This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

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 - Get Report) 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.
1 of 2

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
AIG $58.15 -0.15%
F $15.07 0.53%
GM $33.51 0.24%
MBI $7.31 0.41%
AAPL $110.35 0.78%


Chart of I:DJI
DOW 17,090.54 +39.79 0.23%
S&P 500 2,013.43 +15.91 0.80%
NASDAQ 4,812.1050 +1.3170 0.03%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs