A seasoned pro scoops up mortgage stocks

(Fortune) -- As mortgage insurance stocks have gone into freefall over the past month, speculation has been intense about whether a deep-pocketed investor would step in and start buying, in the belief that the stock prices had fallen too far.

Old Republic International (Charts), a sleepy Chicago-based insurance company led for the last 17 years by Aldo Zucaro, has made that bet.

ORI, which has its own mortgage insurance business, purchased 15% of PMI Group and 11% of MGIC Investment Corporation, the nation's largest mortgage insurer, over the past 11 weeks, according to a Thursday filing that ORI made with the Securities and Exchange Commission.

Zucaro has a reputation in the insurance industry as a conservative, long-term investor who has helped steer ORI through several cycles. As a result, his decision to buy stakes in PMI and MGIC could be seen as a vote of confidence in both companies. On the other hand, the down swing of this housing cycle may be much harsher and longer than past ones, so it could confound even the most experienced investors.

Both stocks rallied strongly Friday, though PMI (Charts) is still down 60% since the end of Sept., while MGIC (Charts) is off 40%. ORI didn't say whether it is up or down on its investment, which together is worth about $350 million.

The core business of a mortgage insurer is to write policies that agree to make up a certain amount of losses for mortgage lenders if loans default. The rising amount of past-due mortgages will hurt the insurers' earnings, and some of them have also had to record big losses on the value of securities and financial instruments in their investment portfolios.

Another source of worry about the mortgage insurers is that they are particularly vulnerable to a cut in their credit ratings, since clients and investors expect insurers to have very high ratings.

Given such fears, why would ORI be scooping up PMI and MGIC in such size? After all, it's a particularly aggressive trade for ORI, because it will add to the overall exposure the company has to mortgage insurance, a business line that recorded an operating loss at ORI for the first time in 19 years in the third quarter.

In an interview, the 68-year-old Zucaro let us into the thinking behind the PMI and MGIC bets.

"These two companies are here to stay," says the CEO. "We bought them on the basis that recent market prices underestimate their long-term value." At today's prices, ORI's PMI stake would be worth around $172 million, and the MGIC holding $177 million.

If these positions in PMI and MGIC had been built evenly over the past 11 weeks, ORI could already be sitting on large losses. But Zucaro appears to be taking a long-term view on this investment. He believes there'll be a strong recovery in their stock prices, but it could take two to three years.

"This investment is not about instant gratification," he says.

One of the bull's arguments about the mortgage insurers is that their cash flows are positive, even if they report losses, because the losses reflect estimates of claims. Zucaro, however, believes that operating cash flows could turn negative for mortgage insurers, but he claims that the companies have good liquidity overall because of their investment portfolios.

But why make an investment like this when a negative ratings agency action could have such a large impact on PMI or MGIC? Zucaro responds: "The rating agencies have got to do what they've got to do and we've got to do what we've got to do, but it is in no one's interest to see these companies go under."

Zucaro also believes that the stress tests that the rating agencies have run for PMI and MGIC factor in the difficulties these two companies will experience over the next two years.

But, thus far, the rising levels of mortgage defaults have happened without an economic recession, so if there were a real downturn in the wider economy, the mortgage companies might have to issue large amounts of new capital to strengthen their balance sheets, a move that would hurt their stocks.

So could the investment in PMI and MGIC hurt ORI itself if it doesn't go well? "No," says Zucaro, "it's a very small part of our shareholders' equity."

That's true, since ORI has equity of $13 billion. But with housing market likely to be in trough for years, it's a very big bet indeed.