Wanna see MGIC's new trick? It's called disappearing earnings.

Go-go home-loan insurer

MGIC Investment

(MTG) - Get Report

said after the close Friday that earnings in the second half of the year would fall around 13% short of analysts' expectations, due to higher loan defaults and large amounts of mortgage refinancing. But because MGIC appears to have been skimping on the protective cushion it keeps for bad loans, expect credit problems to continue crimping profits through 2003.

Though bad-loan fears have been weighing on MGIC stock for more than a year, the Milwaukee company has enjoyed the backing of a loyal band of investors, most of whom consider themselves able to spot stocks that seem to have low valuations. This includes Bill Miller of the Legg Mason Value Trust, which as of June 30 had 6% of its $7.9 billion fund in MGIC.

But bulls may have to rethink their positions after Monday, when the stock plunged $6.44, or 12%, to $48.79. It's quite feasible that MGIC could fall an added $15 if its problems persist, because distressed financial companies shouldn't trade much above the value of their equity, or assets minus liabilities. In MGIC's case, that's equivalent to about $32 a share.¿ The company didn't return a call requesting comment.

Call In the Reserves

MGIC's basic business is to guarantee a portion of a mortgage so that the borrower can have a lower downpayment. Home insurers typically get into trouble when they keep reserves for credit losses, expressed as a liability on the balance sheet, at too low a level. Because additions to this reserve are an expense, there is huge temptation for management to boost earnings in good times by under-reserving, something MGIC appears to be guilty of.

And there's a nasty twist to MGIC's story: The company has been increasing the amount of so-called "bulk" loans, which refers to loans with less documentation as well as mortgages made to borrowers with poor credit histories. These bulk loans carry much higher default rates.

Taking the midpoint in MGIC's new earnings guidance gets to $2.77 of earnings in the year's second half, compared with analyst expectations of $3.19. Adding insult to injury, MGIC didn't hold a conference call to expand on its predicaments and it didn't specify how much of the shortfall was due to credit problems, and how much was due to higher mortgage prepayments.

When borrowers refinance mortgages in a rising market, they often don't need credit insurance on the new loan, because house-price appreciation in the interim has reduced the loan-to-value ratio to the point at which insurance isn't necessary. Financially, this saps revenue and forces the insurers to make an earnings-reducing charge against the asset on the balance sheet that represents the costs of acquiring the now-canceled policy.

The total amount of insured loans delinquent jumped to 3.88% at the end of August from 3.6% at the end of June, MGIC said in its press release Friday. The delinquency rate on subprime loans moved up to 11.57% from 11.11%.

Amazement

MGIC's skeptics have looked on in amazement at the decline in reserving metrics. For example, in the second quarter, the $627 million reserve was equivalent to 2.75 times annualized losses in the period, compared with 3.9 times in the year-ago period and 5.2 times in the second quarter of 2000. Another way of looking at it: for every loan in default, MGIC had $10,570 of reserves at the end of the second quarter, compared with $14,470 in the year-earlier period and $22,250 in the second quarter of 2000.

If MGIC decided to push its reserve back up to 3.9 times annualized losses, it would mean adding $263 million to its reserve, which, after tax, translates into $1.70 per share of costs that may need to come out of earnings over the next 12 months.

If there's one thing investors should've learned over the past year is to be very careful of a company that uses an accounting model that allows management a lot of leeway in booking large amounts of earnings before they actually occur.

Profits at dramatic corporate failures such as

Enron

and

Conseco

were upfronted in an arbitrary way. And, unlike other types of insurers, mortgage insurers don't have to make a reserve until the loss event actually occurs. As a result, investors have to trust management's loss estimates even more than at, say, a life insurer or a property and casualty company.

Yep, beware of this black MGIC.