160,000 in mortgage debt. But they can not purchase low-down-payment mortgages unless some other insurer steps in and covers the other $30,000.
By providing such supplemental coverage, private mortgage insurers help "extend affordable homeownership by facilitating the sale of low-down-payment loans into the secondary market," Essent's IPO filings contend.
Essent competes against entrenched private mortgage insurers such asRadian Group (RDN) andGenworth Financial (GNW), as well as two government agencies -- the Federal Housing Administration and Department of Veterans Affairs -- that also offer insurance on certain loans. With the FHA recently backing away from the market, the competitive landscape right now is very favorable.
The FHA had increased its insurance operations after the housing bubble burst, filling the vacuum left by loss-riddled private insurers. Together, the FHA and VA accounted for 85% of total new insurance volume in 2009.
A New Option
The FHA has more recently been raising rates, however, making it a less-attractive mortgage insurance option. FHA insurance rates were down to a 50-basis-point annual premium in early 2010. But they've since risen dramatically -- to around 130 basis points, Stewart added.
"It's made private capital more competitive," he said.
"The FHA has been pulling back from the industry," said Christine Worley, analyst at JMP Securities.
She expects the retreat to continue. "The government wants taxpayers to be less exposed to the housing market," Worley said.
Since it began writing mortgage insurance only in 2010, Essent is not exposed to the shoddy deals of the loose-lending era that instigated the housing crash. With its capital cushion from "too big to fail" banks and other well-heeled investors, Essent was seen as a safe counterparty to lenders wanting to protect against borrower default.
"Essent was seen as the place to go by mortgage originators," said Worley.
With tighter credit conditions now in force, post-bubble mortgages have been far less likely to default. Those private mortgage insurers that were running losses for years on weak mortgages were soon losing market share to the newly capitalized, financially solid Essent.
What could go wrong? Plenty, actually. As Essent's IPO filings openly state: "Investing in our shares involves substantial risk."
Any pullback in either the housing recovery or the general economic recovery would hurt.
"The main risks are probably economic," said Worley.
A reversal in the long but fairly modest recovery could put pressure on even the stronger mortgages of recent years.
"Post-legacy mortgages could perform less strongly if the economy faltered and unemployment started rising again," she said.
Apart from business cycle risks, private mortgage insurers face risk from the unsettled status of Government-Sponsored Enterprises (GSEs) such as Fannie Mae and Freddie Mac. Any number of "legislative or regulatory actions" could adversely affect Essent revenue and profit, according to the IPO offering circular.
The problem is that while many want to reform the GSEs, there is scant agreement on how to do it. "GSE reform is a huge risk," said Stewart.
But it is impossible to predict now what sorts of changes, particularly those affecting a private insurer like Essent, will emerge.
"There are too many proposals," said Stewart, "to define or quantify" the risk to Essent.