Primus Guaranty, Ltd. Q3 2009 Earnings Call Transcript

Nov. 4.09 | About: Primus Guaranty, (PRSG)

Primus Guaranty, Ltd. (PRS) Q3 2009 Earnings Call November 4, 2009 11:00 AM ET


Richard Claiden - CFO

Tom Jasper - CEO

Chris Gerosa - Treasurer

Nicole Stansell - IR Officer


Good day, ladies and gentlemen, and welcome to the Third Quarter 2009 Primus Guaranty Limited Earnings Call. My name is Eric. (Operator Instructions)

I would now like to turn the presentation over to your host Mr. Richard Claiden, Chief Financial Officer. Please proceed.

Richard Claiden

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 will review our financial statements for the quarter and discuss events following the post of the quarter. Tom will follow with the discussion of these structured market credit environment and provide an update on the progress, we have made on our business priorities and strategic initiatives. 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 on this call, particularly those anticipating future financial performance, business prospects, growth in 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 result could differ materially from those anticipated in forward-looking statements and our future results could differ materially from historical performance.

For discussion of the factors that could affect our results please refer to the risk factors identified in our filings with the SEC. Now in discussing our financial results, I will refer to the earnings release and the supplementary information package, which will both published earlier today and which contain the reconciliation from GAAP to economic results. I will begin by discussing our GAAP results and economic results for the past quarter.

Our GAAP net income was $461.5 million for the third quarter of 2009, or $11.14 per diluted share, compared with a net loss of $390.2 million, or $8.63 per diluted share for the third quarter of 2008.

Our GAAP income from the quarter was primarily driven by unrealized mark-to-market gains on Primus Financial’s credit swap portfolio. Most specifically, declines in the market credits swap premium levels coupled with the reduction in the average remaining tenor of the portfolio resulted in favorable mark-to-market and favor movements in the mark-to-market value the Primus Financial’s credit swap portfolio, the $471.5 million in the quarter.

Our economic results for the quarter was a loss of $9.6 million, or loss of $0.23 per diluted share compared with an Economic Results loss of $62.1 million, or $1.37 per diluted share in the third quarter of 2008.

Economic Results in the 2009 third quarter includes premium income of $21.9 million offset by $21.5 million of credit mitigation payments and operating expenses of $11.2 million. The $21.5 of credit mitigation payments was related to two transactions completed during the quarter. Subsequent to the end of the quarter, we also entered into a third credit mitigation transactions.

Let me take moment to walk you through these three transactions, each with a separate counterparty. In the first transaction Primus Financial terminated certain higher risk credit swaps chiefly referencing monoline insurers at a cost of $15 million, a price below their current market value, the remainder of the counterparty’s credit swaps were assigned by Primus Financial to a separate newly created subsidiary.

Primus Financial paid an assignment fee of $36 million to its subsidiary which in fact capitalized the vehicle. The subsidiary will continue to collect premiums on the assigned swaps and will earn interest on its invested capital. The counterparty may make claims on the capital of the subsidiary if there are credit events on the swaps in the assigned portfolio, but has no further claims on Primus Financial’s capital.

In the second transaction, Primus Financial paid $6.5 million for counterparty to terminate that counterparty's entire 1.3 billion in notional terms portfolio a single name swaps which we believe to increase certain higher risk reference entities and which had a longer than average remaining maturity. The $6.5 million termination payment was significantly below the current mark-to-market value of the portfolio.

Since the end of the third quarter we’ve entered into a third risk mitigation transaction with our largest counterparty. In this transaction the counterparty's entire portfolio of credit swaps which comprised $2.65 billion of dispelled [contra] transactions and approximately $250 million of single name credit swaps was assigned to a separate newly created subsidiary of Primus Financial. As a result of the assignment the counterparty will have no further claim on Primus Financial’s capital.

Primus Financial has paid an assignment fee of $100 million to the subsidiary. The subsidiary has agreed with the counterparty that all the single name swaps would be terminated and that the dispelled tranches would be -- transactions would be restructured. In the tranch restructuring notional principal is reduced to $1.75 billion and the attachment points on certain at the restructure transactions are increased. Also, as a result of the restructuring, future premiums on the restructured portfolio will be reduced by approximately $15 million.

The subsidiary has paid $10 million to the counterparty in connection with the single name terminations and the tranch restructuring. We believe that these three transactions and similar risk mitigating transactions will reduce the overall risk in the portfolio and help us to preserve Primus Financial's capital.

Now let me turn back to Primus Financial's performance during the third quarter of 2009. Primus Financial's credit swap portfolio totaled $19.6 billion as of September 30, 2009, down from $22.5 billion at the end of the 2008. The reduction in notional was mainly attributable to maturities of $1.9 billion during the first nine months of 2009 and terminations of $1.3 billion principally related to the credit mitigation transactions.

After completing the third risk mitigation transaction, which took place after the end of the quarter, the portfolio notional will drop to $18.1 billion. Primus Financial did not write any new credit swaps during the third quarter.

Credit swap premium income for the quarter was $21.9 million compared with $24.4 million in the third quarter of 2008. The decrease in premium is mostly attributable to the lower principal amount on the portfolio in the third quarter of 2009.

During the quarter, Primus Financial did not experience any credit events in its single name portfolio. However, as you probably know earlier this week CIT filed the bankruptcy. Though we have over the past several months work to reduce our exposure to this reference entity at the time of CIT’s filing we did have net single name exposure to CIT of approximately $15 million.

Based on the information to-date, we anticipate there will be a recovery in the range of 60% to 70% on this reference entity, which will limit our net cash payment to $5 million to $6 million.

Interest income for the third quarter of 2009 was $1.2 million compared with $6.2 million for the third quarter of 2008. The decline in interest income was mainly a result of lower interest rates and lower investment balances. The average rate earned on our investment portfolio was 67 basis points in the third quarter of 2009, compared with 2.77% in the third quarter of 2008.

A significant portion of the investment portfolio was held in money market accounts, which yields that significantly during the course of 2009. One of our goals is to increase the return on our investment portfolio and we have taken steps in that direction by replacing some of the money market balances with investment grade corporate securities.

During and subsequent to the third quarter of 2009, we have invested approximately $250 million in selected investment grade corporate bonds with tenors in the one to five year range. The weighted average yield on this investment portfolio is 2.49%.

Turning now to corporate to interest expense, consolidated interest expense and distribution on our preferred securities was $2.8 million in the third quarter of 2009, compared with $5.4 million in the same quarter of 2008.

The reduction in financing costs was primarily a result of lower LIBOR interest rates and reduced level of debt due to outstanding, due to our repurchases. The average effective rate on our debt and preferred securities was 3.14% for the third quarter of 2009, compared with 5.06% in the third quarter of 2008.

Included in the company's capital structure debt issued by Primus Guaranty and Primus Financial debt and preferred securities. Let's take a look at these components more closely.

Firstly, the company issued $125 million in long-term fixed rate debt in 2006. Today we have purchased and retired approximately $30.4 million of this debt leaving $94.6 million outstanding.

We swap $75 million of the company's or Primus Guaranty's debt from the fixed to a floating rate, which is reduced to all-in interest rate on the outstanding debt to 2.7% during the third quarter.

Turning to Primus Financial's Capital you may recall that Primus Financial’s debt and preferred securities were issued in the auction rate securities market, which is not been functioning normally since the fall of 2007.

Primus Financial currently pays the contractually specified maximum spread rates of one month LIBOR on the securities. The average of maximum spread rate on Primus Financial's paper is approximately 3%, which means that for practical purposes we believe we have very inexpensive long-term debt and preferred capital.

As previously announced on our last call, we closed the acquisition of CypressTree Investment Management on July 9, 2009. The CypressTree acquisition added approximately $2.4 billion in assets under management through six Collateralized Loan Obligations or CLOs and three Collateralized Swap Obligations or CSOs and some separately managed accounts. Our asset management fees would be primarily for managing the CLOs and CSOs of $1.3 million from the third quarter compared with $1.1 million in the third quarter of 2008.

CypressTree itself contributed $890,000 of fee income in the third quarter asset management fees. During the third quarter of 2009, we did not receive subordinated fees from certain CLOs under management as the fees have been deferred pending cure of certain tests under the CLO indentures. These subordinated fees maybe recruit later depending on the performance of the CLOs, who [were] not recognizing this income until it becomes collectable.

Our operating expenses for the quarter were $11.2 million compared with $4.3 million in the same quarter of 2008. This change was mainly attributable to an increase in the provisions of variable compensation. In the third quarter of last year the loss of reduction in the provision for variable compensation and this has reversed itself in the third quarter of 2009 when we had an increase in the provision for variable compensation.

Our operating expenses also increased to some degree due to the additional costs related to the CypressTree acquisition and legal and professional fees associated with the credit mitigation transactions which I mentioned earlier.

Looking now at our balance sheet, we have $747.5 million of cash and investments on a consolidated basis as of September 30, 2009, of this amount approximately $690.5 million was held by Primus Financial and its subsidiary.

As you know, Primus Financial’s credit swap agreements provide for the payment of premiums as well the life of these transactions. The counterparties to these agreements are major banks. Based on an assumption that credit swaps are held to full maturity, we would anticipate Primus Financial receiving approximately $185 million in future credit swap transactions after completing the third risk mitigation transaction, which I mentioned earlier.

Of course future premium cash flows maybe affected by any future credit events, credit mitigations and changes in the value of the euro. We continued the share repurchase program during the third quarter 2009 and spent approximately $3.2 million to purchase and retire 950,000 Primus Guaranty common shares at an average price of $3.36 per share. Since inceptions our share repurchase program has reduced the outstanding share count by 14% or 6.5 million shares.

We also continued the buyback of Primus debt securities during the third quarter of 2009 and purchased approximately 52,000 Primus Guaranty notes at an average price of $11.88. This enabled us to retire $1.2 million in face value of debt at a cost of 618,000 which resulted in a net gain on retirement of $643,000 and an interest saving of approximately $91,000 per annum.

Since the buyback program’s inception in 2008 through the end of the third quarter, we have purchased 1.3 million Primus Guaranty notes at an average price of $9.46 and a total cost of $11.50 million. This has enabled us to retire $30.4 million in face value of debt at an interest saving of approximately $2.1 million per annum.

In addition on a like to-date basis, we have purchased $44.6 million in face value of Primus Financial's debt at a total cost of $12.7 million, which generated realized gains of $31.9 million and interest savings of approximately $1.5 million per year.

Now, I will hand you over to Tom for his perspectives on the market and to discuss our strategic plan and initiatives.

Tom Jasper

As Richard has detailed our financial results, I would like to step back and focus on our strategy and the steps we have taken to execute it during third quarter and the first nine months of 2009. Earlier this year, we outlined that strategy and its key elements for you.

As the year progress and as the new dynamics of the credit markets became clear, we refine the strategy into a three year plan. Our basic Primus both then and now remains the same. We believe there are significant value in the Primus franchise in terms of its reputation, expertise, relationships and the business that we have built since up, since its inception.

This platform should enable us to build a strong, resilient, responsive, credit oriented business one that can prosper in the new market environment and that we will remain focus on credit protection, credit asset management and capital allocation.

Well, now that we have completed the third quarter it seems sure to ask, how we doing? I think the short answer is, our company has done well in 2009 particularly given economic and credit market conditions.

Consider that during the first three quarters of 2009, we have increased our economic results book value by 20% on a per share basis from $7.60 to $9.14 per share. I think this compares favorably with other financial institutions.

We have also made solid progress on our key priorities. We have for example improved the risk profile of our credit protection business completing a series of risk mitigating transactions. We are discussing the third of these transactions for the first time on our call this morning.

We have also worked to build our asset management business. During the quarter we closed on the acquisition of CypressTree a leader in leverage loan and high yield asset management. We have effectively allocated our own capital both support our growth and to return value to shareholders through equity and debt repurchases of Primus Guaranty and Primus Financial Securities.

We intent to stay focused on additional opportunities in this area. While I think this performance is good on a relative basis by no means, do I want to suggest that we are anywhere near where want to be or where we need to be. We have a tremendous amount of work ahead to execute on our strategic plan over the next three years.

Fortunately, that appears that we will be helped rather than hindered by generally more favorable conditions. The global economy and financial markets as well as the credit markets are trending more positively as we start to pull out of the deep recession.

I am sure you all remember that it was only four to five quarters ago, that we experienced one of the most volatile and chaotic periods ever in the financial markets. During this time the credit markets basically froze and governments around the world announce plans to bailout guarantee or inject liquidity into the markets.

Since then we have seen a gradual falling of the credit markets, that improvement continued in the third quarter and so far in the fourth.

Interest rates generally and LIBOR rates specifically have remained very low, the VIX Volatility Index returned in September to its long-term average level, indicating that the market does not currently see significant stress in the system.

The investment grade CDX indices reached their lowest levels of the year, leverage loan and high yield debt experienced strong rallies during the period. In the last few days, however, we have seen an uptick in some of these indices which I believe shows increased anxiety around the economic outlook and portending a reduction of liquidity around the year-end.

Several statistics have also pointed to a leveling or a decrease in corporate defaults, the more favorable environment led to a significant and in some cases record increase in debt issuance across the spectrum of credit quality. Much of this capital markets activity was driven by our desire to raise capital at very attractive interest rates levels and repay our refinanced debt.

Taking together the evidence overall seems to indicate that credit oriented investors are returning to the market and they’re appetite for risk maybe returning to more normal levels. Investment grade high-yield on loan mutual funds continues to see net weekly inflows. As I mentioned, demand rose to meet the significant increase in the supply of debt issued during the quarter and throughout the year.

So we hope these more positive market conditions continue, there is no question that these improvements accompanied by lower perceptions of risk have helped us throughout the year. In the third quarter we once again reported sizable GAAP earnings relating primarily to a decrease in credit spreads.

Importantly, we are pleased to report that we did not experience any single name credit events in Primus Financials credit swap portfolio during the quarter. As Richard noted, we do have some exposure to CIT which filed for bankruptcy this week. Including CIT, it’s worth noting that Primus Financial has experienced only two corporate credit events in its single name credit swap portfolio so far this year.

According to the Industry Trade Association, ISDA there have been over 30 credit events across the credit markets in 2009 with five coming so far in the second half. As the credit markets continue to normalize we expect to remain focused on executing our key strategies. First among these is actively managing Primus Financial's credit swap portfolio.

While I am please with Primus Financial's performance this year, there continue to be reference entities in its portfolio that are under stress or monitoring these things closely and we’ll take action as appropriate. Since the end of the second quarter we have entered into three credit risk mitigation transactions with our counterparties.

Richard has provided you with the specifics and I want to spend some time explaining why these are important transactions for shareholders. Let me step back for a moment and repeat what I said in our second quarter call about our approach to managing Primus Financial and amortization.

At that time in August, we have just announced first of three transactions that we have entered into so far. I said then that the goal was to unlock the embedded value in Primus Financial's portfolio, improving its performance and reducing the risk of negative outcomes. So have these three transaction has helped us achieve our stated goal?

To begin with, they have enabled Primus Financial to address certain concentration issues in a small number of higher risk sectors, in insurance, building development and retail among others. We have, for example, reduced our overall monoline exposure. Second, the price we paid to terminate the contracts was substantially less than their market value.

Third, on the two transactions that involved setting up new Primus Financial subsidiaries, we were able to cap Primus Financial's exposures to those transactions by segregating part of its capital at a level that both Primus Financial and its counterparty found attractive.

And added benefit is that any capital remaining at the final maturity of the credit swaps in these two subsidiaries will be return to Primus Financial. What downside? If anyone there to these transactions for one they negatively impacted and resulted in charges against our economic results. You can see this reflected on our third quarter earnings.

In addition, we do lose the future premiums from the contracts we terminated and we will generally receive somewhat lower premiums from the transactions assign to Primus Financial subsidiaries.

I continue to believe however, that any negatives are more than offset by the positive impact these transactions should have on the ultimate value of Primus Financial, as it amortizes its portfolio. They have clearly enabled Primus Financial to improve its risk profile by either terminating or capping its exposure at attractive price levels.

We continue to work on other credit risk mitigating transactions and we will keep shareholders informed. Beyond their immediate value to Primus Financial's credit swap portfolio these transactions also signify two broader points.

The first is that counterparties continue to see value in working with Primus. I believe this reflects our strong reputation in the credit markets and future business opportunities. Second, the transactions also indicate that our counterparties' large global financial institutions continue to want and need ways to reduce their credit and counterparty risks.

There have been a number of recent public policy reports and industry comments on the increased concentration at counterparty risk among the largest firms. With credit derivative product companies such as Primus Financial and other types of in risk taking counterparties no longer and active in the market. The large dealers are forced to hold more risk and increased their transactions with each other as they try to manage their risk. Neither of these alternatives is attractive to either bank credit portfolio managers or policy makers and a central clearing house may help that will not solve the problem.

That is why we continue to believe there is demand in the marketplace for a long-term investor and credit risk, and as why we continue explore different avenues that are potentially opened to vast to structure and bring to the market a seller of credit risk protection.

As we do so, we have recognized that the old credit derivative product company model will not work in today’s environment. Credit swap dealers for better or worse require their counterparties to be collateralized, they also place relatively less emphasis on credit ratings and rating agency capital models. Also as regulated entities, bank counterparties will be more comfortable transacting with another regulated entity.

These issues are however not (inaudible). Our internal research indicates that even in this new environment, the economics are selling credit protection could be very attractive to our shareholders.

For this reason we brought on board as an advisor a very experienced executive with a strong capital market and insurance background to help us navigate through and potentially develop a new credit protection provider. We will continue to keep you updated on our progress in this area.

Turning now to our asset management business, as I mentioned we closed on the CypressTree acquisition during the quarter and completed its integration in the Primus Asset Management.

CypressTree significantly strengthens our platform in the leverage loan and high yield debt markets. These are our investment classes that we believe will continue to be important components of the capital markets.

As I noted earlier, these markets have shown very strong performance so far in 2009. Primus Asset Management now ranks as one of the larger structured credit managers in the country with over $20 billion in assets under management. The company is managing eight CLOs that totaling $3.2 billion in assets, five CSOs totaling $800 plus some separately managed accounts. This is in addition to managing Primus Financial's $20 billion consolidated CDS portfolio.

We are now moving quickly to leverage our strengths in asset management. We have for example developed two new fund offerings. One of these is a balanced credit portfolio of fund. Its portfolio will comprise both long and short individual corporate credit investments via highly liquid corporate bonds and single name credit swaps. The other fund is a credit opportunity fund that we’ll invest primarily in non-investment great corporate investments, including bonds and loans.

Primus Financial has been authorized to invest a modest amount of seed capital in both funds, so that they may begin operations with the goal of attracting third party capital early next year. Toward that end, we are in the process of analyzing and reviewing various options for broadening and strengthening our reach into the investor community. We are further extending our asset management platform with the addition of a new senior portfolio manager with significant experience and a track record in managing investment grade bond portfolios as well as long short credit portfolios.

This is in addition to the two senior portfolio managers and four credit analysts that joined Primus Asset Management with our acquisitions of CypressTree. We are also continuing to pursue additional acquisition opportunities of credit asset managers. As we expected at the beginning of the year, the credit asset management business is undergoing a period of consolidation.

We believe we are an attractive suitor for smaller firms or manager teams wishing to join and help build a strong focused asset management platform. A case in point Primus Asset Management is one of the few asset managers that have actually been able to complete a transaction this year. It's obviously too early to go into more detail here, but at this point it's fair to say that we do expect that we will benefit from industry consolidation.

The last leg of our growth strategy involves allocation of capital. If you look back over the past nine or 12 months you can see that we have been very selective in how we use capital. In several instances, we thought it made sense to lower the risk exposure for our CDS portfolio and we have used Primus Financial's capital to do that.

In another instance it made sense to use Primus Guaranty's capital to acquire complementary CLO manager. In several other times it made sense to acquire Primus Guaranty and Primus Financial debt preferred and/or common equity. I think we will continue on this track remaining opportunistic and moving quickly when we see the potential to significantly build value.

I would like to end my remarks with a brief comment on the current public policy climate in Washington and Europe. It’s probably no surprise to anyone on this call that the [clamor] for derivatives regulation is high right now. While it's likely that there is a long road ahead before any new laws are enacted, it also seems fairly certain that some formal legislation will be passed.

I often get asked how we think this perspective legislation might affect Primus. It's obviously difficult to say at this point, although it will likely impact some of the credit swap related businesses we may set up in the future. But I can say this, nothing that we have seen so far gives us any indication that Primus Financial's current credit swap business might be impacted.

We have every expectation that Primus Financial’s portfolio in its current state would not be affected. We would continue to receive premiums from counterparties in return for providing protection as that company amortizes it's portfolio over the next few years. I also believe that in any perspective derivatives legislation will not change their market dynamic that large financial institutions will need to manage the credit risk in their portfolio.

For three decades now banks have moved away from making money on spreads to pursue and originate and distribute model, that’s partly because of changes in the marketplace and partly because of economics. I don’t see this trend reversing and as a result, I think they will continue to look for counterparties that can analyze price and the hold the risk that they originate.

In addition, I believe there are significant regulatory pressures on the global banks to get out of certain businesses. We are focusing our strategy on these changes and this is a guiding principal for us as we try to position the firm to take advantage of the opportunities ahead.

In sum, let me say that we are generally pleased with our financial and operating performance so far this year. We are executing against our strategy and are making progress in several key areas for managing our credit swap portfolio to building asset management to allocating capital.

The market environment is turning more positive which should benefit us as we work to increase value for shareholders. We know the challenges remain, but we believe we have the right strategy and the right people in place to meet them.

Again, thank you very much for your time and now Richard and I would be happy to take any questions.

Question-and-Answer Session


(Operator Instructions)

Thomas Jasper

I guess, if there are no questions, then we look forward to speaking with everybody at our year-end call which will be in early February. So thank you very much for your time today. And we look forward to that call. Thank you.


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

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