Three Stocks Tied to Risky Debt

Of the $47 billion of value insured by MGIC, 23% covers ARMs and 17.2% covers Alt-A mortgages. Some mortgages may classify as both ARM and Alt-A.

As the housing credit market worsens, I expect MGIC to face unprecedented liabilities. Already, its ratio of delinquency losses to premium revenue has skyrocketed from 44.7% in 2005 to 76.7% in the most recent quarter, and it is likely to worsen. Earnings per share for the most recent quarter were 93 cents a share, down from $1.74 a year ago.

Perhaps a worse blow could come from its C-BASS joint venture, a business that invests in subprime mortgages and of which MGIC has a 46% stake. Earlier this year MGIC agreed to purchase Radian Group(RDN Quote), a deal that would have completed its ownership of C-BASS. But because of C-BASS' uncertain credit status, on Aug. 8 MGIC announced that it will back out of the merger.

Radian Group contends that MGIC is obligated to proceed with the deal, and it will not let MGIC walk away without a fight. At the moment, the future of this deal is unclear. Merger or not, an implosion of the C-BASS business would be a hurtful blow to MGIC as it contributed to roughly 15% of its 2006 net income.

IndyMac Bancorp(IMB Quote): I checked this lender's recent 10-Ks for an analysis of the kinds of mortgages it recently issued. To my surprise, I found that over the last several years IndyMac has brewed a dangerous cocktail of exotic mortgages. Since 2003, this company issued an estimated $153 billion in various adjustable-rate mortgages. Many of these are hybrid ARMs, which may very soon reset from their initial low-interest teaser rates to much higher payments.

IndyMac has also issued a huge number of interest-only hybrid ARMs and pay-option ARMs. Since these types of mortgages do not reduce principal and may even produce negative amortization, IndyMac will face huge losses if it is forced to foreclose on properties with depressed prices in the housing market.

I noticed that management euphemized the nasty "ARM" word in its 2006 10-K by referring to the account as "intermediate term fixed-rate loans." Perhaps management is aware of the impending accident waiting to happen if homeowners cannot afford the higher interest rates when the ARMs reset.

Below is a table I compiled from IndyMac's annual reports describing the types of mortgages issued by IndyMac since 2003.

IMB Loan Production
	2003	2004	2005	2006
Loan Production (billions $)	$30	39	61	90
Alt-A (%)	51.60%	65.10%	66.00%	78.00%
Subprime (%)	6.20%	8.50%	3.70%	3.00%
Fixed-Rate (%)	61%	32%	28%*	21%
Option ARMs (%)	N/A	21%	29%	23%
Hybrid ARM (%)	N/A	24%	19%	19%
Hybrid ARM Interest Only (%)	N/A	23%	24%	37%**
ARMs (total)	39%	68%	72%	~79%
*May include interest-only loans **This figure may also include a small percentage of fixed-rate interest only loans

Most concerning are the repurchase agreements on the mortgages IndyMac securitized for the open market. If customers begin to default on payments, IndyMac will be required to repurchase those securities. If only a portion of that $153 billion is in default, IndyMac will likely not be able to cover it with its current $618 million cash on hand.