Primus Guaranty, Ltd. (PRS) Q1 2009 Earnings Call Transcript May 6, 2009 11:00 AM ET
Richard Claiden – CFO
Tom Jasper – CEO
Thank you, everyone, for joining us to the first quarter 2009 Primus Guaranty, Ltd. earnings conference call. My name is Erica and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will facilitate a question-and-answer session towards the end of this conference. (Operator instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Richard Claiden, Chief Financial Officer. You may proceed, sir.
Thank you, Erica. Good morning, ladies and gentlemen, and welcome to our quarterly earnings call. I am Richard Claiden, Chief Financial Officer for Primus Guaranty. And with me are Tom Jasper, our Chief Executive Officer; Chris Gerosa, our Treasurer; and Nicole Stansell, our Investor Relations Officer.
I will review our financial results for the quarter and discuss events following the close of the quarter. Tom will follow with the discussion of the structure credit market environment and provide an update on the progress we have made on the implementation of our 2009 business outlook and priorities. We will open up the call for your questions after we complete our prepared remarks.
Before I continue, 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, transactions 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.
In discussing our financial results, I’ll refer to both the earnings release and supplementary information packages, which were both published earlier today and contain the reconciliation from GAAP to economic results. I will begin by discussing our economic results and GAAP results for the quarter.
Our economic results for the quarter were a net loss of $6.1 million. These results include premium income of $22.5 million, credit event losses of $25 million, and $5.8 million gain from the purchase of retirement of Primus Guaranty debt, and operating expenses of $8.1 million. Our GAAP net income for the quarter was $107 million compared with a loss of $670 million for the first quarter of 2008. Our GAAP net income for the 2009 quarter was primarily driven by unrealized mark-to-market gains of $123 million on Primus Financial’s credit swap portfolio.
Primus Financial did not write any new swap transactions during the quarter. At the end of the quarter, the portfolio totaled $21.5 billion, down from $22.5 billion at the end of 2008. The reduction in notional was attributable to maturities of $635 million, early termination of credit swaps of $35 million, and a decline in the value of the euro, which reduced the notional on our euro denominated swaps by $373 million.
As I noted earlier, credit swap premium for the quarter was $22.5 million compared with $27.3 million for the first quarter of 2008. The decrease in premium is mostly attributable to the lower notional principal of the portfolio in the first quarter of 2009. However, we also did not record any premium income on the swaps we have transacted with Lehman Brothers Special Financing, a counterparty in bankruptcy, in the first quarter of 2009, whereas we received $2 million in premiums from that counterparty in the first quarter of 2008.
Interest income for the first quarter of 2009 was $2.4 million compared with $9.2 million for the first quarter of 2008. The decline in interest income is mainly the result of lower interest rates on our cash investment portfolio, which is primarily invested in government and agency securities. The average rate earned on our investment portfolio was 1.3% in the first quarter of 2009 compared with 4.3% in the first quarter of 2008.
Most of our cash and investments are held at Primus Financial, which is subject to quite restrictive operating guidelines over its cash and investments. One of our goals in Primus Financial’s amortization will be to improve the return on the investment portfolio and we are taking the first steps in making the changes necessary to achieve that goal, as Tom will describe later.
Interest expense on debt and distribution of preferred securities were $3.7 million in the first quarter of 2009 compared with $7.0 million in the same quarter of 2008. The reduction in financing cost was primarily the result of lower LIBOR interest rates. The average effective interest rate on our debt and preferred securities was 3.7% for the first quarter of 2009 compared with 6.3% for the first quarter of 2008.
You may recall that Primus Financial’s debt and preferred securities were issued in the auction market, which has not been functioning normally since the fall of 2007. We are paying the maximum spread rates over LIBOR, as specified under the terms of the debt and preferred securities. The maximum spread rate over LIBOR averages 3.1% across Primus Financial’s debt and preferred securities. Given the low rates of one month [ph] LIBOR at about 0.5%, we are able to achieve a very low cost of funding for Primus Financial in today’s markets.
Asset management fees, which we earned from managing two CLOs and three CSOs, declined to $419,000 from the first quarter of 2008 versus $1.1 million. The decline reflects a reduction in the subordinated fees on the two CLOs. These fees are not being paid currently pending the cure of certain tests under the CLO indentures. These CS subordinated fees may be recouped later depending on the performance of the CSOs – CLOs, but we are not recognizing this income until it becomes collectible. We also recorded a $609,000 impairment charge on the company’s investment in the subordinated debt of the CLOs it manages.
Our operating expenses for the quarter were $8.1 million compared with $10.0 million for the same quarter of 2008. The lower expense in the first quarter of 2009 was attributable to a reduction in headcount from a year ago, coupled with the lower provision for incentive compensation in the first quarter of 2009. Offsetting these savings to some extent was the net expense of $1 million related to severance.
Now I’d like to discuss the credit event losses in Primus Financial’s credit swap portfolio in some more detail. As of the end of the quarter, there was a corporate credit event on Idearc, upon which we had written $10 million in single-name protection. The net cost of this event was $9.9 million after recoveries.
The quarter also saw a further deterioration in Primus Financial’s CDS of ABS portfolio. During the first quarter of 2009, two asset-backed securities, on which Primus Financial had written a total of $15 million in protection, were downgraded below Caa2 by Moody’s. Under the terms of our CDS of ABS contracts, this constitutes a credit event and we make provision for the estimated cost of this event in our economic results. Currently, only one remaining $5 million CDS of ABS in Primus Financial’s portfolio has not yet experienced a credit event.
During the quarter, the first quarter of 2009, we also paid $24.6 million in cash to counterparties to settle CDS on ABS credit events, which had occurred in prior years. This reduced the outstanding notion on the CDS of ABS portfolio to $43 million as of March 31, 2009. Of the $43 million, $5 million was written with Lehman Brothers Special Financing, which is in bankruptcy, and on which we are not collecting premiums. We continue to collect the premiums on the remaining $38 million.
Looking at our balance sheet, we have $747.4 million of cash and investments on a consolidated basis at March 31, 2009. Of this amount, approximately $682 million was held at Primus Financial. As you know, Primus Financial received premiums from major banks and credit swap dealers on its portfolio of credit swaps.
Based on the assumption that the swaps are held to full maturity, we would anticipate Primus Financial receiving over $250 million in cash in the future, based on the portfolio of credit swaps written as of March 31, 2009. These future premium cash flows exclude transactions with Lehman Brothers Special Financing. Of course, any future premium cash flows will be affected by further credit events and changes in the value of the euro.
During the first quarter, we continued to buy back notes issued by Primus Guaranty, our parent company. During the first quarter, we have purchased approximately 418,000 Primus Guaranty notes at an average price of $10.40 and a total cost of $4.3 million. This enabled us to retire $10.5 million in face value of debt at a net interest saving of approximately $730,000 per annum and a net gain on the return of $5.8 million.
Since the buyback program’s inception in 2008 and through the end of the first quarter of 2009, we have purchased just over 1 million Primus Guaranty notes at an average price of $9.13 and a total cost of $9.4 million. This has enabled us to retire $25.7 million in face value of debt and a net interest saving of approximately $1.8 million per annum.
We also continued our share repurchase program during the first quarter of 2009, where we spent approximately $1.1 million to purchase and retire 700,000 Primus Guaranty common shares at an average price of $1.57 per share. Since inception, our share repurchase program has reduced the outstanding share account by approximately 12%.
Finally, I would note that since the end of the quarter, Primus Financial has purchased $21.9 million of its senior debt and $22.7 million of its subordinated debt at a combined cost of $12.7 million. We purchased the debt following reverse enquiries from investors. We expect to recognize a net gain of approximately $31.3 million in the second quarter and save about $1.7 million in annual interest expense at current interest rates as a result of these purchases.
Finally, I would say, since the end of the first quarter we have seen quite significant further improvements in the mark-to-market value of Primus Financial’s credit swap portfolio. In April 2009, we saw mark-to-market gains of over $300 million, primarily a result of the general reduction in our market credit swap premiums and also partly attributable to the continued reduction in the remaining (inaudible) of the portfolio.
Now I will hand you over to Tom for his perspectives on the market and to discuss the business outlook for Primus for the rest of 2009 and beyond. Thank you.
Thanks, Richard. And good morning to everybody. During the first quarter, there were some welcome signs of improvement in the credit and financial markets. The global corporate investment grade debt issuance, for example, doubled over the year earlier period and reached a record level, helped in part by government guaranty program. In the US, corporate investment grade bond volume was up 80%.
At the same time, though, credit spreads remained wide as investors are demanding to be compensated for the perceived levels of risk. These perceptions have been worn out in part by the significant increase in corporate defaults so far this year. During the first quarter of 2009, there were 15 single-name corporate credit events compared to 12 in the second half of 2008.
Since the end of the quarter, we’ve seen some more signs that the markets are improving. Corporate bond, corporate loan, and credit swap spreads have tightened, and we are seeing signs of stability in the pricing and credit risk. This spread tightening, which is occurring generally across the market, is a sign that investors are beginning to once again commit capital to the credit markets. Additionally, with the recent positive performance of the equity markets, creditors now perceive to be an alternative investment.
So what does this mean for Primus? To start with, our financial performance in the quarter improved certainly on a relative basis and we began to see a reversal in our GAAP numbers. If the spread tightening in the CDS market since the end of the quarter holds, it should positively affect our GAAP results in the second quarter. As Richard noted, the positive GAAP income we reported in the first quarter was driven mainly by portfolio amortization and the reduction in the average life of the portfolio, and not by tighter spreads. The potential combination of the two factors could significantly increase our GAAP earnings going forward.
Given the current environment, Primus Financial’s portfolio of credit swaps continues to perform well. We had only once, and specifically Idearc, which Richard mentioned, of the 15 corporate credit events that occurred in the first quarter. We did see continued deterioration in our CDS of ABS portfolio, which Richard has discussed.
Certainly, recent actions by the G-7 countries to support their respective financial systems are an important consideration for us. A significant bank failure would certainly be an unwelcome event for Primus Financial, given the composition of its portfolio, with 25% allocated to global financial institutions and insurance companies. I believe the general consensus in the market is that the global bank regulators are not likely to let a major bank fail.
Since the end of the first quarter, we have not experienced any credit events in our single-name portfolio. As we announced several weeks ago, we have no exposure to the big three automakers; GM, Chrysler, or Ford. So Chrysler’s recent Chapter 11 filing will not directly impact our portfolio. We do, however, remain cautious in our outlook and expect the level of defaults to continue to rise at least until the global economy begins to rebound. We are particularly concerned about certain single-name reference entities and those industries, which are being impacted by the global recession. Now, retail is a good example.
We also continue to watch closely developments on the monolines, as there were further rating agency downgrades in the sector during the quarter. Also, Sincora’s [ph] decision last week to stop paying further claims led to the first credit event in that industry. Primus Financial did not have any exposure to Sincora, but as we have reported, we do have exposures to other reference entities in that sector.
Another area that we are closely monitoring is our bespoke tranche transactions, where we have seen further reductions in the respective levels of subordination because of the credit events they have experienced over the past six months and most recently, Idearc. The conditions that we have experienced so far this year are roughly in line with our expectations.
As you will remember, during our call in February, we anticipated that the business environment would remain challenging during 2009 with additional write-downs in sales to distress credit assets and further consolidation of major banks and credit swap dealers. We also said that we expected higher default rates and that credit overall would remain extensively priced.
At that time, we discussed our plan to build value for shareholders, given current conditions in the credit markets. The plan is described in further detail in our 2009 business outlook and priorities presentation, which is posted on our website. The plan has four main elements. To begin with, number one is amortizing Primus Financial’s credit swap portfolio. Second is pursuing new opportunities in credit, structure credit and derivative markets. Thirdly is officially allocating our capital. And finally, in terms of our four key points, our aligning cost with our business approach.
I’m pleased to say that we made good progress on our key priorities during the first quarter. In terms of the amortization of Primus Financial’s portfolio, this, as you know, has been driven by the changes in the credit market conditions that have occurred over the past year or so. In today’s environment, credit default swap counterparties require collateral to be posted in their transaction, and that is a requirement that Primus Financial cannot meet.
While some might see this as a source of weakness, as it impedes our ability to write new business for Primus Financial, the reality is that it’s a source of strength. It means that we do not have any ratings triggers that would force us to post collateral and that might require us to unwind Primus Financial’s portfolio in an inopportune manner or in adverse market condition.
In amortization, Primus Financial will not pursue new opportunity to sell credit protection. Instead, its existing credit swap contracts will expire maturity unless they are terminated earlier either by a credit event or the mutual consent of both parties. Approximately $635 million notional amount of single-name credit swap contracts matured in the first quarter of 2009 and an additional $2 billion is scheduled to mature during the remainder of 2009. Next year, $5.7 billion of the portfolio is scheduled to mature. The average remaining maturity of Primus Financial’s credit swap portfolio was 2.86 years at March 31 compared with 3.03 years at the end of the year.
As I have noted, amortization is not a passive strategy, and Primus Asset Management, which manages the Primus Financial portfolio, is in control of the process. Our goal here is to work proactively to maximize the portfolio’s potential value. Towards that end, we continue to actively pursue a variety of approaches that could, if successfully executed, narrow the possible range of negative outcome for Primus Financial’s credit swap portfolio.
One approach we are actively considering is unwinding the credit swaps with our counterparties on our certain reference entities. This would be on a selective targeted basis and would in all likelihood require a payment to counterparties or, as we’ve called it in the past, a credit mitigation charge. This rifle shot approach is difficult to execute in a market where almost every credit swap in our portfolio is trading at historical wide spread levels relative to the fundamental. However, the recent rally in credit swap spreads may provide us with some additional flexibility in considering whether to unwind certain reference entities in Primus Financial’s portfolio.
We are also discussing with a number of counterparties the idea of bilateral commutations on certain transactions. This could involve terminating all of the credit swaps with a particular counterparty for a payment that would represent a discount to the current mark-to-market value of that portfolio. We also had discussions during the quarter with a smaller group of our largest counterparty on the possibility of a broad repositioning of Primus Financial’s credit swap portfolio.
Our team has developed a proposal to these counterparties to substitute a CDS tranche transaction with a significant subordination for their existing credit swap. An important point that I want to underscore is that the decision to move forward with any of these transactions for Primus Financial will depend upon our perception of their costs and benefits.
Primus Financial’s business model is designed to protect the interest of all stakeholders, including Primus Guaranty shareholders, and we cannot be forced to unwind, terminate, or liquidate transactions. So one of our possible approaches to amortizing Primus Financial’s portfolio is to do nothing, to simply let the portfolio run off. Certainly, that will be the alternative that the others are just too costly.
Let me move on now to discuss our asset management business. As we’ve just said, asset management is going to play an important role in the future of our company. To build towards that future, we are intent on establishing a clear, distinct identity for our Primus Asset Management subsidiary. As you know, Primus Asset Management currently manages $23 billion notional and structured credit vehicles, including Primus Financial plus two collateralized loan obligations and three collateralized swap obligations.
We are currently in the process of carving out of Primus Asset Management shared services such as legal, treasury and finance into a new corporate services company. This will give us the standalone asset manager with a broad range of credit asset management experience in a very attractive platform for growth. As we said, we believe that given the current environment, there are interesting possibilities to align with and acquire firms that share our business approach and that find our platform attractive.
During the first quarter, we entered into negotiations with one such firm that would significantly increase the number of funds and amounts of assets that we manage. We have signed a letter of intent with this asset manager, which specializes in the leverage loan market, and we expect to close on the transaction shortly. This will be a major step forward in our plan to gain the size and scale that we need to thrive in the credit markets. Obviously, we will be in a position to discuss this in more detail after the definitive agreement is signed and announced.
In addition to this one specific transaction, we believe there will other opportunities to acquire companies, asset management contracts, and structured credit assets because of the consolidation taking place within the structured credit markets this year. We are seeing good interest so far. We are also working in other ways to position Primus Asset Management for the longer term reopening of the structured credit markets where an experienced manager with an established track record should be able to originate new transactions.
Given the disruptions in the financial and credit markets, there are currently very few of any sellers of credit protection whose strategy is to be an end risk taker. The reality is that the markets want and need this capacity. We believe this could present us with attractive opportunity to create a new company that leverages our fundamental credit platform, a company that’s actively managed with a relative value orientation and that’s generally long credit. This company’s strategy would be to sell protection via credit swaps on single-name corporate and sovereign reference entities. This would be similar in concept of Primus Financial. The major difference, and it’s quite an important difference, is that the new company would post collateral.
We believe Primus Asset Management is one of the few managers that has the credit platform and track record to execute on this type of strategy. Over the last few months, we have built and are managing a $1 billion test portfolio that will help us prepare for the prospective launch of this new credit protection seller. So far, we’ve seen good performance, although we continue to refine and enhance our approach to managing this new test portfolio.
Let me turn now to the use of our capital, which remains one of our key priorities. And I’m very pleased to report that we’ve taken steps during the quarter to accomplish this goal. As Richard noted, we are in the process of enhancing our cash investment guidelines to include corporate securities. We believe we can enhance the investment returns across our $740 million in cash by taking on single-name corporate credit risk in the form of corporate bonds that we would otherwise sell protection on if Primus Financial had the capacity to do so.
I want to make one final point on the investment of our cash capital. During the quarter, we had a series of discussions with dealers about the treasury’s new Term Asset-Backed Securities Loan Facility, better known as TALF. TALF has been set up primarily to encourage the reopening of the securitization markets. I think the TALF is offering opportunities for investors to acquire new, high quality, short-term assets versus TARP –sorry for the nomenclature here, but I didn’t create it – which is focused on legacy assets on bank balance sheets.
We have reviewed the risks and benefits and on balance believe that this could be an attractive opportunity for us, particularly when the range of assets coming out of the TALF options moves to corporate credit. As a result, we will be signing up to participate in the program and are in the process of deciding how much of our cash we should allocate to these assets. We expect at this point that it would be of modest amount and are treating this as an additional opportunity for us under our enhanced investment guidelines.
I’m very pleased with the returns we’ve seen to date from our opportunistic use of capital to repurchase our outstanding debt and equity. Richard described this in detail. I want to add that we believe it’s another concrete example of how we are actively managing the company and our resources to build value.
Let me next mention the steps we have decided to take on Primus Financial’s ratings. As you know, earlier this year we asked for a received approval from Moody’s to withdraw its ratings on Primus Financial. After further discussions with counterparties about the need for a Standard & Poor’s ratings, we recently asked S&P to consider withdrawing its ratings on Primus Financial. We will keep you informed of developments.
In recent months, we have been in discussions with the New York Stock Exchange, as we are one of the many companies that fell below their listing requirements during the financial crisis. I’m pleased to say that these issues have largely been resolved and that we expect to continue trading on the New York Stock Exchange.
Let me conclude with a few comments on the regulatory and public policy environment. There continues to be a significant misperception in the market regarding the role of credit default swaps in starting or exacerbating the financial crisis. Efforts in the US and Europe to impose tighter regulation of the business are continuing. It’s difficult to say how this will ultimately turn out, but my belief is that policymakers will be leery to further disrupt to credit markets by imposing too heavy a burden.
Having said that, regulators and the industry continue to push the concept of central counterparty clearing, and at least one such clearing house is up and running. It’s worth noting that the interest rate swap business has existed for a number of years with a clearing house, without losing any of its momentum or innovation. So there is plenty of reason to believe that a clearing house can exist as an integral part of a broader credit swap market, without dampening its prospects of potential.
I have discussed this point with the Federal Reserve Bank in New York and the Financial Services Authority or FSA in the United Kingdom, and my impression is that they understand the importance of (inaudible) over the counter market operating in tandem with an exchange traded market. Additionally, they recognize that the clearing house will have limitations in terms of counterparty capacity and the products that can be traded on it.
One of the most important dynamics in the ongoing policy debate about credit swaps is the increasing role and increasing voice being given to end users. Not long ago it seemed that most of the issues were settled by and amongst the dealer firms. Today, that seems to be changing. A case in point, Primus and four other end users were recently asked to sit on the credit derivatives determination committee, which was recently formed by the International Swaps and Derivatives Association, better known as ISDA.
This committee would help decide such key issues as whether a credit event has occurred, what deliverables are acceptable in a credit event and similar question. Inherence to ISDA’s Big Bang Protocol, and there were more 2,000 of them, have agreed to abide by the findings of the Credit Derivatives Determinations Committee. We think that’s a good step forward for their business and we are pleased to be serving on it.
With that, let me now open it up for any questions.
Thank you. (Operator instructions)
Well, Erica, there seems to be no questions at this time. So I think at this point, we will hold to the call and thank you all for listening in. We look forward to speaking with you again in the – for the next quarter. Thank you, Tom.
Thanks, everybody. Bye-bye. Bye now.
Thank you for your participation. You may now disconnect and have a wonderful day.
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