Primus Guaranty and the Viability of the CDPC Model
August 21st, 2008 by 
James Cullen
Most people who have read this site during the summer have seen my coverage of Primus Guaranty, a credit derivative products company (CDPC) that sells credit protection via credit default swaps (CDS). On July 22nd, I placed my entire portfolio into Primus, via a combination of its common stock (PRS) and senior debt (PRD). I saw (and see) Primus as a company with very clear risk exposures thanks to the finite and short-lived duration of its swap portfolio, and the fact that a stress-tested loss estimate nets an equity value in the mid-single digits (i.e. about $5/share), which holds even if the company were to enter a run-off.
I’ve tried to clear a number of misconceptions about Primus, the most important being that the company does not face the liquidity risk that took down Bear Stearns, et al. This is not an accident of chance, but due to the capital structure of Primus – because their AAA/Aaa-rated subsidiary that sells CDS protection is a CDPC, they do not post collateral regardless of how bad the mark-to-market losses on their portfolio become. Even a ratings downgrade could not result in counterparties demanding collateral; it simply isn’t how Primus does business. This “continuation” structure is the huge advantage of the CDPC model; not needing to post collateral makes writing business more economical and can make the system safer as a whole by preventing liquidity-driven runs on sellers of CDS. But that only holds true if the CDS sellers don’t take advantage of the collateral exemption and write too much business that goes bad, ultimately leading to insufficient capital to fund their obligations. Because Primus – the first CDPC – received its rating in 2002, there isn’t any historical data on how the model performs in periods of market stress.
From what Primus has been saying about business recently and what I’ve gleaned from the helpful notes by the financial guarantor research team at William Blair, the major concern is that CDS buyers become wary of the CDPC model, and are no longer willing to transact business with sellers who don’t post collateral. Ultimately, it’s a question the market is going to answer – is there a significant difference in the value of CDS protection from a CDPC, and does the counterparty rating count for anything? Monoline-guaranteed bonds have traded at a discount to those backed by Berkshire Hathaway (BRK) Assurance Corp., so it’s conceivable that on the other side of the credit derivatives market mess, some sellers might get slightly better rates than others (we’re talking in basis points, but that counts at 30x leverage), because their balance sheets are perceived to be more solid.
Of the CDPCs listed to date that have been rated by Moody’s, only one has been placed on review for possible downgrade - Athilon (the second Aaa-rated CDPC, behind Primus) – on July 9th. Moody’s has essentially stood behind the CDPC model so far, but that is no guarantee they’ll continue to do so in the future, especially if one or more has a spectacular and highly-visible meltdown. Most of their concerns are limited to the CDPCs that were launched later, because they lack the existing book of business that generates consistent and recurring premium cash flow streams; this is not a problem for Primus, because they already have an adequately leveraged swap book generated good premium income along with an existing healthy cash position.
The most interesting point I gleaned from Moody’s note on CDPCs (keep in mind, this was published in March) is that their estimate of the one-year rate of defaults on investment grade corporate debt is 0.0466%; my stress test model has Primus’ realized credit losses roughly 30x higher at 1.32%, though that isn’t entirely comparable because the actual losses net out recovery, whereas the straight default rate merely shows what percentage of issuers default. This is significant because the recovery rate on some defaulted senior corporate debt can be very high – one person told me they aren’t highly concerned about the concentration of Primus’ swap portfolio in financials because they expect the senior debt to remain intact, I imagine through a combination of white knight guarantees or government backing. On an apples-to-apples basis using a 24% recovery (the lowest recovery rate on senior debt ever in a single year), the 1.32% rate I establish that Primus can survive between now and the middle of 2010 is 120x higher than the loss rate Moody’s estimates translate to. The DCF value of Primus common stock, should no credit losses take place and no new business be written, is $15/share – a triple from the current price. There will likely be some losses, but the probability is that Primus is sufficiently capitalized to weather a spike in defaults and still retain value down through the common stock, which is why I’m invested the way I am.
If you would like a copy of the Excel model I use to value Primus, send me an email at jcullen – at – collegeanalysts.com and I’ll reply as soon as possible.
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August 21st, 2008 at 3:55 pm
Great article James. This is one of the stocks that Mr. Market has unfairly beaten down. With some time and patience, the reward will be great.
August 21st, 2008 at 4:31 pm
James - Interesting work on Primus. I hope you are correct in your thesis. Have you considered taking a look at first marblehead (FMD), another destroyed and undercovered financial? I was not sure where to begin an analysis, myself.
August 21st, 2008 at 7:25 pm
I’m thinking of moving my PRS/PRD position entirely into PRD. My reasoning is as follows:
From your calculations mentioned in various articles as well as my own, I figure in the worst case great Depression style scenario, PRS is probably worth ~3dollars even if they never write any more business. Also lets assume our upside possibility is about the economic book value, or 10-12 dollars. I think they could be worth more considering their unearned premiums, but the likely hood of my having the guts to hold one for more then 12 is slim. There should be better deals out their if and when that point comes.
When PRS was at 3 and PRD was at 6 they both had essentially no downside and 300-400% upside. Now with PRS at ~5 it has a downside of ~40% and an up side of 100-140%, While the bond still has the same downside and an upside of 100-130% When you count the interest payed in between this seems like a no brainer. Yes? No?
August 21st, 2008 at 9:20 pm
Not sure you can definitely say the stock only has upside to 10-12, whereas the bond definitely stops at $25. Looking back a couple years the stock traded at a multiple of book - and if they are lucky enough to skate through without losses, that $10 current economic value keeps rising (it was $9 last quarter now its 10). With growth in that, plus a different market environment, the stock could be at $15, or $20, or whatever. If you are putting an artificial ceiling on the stock cause you dont have the “guts” to hold past 12, then I guess the bond is a better buy. But this is all from your guts-induced point of reference.
I keep having the same challenge of which is better to load up on too….but my biggest regret is that I stumbled onto this when the stock was at $2.90 but I farted around focused more on Steak N Shake and making sure I understood PRS, and waited till after the PRS conf call, and now I am buying in the 4.75 area. Still think its a good buy, but just PO’ed that I might have missed a REALLY good buy!
August 21st, 2008 at 10:18 pm
I guess what I mean is I will likely sell happily when the stock is trading at economic book value, what ever that happens to be at the time. I don’t see myself holding much past that, because My thesis will have played out, and hopefully I’ll have opportunities in drastically undervalued companies to move on t0o. My thesis is basically “this isn’t the worst time ever to be in this business, and if it is I won’t loose much if anything”. All I have to know to verify this thesis is some basis statistics about past default rates and the composition of PRS’s portfolio. Because the valuation is so extreme, I can be pretty ignorant of their business and confidently make this call. I’m hoping this happens within the next 3 years or so, so I doubt the economic book value will be much bigger than 12 by then, but its certainly possible.
Now there is certainly an argument to be made that the unearned premiums are worth something. But I think that’s part of a different investment thesis. To ascribe value to the unearned premiums I think you have to start making some assumptions about how good management is at their job. If they don’t pay out anything their worth about 9. I don’t think its too smart to assume that Primus will never have to payout. I would not want to have to try to find a person willing to believe that to sell my shares too, though as you say they have traded at that level before.
I think I would value the unearned premiums at about half or 4.5. That’s roughly the fraction they’ll get to keep if the default rate and recovery rate matched the historical average $9 x (44-20)/44 basis points. But I think to hold at 12 waiting for 17 your thesis has to be that Management is really good at what they do. Its probably a safe bet, givenJasper’s reputation, but I’m not confident I have the ability to make that call. I’d have to learn a lot more then I know now. I’d have to know something about their credit model and enough to judge the merit of that model. I don’t see myself picking up that kind of expertise, so I think 12 is probably a decent estimate of the ceiling for me, though I’m certainly open to being convinced otherwise.
August 26th, 2008 at 10:15 am
Travis, I see where you’re coming from. Trading at a multiple of book was a few years ago, before anyone was thinking about a “credit crunch.” That was valuing the business as a vibrant, ongoing, growing concern.
Now, there are many risks uncovered. Biggest is will these guys emerge through this credit storm with their lives. I understand the logic vs historical default rates, but I think we also need to admit that this is a new environment, and more importantly, none of us can see their actual book of bets. We are trusting that they are diversified and that the nearly 15% of the book - billions of dollars in exposure - to financials is to the right names. There is very real possibility that Fannie and Freddie are going to be bailed out - who thought that was any remote possibility a few years ago?
Second, there are some real questions about whether this company will be in a position to emerge and be a viable, competitive player. Questions re: posting of collateral or not, or newly capitalized players with lower cost structures. If these guys emerge but are not writing any significant new business, then I agree with you that there is no way this thing trades at a premium to book, and will be in rundown mode trading at some discount to book to reflect potential future hits even if we are through the “credit crunch”
September 2nd, 2008 at 3:26 pm
I havent seen James’ model but I put together something and I am coming up with a stress factor of approx 4-5x historical default rates, and 1x historical downgrade rates, there is still some value in the equity thru 2011 (less than $2). Or you can run 3-4x default rates and 2x downgrade rates and come up with similar.
This is a little more realistic than the way James quoted it (eg 130x historical rates - but that is cause he was quoting the overall off the very low numbers in the higher IG areas) so I feel comfortable, although I haven’t gone back to take a look at the PEAK default rates during a recession - if those are significantly higher then my “stress” might not be 4x but less.
The key is the BB, B areas and how much exposure they have there vs those default rates which are historically quite high. Still, this assumes we have 3 years straight of 4-5x historical defaults.
I havent looked in depth but it would appear that just one bad year, or some unfortunately placed hits on some of their bigger exposures, could really screw these guys up with the rating agencies as it would quickly knock their equity cushion down, which would then mean they are out of bounds on various diversity and holdings limits, forcing them to either increase capital or somehow close out positions (although that might require them further payouts to do so). So while our stress models show value, it would really be in runoff mode if anything close to these sorts of stresses hit as they would likely no longer be AAA company, and I cant imagine anyone doing new business with them at that point.
September 9th, 2008 at 12:20 pm
[...] new business, so any future profitability is a bonus. I’ve also looked at the standing of various credit derivative products companies (CDPCs) with the ratings agencies and [...]