Primus’ Jasper: Fannie/Freddie Impact Minimal, CDS Will Endure
September 9th, 2008 by 
James Cullen
Yesterday, Primus (PRS) CEO Tom Jasper made a presentation at a Lehman Financial Services Conference; this is an extraordinary coincidence of timing given all the questions regarding the settling of credit default swaps (CDS) on the various pieces of Fannie (FNM) and Freddie (FRE) capital. A settling of CDS contracts (which appears likely given comments by ISDA, the International Swap and Derivatives Association) would be the largest such action ever taken, and this has people nervous. As Primus’ 8-K filing yesterday suggested, however, it really should be close to a non-event for all the CDS on references above the government’s new senior preferred stock. Those have become “full faith and credit” obligations of the US government, and should therefore trade at a very tight spread to regular Treasuries – and because the loss on a CDS contract equals the payment (par value) less the recovery value (extremely close to par), Primus’ $215 million in notational swaps on the senior and subordinated debt of Fannie and Freddie shouldn’t net out to any significant losses.
Jasper made an off-hand comment that he didn’t understand why ISDA would go through such a huge settlement process when the impact on the senior and subordinated debt seemed to be minimal in an absolute sense and, relatively speaking, positive for CDS sellers. One possibility: this is a large-scale but low-stress dress rehearsal in case there comes a point in time when the CDS market needs to settle a default of another entity with huge notional values outstanding… because next time, the government might not be assuring the impact is minimal.
The other major focus of Jasper’s presentation was to outline the current conditions in the CDS market, and where that market will be moving longer-term. Right now, there is an unwillingness by larger swap dealers to transact with Primus and other small companies because they’ve been burned by monoline exposure, and are lumping Primus in with that segment. Jasper has continued to argue that Primus is substantially different than the monolines, and the company has been able to transact a bit of business this quarter while suggesting that CDS market is still a few quarters from full recovery. Jasper has been extremely vocal in saying that the CDs market is a crucial part of the financial system, and he expects it to fully recover in terms of dealers and level of demand. Ultimately, Primus should be able to deliver a mid-to-high teens return on equity while using a reasonable degree of leverage on its capital base.
From my perspective, I’ve modeled the expected equity value of Primus in a run-off with no 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 market.
Finally, it was nice to hear Tom making some comments about the divergence between the stock price and the company’s underlying financial metrics. And, while I appreciate the conservative management style of the company in terms of conserving capital, it was good to know that the possibility of a buyback of either the equity or debt has been thoroughly discussed and would be undertaken should Primus deem themselves sufficiently overcollateralized against potential claims.
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Disclosure: I own shares of PRS and PRD.
See more FNM, FRE, Financials, James Cullen, PRD, PRS, Small Caps | 
September 10th, 2008 at 4:13 pm
Did Mr Jasper happen to mention the impact of Lehman, or WaMu?
Still a bit fearful of that 13% allocation to financials - but hopefully they are well diversified with respect to any one name, and that fear in my gut is the reason that PRS is trading where it is.
Bought some more PRD today too - someone was apparently interested in selling some volume which moved the price below 9 for a time, too bad I was too slow on the trigger to get it there.
September 10th, 2008 at 11:46 pm
Hogan,
Their policy seems to be minimal disclosure of specific names, i.e. not to do so except in the case of a material event; as such, I don’t know the exact exposure other than what the ratings agency guidelines stipulate could be the maximum.
Also saw the action in PRD today - wished I could have bought more, but I’m tapped out on cash and couldn’t arrange temporary financing in time.
September 11th, 2008 at 4:27 pm
James, would be quite interested in your thoughts re PRD vs PRS. Picked up some more PRD at 9.5 today - I feel like my wife at a shoe sale.
Back to topic though - is there a view on how to compare the values of PRD vs PRS? As in when I am looking at my screen and I decide I want to bring another $XX to the Primus story, I should buy PRS, or PRD, depending on their relative prices? Even more aggressive and not something I would do, but trying to arb by shorting PRS and buying PRD, for example?
I simplistically look at the facts - PRD has 2.6x upside max, and while you wait it pays you 18% per year, so over time that 2.6x creeps up. PRS has “unlimited” upside, but realistically probably high teens at least over the next several years even if you assume there are minimal credit losses and you give them credit for the future contractual revenue streams. That could 3-4x upside. But then, PRD should be more defensive on the downside if they start to get hit with some losses, as it is senior to the equity and has a quarterly yield.
In the end it seems to be a judgment between weighing the upside option that PRS provides vs current income and seniority, which both serve to lower your risk position over as time marches along. Just wondering as a bright student whether there is a way to quantify this - eg if PRD is at 11 and PRS is at 3, my gut would be to buy PRS, but if PRD is at 9.5 and PRS is just below 5, by gut tells me to buy PRD (which is exactly what I did).
Thanks for any insight
September 13th, 2008 at 12:26 pm
I typically look at a 6 year internal rate of return comparison between the two choices - kind of arbitrary, but when I was buying my PRD I figured the return would be 37% annually between yield and reaching par value over the time horizon, and the common would need to go to $20 to offer the same return for more risk.
I’m not a pro at capital structure arb, so I’d be hesitant to do a long/short trade…
September 13th, 2008 at 2:42 pm
Wonder if some of the price action is/was due to the Moody’s announcement that came out on PRD. I guess one should not be surprised that a note trading at 18% yield might deserve to be on downgrade watch from Baa1 though - but could be interesting if they take it down to junk status whether some people might flee.
Gotta hope a Lehman failure doesnt set off a chain of events that makes me regret this holding, but obviously that 13% financials exposure is what keeps us all up at night. That and counterparty risk although I guess if the other side can’t pay, then the CDS is cancelled so you’re giving up future income but also zapping the liability.
September 13th, 2008 at 4:00 pm
barrons had an article lately (maybe this weekend’s edition) about preferreds… about how they are all discounted, and if they recover, returns will be great. FRE/FNM preferreds are less than 10% of par (for good reason), while even the prefs of bigger, safer banks are trading at a discount.
i have publicly and privately applauded James for his timely and ballsy buy of PRS/PRD. hopefully, as hogan said in his last reply, they won’t trade based on LEH, FRE, etc. preferreds as Primus is a whole different type of animal.