Normally when I read financial statements where management pushes an alternative method of accounting, I become highly suspicious. But sometimes, those alternative methods of accounting are actually the best way to understand the state of the company’s operations. Such is the case for Primus Guaranty (PRS), a seller of credit default swaps (CDS).

Reading Primus’ recent financials can paint an ugly picture, with mark-to-market losses being recognized per GAAP rules making it seem like the company has lost a multiple of its market value from operations and is thus doing terribly. But reading the underlying explanation for the losses and taking the time to understand Primus’ business model might lead to a different conclusion - the company is actually a gem selling at a sharp discount to book value despite operating in a rapidly growing niche.

Primus has lost two-thirds of its market value in the last year, something I believe is due largely to the headline risk associated with what the company does - essentially, insuring corporate credit risk. Looking at this company requires properly understanding (and dividing) the various debt instruments in play today, and the relative concerns of each.

Let’s say the main issue here is the so-called “muni bond insurers” - namely Ambak (ABK) and MBIA (MBI). Concerns about their solvency and ability to back municipal debt offering have led to some of the widest spreads ever seen on muni debt relative to Treasuries, as David Merkel points out. But why the concern about those companies, and thus those bonds? It isn’t due to the core business - the actual municipal bonds - but the once-peripheral business of insuring structured finance products, namely CDOs.

Now take a step further - why the hand-wringing about CDOs? This hits on two points:
1. The cash flows seem at-risk, as some people who probably shouldn’t have gotten loans, did
2. Collateral value (home values) has, on average, declined

The second point is crucial because if the loan payments can’t be made, high collateral value will translate to a large recovery and hence minimal overall losses. The shortcomings on both of those points are combining to create a serious problem for many lenders. But the crucial point for our purposes is that the bad lending more-or-less stops at home finance. The pain that is being felt across the muni field is stemming from the spillover from home finance, not inherent insolvency on the part of municipal borrowers. The net effect, however, is a broad distrust of structured finance - even if it is completely unrelated to either home finance or tenuously-insured muni bonds. So how does Primus fit in here?

Note that there is no direct linkage to general corporate debt in there, and Primus insures corporate credit risk - not that such a fact has stopped the market from selling it off. More importantly, I would argue that corporate credit risk is still very low, even though the pricing of CDS contracts say differently. This should allow Primus the opportunity to write protection at very favorable prices - something the company looks to have taken advantage of recently, with higher notional amounts written in the last quarter.

Now the accounting: because Primus writes CDS protection with the intent of holding to maturity, the changes in market value of the CDS should net out to zero, with the gain being the premiums received. If this was typical corporate debt the company was holding, they could classify it as “held-to-maturity” and remove the need to mark it to market and reflect changes on a quarterly basis. Alas, GAAP rules treat these differently, so although changes in market value have no real impact on Primus, it looks like the company has suffered serious losses. In reality, the company can only suffer a loss in the case of default by an entity it has written protection on - something the people at Standard & Poor’s recognize. Could it be possible that a ratings agency is actually ahead of the curve here? Consider:

“The reported fluctuations in the market value of [Primus Financial Products] PFP’s credit swap portfolio didn’t have a direct effect on our view of PFP’s issuer credit rating due to the ‘continuation’ structure that allows PFP to hold these positions through maturity rather than forcing it to liquidate them over a short time period. In addition, PFP does not post collateral in favor of any counterparties with regard to any swap positions that have a negative mark-to-market.”

Then S&P’s opinion on the quality of Primus’ portfolio:

“Other than its 0.33% exposure to RMBS, PFP does not have exposure to structured finance or asset-backed securities. Its single-name corporate credit exposure is approximately 80.00% of the total overall portfolio, 2.15% of which represents single-name monoline insurer credit exposure. PFP also has 1.29% monoline insurer exposure across its tranche credit default swap portfolio, which makes up 20.00% of PFP’s overall portfolio.”

Or, doing a bit of math, muni bond insurers are less than 2% of the portfolio.

Remember, the ratings agencies messed up with the slice-and-dice side of structured finance. Their ratings on most everything else have proven reasonable. Primus’ portfolio is comprised of investment-grade reference entities (again, the companies they write credit protection on), and the industry distribution seems well-diversified.

As I alluded to earlier, the best way to understand Primus’ financial state is to use economic book value accounting, as opposed to GAAP. Using economic accounting involves excluding the quarterly GAAP need to mark-to-market the CDS portfolio, which should net out to zero over the life of the swap. Using this method of accounting, Primus trades at less than half of book value per share ($9.10), and the company looks to be healthy. In other words, simply unwinding Primus’ book could yield excellent gains - but the CDS business is still growing and now that premiums are high, this is an excellent time to be writing more swaps.

Yes, PRS is more speculative than I typically go for, but the risk/reward is compelling. I’m sure that once credit spreads begin to tighten again and the portfolio value is marked up substantially, more people will get behind Primus - but it will be easy to do then, because the stock could easily look like it sells for a fraction of earnings. Right now it is difficult to stand up and like Primus with its $12/share GAAP loss, and much like cyclical stocks, that means the time is right to put some money on the line and buy.

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