Soaring Default Spreads Sock a Swap Seller

Primus did not return calls seeking comment for this story.

The only time Primus experiences realized losses is when it unwinds its swap agreements or there is an actual credit event that triggers certain protection payments. In the fourth quarter, the firm experienced its first credit event, recording a $41 million charge related to swap protection it sold on residential mortgage securities that S&P downgraded. (Primus' assumption is that it will have to be pay out this dollar amount to swap counterparties).

Soaring Spreads

From 2005 to the summer of 2007, the U.S. CDX investment grade index -- a basket of corporate credits -- generally traded at spreads of below 50 basis points, with the exception of when they peaked at around 75 in May 2005 when Ford MotorF and General MotorsGM were downgraded to junk status, according to Bear Stearns research.

During this timeframe of relatively low risk, Primus was a big seller of credit default protection. But in the summer of 2007, spreads on the CDX investment grade index widened to 100 basis points, as fears of the brewing credit crunch drove up the cost of protection. Spreads dipped in the fall, but rose to a record 143 basis points on Tuesday, according to Markit.

These widening spreads mean even more writedowns are coming at Primus as it reflects the worsening market values of the swaps.

To be clear, these unrealized losses do not put the firm's credit rating in jeopardy. Nonetheless, they come amid concerns about further actual economic losses in the existing portfolio.

Primus recently revealed that it has $500 million of exposure to the monoline industry -- which has been battered by capital worries from big players Ambac ABK and MBIA MBI -- and roughly $1 billion of exposure to the homebuilder and developer industry. If defaults among these sectors turn into economic losses, Primus' capital situation could be put under severe stress.

High Costs

Even without such economic losses, Primus is facing the problem of having a very high cost structure. By backing out a one-time restructuring charge, Primus' total operating expenses last year amounted to 26 basis points of the $23 billion swap portfolio. Other credit derivative product companies in the market are said to have operating costs totaling 10 to 15 basis points of their swap portfolio, according to market sources.

DeSari Capital, an alternative fixed-income manager that is raising funds to launch a competing platform to Primus, is telling investors its cost structure will be in this 10 to 15 basis point range, according to a person familiar with DeSari Capital's fundraising efforts. DeSari Capital was formed by veterans of fixed-income investment firm Deerfield Capital Management.

Primus' high cost structure likely relates to the firm's venture into disappointing business lines, such as asset management, in recent years. The firm recently closed its failed hedge fund Harrier -- a name that means a type of plane, and also, perhaps more appropriately, a dog.

As well, Primus' executive compensation remains high. Jasper brought home $2.7 million in total compensation in 2006 and is guaranteed at least a $2.5 million payment if he is fired, according to the Primus' latest proxy filing. Jasper helped launch Primus in 1999 after having built up the credit derivatives group at Salomon Brothers in the 1990s.

Given Primus' high cost structure and its book of credit protection that could be easily replicated today at much better prices, the stock will remain in trouble.

At some discount to book value, the stock may surely become attractive. However, given the negative book value today -- which is only getting worse as spreads continue to widen -- it's hard to say where the bottom is for Primus' stock.