Primus Guaranty: Prime Value
Since all of my readers know how successful my past forays into financial institutions have been, I’d like to introduce you to another today, a company called Primus Guaranty (PRS). Primus’ main line of business is selling credit default swaps (CDS) to institutions needing to hedge their corporate bond portfolios, and their market value is about $215mm. They call themselves a CPDC, or credit derivative product company.
“…thus our derivative positions will sometimes cause large swings in reported earnings, even through Charlie (Munger) and I believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter and we hope you won’t either….we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run.”
The Business
When I look at Primus Financial, I see an insurance company, for all intents and purposes. We’ll take Citigroup as an example. Citi owns billions of dollars in corporate bonds, all placed nicely on their balance sheet collecting interest payments year after year. However, were any of these bonds to default, Citi would be on the hook with potentially worthless bonds, or if not worthless, severely impaired.
This is where Primus comes in. For a quarterly premium, Primus will say to Citi, “We’ll take that risk off your hands. Pay us 70 basis points (0.7%) of the principal value every year and we’ll pay you the full value of your bonds in case they default, and you can hand over the bonds.”
Now, obviously this fee will vary from company to company (or Reference Entity, as Primus refers to single companies). If you are selling protection on Berkshire Hathaway, the fee is tiny, maybe 30 bps on a normalized basis. If you are selling protection on Circuit City, the fee is probably much higher, maybe 130 basis points (I’m using hypothetical numbers). Thus, Primus is offering insurance on the default of institutions.
Not only do they offer insurance on single companies, they also do business selling swaps on tranches, or a large swaths of corporate bonds. So for a fee, again, Primus might insure the risk that a $10mm pool of GE, BRK, MSFT, AAPL, and RIMM experiences a credit event. Generally, a “credit event” is bankruptcy, default, or restructuring. Most importantly, Primus holds these contracts to maturity; they are not trying to profit off of trading gains and losses.
The Swaps
To give you a little insight into their swap portfolio, the weighted average S&P rating of the companies in their portfolio is an A, with 97% of the total being investment grade or higher. Their total swap portfolio is $24.3B in notional amount, $19.5B being single names, and $4.7B being tranches, with a very small amount of CDS on Asset Backed Securities.
The great thing about the business is that Primus, with its “hold to maturity” approach on these contracts, is never required to put up collateral with their counterparties, no matter how much value the contracts lose. As such, Primus’ swap selling subsidiary is rated AAA (Aaa) by the rating agencies, and is a counterparty of the highest quality. Scaling up to a ‘AAA’ rating isn’t easy, thus providing Primus with stability and a nice competitive advantage.
The Other Stuff
Primus is no one trick pony, folks. While the vast majority of their capital is tied up in the swap business, they also are beginning to build an asset management business as well. At March 31, they currently have $1.6B in assets under management. They manage a few CDO’s, and a few CLO’s as well. But Jeff, CDO’s are toxic waste! Well, that doesn’t matter for Primus; they are merely managing the CDO’s not investing in them, and they receive management fees for doing so. The total capital they’ve put into the CLO’s themselves? About $14mm.
This is still a small part of the business but according to management, it is one they are trying to build. We’ll see where it goes, but for now in the 1Q management fees only accounted for $1.1mm of revenue.
The Manager
The fella’ who runs the joint is Chairman and CEO Tom Jasper. If there is a respectable person out there running a business in swap selling, it is Tom Jasper. Mr. Jasper is one of the legends of the swap business; he helped create and run the ISDA: the International Swaps and Derivative Association. Mr. Jasper is also an inductee to the Risk magazine hall of fame. I like it when my managers are in the Risk Hall of Fame, like Mr. Jasper, rather than at home eating potato chips, like Merrill Lynch’s former CEO Stan O’Neal.
Another attestation is from Tom Brown who runs a hedge fund called Second Curve Capital and the terrific website, Bankstocks.com. I mentioned Tom in my article about First Marblehead. Tom wrote up an article refuting Primus’ critics a few months back, and gives some great information on the company, I highly recommend reading it. In the article, Mr. Brown says of Tom Jasper:
“I’ve met many, many CEOs over the past 30 or so years, and would rank Tom Jasper among the very top, especially as regards his integrity, business prudence, and conservatism.”
One more thing I liked about Jasper was that even though he began to creep into selling CDS on asset backed securities, which went bad, he did it very, very slowly. The peak notional value on CDS of ABS was only $80mm, peanuts compared to their corporate stuff. Unfortunately, half of those were downgraded below investment grade, and the company was hit with a “credit event” at the end of last year, which hurt their economic earnings. But they are out of that business completely with just a bruise to show for it.
The Irony
The funny thing about Primus, and the way the market looks at it, is that as their GAAP numbers get worse, their business is probably getting better. How the GAAP numbers work is such: Primus must “mark to market” their unrealized gains and losses on swap contracts. Thus, as credit spreads widen (read: recently) their swaps lose value at market, thus making their GAAP earnings and book value horrendous. As an example, they lost $14.85 a share in the first quarter according to their income statement, but I’d argue the business is better than ever.
From the end of last year, to the beginning of this year, spreads widened so deeply that even on AAA rated entities like GE, Primus was writing business at unbelievable spreads! If they were getting 35 bps for insuring GE in August 2007, by January they were getting 70 bps instead. Has GE gotten that much worse? ‘Course not.
The company has a habit of increasing the credit swap business as spreads widen, as they have in the past 6 months, and decreasing activity as spreads come back down. Check out this chart to see what I’m talking about. As the CDX index went up (thus indicating widening spreads), their CDS volume followed suit. Seems pretty smart, eh?
So I mean it when I say, as the GAAP numbers get worse, the real numbers are probably improving. That creates a buying opportunity for those willing to look at the economics of Primus’ business.
The Valuation
Ok, so you know the business, you know the manager, you know why business is good right now. What is Primus worth?
The answer is: I can’t give you an exact value. I can, however, show you how
cheap it currently is, and you can decide for yourself. The first you thing you have to do, however, is look at the real numbers that show the business’ value, rather than the GAAP numbers which mean Squanto.
In their annual and quarterly reports, Primus gives a reconciliation of GAAP to what they call “economic” earnings. In doing so, they add back the unrealized gains and losses, and even realized gains on swaps sold before maturity. They then add amortize those gains over the remaining life of the contract, so those gains get added back eventually. The main thing here is that mark to market losses, which are meaningless, get added back.
Looking at the numbers this way, Primus earned $1.20 a share last year on a normalized basis (excluding the one-time CDS of ABS credit event), and $.49 a share in the first quarter. The current stock price is about $4.75. That’s about 4x last year’s earnings, 2.5x earnings if you do a run rate on their 1Q earnings: Cheap.
Another way to look at is through economic book value. This, again, adds back those pesky marks. Their Economic Book value is about $9.58 a share.
So we have a company in its sweet spot, with a fantastic manager, selling at 3-4x earnings and half book value. I like what I see.
The Risks
I can’t give you all the roses without a little blood, however. The company has risks in that if their corporate Reference Entities experience default or bankruptcy, the company is on the hook. The company has about $800mm in capital supporting the $24.3B in swaps. Thus, the company has to be careful in its risk management. This is the main focus of the company, luckily for us, and with Tom Jasper’s history I am confident that they are keeping a close eye on the companies and tranches they’ve sold swaps on. Not in their 4 year public history have they experienced a credit event on a corporate bond.
If a company does begin to deteriorate, I believe Primus would begin cutting their losses early by selling the swaps at a loss, rather than experiencing defaults and having to pay out. This practice would hurt earnings near team, but keep them from having to make massive payouts. In this case, you have to like the portfolio being 97% investment grade bonds; bonds that rarely default.
In an added note, Primus doesn’t take too much counterparty risk because it in all essence they are the major counterparty. If one of Primus’ customers were to go under (unlikely, since Primus deals with major global financial institutions), Primus would merely stop receiving premiums. Again, this might hurt earnings but Primus itself would be fine.
Conclusion
Primus is a company that I like; very simple for a financial institution, and I feel that I understand the balance sheet and economics of the company. There’s no off balance sheet entities, CDO investments ready to go bad, or black box financial statements I don’t comprehend. Mostly, Primus just is just getting cash for insuring bonds against default, and that’s it. Best of all, they get paid in cash. I like cash.
You can download my spreadsheet of Primus’ numbers here.
If Primus interests you, I recommend you get together all of their filings and read up on the business and get to know the numbers yourself, rather than take my word for it. I could easily be wrong, or have missed something, so get comfortable with everything on your own.
Disclosure: I am long Primus Guaranty.
Could you please further explain the “spreads” that PRS receives?
I guess I didn’t explain that well, for people who are unfamiliar. PRS doesn’t actually recieve a “spread,” but as spreads go up, they benefit
The “spread” refers to the difference a company pays on its debt vs. the spread on a comparable treasury bond.
If treasuries yield 5%, then GE might pay 6%, a spread of 100 basis points. Thus, as “credit spreads” go up, it means investors are becoming more risk-averse, and thus require a higher yield on bonds vs. a comparable treasury bond.
This situation is profitable for PRS because as credit spreads widen, their “fee,” or premium, is higher to insure the same company against default. So if GE’s credit spread on a 10 year bond went from 100 basis points to 150, PRS will get a 50% higher premium (may not work 1:1 like that, but you get the idea).
I hope that clears it up.
-Jeff
Do you know how Primus differs from a monoline insurer like Ambac/MBIA/FSA/etc? Do they insure only corporate bonds (not structured stuff like credit card loans, student loans, etc)? Are they unregulated?
Without knowing anything about this company, but based on following my disastrous investment in Ambac, I think the things to watch out for are:
(i) How much they insured in low-quality but seemingly OK quality bonds in the last few years. There was a lot of debt issued due to LBO takeovers by private equity in the last few years. Some of these companies may have decent, but low, rating (say A or BBB). But my gut feeling is that some of these companies are on shaky footing and may run into massive problems. The monoline insurers’ big problem was that they insured a lot of seemingly decent quality bonds charging low premiums, that turned out to be trashy mortgages. Similarly, what Primus guarantees may end up being trash and get downgraded.
(ii) Primus already seems to have negative book value. You might want to check if Primus will lose access to bank loans (and hte like) if book value gets worse (due to mark-to-market losses) and/or if the bonds it insurers are downgraded. SCA, a monoline insurer, literally went bankrupt overnight because it needed to post collateral when the mortgage bonds it insured were downgraded (Ambac, MBIA, et al, don’t have to post collateral).
I’m just pointing out some of the worst case scenarios. I don’t think insuring corporate bonds is going to be anywhere near as bad as the insurance of mortage assets. But similar to how mortgage bond insurance was underpriced in the last 5 years due to tight spreads, there is a possibility that corporate bond spreads were underpriced due to low spreads in the recent past. But, as you point out, spreads have been widening and this is good for new business–the worry for any insurer is the old business that was written.
Thanks Sivaram, and those are great questions. I actually went short MBIA at $15, so I am familiar with the bond insurers as well.
The thing to understand about Primus is that it isn’t an actual bond insurer. I call them an “insurer” because for all intents and purposes that is what they provide, insurance.
What Primus actually does is sell credit default swaps in the notional amount of bonds owned by the counter party. If Citi owns $10mm in GE bonds it wants to insure, it agrees to pay Primus 50 bps/year quarterly and Primus is on the book for $10mm if GE defaults.
Regarding downgrades, they have no effect on Primus in the case of corporate bonds. A credit event, or an event in which Primus would be required to pay out, would only occur if the bonds go into default, the company goes into Ch. 11, or there is a major restructuring the devalues the debt. Mere downgrades, while possibly indicative of future defaults, are not a credit event in an of themselves.
You asked what Primus insured: as I mentioned in the article Primus has $24.3B in notional exposure: >$24.2B is corporate debt. They briefly dabbled in selling swaps on ABS, and they got hurt last year. Luckily, it was only $80mm notional. They are currently on the hook for about $35mm of that. If they had gone headlong into it, they could have gotten smashed, but they did not and I attribute that to good risk controls and careful management by Tom Jasper, the CEO.
Re: collateral, Primus will never have to post collateral with its counterparties. They sell swaps and receive the quarterly premiums, and the capital they hold is under a regulatory model. The regulatory model acknowledges that Primus’ business model is to hold the swap contracts to maturity, not trade them. Thus, mark to market losses have no impact on Primus’ capital levels, or their borrowing capabilities.
Obviously, in this case, you have to have some faith in management regarding risk management, and I feel comfortable with that aspect of the company. They have yet to experience a credit event on a single corporate name or tranche, in their history of operations. Jasper is a Risk Hall of Fame inductee, and an absolute legend in industry. Likewise, their swap selling entity is rated AAA by the agencies, so I feel comfortable their capital levels are adequate.
While the rating agencies are not a panacea, as we’ve seen with MBIA and Ambac, among other insurers, PRS has not gotten themselves deep into selling swaps on “the bad stuff,” as did those bond insurers.
[...] create the swap market running the place, a man in the RISK Hall of Fame. I won’t go through the whole thesis again, but the point is that Primus passes all of my mental filters. Do I throughly understand the [...]