When banks don’t want to carry risk on their own books, they call Genworth Financial (GF), which will soon sell about 40% of Genworth Australia in a float this month.
Genworth has about 45% of the Australian lenders’ mortgage insurance (LMI) market, ahead of second-placed QBE Insurance with about 35%. LMI is paid for by the borrower and is often required by lenders for mortgages of more than 80% of a property’s value. In the event of default, Genworth covers the lender for any shortfall after a property is sold. That’s the idea anyway.
About a third of the company’s loans started out at more than 90% of the secured property’s value, with another third being added between 80% and 90%. Genworth estimates that, due to repayments and house price rises, the effective LVR across its portfolio is now about 59%. About a quarter of the book is for investment properties and about 90% of loans qualify as ‘standard’, with 7% being ‘low-doc’.
So here’s the problem. About 66% of Genworth’s gross written premiums come from three of the big four – CBA, NAB and Westpac – with CBA accounting for 43% on its own. If CBA decides one day to switch to another provider, there goes half Genworth’s business. And even if CBA doesn’t switch, you’d think it has the whip-hand in any future negotiations over price.
Here’s the next problem. There’s no legal requirement for LMI and, when you think that APRA bases its capital requirements for Genworth on a ‘probable maximum loss’ (PML) from a hypothetical three-year downturn of $2.6bn, you have to wonder why the banks bother at all.
Between them, Genworth’s three biggest customers, contributing two-thirds of its business, made net profits of $20bn in 2013 and had $138bn in shareholders’ equity. Why not take on the risk of a ‘probable maximum loss’ of $2.6bn themselves?
The banks probably think they have better uses for that capital, although in its prospectus Genworth expects some of its customers ‘to seek the flexibility to retain greater levels of risk’, particularly CBA. What that means is that Genworth is far more reliant on the big banks than the big banks are on it.
Whilst the major banks enjoyed an average return on equity of 15% in 2013, Genworth managed just 8%. That tells the story. The banks can cherry-pick the businesses that can earn them their mid-teens ROE whilst Genworth gets the rest on a take-it-or-leave-it basis.
The risks don’t end there. That $2.6bn PML figure from APRA might not mean much to the big banks but it would pretty much wipe out Genworth Australia’s shareholders' equity of $2.2bn, even after the benefits of $844m of reinsurance currently in place.
After reaching a ‘probable maximum loss’ for Genworth of $2.6bn, APRA deducts allowable reinsurance and makes a couple of other minor adjustments to give Genworth’s required capital of $1.7bn, covered a comfortable 1.3 times by the company’s shareholders’ funds. Sure, it’s comfortable for APRA but shareholders are left mulling the possibility that APRA’s ‘probable maximum loss’ would swipe three-quarters of their money.
And how likely is that kind of property market collapse? Well, look what happened to Genworth’s US business in the GFC. After making profits of around $300m a year from 2005 to 2007, in the five-year period from 2008 to 2012, it lost a total of US$3.2bn – an average of $640m a year.
Genworth has learnt its lesson and the Australian business appears to have placed its reinsurance more carefully. However, it operates from a similar capital base to that of the US business in 2008, with less reinsurance, and it’s safe to say that it wouldn’t last long if it started making losses of $600m a year.
That the overall Genworth Group survived the GFC at all is down to its life and protection insurance businesses in the US and the profits that continued to be made by its international mortgage insurance business (including Australia).
QBE Insurance, which we’ve recommended in the past and which we continue to hold in our model Growth and Income portfolios, also has the benefit of diversification, combining its mortgage insurance business with a broad range of personal and business lines. But we still only give it a low maximum portfolio weighting of 3%.
All in all, it’s hard to get excited about Genworth Australia, even at a discount to book value of up to 35% and a prospective dividend yield range of 6.7–8.9%. Who cares what the yield is when the possibility of a disaster could wipe out your shareholding entirely?
Many Australian investors will have plenty (and quite possibly too much) exposure to the housing market but, if you needed more, the banks would be a better bet than Genworth. AVOID.
