Most people who have followed my writing during the summer have seen my coverage of Primus Guaranty, a credit derivative products company [CDPC] that sells credit protection via credit default swaps [CDS]. On July 22nd, I placed my entire portfolio into Primus, via a combination of its common stock (PRS) and senior debt (PRD). I saw (and see) Primus as a company with very clear risk exposures thanks to the finite and short-lived duration of its swap portfolio, and the fact that a stress-tested loss estimate nets an equity value in the mid-single digits (i.e. about $5/share), which holds even if the company were to enter a run-off.
I've tried to clear a number of misconceptions about Primus, the most important being that the company does not face the liquidity risk that took down Bear Stearns, et al. This is not an accident of chance, but due to the capital structure of Primus – because their AAA/Aaa-rated subsidiary that sells CDS protection is a CDPC, they do not post collateral regardless of how bad the mark-to-market losses on their portfolio become. Even a ratings downgrade could not result in counterparties demanding collateral; it simply isn't how Primus does business.
This "continuation" structure is the huge advantage of the CDPC model; not needing to post collateral makes writing business more economical and can make the system safer as a whole by preventing liquidity-driven runs on sellers of CDS. But that only holds true if the CDS sellers don't take advantage of the collateral exemption and write too much business that goes bad, ultimately leading to insufficient capital to fund their obligations. Because Primus – the first CDPC – received its rating in 2002, there isn't any historical data on how the model performs in periods of market stress.
From what Primus has been saying about business recently and what I've gleaned from the helpful notes by the financial guarantor research team at William Blair, the major concern is that CDS buyers become wary of the CDPC model, and are no longer willing to transact business with sellers who don't post collateral. Ultimately, it's a question the market is going to answer – is there a significant difference in the value of CDS protection from a CDPC, and does the counterparty rating count for anything? Monoline-guaranteed bonds have traded at a discount to those backed by Berkshire Hathaway (BRK) Assurance Corp., so it's conceivable that on the other side of the credit derivatives market mess, some sellers might get slightly better rates than others (we're talking in basis points, but that counts at 30x leverage), because their balance sheets are perceived to be more solid.
Of the CDPCs listed to date that have been rated by Moody's, only one has been placed on review for possible downgrade - Athilon (the second Aaa-rated CDPC, behind Primus) – on July 9th. Moody's has essentially stood behind the CDPC model so far, but that is no guarantee they'll continue to do so in the future, especially if one or more has a spectacular and highly-visible meltdown. Most of their concerns are limited to the CDPCs that were launched later, because they lack the existing book of business that generates consistent and recurring premium cash flow streams; this is not a problem for Primus, because they already have an adequately leveraged swap book generated good premium income along with an existing healthy cash position.
The most interesting point I gleaned from Moody's note on CDPCs (keep in mind, this was published in March) is that their estimate of the one-year rate of defaults on investment grade corporate debt is 0.0466%; my stress test model has Primus' realized credit losses roughly 30x higher at 1.32%, though that isn't entirely comparable because the actual losses net out recovery, whereas the straight default rate merely shows what percentage of issuers default. This is significant because the recovery rate on some defaulted senior corporate debt can be very high – one person told me they aren't highly concerned about the concentration of Primus' swap portfolio in financials because they expect the senior debt to remain intact, I imagine through a combination of white knight guarantees or government backing.
On an apples-to-apples basis using a 24% recovery (the lowest recovery rate on senior debt ever in a single year), the 1.32% rate I establish that Primus can survive between now and the middle of 2010 is 120x higher than the loss rate Moody's estimates translate to. The DCF value of Primus common stock, should no credit losses take place and no new business be written, is $15/share – a triple from the current price. There will likely be some losses, but the probability is that Primus is sufficiently capitalized to weather a spike in defaults and still retain value down through the common stock, which is why I'm invested the way I am.
If you would like a copy of the Excel model I use to value Primus, send me an email at jcullen – at – collegeanalysts.com and I'll reply as soon as possible.
Read the Primus Guaranty Stock Report for more.
Disclosure: Long PRS and PRD.
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This article has 5 comments:
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D-leverage
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4 Comments
Aug 22 10:37 AMThe Primus stock is suffering from a massive uncertainty discount and that is probably a good thing for the longs, because if the company had greater transparency, it could be trading much lower.
Just like when a company is being worked out, the devil is in the details -- and just like when understanding whether your RMBS is going to pay off, the painful process of understanding each MBS is critical.
You're homework really is quite extensive (and in my view commendable), but here's also my view of the #1 problem with Primus -- we don't know what's in this portfolio of exposures. From what I can tell, the company only discloses industry diversity and ratings diversity -- $23+ billion of notional on $800 million of equity – that’s 18bps of equity on notional – I would feel better with maybe 200bps. Most importantly, I would not touch this thing without more disclosures. Let’s pile on a serious flaw in the business model AND the muddied waters of GAAP accounting to make the problems even worse.
Fortunately for Primus, most exposures are represented by fundamental, corporate ratings, as opposed to ABS/structured ratings, which fly by a different set of rules (model and underlying rating dependent). With 13% of the portfolio written to "Financial Intermediaries", you can't help but wonder if some of that notional is the $120 billion of long-term debt on Lehman's books (or name your favorite overleveraged financial intermediary). Bonds such as these are being supported by a myriad of RMBS/CDO assets that may be on there way to suffering more losses.
Furthermore, on the business model point... Ask yourself: In order to ensure that I get paid when my bonds go bad, would I want my counterparty to be posting collateral or would I want them to NOT post collateral??? A 50T CDS market lives with posting collateral but Primus gets to not post collateral because its triple-A rated and meets some rating diversity and concentration tests??? Posting collateral has been a serious, as of now, life-saving governor on the CDS market. Primus is like the 5’ 1” Lithuanian lightweight women’s team playing against Labron and Kobie -- and Primus is playing with its pants down. One of these CDS players is not like the other...
Take lesson # whichever from the great credit meltdown of 2007 (and beyond) – be awfully careful how much weight is placed on credit ratings for investment decisions.
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James Cullen
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142 Comments
My Website
Aug 25 12:08 AMGAAP doesn't help, but I feel that the industry players are smart enough not to let something like those marks in a continuation vehicle impact their presumption of solvency. Now, if I'm a risk manager I'd be very wary of most counterparties right now - particularly a smaller, newer company like Primus - but should the company come through this market in tact, I'd think it would be difficult to justify not transacting business with them. That's a management problem though, and I trust Primus' management...
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fxtrader07
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618 Comments
Sep 15 07:04 AM-
Super SWF
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1 Comment
Nov 15 12:55 PM-
James Cullen
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142 Comments
My Website
Nov 15 11:39 PMI'd say the model sounded like a good idea in quieter times, but now with the overall skittishness (particularly regarding posting collateral) they're not really desirable counterparties.