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M&A possibilities emerge for US mortgage insurers, but deals may prove elusive

The mortgage insurance industry's reputation is finally emerging from the long shadow cast by the Great Recession, industry observers believe.

Loose underwriting standards in the housing boom that preceded the crisis, and an acceleration in risk-taking after the downturn began, left a black mark on the industry, and hazardous incentives to take excessive risks remain in place, according to an academic study published in 2018.

In the years since the crisis, though, mortgage guaranty insurers have applied reinsurance and pricing technology to improve their financials, and they now believe they can withstand an economic storm and attract buyers. In October, Moody's upgraded insurers in the space, citing their improved credit profile.

However, market conditions might have to change to make mortgage insurers attractive in the near term, even to each other, said Houlihan Lokey adviser Arik Rashkes. Consolidation within the industry is a possibility, and the players are probably in regular talks privately, but the conditions would need to be near-perfect for a merger, he added in an interview.

Valuation is one hurdle, with stock prices for the publicly traded companies having been on a run in 2019, he noted. The group's shares have, for the most part, outperformed the S&P 500 Insurance Underwriters Index in 2019, leaving mortgage insurers trading at high multiples, Rashkes said.

In addition, the multiline companies have not had a good run of major acquisitions of late and probably would not have the appetite for a mortgage guaranty underwriter, he said.

"It wouldn't totally shock me, but it would have to be at the right time, for the right price and the right reasons," the adviser said.

In November, Essent Group Ltd. CEO Mark Casale tossed around combination possibilities for the company following third-quarter results that topped consensus EPS estimates. Casale said on a conference call that the company might be interested in a combination, but not, as a questioner inquired, with a company underwriting along the mortgage transaction process like title.

"I think we would look longer term to be a consolidator on the [mortgage insurance] side should the opportunity arise," Casale said. Alternatively, Essent could prove a "better fit" with a P&C organization or a larger multiline insurance company, the CEO said.

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BTIG analyst Mark Palmer questioned whether the companies' management teams have the incentive to combine. Since the release of federal capital requirements called private mortgage insurer eligibility requirements, or PMIERs, pricing has stabilized for mortgage insurers, Palmer said in an interview. Fears of a pricing war have been an overhang, but self-destructive premium rate competition has never materialized, he noted.

"From our standpoint, the group has demonstrated that it can compete while not competing each other into the ground," Palmer said.

Given the steps the companies have taken to reduce volatility, they could entice outside buyers — either insurers looking for a strategic acquisition or private equity firms, Palmer said. The change in business profile that promises more reliable earnings has attracted the interest from the latter, the analyst said.

"We know that private equity has been sniffing around the group in the past, and part of that is the fact that the use of reinsurance can create a much more stable cash-flow stream that makes increased leverage a greater possibility," Palmer said.

Meanwhile, a study of the sector by The Wharton School at the University of Pennsylvania offers a word of caution for the sector's outlook the next time home-buying takes a sharp decline. Some of the underwriting and risk appetite deficiencies prevalent in the run-up to the crisis remain on the business landscape, said Benjamin Keys, a Wharton associate professor of real estate who co-authored the study.

The insurers' primary customers are the government-sponsored entities Freddie Mac and Fannie Mae. The implicit assumption that the federal government will bail them out is a disincentive for managing risk in the relationship, Keys said. The new capital standards and sophisticated pricing should help, but the test of the new business profile will be whether the mortgage insurers will maintain disciplined underwriting for their main revenue source if another housing bubble occurs, he said.

"The big question is ... whether we see that independence from this private industry, and a willingness to say 'no' to the GSEs and say these policies are too risky," Keys said, adding that the companies will need to learn to push back or decline insurance if necessary.