ACT - Enact Holdings: Resilient Balance Sheet For A Tough Mortgage Environment

Summary

• Private mortgage insurer Enact Holdings has performed better than peers over the last 12 months in spite of common headwinds from the housing.
• Going into 2023 which is expected to be a slow year for new mortgages, the balance sheet appears robust, with shares at a slight discount to book value.
• Shareholders' interests are looked after with a capital allocation approach that is gaining flexibility.

In my daily life, I rub shoulders with people whose job responsibilities include dealing with requests from homeowners to have their mortgage insurance policies cancelled as the equity in their homes hits the point that it is no longer required. I was chatting with one of these acquaintances at the water cooler recently, and got on the topic of his observations of dealing with some of the major PMI providers, including Enact ( ACT ), MGIC ( MTG ) and Radian Group ( RDN ). From his vantage point, they each had pros and cons - MGIC was easier to get a live agent to talk to than others, whereas Enact had a better online interface for looking up and taking care of the items he needed to address. Radian was not as slick in its user interaction, but seemed to have an outsized portion of the bigger policies. As a shareholder in Enact Holdings and a previous shareholder in Radian Group, I found this an interesting conversation, and I may look to talk to him more for his first-hand impressions in the future.

For a brief primer, private mortgage insurance is a business built on protecting mortgage lenders against defaults, by requiring those with relatively less equity in their homes to pay a premium, normally bundled right into the monthly mortgage payments. If a homeowner defaults while having relatively little equity in the home, the lender can recover some portion of the loss from the private mortgage insurance in place. Once a homeowner has sufficient equity, normally 20%, the insurance requirement can be dropped, and in fact as a consumer protection must be dropped when past a certain threshold. If a mortgagee has been making extra payments on principal, or the value of the home has increased, or some combination, he can request getting the insurance requirement dropped. There are all sorts of variable involved in terms of whether the homeowner get his wish, such whether Fannie Mae or Freddie Mac own the mortgage versus or other investors, or the value conclusion of a new appraisal, but eventually the requirement goes away on its own, so no homeowner pays the PMI in perpetuity.

Mortgages: Review of 2022 and Looking Ahead

2022 was a year of rapid, large increases in interest rates that appear likely to settle over the course of 2023 as the Fed battles inflation. The changes have clearly impacted mortgage demand, along with other forms of credit. Fannie Mae's review and overall economic outlook was updated a couple of weeks ago, providing some telling data points. To quote their outlook, Fannie Mae's report states:

We now expect total home sales in 2022 to be 5.72 million units, up from 5.67 million in our prior forecast. Sales in 2023 are forecast to total 4.57 million units (previously 4.42 million). We forecast a rebound in 2024 to follow thereafter, with total sales rising 14.7 percent to 5.24 million units (previously 5.25 million) as we expect economic growth to return and mortgage rates to stabilize.

So 2023 is expected to be a tough year in volume terms relative to 2022, which should not take anyone by surprise at this point. The expectation for 2024 to see a return to growth is premised on stabilization, or even declining, mortgage rates, though growth would not quite return to the level seen in 2022. The corollary is that is home prices will likely be forced to adjust downward; even in expensive markets with high demand and limited supply, there is some evidence that prices are coming off their highs.

We've already seen the impact on non-bank mortgage lenders themselves, with the likes of loanDepot , Ruoff Mortgage , and Homepoint shedding jobs, and even Wells Fargo ( WFC ) started to scale back its mortgage department, with many anticipating further job cuts. Publicly traded Rocket Companies ( RKT ) has seen its market valuation plummet over the last year, along with the likes of real estate broker Redfin ( RDFN ), both to a greater degree than the broader S&P index ( SPY ).

These price trends reflect the poor outlook for the next year, but interestingly, one corner of the mortgage-related market has been able to hold its own, at least so far.

In the United States, there are a handful of major private mortgage insurance [PMI] underwriters - the three mentioned above of Enact Holdings, Radian Group, and MGIC Investment Corp, as well as Essent ( ESNT ). Over the last 12 months or so, all four of these insurers have at least matched, but mostly outperformed, the S&P index on a total return basis for their shareholders. Of these four, Enact Holdings is the clear winner, though ending the last two months of the year in a fairly narrow range.

Given this outperformance for creating shareholder value, it is a good time to dig a little deeper again into Enact to assess what might be separating it from the others, and if it is still positioned to continue.

Enact Holdings: Resilience & Capital Allocation

The share price for Enact since my last article in September is little changed, though the company has delivered shareholders a quarterly dividend of $0.14, as well as a special dividend of $1.12, clearly contributing to the overall total return figures. However, that capital allocation is far from the whole story.

For context, Enact Holdings has not been a stand-alone company all that long, having been spun out to trade separately from Genworth Financial ( GNW ) in late 2021. Therefore, the one-year returns represent most of Enact's total lifetime existence as a publicly traded security. Genworth is still the majority owner of Enact, with about 81% of the shares.

As of the end of Q3 of 2022, Enact had $242 billion of insurance in force, a function of multiple variables, from persistency (that is, how well a business keeps its existing customers - the opposite of customer churn), total new mortgage volume as well as mortgage refinancing activity (a transaction when the PMI provider might change), overall market share, and the dollar value of mortgages. For example, with higher interest rates now than a year ago, refinancing volume is logically lower, but that supports higher persistency for Enact (and the other PMI providers as well), which in turn supports having more insurance in force.

Writing new policies was showing a distinct slow-down into the 3rd quarter, with $15 billion in new insurance in force, and will likely be this low or lower in the 4th quarter, between seasonal slowness starting in the winter months and the broader issues facing housing sales. While the impact of rising rates is a headwind on the mortgage origination side of things, it is a mixed bag for Enact, as like most insurers it invests the premiums it receives in high quality bonds. The value of older bonds in its portfolio have been hurt by the rising rates, though management generally plans to hold them to maturity. At the same time, the new bonds being added are getting the benefit of yielding significantly more than the maturing ones, approximately 5.1% according to Daniel Kohl, the company's CFO, on the Q3 earning call .

Total investments are marked on the balance sheet at $4.9 billion, with an additional $0.5 billion in cash on hand. The cash balance matches up closely to the loss reserve liability, a figure that has been coming down steadily over recent quarters, but always bears watching. Overall, the balance sheet is quite clean, with $0.7 billion in long-term borrowings, $0.2 billion in unearned premiums, leaving the book value of equity at $4.1 billion, or book value per share of $25.28, reasonably close to the current market value around $23.50.

The strong net cash and short term investment position is a good starting point as an indication of its overall ability to withstand a recession. The options for the uses of cash are fairly straight forward - pay claims as needed, transfer risks, invest in prudent financial instruments, pay down debt, or return to shareholders (physical capex is minimal). At the base dividend rate of $0.56 per year, the Enact pays out $91 million in regular distributions. However, this may be coming down over time, as a $75 million share repurchase program rolls out in 2023. To fund these uses of cash, the company managed to create plenty of cash internally, to the tune of $400 million in cash from operations over the first 9 months of 2022.

If new insurance in force being added is slowing down on low volumes of mortgage originations, so long as losses are accurately provisioned, the cash for investments should mostly come from existing investments. As of Q3 2022, Enact had put approximately $1.1 billion into investments, but largely funded with about $825 million from the sale or maturity of existing investments. As new investments get added at higher yields, it is possible that even less cash will be required to fund the risks of the insurance in force, and the extra cash could be put to other uses. I don't know that this will happen, but it is something I will be watching, as I think it is possible that either the regular dividend will be raised, or further special dividends will be declared.

Conclusion

Whether the loss reserve will need to start creeping up again in the current or expected recessionary economic environment will be answered in time, but there is not yet any clear indication of an imminent hard landing. Regardless, knowing how well Enact is positioned to handle a downturn, whether mild or severe, is an important investor consideration. Fortunately, Enact has also been actively adding reinsurance to its policy portfolio, and appears well positioned to get through a bumpy ride in housing in 2023. In response to a question from an analyst, CFO Dean Mitchell had this to say about striking the balance on credit risk transfer and capital allocation [lightly edited for readability]:

Our focus... has been positioning us for -- putting us in a position of strength. When we think about that from a finance perspective, we're running multiple scenarios to make sure that we're well positioned with a strong balance sheet with enhanced financial flexibility. And I think Rohit's [CEO Rohit Gupta] kind of laid out important steps that we've done to enhance our resiliency. We've increased price. We've enhanced the credit profile of our portfolio. And to your point, we further mitigated risk through our credit risk transfer program. So we're really trying to prepare ourselves for whatever comes down the pike, could be prepared to fund the growth for the business and ultimately balance that with returning capital to shareholders.

I consider Enact Holdings to be a relatively defensive position, with well managed risks and a commitment to shareholders' interests. For long-term investors, I continue to consider it a "buy," although I anticipate there may be more attractive entry points possible in the first half of 2023 while the market digests mortgage numbers that are likely to look abysmal.

For further details see: