How will New Century's almost certain collapse hurt mortgage insurance?

I would not do so even though I think these companies will experience a slow down. That's because I like the idea of shorting stocks where there's a reasonable chance that they'll go bankrupt. And I don't see that happening soon at least for the industry leader -- MGIC Investment Corp. (NYSE: MTG) which is about to get even bigger due to a merger it announced last month with another big mortgage insurer, Radian Group Inc. (NYSE: RDN).

Although MTG has tumbled 16% since February 6th when it announced the merger, due to a potential Fitch ratings downgrade revealed on February 11th, MTG could fall further. However, MTG is generating cash ($99 million in 2006), has limited debt (18 cents per dollar of equity), and limited risk exposure (in the prospectus for NovaStar's recent MBS offering, MGIC was on the hook for 55% of the reduction in the loan-to-value ratio for 43% of the mortgages). Nevertheless, MGIC's sales and profits have recently declined, down 3.8% and 5.2% respectively and its net margins fell to a still robust 27% in 2006 below its 30% five-year average. While MTG could drop further -- particularly as investors become more aware of its subprime connection -- it does not appear to be headed for bankruptcy.

But that's not all.

In Sunday's New York Times [registration required], Gretchen Morgenson added to my understanding of subprime's economic metastasis by exploring two important details:

• Liar loans. Mortgages requiring little or no documentation became known as "liar loans" -- 40% of of the $1.3 trillion worth of subprime mortgages are liar loans. How big were the lies? An April 2006 report by the Mortgage Asset Research Institute, a consulting firm in Reston, VA, analyzed 100 loans in which the borrowers merely stated their incomes, and then looked at documents those borrowers had filed with the I.R.S. The differences were significant: in 90% of loans, borrowers overstated their incomes by at least 5%. But in 60% of cases, borrowers inflated their incomes by at least 50%!
• Shoddy MBS accounting. As a result of all the liar loans, it is highly likely that a significant portion of the mortgage payments that MBS investors expected are not being made. Therefore the economic value of their MBS investments has declined. However, MBS accounting conventions require an investor to mark his holdings to market only when they get downgraded. So the investor may be assigning higher values to his positions than he would receive if he had to go into the market and find a buyer. That delays his need to count his losses.

This leads to a new factor that could force MBS investors to recognize big losses. In the wake of the MGIC/Radian merger mentioned earlier, Fitch placed MGIC's rating on "rating watch negative" and Moody's changed the outlook for its rating from stable to negative. According to that NovaStar prospectus, "any reduction in the ratings assigned to a mortgage insurance provider by the rating agencies could result in the reduction of the ratings assigned to the offered certificates. This reduction in ratings could adversely affect the liquidity and market value of the offered certificates."

The biggest mortgage insurer for the NovaStar offering? MGIC. So if MGIC's rating is reduced, holders of the NovaStar MBSs -- and probably any other MBSs insured by MGIC -- will be forced to report their losses.

Given the large number of European investors owning MBSs, the shock waves from this reckoning could spread around the globe.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter He has no financial interest in MGIC, Morgan Stanley, New Century, NovaStar or Radian.