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Soaring Default Spreads Sock a Swap Seller

Over the past two years, derivatives veteran Tom Jasper bet the farm by going long credit risk. Now, his firm's $23 billion credit portfolio is losing hundreds of millions of dollars per quarter as corporate credit fears multiply.

The wild part of the story is that Jasper is not a hedge fund manager, and he still has a job, despite such abysmal performance. As CEO of Primus Guaranty (PRS), Jasper remains safe and well-paid, while the company's stock has tumbled to $4 from its $13.50 IPO price in 2004.

Primus Guaranty -- which reported a $404 million loss in the fourth quarter, its largest ever -- remains a relatively unknown company that is nonetheless a major player in the credit default swap market. Primus essentially does only one thing: sell credit default swaps on single-name corporate bonds.

Credit default swaps, or CDS, are insurance agreements against defaults on corporate bonds and asset-backed securities. The swaps allow parties to bet on credit views without taking interest rate risk.

Primus' main problem is that most of its credit default swaps were sold at a time when credit risk was low. The bulk of the company's recent quarterly losses have been on paper only, relating to the its markdown of credit default swaps based on deteriorating market values as credit spreads widen.

Primus isn't set to blow up in a liquidity crisis. The problem, rather, is that the company's cost structure is too high and its book of business was created at a horrible time -- raising questions about how much earnings will actually be left at the end of the day for shareholders.

Primus' writedowns in the fourth quarter wiped out the firm's shareholders equity (it is now negative $93.5 million). Against this book value is the $23 billion of notional default swaps outstanding -- meaning the firm is very highly leveraged.

"If Primus was a hedge fund, it would be gone," says one industry observer.

However, Primus remains in better shape than your average highly leveraged hedge fund that owns corporate credit, because the company's financial subsidiary, which sells the swaps, has a Triple-A credit rating. This means Primus is able to avoid margin calls, since it is not required to post collateral for trades.

Unrealized Losses

Volumes of CDS surpassed $45 trillion last year, according to the International Swaps and Derivatives Association, and Bear Stearns research says the market has been growing at an annual rate of nearly 100% over the past four years.

Billionaire superinvestor Warren Buffett has been vocal about the dangers inherent to the derivatives market -- which includes CDS. Earlier this week, insurance giant AIG (AIG) warned of a large mark-to-market loss on its CDS portfolio.

Primus, as the seller of the swaps, goes long credit risk and receives premiums from the buyer for providing the insurance on corporate bonds. This situation works well for sellers like Primus, so long as the corporation doesn't default.

If a company does default, Primus must pay out a protection payment in return for the underlying defaulted bond, or cash equaling that bond's value. But the company's main losses haven't been tied to the defaults, but instead only to the perceived increased risk.

Jasper, Primus' CEO, has argued that mark-to-market losses don't really mean much, since they are unrealized losses.

"I continue to be very frustrated with the disconnect that exists between our equity market valuation and my view of intrinsic value," Jasper told investors on Primus' earnings call in early February.

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