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Will C-Bass Sink the MGIC-Radian Merger?

Analysts think the floundering loan servicer's liquidity woes could threaten the merger of the two mortgage insurers that control it

Market players are still debating how serious the credit crunch spurred by subprime loan fears will be. Meanwhile, a proliferation of margin calls by nervous lenders is causing a real liquidity crunch for companies that service and package low-grade loans.

The latest victim is C-Bass LLC, a joint venture owned by mortgage insurers MGIC Investment Corp. (MTG) and Radian Group Inc. (RDN). After the closing bell on July 30, MGIC and Radian said their investments in the company had been "materially impaired" and would prompt writedowns of as much as the full value of those investments.

Shares of MGIC and Radian each fell around 15% in late trading July 31.

MGIC and Radian each have a 46% equity stake in C-Bass worth $466 million and MGIC also provided a $50 million credit line to the joint venture.

An unprecedented number of margin calls has caused C-Bass's liquidity to dry up in the past month, forcing it to seek out loans that are certain to come at hefty interest rates if they materialize at all. C-Bass managed to meet $290 million of lender margin calls stemming from a cascade of market alerts about potential defaults on subprime mortgage loans during the first six months of this year. Those margin calls ate up nearly all of the $302 million of cash C-Bass had on hand at the start of 2007, which represented more than 30% of its $926 million in capital. The company ponied up additional $260 million for margin calls in the first 24 days of July.

The failure of two Bear Stearns hedge funds that were heavily exposed to subprime loans in June re-ignited banks' jitters over the risky loans and caused them to accelerate their margin calls.

"When you have the ABX index trading very low on a lot of concerns about subprime loans, [negative] psychology begins to take over," said Michael Grasher, senior research analyst at Piper Jaffray & Co. To meet the margin calls, C-Bass had to sell down some of its assets. Now, strapped for cash, it's being forced to look for other sources of cash, such as loans. The mortgage loans the company has invested in continue to perform as they had been, he said.

The cash crisis at C-Bass doesn't have any wider implications for other mortgage insurers, as MGIC and Radian were the only companies that have invested in a company that services and packages subprime loans, he added.

In February, MGIC and Radian agreed to merge to form a new company, to be called MGIC Radian Financial Group Inc., that will have nearly $15 billion in total assets, and offer more than $290 billion of primary mortgage insurance. Under the merger agreement, 0.9658 shares of MGIC common stock will be exchanged for each share of Radian common stock, with the merger meant to qualify as a tax-free reorganization for U.S. shareholders.

It's no secret that the two companies had planned to sell down their combined stake in C-Bass by 50% at the time of the merger, which is slated to close in the fourth quarter. But analysts say C-Bass's liquidity crisis now throws a sale into question.

The meltdown of C-Bass, combined with the risky nature of Radian's portfolio, could end up derailing the merger between MGIC and Radian, Standard & Poor's said in a research note. The research outfit maintained its hold rating on MGIC but trimmed its target price by $4 to $51 per share. That's 1.04 times the estimated book value of $49, assuming a complete writedown on the C-Bass investment, a discount to historic levels, the note said. (Standard & Poor's, like BusinessWeek, is owned by The McGraw-Hill Companies [MHP].)

While the market is now questioning the likelihood of MGIC and Radian being able to sell half their interest in C-Bass, that doesn't pose a threat to the merger, as the ratings agencies weren't giving the companies credit for their equity stakes in the joint venture anyway, said Grasher at Piper Jaffray.

In light of the fact that both MGIC and Radian are suffering from the same C-BASS exposure, problems at the joint venture aren't enough to scuttle the merger, analyst Steve Stelmach at Friedman Billings Ramsey said in a research note on July 31. "In fact, we see greater need now for the two companies to combine and realize some level of expense efficiencies to offset the lost revenue of C-BASS," the note said.

The market, however, is clearly betting against the merger being completed, Stelmach said in an interview with BusinessWeek. He cited an 11% arbitrage spread between the prices at which the two stocks were trading Tuesday afternoon, based on the fixed exchange ratio of 0.9658.

"That's a heck of a return between now and October, if [the deal] goes though," he said.

Stelmach had estimated that the aggregate investment in C-Bass would account for 13% of the combined companies' 2008 earnings.

Although a buyer would presumably still be interested in C-Bass, if there is a sale, creditors would have higher priority in getting paid, which begs the question of whether there would be anything left over for equity holders, he said.

He said he had already baked a complete writedown of the C-Bass investment into his earnings estimate for MGIC. Full impairment of its $516 million investment in the joint venture would reduce MGIC's book value by an estimated $4.10 per share to $49.58 per share, he said in his research note. He lowered his 2008 earnings forecast for the combined company to $4.25 from $5.50 per share and cut his price target to $43 from $55 but upheld his market perform rating on the stock.

FBR has received compensation for investment banking services from Radian within the past 12 months. Piper Jaffray does investment banking with MGIC, makes a market in the company's securities and was a managing underwriter of a public offering for MGIC or its affiliates within the past 12 months.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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