Description

 Primus Guaranty Ltd ("PG") is a Bermuda based holding company whose primary subsidiary, Primus Financial ("PF") wrote credit swaps on investment grade debt obligations during the peak of the credit bubble.  Subsequent devastation in the credit markets precipitated massive realized and unrealized losses on the Company's swaps.  The sell-side suspended coverage and in early 2009 Primus requested that S&P and Moody's cease rating PF's debt securities.  It appears the Company dropped the Q&A portion of its 1Q10 earnings conference call after receiving no questions over the last year.  If you seek downside protection in an ugly double-dip, this is not the name for you.  Ultimately, we are still talking about $13bn in swap exposures against $290mn in economic capital or 45:1 leverage (though this is quickly unraveling), leaving little room for error in the near term.  To get comfortable with this investment you have to believe that the worst of the credit cycle is over and that the sr. and subordinated debt instruments of major investment grade European financial institutions will not suffer haircuts over the next 2-3 years.

 We don't want the make the mistake of analogizing book value to "par" on a finite-life bond since there is no intention to liquidate.  While companies should know when they are worth more dead than alive, a ~40%+ discount to economic book value more than prices in the possibility of Primus perpetually under-earning its cost of equity capital, in our opinion.  We believe management could successfully bootstrap the Company into book value if it can successfully roll off its existing swap book and ramp up its fee-based asset management business, providing ~65%-80% upside to today's price.

Description

Primus Guaranty operates two main businesses:

Primus Asset Management ("PAM") is as a manager of Collateralized Loan Obligations (CLOs) and collateralized swap obligations (CSOs - swaps sold against investment grade corporate or sovereign debt).  Primus Asset Management gets paid management fees based on a percentage of AUM and collects interest income on its subordinated ownership interest in CLOs.  Company has talked about expanding its asset management footprint.  To become a scale CLO manager, management believes it needs more capital than is available at PG (and they can't touch the capital at PF) and is having conversations with strategic partners (they have not disclosed any information beyond this).  As of 1Q10, PAM managed PF's credit swap portfolio of $16bn together with third party assets of $3.5bn, mostly obtained through its July 2009 acquisition of CypressTree, a CLO manager.

Primus Financial was formed to sell CDS against primarily investment grade corporate and sovereign debt to financial institution counterparties.  As in a typical credit swap transaction, Primus Financial is paid a quarterly premium on the notional amount protected but upon a credit event (default) is required to pay notional less recovery as determined in an industry-sponsored auction.  The underlying against which Primus Financial sells protection comes in three different forms: single names (sr. and subordinated debt obligations of a specific investment grade issuer), tranches (bespoke tranches of pools of primarily investment grade corporate and sovereign issuers), and ABS (mortgage-backed securities).

Economic Book Value

If you screen for financials trading under book value, Primus will not show up.  On a GAAP reported basis, Primus trades at 1.7x book value.  However, certain adjustments need to be made to better capture economic value.  See the balance sheet in the most recent Q.  Shareholders' equity is $100.8mn.  However, this includes $1.9mn of unrealized gains on credit swaps as an asset and importantly, $564.4mn of unrealized losses on credit swaps as a liability.  If you can gain comfort that the underlying swap book will mature money good, then these unrealized losses/gains should be added/subtracted from GAAP book.

The Company reports "Economic Results Book Value" in its earnings press releases that recaptures these unrealized losses/gains, as well as other far more minor adjustments.  A historical look at economic book value per share:

                    (1) Economic BV/Sh*                          (2) Stock Price (at quarter end)                              (2)/(1)

4Q08:                     $7.60                                                      $1.14                                                        15%

1Q09:                     $7.89                                                      $1.57                                                        20%

2Q09:                     $9.09                                                      $2.36                                                        26%

3Q09:                     $8.77                                                      $4.27                                                        49%     

4Q09:                     $7.93                                                      $3.05                                                        38%

1Q10**:                 $7.20                                                      $4.24                                                        58%

Unrealized losses on credit swaps sold as of:

4Q02:                     $5.9mn

4Q03:                     $68k

4Q04:                     $259k

4Q05:                     $3.5mn

4Q06:                     $2.9mn

4Q07:                     $545mn

4Q08:                     $2.17bn

1Q09:                     $2.05bn

2Q09:                     $1.50bn

3Q09:                     $1.03bn

4Q09:                     $692mn

1Q10:                     $564mn

*Economic BV/Sh differs from the Company's reported number because we use the diluted share count

**The GAAP reported BV/share as of 1Q10 is not entirely comparable to prior quarters due to an accounting change that required Primus Asset Management to consolidate 8 CLOs, eliminating the Company's investment in the subordinated notes of the CLOs for reporting purposes.  PG has no obligation to settle the liabilities of these CLOs nor is it required to provide funding or support.  The consolidation resulted in an increase to shareholders' equity of $355mn, which was subtracted to arrive at "Economic BV/sh"

History

Primus Guaranty was capitalized in March 2002, began selling credit swaps in June 2002 and IPO'ed in October 2004 to raise $112mn, $60mn of which was down-streamed to Primus Financial Products to expand its swap business.  The other $50mn later capitalized PRS Trading, a credit derivatives trading unit that later merged into Harrier, another newly created, wholly-owned trading entity that fell upon hard times and was dissolved in February 2009.  With its AAA rating in hand (which was lost when S&P lowered its rating to AA+ in 3Q08), PF expanded its credit swap portfolio from $4.7bn in December 2002 to $24bn+ at its peak in 1Q08.  In April 2005, PF recorded its first corporate tranche transaction for $78mn notional, a business that grew to $5bn at its peak.  In late 2006, Primus expanded yet again and received rating agency approval to sell credit swaps against BBB-rated ABS tranches, whose notional amount grew from $27mn in 1Q07 to $80mn by 4Q07.

                     Notional swap value ($bn)               PF Capital* ($mn)       PG Econ BV ($mn)                 PF Cap Lev        PG BV Lev

4Q06                      $15.8                                             $625                                $387                               25x                     41x                                    

4Q07                      $23.0                                             $750                                $410                               31x                     56x                    

4Q08                      $22.5                                             $687                                $329                               33x                     68x

1Q09                      $21.5                                             $682                                $323                               32x                     67x    

2Q09                      $21.3                                             $676                                $375                               32x                     57x    

3Q09                      $19.6                                             $691                                $363                               28x                     54x 

4Q09                      $17.5                                             $652                                $325                               27x                     54x                    

1Q10                      $16.4                                             $585                                $290                               28x                     57x 

*Resources with which to pay claims

Company strategy

Following the credit turmoil of the last several years, management has outlined a 4-pronged strategy:

1)  Actively managing the amortization of existing credit swap portfolio.  This means reducing concentration to at-risk sectors by commuting swaps with counterparties where appropriate and repositioning others.  There is obviously a trade off with these transactions.  On one hand, Primus minimizes its tail risk to credit loss exposures. On the other, Primus realizes losses and re-sets its premium stream to a lower level over the remaining life of the swap.  We obviously would not want to see management commute its exposure to, say, CDS written on Clorox, which will almost certainly recoup any unrealized losses over the remaining 0.57 years of its life, but welcome efforts to terminate monoline exposure at reasonable prices. 

Here is a summary of the swap termination and portfolio repositioning transactions completed in 2009/2010:

• During 1Q10, PF terminated CDS referencing Ambac Finl Group with a notional amount of $70mn for $19.2mn, implying 73% recovery. Subsequent to Q1, PF terminated another $15mn exposure to Ambac for $8.5mn in fees, implying 43% recovery

• In February 2010, PF terminated three tranche transactions of $300mn notional that were running low on subordination for $35mn

• November 2009: PF transferred $2.65bn of bespoke tranche swaps and $250mn of single name swaps to a 2^nd wholly owned subsidiary, paying an assignment fee (basically injecting capital) to the subsidiary of $100mn. PF and the counterparty then subsequently agreed to terminate the single names and restructure the tranches such that the notional was lowered to $1.75bn (in exchange for $10mn payment which was subtracted from the sub's capital). Subsidiary's total liability is limited to this $90mn (+ earned interest and future premiums)

• September 2009: PF terminated a counterparty's entire swap portfolio with $1.3bn of notional principal for just $6.5mn, a large discount to market value

• July 2009: PF and a bank counterparty commuted $40mn of notional exposure on FGIC, a troubled monoline. Primus paid the counterparty $15mn, a significant discount to market value. PF transferred $1.2bn of the bank counterparty's exposure to a new, wholly owned subsidiary and capitalized that subsidiary with $36mn. The subsidiary's total liability is limited to this $36mn (+ earned interest and future premiums). At the maturity of this swap portfolio, an capital remaining at this sub will be returned to PF

We should not be alarmed by, and indeed should expect to see, continued realized losses attributable to risk mitigation transactions.

2)  Grow assets under management.  Management sees the credit asset management business in consolidation and hopes to be a beneficiary of this trend.  In July 2009, Primus acquired CypressTree, a CLO manager for ~$12mn, gaining access to $2.3bn in AUM.  During 1Q10, the Company launched 2 new fund offerings with $40mn in seed capital from PF.  The funds have $27mn in corporate debt investments and are seeking 3^rd party capital.

3)  Efficiently allocate capital.  Since implementing its stock buyback program in October 2008, Primus has repurchased 8.1mn shares (or ~18% of outstanding shares) at an average price of $1.68 (much of the repurchase activity was concentrated around 4Q08).  Primus has also made significant progress buying back its own debt at sizeable discounts to par: 

($mn)

                                    2008                   2009                       1Q10

PG 7% Sr. Notes

   Cost                       $5.1                   $6.4                           $4.4

   Par                        $15.3                 $15.1                         $10.5

   % par                       33%                  42%                            42%

PF sub debt

   Cost                                               $16.8                           $6.6

   Par                                                 $52.4                            $11.5

   % par                                                32%                             57%

PF preferreds

   Cost                                                $0.9

   Par                                                  $5.5

   % par                                                16%

4) Re-igniting the credit protection business at lower leverage levels and with collateral posting requirements, taking advantage of the void left by insurers and monolines who have exited the business.  Management believes the economics of this business work for shareholders in the current environment, though there is a lot of uncertainty around what this business will ultimately look like.

Quick statement on swaps-related liquidity

AIG's downfall came in the form of collateral posting requirements tied to both the credit ratings and unrealized losses of wraps on its underlying referenced entities at AIG Financial Products.  The monolines, for the most part, are not exposed to this liquidity risk, and are instead required to pay claims as they come due.  No question that both AIGFP and the monolines wrapped a lot of junk; it's just that the former faced a liquidity AND capital problem, the latter primarily a capital problem (that's not entirely true of course, since the monolines' GIC businesses did present real liquidity challenges; I'm isolating the wrap business to draw an important distinction).  Primus falls in the latter camp as it is not required to post collateral against its wrap business, and the Company arguably belongs in neither camp based on its underlying exposures.

Swaps exposures and potential losses

On June 23, 2010, Primus released a 24 page data book that provides quite a lot of transparency on its swap portfolio.  (The data is only available through pdf so it may be painful getting this into Excel).  We should expect another ~$1.5bn to mature over the remainder of 2010 and PF's entire swap book should be completely amortized by 2014.  Primus' swap exposure is well diversified across names, though there is industry concentration in financials (~16%).  Here is a summary breakdown of exposures, which includes $1.2bn of notional credit swaps that PF entered into with bankrupt counterparty Lehman Brother Special Financing for which PF believes it is not responsible:

Single-Name

($ millions)

# referenced entities: 443

Total notional exposure: $9,175

Avg. exposure:  $21

Max exposure:  $135

Top 5 exposures % total: 5.7%

Top 20 exposures % total: 16.6%

The top 5 largest single-name exposures are JP Morgan ($135mn), Wells Fargo ($115mn), General Electric ($95mn), Bank of America ($90mn), and Credit Suisse USA Inc. ($90mn).  We are confident these names will not default in the next 2 years.

Having looked through the 440+ entities, I've selected the following names as candidates for default in a bear case.  The exercise is somewhat academic as correlations would likely step-function higher if certain systemically important high-grade names defaulted (and there is no predicting how governments would respond to this systemic risk event), so take it all with a grain of salt. 

Data as of 6/21/10

                                                                Notional ($mn)                        Time to maturity (yrs)

CIFG Assurn NA Inc.                                     $80                                                   1.35

Commercial Metals Co                                  $5                                                     0.50       

Iceland                                                         $30                                                   1.00

MBIA Inc.                                                     $15                                                   0.83

MGIC Invt                                                    $30                                                   0.75

Norbord Inc.                                                $5                                                     2.00

PMI GP                                                        $30                                                   0.75

Pultegroup                                                  $10                                                   1.62

Radian GP                                                  $10                                                   0.62

Thyssenkrupp AG                                       $12                                                   1.50

Total                                                      $227mn

Recovery                                               40%

Claims paid                                          $136mn

Future premiums*                             $61mn

Net losses (Claims paid less Adj. future premiums): $75mn

*There will be some future premium lost due to terminations, but we think it is too small to matter

Tranches

# tranches: 14

Total notional exposure: $3,800

Maturity dates: 2012-2014, with most maturing 2Q/3Q 2014

                                                                Attachment Pt                                    Detachment Pt                     Notional ($mn)                         Maturity

Tranche 1                                                  0.58%                                                    2.68%                                        $50                                 6/20/13

Tranche 2                                                  3.03%                                                      5.04%                                      $50                                  9/20/13

Tranche 3                                                  8.14%                                                    11.26%                                      $200                               3/20/14

Tranche 4                                                  4.08%                                                      7.20%                                      $100                               3/20/14

Tranche 5                                                  8.98%                                                     12.09%                                     $400                               6/20/14

Tranche 6                                                  7.71%                                                     10.90%                                     $200                               6/20/14

Tranche 7                                                  5.62%                                                       8.81%                                     $450                               6/20/14

Tranche 8                                                  5.99%                                                       9.15%                                     $300                               9.20/14

Tranche 9                                                  8.09%                                                     11.25%                                     $100                               9/20/14

Tranche 10                                             10.59%                                                '    13.71%                                     $200                               9/20/14

Tranche 11                                               8.50%                                                     11.50%                                     $475                             12/20/14

Tranche 12                                               9.00%                                                     12.00%                                    $475                               12/20/14

Tranche 13                                               7.50%                                                      10.50%                                    $375                               12/20/12

Tranche 14                                               7.50%                                                      10.50%                                    $425                               12/20/14                               

Given the high degree of embedded leverage and thin tranches, all else equal, we would be more concerned about the tranche wraps.  Fortunately, the higher notional tranches seem to have higher attachment points.  The only tranche where we would expect to see claims payments is Tranche 1, due to its meager subordination and exposure to suspect names such as Ambac, MBIA, MGIC, PMI and RDN.  If these names were to default, we think the Company could be subject to claims on the full $50mn notional. 

Total future premiums: $57mn

Net gains (Adj. future premiums less claims paid): $7mn

CDS on ABS

This is where we have the least transparency, so I am writing the $23.7mn of exposure down to "0".

For historical context, in 2008, Primus experienced 5 credit events (FNMA, FHLC, Lehman, WaMu, and Kaupthing Bank hf) on $346mn notional, realizing losses of $146mn, implying 59% recovery.  In 2009, Primus experience 3 credit events (Idearc, CIT, and FGIC) on $65mn notional, realizing losses of $45mn, implying recovery of 31%.  In my bear case, I am assuming 10 defaults on $227mn notional with 40% recovery.

Non-swaps considerations

PG has $147mn in cash and equivalents and $290mn of available-for-sale corporate debt (net of $37mn of restricted investments comprised of a corporate note issued by a counterparty).  We think the Company is in a strong position to meet contractual obligations over the next 12 months and will have ample resources to implement further capital allocation actions in the form of stock buybacks, below par debt repurchases, swap repositioning and termination.  We think it is appropriate to look at PG's P/L outside of swaps as follows ($mn):

Sources of cash

Investment income: $11  ß wtd avg yield on investments was 1.86% as of 1Q10

Asset mgmt / advisory fees: $1

CLO income: $6 ß with improvement in credit markets, PAM's sub notes started cash flowing

Total: $18

Uses of cash

Operating expenses: $40

Interest expense

    PG Sr. 7% Notes: $2 ß coupon is 7% but due to interest rate swap, effective rate is 2.53% on $94.5mn outstanding

    PF Sub debt: $4 ß $136.1mn outstanding at 3.25% rate

    PF perp preferred: $3 ß $94.5mn outstanding at 3.17%

Total: $49

So, we think outside the swaps business, PG is losing about $30mn annually.  We think these losses decline over the next several years as the asset management business gains scale and debt continues to be repurchased. 

Upside / Downside

Downside scenario

    Net losses on single-names: $75mn

    Net gain on tranches: $7mn

    Net losses on ABS: $24mn

    Net losses outside swaps over 3-4 years: $70mn

Total book value impairment: $162mn

New Economic BV: $290mn less $162mn = $128mn

                Per diluted share: $3.18 (23% downside)

Reasonable upside scenario

The upside is tough to peg because it depends on how much the Company pays to terminate questionable exposures and reposition the portfolio.  However, based on what we've seen so far, management seems to be terminating at high recoveries (60%+) and below market.  We think management will attempt to at least rid itself of single-name monoline exposure, which comes to $105mn, so 40% of that gets you to $42mn.  If the Company does the same to Tranche 1, that gets you to another $20mn.  Swap premiums offset the operating losses in the non-swaps business, which in aggregate decreases economic book value by about $15mn ($118mn in swap income less $70mn in losses outside swaps less $62mn cash payments).  That leaves $275mn in economic book value, or $6.83 per diluted share, ~65% upside.

There is also incremental upside from further debt and stock repurchases.  There is $26.4mn that can be spent on stock repurchases and/or the 7% Sr. notes.  Another $50mn in face value reduction at 50% of par would deliver another $0.60/share or so of book value, providing ~77% upside.  Alternatively, at current prices, $26.4mn retires 6.4mn shares, which delivers an incremental ~$0.50/share.   Some of this benefit will be offset by restricted share issuances to officers.  In January 2010, Primus' Compensation Committee awarded restricted share units (242k shares each to the CEO and CFO) that vest ratably over three years if the closing price of the stock equals or exceed $4.50/$5.50/$6.50 for each of 20 trading days during any 30 consecutive trading day period.  Options appear to be far out of the money, with a wtd average strike price of $11.45.

Risks

Regulatory risk: Conversations regarding regulation of the CDS market in Washington continue and may impact Primus future credit protection business.  Regulation requiring Primus to post collateral on its existing swap book would be devastating

Leverage: $13bn swap book backed by $290mn in economic capital (45:1 leverage), leaving little room for error

Europe: Primus has meaningful exposure to European bank debt.  The risks of European sovereign defaults domino'ing into European bank defaults have been well advertised

Counterparty risk: Primus has outstanding swap agreements with 28 counterparties as of December 2009.  The top and top 5 counterparties represented 12% and 43% of credit swaps, respectively

Tax: Primus believes it is a Passive Foreign Investment Company ("PFIC").  Primus Guaranty and certain subsidiaries are under IRS audit for tax years 2004-2006, with unknown consequences

Foreign currency: Approximately 53% of Primus Financial's notional exposure was denominated in euros as of 1Q10.  The Company does not hedge FX risk

Bermuda company and all the usual noise including potentially unenforceable judgments of US courts.  Under Bermuda's Tax Protection Act, Primus is protected from adverse corporate tax laws legislated in Bermuda until March 28, 2016.  Bermuda is on the OECD's "white list" as a country that has largely implemented internationally agreed upon tax standards

Turnaround risk: There is not a lot of visibility on what Primus will look like years from now.  Management does not want to completely exit the credit protection business but rather re-invent it.  Primus has been in discussions with a number of counterparties about being a longer term seller of credit protection at lower leverage levels and with collateral posting

Catalyst