Primus Guaranty Q2 2009 Earnings Transcript

| About: Primus Guaranty, (PRSG)

Primus Guaranty, Ltd. (PRS) Q2 2009 Earnings August 5, 2009 11:00 AM ET


Richard Claiden - Chief Financial Officer

Thomas W. Jasper - Chief Executive Officer


Good day ladies and gentlemen and welcome to the Second Quarter 2009 Primus Guaranty Limited Earnings Conference Call. My name is Novelia and I'll be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question and answer session towards the end of today's conference. [Operating Instructions]. As a reminder, this conference is being recorded for replay purposes.

I would now like to hand the presentation over to your host for today's conference, Mr. Richard Claiden, Chief Financial Officer. Please proceed sir.

Richard Claiden

Thank you, Novelia. Good morning ladies and gentlemen and welcome to our quarterly earnings call. I am Richard Claiden, Chief Financial Officer of Primus Guaranty and with me are Tom Jasper, Chief Executive Officer, Chris Gerosa, our Treasurer and Nicole Stansell, our Investor Relations Officer.

I'll review our financial results for the quarter and discuss events following the close of the quarter almost followed with the discussion of respective credit market environment and provide an update on the progress we've made on the implementation of our 2009 business outlook and priorities. We will then 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 and involve a number of assumptions, risks and uncertainties which change overtime.

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'd refer to both the earnings release and the supplementary information package which we both published earlier today and contain a reconciliation from GAAP to economic results. I'll begin by discussing our GAAP results and economic results for the quarter.

Our GAAP net income was $596.9 million for the second quarter of 2009 compared with 262.6 million from the second quarter of 2008. Our GAAP net income for the quarter was primarily driven by unrealized mark-to-market gains on Primus Financial's credit swap portfolio.

During the second quarter, we saw an improvement in the credit markets which resulted in favorable movements in the mark-to-market value of Primus Financial's credit swap portfolio, a $552.6 million. As a result of general declines in market premium levels in the quarter, coupled with the reduction in the average remaining tenure of the portfolio. Since the end of the quarter, this trend has continued and we've seen a further improvement of approximately $300 million in the month of July, as market premium levels continue to fall.

Our economic results for the quarter were $47.5 million or $1.15 per diluted share compared with $0.41 per diluted share in the second quarter of 2008. The $47.5 million of economic results in the second quarter includes premium income of $22.2 million and a $33.2 million gain on the purchase and retirement of Primus Guaranty's and Primus Financial's debt.

Primus Financial did not write any new credit swap transactions during the quarter. At the end of the quarter, Primus Financial's credit swap portfolio totaled 21.3 billion, down from 22.5 billion at the end of 2008. The reduction notional was mainly attributable to maturities of 1.2 billion during the first six months of 2009.

Credit swap premium income for the quarter as I mentioned, was $22.2 million compared with 27.2 million in the second quarter of 2008. The decline in premium is mostly attributable to lower notional principle amount of the portfolio in the second quarter of 2009. Additionally, we did not record any premium income on the swaps we have transacted with Lehman Brothers special financing, a counterparty in bankruptcy in the second quarter of 2009, whereas we received approximately $1.8 million in premium for that counterparty in the second quarter of 2008.

Interest income for the second quarter of 2009 was $1.1 million compared with $6.3 million for the second quarter of 2008. The decline in interest income is mainly a result of lower interest rates on our cash investment portfolio which is primarily invested in government and agency securities. The average remaining life of the investment portfolio was just under six months as of June, 30, 2009. The average rate and in our investment portfolio was 61 basis points in the second quarter of 2009 compared with to 2.88% in the second quarter of 2008.

Most of our cash investments reside at Primus Financial which has been subject to quite restrictive rating agency based operating guidelines over its cash investments through most of the quarter. One of our goals is to improve the turn in our investment portfolio and we have taken steps in that direction during and subsequent to the end of the quarter as I'll describe now.

During the quarter, we invested approximately $20 million of Primus Guaranty's capital in selected investment grade corporate funds with remaining tenants in the two to five year range. Since the end of the quarter, we've also began to invest a portion of Primus Financial's in similar corporate funds. During the quarter, we announced that to withdraw it's rating on Primus Financial. We have taken similar action at Moody's Investment Services in the first quarter.

We now have more flexibility in how we manage Primus Financial's tax capital and the rate on the investment portfolio is now higher than it was before initiating our new investment program.

Interest expense on debt and distributions on preferred -- and distributions on preferred securities with $3.4 million in the second quarter of 2009 compared with $5.9 million in the same quarter of 2008. A reduction in financing cost was primarily a result of lower LIBOR interest rates. The effected interest rate on our debt and preferred securities was 3.71% in the second quarter of 2009 compared with 5.57% in the second quarter of 2008.

You may recall that Primus Financial's debt and preferred securities we issued in the auction rate securities market, which has not been functioning normally since the fall of 2007. Primus Financial currently pays the maximum spread rates over LIBOR which averaged 3.1% as specified under the terms of the debt and the preferred securities.

Primus Financial's outstanding debt and preferred security balances declined by approximately $50 million as a result of buybacks during the quarter. The full impact of the buybacks at Primus Financial in subsequent course will be discussed later in the call.

Asset management fees which we earned from managing two CLOs and three CSOs declined to $387,000 for the second quarter of 2008 compared with $1 million fees in the second quarter of 2008. The declines represents a reduction in subordinated fees being paid on the two CLOs. These fees were not paid during the quarter depending on the certain test on to the CLO indentures. These subordinated fees maybe accrued later depending on the performance of the CLOs, but we're not recognizing this income until it becomes collectable. We also recorded a $152,000 impairment charge on the company's investment in the subordinated debt of the CLOs it manages. Senior fees on our two CLOs continue to be paid.

Operating expenses for the quarter were $8.7 million compared to $9.8 million in the same quarter of 2008. Lower expense in the second quarter of 2009 was mainly attributable to a reduction in compensation expense following a decline in headcount from a year ago. However, we did increased the rate of which we accrued for incentive compensation from the first quarter of this year.

Our credit protection business did not incur any corporate credit events during the quarter. However, we did pay $3 million in cash to counterparties to settle CBS on ABS credit events that had occurred in prior periods.

Looking at our balance sheet, we had $738.6 million of cash and investments on a consolidated basis as of June 30, 2009. Of this amount approximately $675.6 million was held at Primus Financial. As you know, Primus Financial's credit swap agreements provide for the payment of premiums over the life of these transactions. The counterparties for these applied payments are major banks. Based on the assumption that the credit swaps are held to full maturity, we would anticipate Primus Financial receiving over $230 million of cash in the future based upon the portfolio credit swaps written as of June 30, 2009.

Any future premium cash flows will be affected by any further credit events, credit litigations and changes in the value of the euro on the portion of Primus Financial's portfolio denominated in that currency. We continued the share repurchase program during the second quarter. During the second quarter we spent approximately $619,000 to purchase and retire 317,232 Primus Guaranty common shares at an average price of $1.95 per share. Since inception, our share repurchase program has reduced the outstanding share count by about 12% or 5.5 million shares.

During the second quarter, we also continued to buyback the notes issued by Primus Guaranty and Primus Financial. During the second quarter, we purchased approximately 122,000 Primus Guaranty notes at an average price of $10.66 and a total cost of 1.45 million which enabled us to retire $3.4 million in face value of debt, which resulted in an interest saving of approximately 231,000 on an annualized basis and a net gain on retirement of $1.8 million.

Since the buyback program's inception in 2008 and through to the second quarter of 2009, we have purchased 1.16 million Primus Guaranty notes at an average price of $9.40 and the total cost of $10.9 million. This has enabled us to retire $29.1 million in face value of debt and interest savings of approximately $2 million per annum.

Also during the quarter, Primus Financial purchased $44.6 million of its senior net debt and subordinated debt, at a combined cost of $12.7 million. We purchased this debt following reversing queries from investors. We recognized the net gain of approximately $31.4 million in the second quarter and will save about $1.7 million in annual interest expense at current interest rates, as a result of these purchases.

Now, I'll hand it over to Tom for his perspectives on the market and to discuss the business outlook for Primus in the rest in 2009 and beyond.

Thomas W. Jasper

Thanks Richard and good morning to everyone. I'd like to start today by providing a brief overview of the markets that we operate in. The status of the debate surrounding the regulation of the credit swap market and a progress report on our key business priorities for 2009.

Since our last call we have seen further signs of steady improvement in the credit and financial markets. Stimulus packages by governments around the world coupled with the benign interest rate environment are helping to mitigate some of the decline in economic activity. Government bailout and guarantee programs also appeared to be having a desired effect. The global capital markets are beginning to return to normal, as investors are deploying funds across the investment grade and high yield markets.

In short, confidence is returning to the markets, the VIX or fear index has declined significantly from 68 at December 1, 2008 to 26 at mid-year 2009. There has also been a significant rally in credit spreads, CDX index spreads at June 30th which is a index of credit swap prices on investment grade names now 32% from their peak in March of 2009. This narrowing has continued through July.

Additionally, the S&P/LSTA loan index was up 34.5% for the year-to-date through July 15, 2009. Investor interest in credit as an asset class is on the rise, net inflows of capital to bond mutual funds in the second quarter totaled 81.2 billion compared with 16.4 billion for stock mutual funds. Perhap’s the clearest signs of change in the credit markets can be seen in our own GAAP results.

As we've discussed with you in the past, we expect that spreads would eventually narrow. We also expect that as they did and as the average life of the of our portfolio credit swap shortened, there would be a positive impact on the fair value of Primus Financial's credit default swap portfolio. This is precisely what happened this quarter and as Richard has mentioned, continues in July.

Our GAAP net income in the first six months of 2008 was a loss of 407.5 million and for the first six months of 2009 was 703.7 million or over $1 billion positive swing. Even with these signs of improvement, uncertainly remain the washboard in the capital markets today. Credit spreads while significantly narrower than their widest levels in 2009 continue to imply higher default probabilities in the fundamentals. The creditability of credit rating agencies is less than it was a year or two ago. The cost of capital is high as investors demand higher risk premiums, counterparties remain vary and there are fewer doing business today. Those that remain active are largely focused on strengthening or reducing the balance sheet, increasing capital and reducing leverage.

Another uncertainty relates to the government involvement in the credit default swap market. As you know, there is quite a bit debate on this subject in Washington and other end, other capitals. We recently retained a Washington public correspondent to help us better understand and navigate through all of this.

Our current understanding is that the prospect for some form of CDS legislation is high but that it is unlikely to happen this year. The exact form on that legislation and regulation also remains clear, but its centers on two issues. The first relates to clearing houses; who will use them and what products will be cleared or standard CDS transactions, representing standards CDS transactions versus non-cleared or non standard CDS transaction.

The second relates to capital, what will capital requirements be for cleared and non-cleared transactions. In our view it'll be important for bi-side firms like Primus to have access to clearing houses on an equal footing as other firms and there is a strong push amongst bi-side firms to achieve this goal. I also want to add that this debate and its ultimate resolution should not have any impact on our current credit swap portfolio or on the risk mitigation strategies we employ as it amortizes.

In this market environment, I am pleased with the progress we've made so far in 2009 on our key business priority. As we outlined in our strategic update presentation in February, those priorities include, first amortizing Primus Financial's credit swap portfolio. Second, pursuing new opportunities in credit, structured credit and derivatives markets. Third, efficiently allocating capital and fourth aligning costs with our business approach. Let's look at these in more details, beginning with portfolio amortization.

Primus Financial's credits swap portfolio performed relatively well in the second quarter and so far in 2009. As Richard mentioned we have no credit events in the single name credit swap portfolio in the second quarter. And we've had only one corporate credit events since the beginning of the year. In the broader market, there were by contrast 13 corporate credit events in the April to June quarter and 28 corporate credit events so far this year.

While we are pleased with the performance of the credit swap portfolio in 2009, Primus Financial continues to have exposure to some sectors that are under stress. Including financials particularly in demand lines as well as publishing in retail. We will continue to focus on these sectors over the course of the year.

As you know, earlier this year we asked and received approval from Moody's to withdraw its ratings on Primus Financial. After further consideration and in the second quarter we asked Standard & Poor's to withdraw its ratings. We believe that operating Primus Financial without ratings provides us with added flexibility in managing our credit swap portfolio in amortization and in investing its cash as Richard has mentioned.

To remind you, the goal of portfolio amortization is to unlock the potential embedded value that we see in Primus Financial over its remaining life. Our subsidiary's current credit swap portfolio has a weighted average life of 2.7 years. Our focus is on actively managing the CD of the credit swap portfolio with the objective of improving its performance and reducing the risk of negative outcomes.

As we have discussed, this could include targeted credit mitigation in portfolio repositioning. The credit mitigation transaction that we executed and announced last week shows the strategy at work. It limits our potential exposure to the credit swap written with this institution at a level of segregated capital that both Primus Financial and its counterparty found attractive. And it reduces Primus Financial's exposure to some of the riskiest names at a reasonable economic cost.

Under the agreement, we took about 1.2 billion of the credit swap protection that we have sold to the counterparty and assigned it to a newly formed wholly owned subsidiary of Primus Financial. The new subsidiary was paid an assignment fee of approximately 36 million. Its exposure to the credit default swap contracts with this counterparty is limited to the 36 million plus future premiums. The swaps that we assigned have an average life of 2.3 years.

After maturity any remaining capital on the subsidiary will be returned to Primus Financial. To the extent that our assessment of the risk in this specific portfolio of credit swaps is correct, we believe there will be capital remaining in this subsidiary. It's important to note that the counterparty has no further claims on Primus Financial's capital.

We also terminated with the same counterparty 40 million notional of CDS written mostly on a mono-line reference entity. In exchange for agreeing to this termination, we paid a fee of $15 million to the counterparty. We believe that this is a favorable transaction overall for both Primus Financial and its counterparty. We are pursuing other risk mitigating transactions with a handful of counterparties which we believe, makes economic sense. We will keep you informed of future developments.

Let me turn next to the second business priority pursuing new opportunities in the structural credit markets. Our goal is grow Primus Asset Management's assets under management to achieve the scale and scale we need to generate attractive returns for investors.

During the second quarter, Primus Asset Management was managing two CLOs and three CSOs. Our CLOs consisted primarily of non-investment grade senior secured corporate loans. During the quarter, we saw some deterioration in these two Primus managed CLOs including actual defaults in the portfolio as well as negative rating migrations. This impacted the fees we received from managing these portfolios as Richard has mentioned.

Recently however, the loan market has experienced a healthy rally with prices generally improving across the board. This has provided Primus' Asset Management with the opportunity to improve the overall quality of its CLOs and in one case we are again starting to receive some of the subordinated fees. We are very focused on continuing to improve portfolio quality with the goal of receiving all of the subordinator fee.

Towards the end of the quarter, I was pleased to announce an important addition to our asset management business and capability. As you no doubt know, we acquired Cypress Tree Investment Management which manages $2.4 billion in leverage loan and high yield bonds in a variety of investment products including Collateralized Loan Obligations or CLO and Collateralized Swap Obligations or CSO. With this acquisition, Primus Asset Management's non-investment grade assets under management grew from 800 million to 3.2 billion. The transaction will enable us to begin to achieve the economies of scale we are looking further build a robust loan and high yield platform.

Cypress Tree like Primus is a fundamental credit investor. As we have said, we both rely on our own in depth analysis underwriting and ratings criteria when we assess a credit and to determine the optimal risk adjust to return profile. This approach will remain a defining part of our company as we move through and out of today's volatile credit environment.

Cypress Tree also brings to Primus, an experienced credit team and culturally, the two companies are an excellent fit. As a result of this acquisition, Primus Asset Management is now a leading manager of high yield structured assets. This will position us well for the future. Primus Asset Management is now managing over 25 billion in assets under management including the $21 billion notional credit default swap portfolio Primus Financial product as well as eight CLOs, with 3.2 billion in assets and five CSOs totaling 857 million in underlying capital. We believe there are additional opportunities ahead to further grow our asset management business. Some of this growth maybe through acquisitions such as Cypress Tree. There are other attractive acquisition opportunities acquiring either assets or contracts or companies, and we're sharply focused on exploring them.

Some of the growth that we're planning in our asset management business will also be organic. In our view, the evolving credit market environment and likelihood of a protracted credit cycle creates significant opportunities for an established manager, such as Primus Asset management. We intend to develop and launch structured credit vehicles who take advantage of our unique skills at cross asset classes. We're currently considering for example different types of credit funds that would be managed by Primus Asset Management utilizing our expertise and investment grade and high yield corporate credit.

As I mentioned during our last call over the course of 2009 we've been exploring and discussing with counterparties the idea of forming a new Primus sponsored long-term seller credit protection. It's clear that in today's environment such a vehicle would need to operate at relatively lower levels of leverage and would also need the post collateral.

Over the course of the year we have tested this concept by constructing and managing a $1 billion notional test portfolio. The results of this portfolio have to date and encouraging. We believe that a new credit protection seller can capture a solid market niche and generate attractive return. We're discussing our strategy with potential investors and counterparties and are encouraged by the dialogue to-date. This is obviously a longer term initiative and much depends on the state of credit markets, financial systems and global economy.

I would also like to read the comment on the third business priority that we identified and outlined in our strategic update. Our goal is to be affective and that was to be affective stewards and allocator's of Primus's Capital. We've recognized that with the finite amount of capital we need to deploy and ways that offer the most value to our shareholders.

As we have said, this means using our capital on one of three ways. Number one, repurchasing Primus Guaranty equity; number two, repurchasing the debt of Primus Guaranty and three, funding the growth of our company. Effective deployment of Primus Guaranty's capitals, one of management's most important responsibility and its one that we spend a considerable amount of time on.

I expect that we will continue to be opportunistic in our approach to equity and debt repurchases. Certainly we have sufficient authority on our current plans to repurchase additional Primus Guaranty equity and debt. It's important to realize that our ultimate focus here is on optimizing value for shareholders and it's to our advantage to have a flexibility to capitalize on opportunities that arise from time to time.

We are also active in the quarter in utilizing Primus Financial's capital to buyback its debt and preferred securities. We will continue to be active at Primus Financial as opportunities arise. We continue to believe that there can be an attractive use of Primus Financial's capital as it's -- we continue to believe that this can be an attractive use of Primus Financial's capital as its portfolio amortizes.

During the second quarter, we also allocated capital to support our growth strategy through the Cypress Tree transaction. This is indicative of the type of acquisition we are interested in. It clearly complements our existing franchise, at size and scales and it is a seamless cultural fit. We believe that it like any further acquisitions adds tangible value to our shareholders.

I am pleased with the progress we've made in implementing a new investment policy for Primus Guaranty and Primus Financial. We've been discussing this for the past few quarters and in the second quarter we began to implement our approach. We expect it will enable us to generate better returns on our cash investments in the future.

Let me sum up by saying that we remain committed to executing our 2009 business priorities. Overall conditions in the credit markets remain uncertain, but generally appear to be improving. We are pleased with the progress we've made to-date but at the same time we know that there are opportunities and challenges ahead.

Thank you very much for your time and now Richard and I will take your questions.

Question-and-Answer Session


(Operator Instructions).

Richard Claiden

I guess if there are no questions, we will end the call. And again thank you for your ongoing support for the company and we look forward to speaking with you at the end of the next quarter.

Thomas Jasper

Thank you.


Thank you for your participation in today's conference. This concludes your presentation and you may now disconnect. Have a great day.

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