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.

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 Motor ( F) and General Motors ( GM) 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.

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