Subprime Mess Impairs a Merger

A court battle between two pending merger partners is the latest fallout from the subprime credit crunch.
Marie LeoneAugust 22, 2007

The subprime meltdown may soon claim another victim. This time it’s a pending $5-billion merger between mortgage insurers MGIC Investment Group and Radian Group.

On Tuesday, MGIC filed a law suit against Radian Group to force the merger target to hand over additional information related to its financial health. MGIC is hoping that the new information will help its board decide whether the company has the legal right to back out of the anticipated deal, which was slated to close during the fourth quarter.

The new lawsuit comes on the heels of several investor class-action suits filed last week against Radian. The law firms organizing the suits are still searching for lead plaintiffs, but the complaints allege that Radian, as well as its CEO S.A. Ibrahim and CFO C. Robert Quint, issued materially false and misleading statements about a MGIC/Radian joint venture known as C-BASS (Credit-Based Asset Servicing and Securitization LLC).

C-BASS and its financial performance are at the center of both the MGIC and investor lawsuits. C-BASS, which is considered a non-consolidated joint venture by its parents, invests in the credit risk of subprime single-family residential mortgages. The joint venture finances its investments via balance sheet borrowings and off-balance sheet securitization deals. In 2006, C-BASS accounted for 15 percent of MGIC’s earnings, and 16 percent of Radian’s earnings, and each company has ponied up about $500 million to fund the venture.

The MGIC lawsuit focuses on determining whether C-BASS will retain enough value when the merger is finalized to produce a tidy profit if a piece of it is sold. Indeed, MGIC and Radian plan to sell off up to 40 percent of the joint venture and use the proceeds to repurchase shares of the combined company in 2008. The share buyback is expected to increase the new company’s earnings-per-share, and make the merger accretive to shareholders.

But in July, both MGIC and Radian announced that their investment in C-BASS was impaired by sagging subprime market conditions. In fact, that month C-BASS also disclosed that it was having liquidity problems, noting that the “severe state of disruption in the credit market” subjected the company to an unprecedented amount of margin calls from its lenders.

To figure out whether the C-BASS impairment would materially affect Radian, as well as the C-BASS valuation, MGIC’s board asked for more information from its merger partner. Among other things, MGIC requested data on the insurance that Radian writes for pools of assets known as NIMs, or net interest margin securities. NIMs are created by securitizing residual cash flows from mortgage-based securities. The insurance that C-BASS provides allows NIMs issuers to collect future cash flow immediately. In addition, the insurance is a credit enhancement for NIMs buyers, which allows a bond to be placed in the market at attractive spreads.

Along with the NIMs data, MGIC also is asking Radian to turn over information related to second mortgage transactions, risk-to-capital calculations, recent presentations to rating agencies, recent financial statements, and financial forecasts for the final two quarters of 2007 as well as forecasts for 2008 and 2009. MGIC claims that Radian was not complying with its request, and that MGIC was therefore was forced to sue its potential partner.

In responding to the lawsuit, which was filed in U.S. District Court in Milwaukee, Radian explained that since the merger was announced in May, the company has provided MGIC with “significant detailed information,” even after MGIC announced the C-BASS impairment. Radian also asserted that it would not release all of the additional material because doing so could provide the rival insurer with an unfair competitive advantage if the merger falls through.

Radian officials contend that the company has fully complied with the obligations of the merger agreement, specifically noting that stockholders of both companies have approved the deal, and emphasizing that they remain committed to the merger.

The investor lawsuits against Radian, which did not return CFO.com’s request for comment on either issue, have been filed in U.S. District Court in Philadelphia. In general, those suits charge that between January 23 and July 31, the company and its two key officers misrepresented, and failed to disclose, several material issues. The suit alleges that Radian failed to disclose that its initial equity investment of $468 million in C-BASS was materially impaired, and losing value as margin calls increased; that Radian materially overstated its financial results by failing to properly value its investment in C-BASS and failing to write-down the investment in a timely manner; and that the company violated generally accepted accounting principles by failing to properly record and disclose the losses. The amount of damages and penalties being sought from Radian was not disclosed.