Primus Guaranty, Ltd. (PRS) Q3 2008 Earnings Call November 5, 2008 11:30 AM ET
Richard Claiden - Chief Financial Officer
Thomas W. Jasper - Chief Executive Officer
Chris Gerosa – Corporate Treasurer
Nicole Stansell – Investor Relations
Good day ladies and gentlemen and welcome to the Third Quarter 2008 Primus Guaranty Ltd. Earnings Conference Call. My name is Lacy and I will be your coordinator for today. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.
I would now like to turn the presentation over to one of your hosts for today’s call, Mr. Richard Claiden Chief Financial Officer.
Good morning ladies and gentlemen and welcome to our quarterly earnings call. With me today are Tom Jasper, Chief Executive Officer; Chris Gerosa, Corporate Treasurer and Nicole Stansell our Investor Relations Officer.
In contrast to our usual practice and given the events of the last few months, Tom will open the call giving his perspective on the quarter and the current state of the credit markets. I will follow to give you more detail in relation to the portfolio and the financial results for the quarter. We will open up the call for your questions after we complete our prepared remarks.
Before I hand you over to Tom, I should caution you that some of the statements we may make in this call, particularly those anticipating future financial performance, business prospects, growth and operating strategies and similar matters are forward-looking statements that involve a number of assumptions, risks, and uncertainties which change over time. We assume no duty to update any forward-looking statements. Our actual results could differ materially from those anticipated in forward-looking statements, and our future results could differ materially from historical performance. For a discussion of the factors that could affect our results please refer to the risk factors identified in our filings with the SEC.
I will now hand you over to Tom.
Good morning everybody. Clearly the third quarter was one of the most difficult if not the most difficult periods of the global financial markets that I have experienced in my three decades in the business. We saw unprecedented failures of highly rated institutions. Many other firms came under significant pressure due to under performing assets, leverage, and lack of liquidity. Credit markets were frozen with very little trading volume and wide and volatile price swings. Global equity markets saw significant drops in their respective indices and there was also extreme daily price swings.
The VICS index, a measure of market risk, hit an all time high.
Governments and central banks around the world announced a range of initiatives to increase liquidity and capital and strengthen confidence in the financial system. This included taking equity stakes at many of the largest global banks and initiating mergers of weaker banks with stronger ones.
At this point in time these measures seem to be having a positive effect, but we are now seeing growing fears of a severe global economic slow down. There is no question that the turmoil in the credit markets had and is having a negative impact on our company.
During the quarter we experienced credit events on several names in the portfolio, specifically Fannie Mae, Freddie Mac, Lehman and Washington Mutual. The no show amount of these exposures totaled $280 million and we had net realized losses of $84 million on them. Richard will speak to this in greater detail.
After the close of the quarter we experienced additional credit events which we have already reported to you. This included the Icelandic Financial Institutions Kaupthing Bank; it also included a technical credit event due to the downgrade to CCC of one of the remaining CDS of ABS positions from the 2006 vintage. Richard will also update you on these items.
Finally, during the month of October our Primus Financial subsidiary was downgraded by both S&P and Moody’s to AAA+ and AA1 respectively with negative implications. Additionally Standard and Poor’s and Moody’s downgraded to BB and BA1 respectively, the 7% notes issued by Primus Guaranty.
The CDS market has shown some recent signs of improvement in response to the many steps that have been taken by governments and Central Banks to stabilize the markets. Nonetheless, Primus Financials counter parties, for the most part, remains frozen and are not providing any liquidity, particularly to a rated, structured, operating company like Primus that does not post collateral.
I do not expect this environment to change for some time. When combined with Primus Financials ratings downgrades we have concluded that it will be difficult for us to write any new business for the foreseeable future. Given current and expected market conditions and their impact on our business, what does this mean for Primus and its shareholders? What it means is that we are shifting from managing our credit protection business around our growth model to managing it around an amortization model.
Now as shareholders consider this change in approach it is important to keep in mind a few fundamentally important points about our company:
First, Primus is Financial is still in business and its operating model was able to withstand the unprecedented events which occurred in the third quarter. We have a large block of CDS contracts with a three-year average life that remain in force.
Second, those contracts are backed by a substantial amount of capital. Even after giving effect all of the credit events that have occurred during the quarter, Primus Guaranty’s consolidate capital was $830 million.
Third, it is important to realize that the rating downgrades that Primus Financial has experienced have no impact on its current book of business. It is counter parties remain obligated to pay over $300 million in premiums over the remaining lives of these contracts.
Fourth, and as we said many times, there are no ratings triggers in Primus Financials credit swap contracts, so it cannot be forced to provide collateral against its current negative mark-to-market.
Fifth, Primus Financials credit swap contracts will revert to zero mark-to-market value at maturity. This means that we will get a significant mark-to-market benefit as the average life of the portfolio shortens. It also means that the company will likely show positive GAAP numbers once the credit markets stabilize and credit swap spreads return to more historically normal levels. As an example, the CDX index, IG index, at October 27th traded as wide as 225 basis points and it’s narrowed significantly to 186 basis points as of yesterday, again as tensions in the market began to ease.
Sixth, we have a significant benefit in that the maturities of our liabilities significantly exceed the maturity of our assets. We are not exposed to any refinancing risks in what would be a very difficult market to raise new capital.
Additionally, the cost of these liabilities is quite low in the current environment and has the potential to decrease more if LIBOR responds to recent government actions.
Finally, the steps taken by the Worlds Central Banks shore up and restore confidence in the financial system, reduce the risk that Primus Financial has with regards to protections sold on financial intermediaries. As you know, this sector is the largest in the portfolio.
All of these points underscore why we believe there is significant value embedded within our company, our franchise, and our portfolio today. As we change our approach to managing our credit protection business our primary focus is on preserving that value and in unlocking it for shareholders. We clearly believe the value of our company is not reflected in our share price today.
We are of course very mindful of the impact the global economic slowdown could have on Primus Financials credit swap portfolio. It is a definitively more risky environment for credit even in the investment grade universe where Primus Financial focuses.
Let me describe some of the steps we have begun to take to conserve value for shareholders:
To begin with we are aggressively using Primus Financials existing capital base to improve its capacity to absorb any additional credit losses. This is a very clear departure from managing to a AAA capital model or growth model. Primus’s AAA ratings were important when it was growing and needed counter-party capacity, but are less so given our current approach.
I want to be clear that I am not trying to dismiss the ratings downgrade as insignificant. Rather, I believe Primus Financial is facing a new business reality in which it does not require an AAA rating. As part of this reality we have decided that it is not a prudent use of Primus Guaranty’s capital to attempt to bolster the ratings of Primus Financial, given that, as I said, we do not expect to write any new business in that company.
To conserve the value in our credit protection portfolio, we are considering a range of risk reduction transactions. This includes unwinding individual credit swaps with counter parties to reduce our exposure to specific reference entity. It also could include restructuring, or optimizing, some of our Mezzanine tranches. While there could be a capital cost associated with some of these risk reduction transactions in today’s markets, we are balancing this cost against the potential benefits of additional portfolio resiliency.
We have met recently with the rating agencies to discuss near term business opportunities and the market environment for Primus Financial. We are working with them to simplify the operating guidelines to enable us to better manage the risk in the portfolio as I discussed above. We are also meeting with Primus Financials counter parties to outline our change in approach and to discuss the various risk reduction transactions I just mentioned. We will certainly need their support to complete these transactions.
Finally, we have taken steps to align our expense base with our current and expected revenue stream given the realities of business today. During the quarter we began to aggressively cut expenses and we recently reduced staff by 15%. I want to add that while we recognize the importance of cutting expenses, we are also mindful of the need to preserve the expertise and infrastructure required to manage our existing portfolios in a difficult environment and preserve our franchise values.
Those are the steps that we are taking to conserve the value in our business today. There are also other near term opportunities we are exploring that leverage our expertise and operating platform. We continue to be very interested in acquiring CLO collateralized loan obligations and collateralized swap obligation management contracts.
Coming out of the credit market chaos we also believe there will be a large and growing opportunity to acquire orphaned assets or other structured credit vehicles that are operating in a run-off mode. As an example, Morgan Stanley recently sold its credit derivative product company, Corno, to a large hedge fund which intends to run it off. However, we do recognize that we will need additional capital to capture the potential we see and this means that we need to find an appropriate strategic partner. Toward that end we are continuing to explore various strategic alternatives for the company.
On a broader long-term basis we do expect that that structured credit markets will re-open creating additional avenues of opportunity for us. It may, however, take six to twelve months for this to happen and at the very least it will require a degree of market stability and confidence that we are not currently seeing.
Just quickly moving to another subject, I wanted to update you on two key structural issues that the credit swap industry is currently intensely focused on. One is the establishment of a credit swap clearing house, and secondly is a regulatory framework for the credit swap market. Both of these issues are taking a significant amount of time and attention in the industry.
From my perspective, I expect that the market will move forward with one or more credit swap clearing houses by year-end or early 2009. Membership in those clearing houses will likely be limited to the major credit swap dealers and perhaps some large hedge funds. So what does that mean to market participants that are not members or could not be members, such as Primus? I believe it will likely be mid to late 2009 before it comes clear what components of the credit swap market will trade through the clearinghouse versus over the counter.
The interest rate swap market trades both on an exchange and on an OTC basis, so it is reasonable to conclude that the credit swap market will evolve along those same lines. I also that congress of the new administration will likely move forward with developing a regulatory framework for the credit swap market. Again the precise details and parameters are unclear at this stage and, as you know, the devil will be in the details.
Until these issues are resolved, it is difficult to know how the credit swap market will evolve. We certainly remain hopeful that the industry will continue to be as dynamic and innovative over the long-term as it has during the past decade, and that Primus can be an active participant in this innovation. However, our focus has to be on what tangible actions we can take in the short run that will provide more immediate value to shareholders.
I have already spoken about the steps we are taking on Primus Financials portfolio to unlock its value. An additional step we are taking includes deploying a portion of the $80 billion capital at the holding company level in order to opportunistically buy back Primus Guaranty’s debt and stock. Under plans approved by our board, we can repurchase a total of $25 million of our debt or stock and we are moving ahead on both fronts. In the future we are also planning to use any excess capital at Primus Financial for the benefit of shareholders.
Let me wrap up by summarizing where I believe Primus is today and where it is going. It is clear that the current market environment calls into question whether a credit derivative product company generally, or and Primus Financial Specifically, can continue to grow and thrive in their existing form. The playing field has changed significantly with the events of the last quarter. What is not in question, at least in our minds, is the real value that is embedded within our credit derivative product company and our company today.
Job one for our team is conserving and unlocking that value for shareholders. It’s a process that we believe will occur over time, but it’s one that we are committed to achieving. We are hard at work arranging risk reduction transactions currently, continuing to cut expenses, repurchasing debt, and as we announced today, repurchasing stock. We are also exploring all avenues of value [curash] in the structured credit markets where we can profitably deploy our business franchise and will continue to do so.
I will now turn it over to Richard for a detailed review of the quarter.
In discussing our financial results I will refer to both the earnings release and supplementary information package, which were both published earlier today and contain the reconciliations from GAAP to economic results. I will discuss both our economic results and our GAAP results for the quarter.
Economic results for the quarter were a -$62.1 million including net realized loss of $84.4 million for credit events which occurred during the quarter. This loss reflects the logical principal of the stock contracts Primus Financial has written on defaulted reference entities less recovery values on those contracts, as I will discuss in greater detail later in the call.
In terms of our credit swap portfolio Primus Financial wrote $74.3 million in U-swaps during the quarter. By the end of the quarter the portfolio totaled $22.9 billion, down from $24.2 billion at the end of the second quarter of 2008. The reduction in notional from the second quarter was caused by several factors including maturities of $222 million, termination of credit swaps due to credit events of $280 million and a fall in the value of the euro which reduced notional, in dollar terms, by $870 million. These items were partially offset by the $74 million of U-swaps that were added during the quarter.
Premium income for the quarter was $24.4 million compared with $22.3 million for the same quarter as 2007. The increase in premium was due to a higher average notional principle on the portfolio during the third quarter of 2008 compared with the third quarter of 2007.
I would like to point out that during and subsequent to the third quarter of 2008 Lehman Brothers holding and its subsidiary, Lehman Brothers Special Financing, a counter-party of Primus Financial, both filed for bankruptcy. We have not included the premiums on the credit swaps that Primus Financial has written with this counter-party in our third quarter of 2008 premium income.
Net interest income in the third quarter was $841,000.00 compared with $3.86 million in the third quarter of 2007.
Interest income was $6.2 million at an average rate of 2.77% compared with $10.8 million at an average rate of 5.18% in the same quarter of the prior year.
Interest expenses and preferred distributions were $5.4 million compared with $7.0 million in the same quarter of 2007.
The average financing expense on our $425 million of debt in preferred was 5.06% compared with 6.6% in the prior year.
The interest rates on Primus Financials auction rate debt and preferred continue to set at their contractual maximum rates given their current ratings.
Subsequent to the end of the third quarter both Moody’s and S&P downgraded Primus Financials debt. Under the terms of Primus Financials auction rate debt agreements the maximum spread rates over LIBOR increase if the debt is downgraded. The impact of the downgrades on our AAA notes and AA notes to AA and A respectively will be an extra debt expense of $281,000.00 for a full quarter. The [raise] in absolute capital at maximum rates should multiple further downgrades occur. If we reach the absolute cap maximum spread rates the additional costs will be approximately $578,000.00 per quarter.
Income for our asset management activity, mainly CLOs and CSOs was $1.1 million. We also earned $292,000.00 on investments in the equity of the CLOs we manage. This revenue is included in interest income in our financial statements.
Our operating expenses for the quarter were $4.3 million compared with $9.4 million in the same quarter of 2007. The primary reason for the lower expenses in the third quarter of 2008 was a significant reduction in accrued incentive compensation. We have also introduced a number of other cost saving measures, principally in bed technology and data expenses which helped reduce our expenses in the quarter.
Subsequent to the end of the third quarter our employee base fell by nine people or about 15%, as Tom mentioned. After these expense reductions our mobilized operating expenses are now running at approximately $30 million a year, or $7.5 million per quarter.
Let me now address the specific credit events during and subsequent to the third quarter.
Primus Financial had the following reference entities in its credit swap portfolio and incurred the following net realized losses as a result of credit events: On Fannie Mae and Freddie Mac our net realized losses were $4.8 million on a notional of $190 million. On Lehman Brothers holdings net realized losses were $73.1 million on a notional of $80 million and at Washington Mutual net realized losses were $6.6 million on a notional of $10 million. As you can see, the recovery rates fluctuated considerably depending on the circumstances of the reference entity.
In the aggregate our total net realized losses were $84.1 million on a notional of $280 million.
Subsequent to the end of the third quarter we incurred a credit event on Kaupthing Bank in Iceland, on which Primus Financial had written credit swaps for a total notional of $68.2 million. Primus Financial also incurred credit events due to the downgrade below a rating of CCC or Caa2 of the remaining 2006 ABS bond upon which we had written $10 million in protecting as Tom noted. A further ABS bond upon which we had sold $5 million in credit protection to Lehman Brothers was also downgraded below CCC or Caa2 since the end of the third quarter.
As we have mentioned the bankruptcy of Lehman Brothers holdings and its special financing subsidiary affected us both as a seller of protection and as a credit swap counter-party. The bankruptcies, coupled with the fact that Lehman did not pay premiums when due, constitute events of default on the part of Lehman as a swap counter-party.
From a legal perspective we believe Lehman, as a counter-party, is in default and will be unable to cure that default. From an accounting perspective we are obligated to carry the swaps under the standards set by GAAP. This means we continue to show the notional and the mark-to-market liability of these swaps in our financial statements. However, as I noted earlier, we have excluded the premiums that Lehman failed to pay from premium income for the third quarter, although we offset the premium amounts due against the mark-to-market liabilities on these swaps.
Turning to our GAAP results, we had a GAAP loss of $390.2 million for the third quarter of 2008 compared with a GAAP loss of $128.4 million for the third quarter of 2007. The primary driver of the loss in the third quarter of 2008 was in increase of $327.6 million in a negative fair value of our credit swap portfolio. This mark-to-market loss is after a favorable adjustment of $346.6 million to reflect the risk of our own non-performance, as required by FAS 157 which we implemented in 2008.
Looking at our balance sheet, we have $913.8 million in cash and investments on a consolidated basis at September 30, 2008. Of this amount $820.4 million was held at Primus Financial. Since September 30 Primus Financial has paid out $84.4 million to settle the credit events that occurred during the third quarter and we will make further payments in the fourth quarter to settle the Kaupthing Bank credit event.
As you know, Primus Financial also receives premiums in cash on its portfolio credit swaps. Based on the assumption that swaps are held to full maturity, we would anticipate receiving over $300 million in cash in the future based on our portfolio of credit swaps written as of September 30, 2008. These future premium cash flows exclude transactions with Lehman Brothers Special Financing. Of course, future cash flows will be potentially affected by any further credit events and changes in the value of the euro.
Since the end of the third quarter we have also commenced the buyback of notes issued by Primus Guaranty. By the end of October we had purchased approximately 244,000 PRD bonds at an average price of $7.45 at a total cost of $1.8 million. This enables us to retire approximately $6 million in face value of debt at a net interest saving out of approximately $427,000.00 each year. We intend to continue this program; in addition we are initiating a share repurchase program as Tom noted. In total we have been authorized to spend up to $25 million of the cash held by Primus Guaranty, our parent company, for stock and debt repurchases.
In summary, it has been a difficult quarter for the market as a whole and for our company. As a result of the ground changing events in the financial markets we are evolving our strategy and we will now be managing in an amortization mode. Conservation of capital is paramount in this environment and we are actively exploring measures that will enable us to most effectively achieve this goal and to unlock value for our shareholders.
Thank you and we will not open up the call to your questions.
(Operator Instructions) At this time I show no questions in the queue. I would not like to turn the call back over to Mr. Thomas Jasper for closing remarks.
Again, it was a very difficult quarter, as we said, for us and we are working very hard for our shareholders and we look forward to talking to you on our next call.
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