RDN

Business Context and Reporting Period

Radian Group Inc. (Radian) is a provider of mortgage insurance and financial guaranty insurance. This Form 10-Q covers the quarterly period ended September 30, 2008. The company operates through three segments: Mortgage Insurance, Financial Guaranty, and Financial Services. The reporting period was characterized by severe deterioration in U.S. housing and credit markets, leading to significant increases in mortgage defaults and claims. In response to these conditions and rating downgrades, Radian ceased writing new financial guaranty business and contributed its financial guaranty subsidiary to its mortgage insurance subsidiary to bolster capital.

Key Financial Metrics

Material Changes vs. Prior Period

• Net Income Volatility: The company reported a net income of $36.7 million for the quarter, a significant improvement from the $703.9 million loss in the same period of 2007. This turnaround was primarily driven by a $164.8 million gain in the change in fair value of derivative instruments, largely due to the adoption of SFAS No. 157 which incorporates the company's own non-performance risk (credit spread widening) into liability valuations. This offset substantial operating losses.
• Loss Provisions: The provision for losses increased 64.9% year-over-year for the quarter to $544.9 million, driven by a 16% increase in first-lien primary defaults and higher claim severity. The mortgage insurance segment recorded a net loss of $47.0 million for the quarter.
• Premium Deficiency: Radian reduced its reserve for premium deficiency by $252.2 million in the quarter, resulting in a net benefit. A first-lien premium deficiency reserve of $150.1 million remained at period end, down from $421.8 million established in the prior quarter.
• Derivative Valuation: The adoption of SFAS No. 157 resulted in a cumulative unrealized gain of approximately $2.3 billion for the nine months ended September 30, 2008, significantly reducing the fair value of derivative liabilities as the company's credit spreads widened.
• Segment Performance: The Financial Guaranty segment reported net income of $74.4 million for the quarter, compared to a loss of $154.1 million in 2007, also driven by derivative valuation changes. The Financial Services segment contributed $9.3 million in net income, primarily from its equity interest in Sherman Financial Group.

Guidance, Outlook, and Risks

• Outlook: Management expects a significant increase in new first-lien primary defaults for the fourth quarter of 2008 due to seasonality and ongoing economic deterioration. Claims paid in 2009 are expected to significantly exceed 2008 levels.
• Capital Plan: Radian executed an internally-sourced capital plan by contributing its financial guaranty business to its mortgage insurance subsidiary. This provided immediate regulatory capital credit and is intended to provide cash infusions over time. However, the success of this plan depends on the dividend capacity of the financial guaranty business, which could be restricted if its portfolio performance deteriorates.
• Ratings Risk: Radian's credit ratings were downgraded by S&P and Moody's in 2008. The company's mortgage insurance subsidiaries are on "Negative Outlook." There is a risk of losing "Top Tier" eligibility with Fannie Mae and Freddie Mac, which would severely impair the mortgage insurance franchise.
• Liquidity: Radian Group held approximately $400 million in current liquidity. The company has no additional borrowing capacity under its credit facility, which was reduced to $150 million. Future capital needs may require asset sales or equity issuance, which may not be possible on favorable terms.
• Unusual Items: The financial results are heavily influenced by the accounting treatment of derivatives under SFAS No. 157. The reported gains are non-cash and reflect the market's perception of Radian's credit risk rather than operational performance. Additionally, the company faces an IRS examination regarding tax losses from REMIC investments, with a proposed adjustment of approximately $121 million.

Key Facts for Investor Verification

• Derivative Accounting Impact: Verify the sustainability of the $928.8 million derivative gain for the nine months, which is driven by the company's own credit spread widening (non-performance risk) rather than asset performance.
• Loss Reserve Adequacy: Assess the adequacy of the $2.5 billion loss reserve and the $150.1 million premium deficiency reserve given the accelerating default rates (9.71% of primary loans in default) and the sensitivity of these reserves to unemployment rates and home price depreciation.
• Top Tier Status: Monitor communications with Fannie Mae and Freddie Mac regarding the retention of "Top Tier" eligibility following recent rating downgrades.
• Capital Sufficiency: Evaluate the risk-to-capital ratio of Radian Guaranty (14.5-to-1 at Sept 30, 2008) and the company's ability to raise additional capital if the ratio continues to increase.
• IRS Dispute: Track the status of the IRS examination regarding the $121 million proposed tax adjustment related to REMIC investments.