The Genworth Outlook, A Review of the Q Investor Presentation

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1 In this quick note we look at the recent Genworth Australia disappointment adding color on how the process works down under, where the rise in defaults are being hidden, and what is likely to happen next. Mark Hanson Summary The Genworth presentation tries in vain to blame isolated geographic regions and other specific factors for a temporary poor performance when an analysis of the data clearly indicates a very poor outlook for Genworth and, therefore, the Australian financial system. Genworth s Siamese twin, QBE LMI, shares the same market and risk. Therefore, you can safely bet that the same situation is unfolding; although we suspect on the numbers above that QBE has a larger exposure proportionally in Victoria, which is a concern. There is one other factor which we would like to highlight. The capital requirements of both Genworth and QBE LMI are based primarily on their exposure relative to the LTV ratio of the mortgage being insured. As house prices decline, the Australian Prudential Regulatory Authority s (APRA) capital adequacy rules require that the LMIs must increase their minimum capital requirements because lower house prices significantly increases their risk exposure. With the information that APRA now has on performance, it is likely to significantly increased capital requirements well before the dramatic increases in LMI claims occur. The Genworth Outlook, A Review of the Q Investor Presentation by Leith van Onselen In this Update, we will dig a little deeper to see what the future might hold for the mortgage insurer, Genworth Australia, based on its Q Investor Presentation released last week. Firstly, let s remind ourselves what mortgage insurance actually entails in Australia. A mortgage insurer in Australia insures the lender under a mortgage for 100% of the balance of a loan for the life of the loan. Generally, the loan-to-value (LTV) ratio on insured loans is greater than 80% on settlement. Although the borrower pays the once-off premium at

2 the time of entering the loan, the borrower receives no benefit from the insurance. Regardless of whether a lender successfully claims against the mortgage insurance, the borrower is still liable for repayment of the loan. Mortgage insurance is an unusual business because it is in essence a one way bet on house prices. You receive a premium up front, set your risk position and wait for the train to hit, as surely it will. If house prices are rising even modestly, it s generally a high cash generation business with low claim rates. However, when it turns, the reverse occurs, with no ability to re-price the risk in force to offset rising claims in both numbers and amounts. Genworth Australia has reported that their exposure or Risk-in-Force (RIF) in Australia is $100.5Bn. RIF is 35% of Genworth s total exposure because it believes that it would not lose more than 35% on any loan. The total balance of loans insured, therefore, is $287Bn. Against this risk, Genworth has a regulatory capital base of $2.3Bn or 0.8%. The capital ratio is a slight improvement from the previous 0.7% that we quoted previously [see December 15, 2011 note] due to the raising of Tier-2 subordinated debt and extra provisioning. In a stable market for mortgage exposure, this capital ratio, although thin, is sustainable especially with the size and diversity of exposure that Genworth holds in Australia. However, and as the Genworth report shows, stable mortgage exposure is not what is happening or being forecast. The Genworth Investor Presentation reports four reasons why they are strengthening their provisions (Presentation available fordownload here) 1) Coastal Queensland Economic Downturn. Queensland s (QLD) property market downturn has been underway for a number of years, with prices now back at 2007 levels. The most interesting development in the Genworth Presentation is the huge Q12012 uptick in claim size, especially in coastal QLD. Claim size has risen from around $90,000 to around $140,000 in the last 12 months (see below chart). Is coastal QLD, am outlier? We do not believe so. As explained previously, the Melbourne (Victorian) housing market is likely to be the

3 epicenter of the coming Australian housing bust, owing to its significant oversupply (both in terms of homes for sale and new home construction), over-inflated prices, and deteriorating economy. $66Bn of mortgage loans are insured by Genworth in Victoria, which is even higher than those insured in QLD. 2) Small Business/Self-Employed In Books. Genworth has an exposure of $43Bn to low doc loans taken out by Australian small businesses/self-employed persons (arguably Australia s version of sub-prime lending). As the domestic economy deteriorates even further, we expect that the number and amount of claims in this class will continue to rise.

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5 3) Lender Servicing/Forbearance Impact. Australia operates a range of programs (loosely known as Borrower Assist ), which are a potential sleeper risk that could suddenly accelerate the spiral down. In effect, borrowers in Australia have been given rights to delay foreclosure processes in order to allow themselves more time to become current on their mortgage payments (see here for details). The process is either by agreement with certain lenders or through a government sanctioned process. Our understanding is that most mortgage lenders allow for up to 12 months payment deferral (i.e. capitalization) for hardship, which is not usually classified as arrears. Genworth has shown the dramatic increase in the time taken from 13 months to 21 months - for a claim to be made from delinquency has dramatically increased the size of Genworth s claims. Anyone wondering why Australian mortgage delinquencies have not risen more quickly, Borrower Assist is your smoking gun.the stretching of lender forbearance, most likely via the Borrower Assist programs that all banks are required to run, operate like purgatory buckets from which the banks can delay and then drip feed delinquencies onto the market. While Borrower Assist is not necessarily a bad policy, it does lead to an understatement of the true level of stress (and risks) in the Australian mortgage market, particularly when house prices are falling as is the case currently. Lenders have not consistently reported the numbers and exposure to borrowers in all forms of Borrower Assist; therefore it is not currently possible to ascertain the extent of their exposures. We would hazard a guess that most distressed borrowers go into Borrower Assist programs first, and not straight into foreclosure. As such, there are likely to be a significant number of delinquent mortgages floating underneath the surface. 4) Paid Claims. Genworth reports an increase in the number of claims paid in the quarter of 76% - i.e. from 483 to 852 (see below charts). Is this a one off event, or the start of a trend? Time will tell. It is significant, however, that Genworth were not able to predict this dramatic increase in claims and both provide for it and disclose it. With

6 house prices falling across most of Australia, and the domestic economy deteriorating, it is hard to not come to the conclusion that the claims against Genworth mortgage insurance will continue at elevated levels. In summary, the Genworth presentation tries in vain to blame isolated geographic regions and other specific factors for a temporary poor performance when an analysis of the data clearly indicates a very poor outlook for Genworth and, therefore, the Australian financial system. Genworth s Siamese twin, QBE LMI, shares the same market and risk. Therefore, you can safely bet that the same situation is unfolding; although we suspect on the numbers above that QBE has a larger exposure proportionally in Victoria, which is a concern. There is one other factor which we would like to highlight. The capital requirements of both Genworth and QBE LMI are based primarily on their exposure relative to the LTV ratio of the mortgage being insured. As house

7 prices decline, the Australian Prudential Regulatory Authority s (APRA) capital adequacy rules require that the LMIs must increase their minimum capital requirements because lower house prices significantly increases their risk exposure. With the information that APRA now has on performance, it is likely to significantly increased capital requirements well before the dramatic increases in LMI claims occur. Best Regards, Leith van Onselen Mark Hanson DISCLAIMER: This message and attachments are for the sole use of the addressee and are privileged, confidential and exempt from disclosure. If you are not the addressee, copying, dissemination, or distribution of this communication is strictly prohibited. You must delete the e mail and destroy any copies. In publishing research, Hanson Advisors, JCLMH LLC, and MAHA, Inc (the Company) is not soliciting any action based upon it. The Company's publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, the Company does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing in the Company's publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither the Company nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, the Company and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. The Company is not liable for any loss or damage resulting from the use of its product. The Company is CA Corp registered in the state of CA.