Primus Guaranty Q3 2007 Earnings Call Transcript

|
 |  About: Primus Guaranty, Ltd. (PRSG)
by: SA Transcripts

Primus Guaranty Ltd. (PRS) Q3 2007 Earnings Call November 6, 2007 ET

Executives

Richard Claiden - CFO

Tom Jasper - CEO

Chris Gerosa - Corporate Treasurer

Nicole Fatica - IR

Analyst

Ken Zerbe - Morgan Stanley

Darrin Peller - Lehman Brothers

Geoffrey Dunn - KBW

Mark Lane- William Blair

Gregory DiMarzio - Century Capital

Greg Eisen - ICM Asset Management

Operator

Good day ladies and gentlemen, and welcome to the ThirdQuarter 2007 Primus Guaranty Earnings Call. My name is Coressa and I will beyour coordinator for today. At this time, all participants are in a listen-onlymode, we will be facilitating a question-and-answer session towards the end oftoday's conference. (Operator Instructions).

I'd now like to turn the presentation over to your host fortoday's conference Mr. Richard Claiden, Chief Financial Officer. Please proceedsir.

Richard Claiden

Thank you, Coressa. Good morning ladies and gentlemen,welcome to our quarterly earnings call. I am Richard Claiden, Chief FinancialOfficer for Primus Guaranty, and with me is Tom Jasper, Chief ExecutiveOfficer, Chris Gerosa, our Corporate Treasurer and Nicole Fatica, our InvestorRelations Officer.

I'll begin the call, discussing the Company's overallfinancial results for the quarter and current portfolio size, later focusing onour financial results for the quarter in greater detail. Tom will then give hisperspective on the third quarter, the market and business developments sinceJuly and provide discussion of our business outlook. I will follow Tom bydiscussing the company's overall financial results for the quarter.

Some of the statements included in our discussion,particularly those anticipating future financial performance, businessprospects, growth and operating strategies and similar matters areforward-looking statements that involve a number of risks and uncertainties.For those statements, we claim the protection of the Safe Harborfor forward-looking statements contained in the Private Securities LitigationReform Act of 1995. For a discussion of the factors that could affect ouractual results, please refer to the risk factors identified in our 10-Q.

We expect to take about 30 minutes to complete our sections,and then plan to open the call for your questions. In discussing the results,I'll refer to both, the earnings release and supplementary information package,which were both published earlier today and contain the reconciliation fromGAAP to economic results. I will focus on our economic results while I alsorefer to our GAAP results.

As many of you know, we derive our economic results byexcluding from our GAAP income, the unrealized gains or losses on our portfolioand credit swaps sold in private by Primus financial products at any realized gainson the early termination of credits swaps sold, although those gains areamortized into economic results of the original lives of the terminatedcontracts.

Our economic results for the third quarter of 2007 were$12.6 million or $0.28 per diluted share, compared with $12.7 million or $0.29per diluted share in the same quarter of 2006. During the quarter we generatedhigher credit swap premium income, higher CLO, CDO asset management fees andnet interest income compared with the year earlier period. In credit, this waspartially offset by loss at our credit, Harrier Credit Strategies Fund.Harrier's results reflected trading loss of $6.5 million in the fundsinvestment portfolio, resulting from volatility and de-liquidity in the creditmarkets. The company's operating expenses for the quarter were practically flatfrom the year and a year period.

Turning to our credit protection business, as of September30th 2007, Primus Financial's portfolio and credit swaps sold including singlename credit swaps, tranches and credit swaps on asset-backed securities was$24.4 billion in total with a weighted average premium of 44 basis points andA/A3 rating and the remaining tenor of 3.7 years.

We sold $2.8 billion of new credit swaps in the quarter.This represents the highest level of new transactions since becoming a publiccompany in 2004. These new transactions would generate over $65 million infuture premiums, assuming the contracts are held to term.

Breaking the new transaction volume in two components, wesold $2.2 billion in single name credit swaps with a weighted average premiumof 41 basis points, a weighted average rating of A+, A/A2 and an average tenorof 5.1 years.

New tranches transactions in the quarter total $600 million,with the weighted average premium of 60 basis points, weighted average ratingof AAA and an average tenor of 7.1 years.

New transactions volume for credit swaps on asset-backedsecurities in the quarter was $5 million with the weighted average rating ofAA-, A2 and weighted average premium of 280 basis points.

Our GAAP net loss for the third quarter of 2007 was $128.4million compared with net GAAP income of $23.7million in the third quarter of2006. The major contributor to the GAAP results in this last quarter was anunrealized mark-to-market loss of $140 million in Primus Financial Productscredit protection business. This loss was primarily attributable to the generalincrease in market premium levels during the quarter.

As many of you know, when market credit spreads widen, thelikely result is an unrealized losses in our credit swap portfolio, resultingin diminished or a negative GAAP net income. However, quarterly fluctuations inthe value of a credit swap contract will net out to zero if the contract isheld to maturity. In addition, as credit spreads widen, Primus Financials' newbusiness activity will be written at higher premium levels.

At quarter end, the fair value of Primus' credit swapsportfolio was a negative $128 million, broken down as follows: single name creditswaps and unrealized losses, $13 million; tranches and unrealized loss of $86million and CDS on ABS credit swaps on asset-backed securities and unrealizedloss of $29 million.

It’s important to bear in mind that GAAP results have noimpact on Primus' AAA ratings. Our rating agency capital models, our cash flowmodels and unrealized gains on losses in the portfolio do not impact thecapital base supporting them. Also, in our credit protection business, we donot post collateral, and Primus Financial does not face margin calls or provideratings triggers.

I hope this information is helpful in understanding Primus'third quarter performance.

Now, Tom will discuss our business strategy and performancein greater detail.

Tom Jasper

Thanks, Richard. Good morning, everyone. During the thirdquarter, our business performance and financial results were mixed, reflectinga very challenging credit market environment. Out credit protection businesshad a very solid quarter with strong growth in new transaction volume andportfolio size. Our Harrier Credit Strategies Fund, however, had a difficultquarter and did not perform according to plan.

As announced in our earnings release, given the challengesof toady's credit markets and the difficulties of raising third-party capitalfor the fund, we have decided to discontinue its operations, which will free upcapital to invest in the growth of our credit protection business.

Now, prior to commenting in detail on our business lineperformance and our strategic priorities, I would like to discuss the currentmarket environment, given its impact on our business.

Anyone following the financial markets over the last fourmonths is more than aware of the impact that recent credit dislocations has hadon financial institutions. The level of anxiety in illiquidity, which beganearly in the quarter, led to a re-pricing of credit risk across a number ofsectors in the credit markets.

One indicator of this re-pricing of risk was performance ofthe Dow Jones investment grade index. It practically doubled at its peak from41 basis points at the end of June to 81 basis points at August 3rd and thensubsequently settled back to levels in the mid 50's by the end of the quarter.Many of the largest participants in the credit markets, the dealers and banks,took large charges across their portfolios of structured credit assets.

There were periods where there was a complete lack oftrading activity and liquidity in various sectors of the markets. The FederalReserve cut rates twice since the end of the second quarter. Stock markets werevery volatile. I can go on and on, but it's fair to say that navigating throughthe series of market events has been a challenge for us, but it has alsooffered us opportunities.

I believe we demonstrated during the quarter that we arewell positioned to capitalize on a widening in credit spreads as we saw asignificant acceleration in new transaction volume in our credit protectionbusiness at much more attractive levels.

Much of our activity during the quarter was focused on thosesectors that were impacted by the credit crisis, particularly financialinstitutions and dealers. We did not see a broad widening across globalcorporates, although that has started to change recently as announcements of disappointingthird quarter earnings have become more pronounced.

There were no new announced LBOs during the quarter, and therisk to us associated with the leveraging of the corporate balance sheet hasbecome less of a factor in managing our portfolio. Yet, the recent completionof last debt transactions for some LBOs indicates that the capital can beraised to support these transactions. So we continue to be mindful of the risk.

Our credit mitigation charges were quite limited in thequarter and certainly below the historical two basis points or total notionalwe had taken in the past. As you know, we managed the business for the longterm, and we continue to use the range of five to seven basis points for creditmitigation charges for our business planning purposes.

We continue to be very disciplined in the quarter inresponding to what we believe is a riskier market environment and our view thatcredit fundamentals are likely to deteriorate in 2008.

As in the second quarter, we focus most of our activity onhigher-quality corporate reference entities rated A+ and better, which offeredvery attractive risk returns. This is also the reason why the weighted averagepremiums on our new transaction volume did not show the same sort of increasethat you might have expected using index levels as a point of reference. Overthe past two quarters, I am very pleased that we have been able tosignificantly improve overall portfolio quality to a solid A/A3.

Much of our new transaction volume in the quarter was in singlename credit swaps versus tranches. Essentially, this was the reverse of what wesaw in the second quarter during which we had relatively more tranche activitythan single name activity.

Part of the reason for the change in tranche versus singlename volumes was due to illiquidity and volatility in the tranche marketsduring the period which made price transparency and the ability to execute atmarket levels very difficult.

Tranche activity volume was more than offset by increaseddemand from a broad universe of credit protection buyers on single name creditswaps. I believe this continues to show the results of steps we have taken overthe past of couple of years to enhance our talent pool and operatingflexibility so that we can offer a broad range of credit protection products toour customers.

I believe it is very important for us strategically, in ourcredit protection business, to have the ability to move between tranches andsingle name credit swaps depending upon the market opportunity and demand.

I have spoken to you on a number of occasions about the riskto our growth strategy including access to capital and counterpart thecapacity. Our ability to manage these two issues becomes paramount in a periodlike the third quarter, as we want to have the ability to grow our creditprotection business when the risk returns are most attractive.

Let me start with our capital position. Primus Financialcurrently has in excess of $675 million in capital, which under our 35 to 1leverage ratio, means that it could support our portfolio well above itscurrent level. I want to note here that at the 35 to 1 leverage, we would stillbe maintaining a significant capital cushion that is substantially beyond thelevel require by the rating agencies for our AAA ratings. Based on our currentforecast, our current capital base plus the additional capital injection fromDecember premium payment, will certainly allow us to grow the portfolio throughthe first quarter of '08, and perhaps longer depending, of course, upon themarket opportunities.

As you know, we do manage our business for the longer term,so we are also looking out past this timeframe. We have initiated discussionwith our investment bankers to help us analyze and address capital raisingopportunities. Unfortunately, in the current market environment, there are noclear answers from our bankers on when we could raise the capital, in what sizeor what it would costs. This is clearly a risk to our growth strategy and issignificantly factored into the very difficult decision we made regardingHarrier, which I will address in a moment.

As for the other risk to our long-terms growth strategycounterparty line capacity, I believe we have the capacity we need to continueto grow our credit protection business beyond its current levels. A smallnumber of counterparties indicated to us during the quarter, that they hadreached their limits for monolines and credit derivative products companies atleast for the near future. We were assured this was not a Primus issue, but anoverall industry concentration issues.

The counterparties do understand the distinction between ourbusiness model and business focus on those were monolines but nonetheless,Primus's group collectively under the same counterparty umbrella in theseinstitutions.

Clearly, some counterparties are racked the overall marketenvironment and generally speaking, will take some time before we can expect anincrease in our lines from them. In the meantime, we do have the capacity toreplace maturing swaps with some of these counterparties.

We have been moving our new transaction volume to otherswithin our group of 47 counterparties. We did not see any constraints on ourability to grow the portfolio on the third quarter, so I am very pleased we wereable to adapt to the changing market conditions. During October, for example,we transactioned with 13 different counterparties, it is also a validation ofour long-term focus to grow our counterparty relationships beyond the mostactive dealers in the market. The good news is that we saw capacity in thequarter to grow the portfolio in a very attractive spread environment. But weare also clearly aware that our access to counterparty capacity can changequickly for reasons that have nothing to do with Primus.

Given the importance of the counterparty capacity issue, weare planning to include a more detailed discussion of how we manage ourcounterparty relationships at our upcoming Investor Day in early December. Iwant to bring you up to date on our current approach to credit default swaps onasset backed securities or CDS of ABS. As well as, some of the issues that haveimpacted, our $80 million portfolio during recent months. As Richard noted, weadded one $5 million AA rated transaction to our portfolio during the thirdquarter.

Just a quick refresher, this activity involves sellingprotection on specific bonds that reference a pool of underlying residentialmortgages. We always sell protection on a rated slice of bonds capitalstructure at BBB or better level. This means that there is significant capitalunderneath us to protect us against losses in the underlying mortgage pool.

We have 14 transactions in our ABS portfolio and it is welldiversified across originators and loan pools. The largest position is $10million. Ouroriginal forecast for this activity showed much higher growth than we haveexhibited in the past quarters, past couple of quarters. But as the continuingflood of bad news has hit this market, we have been very cautious about addingrisk to this portfolio. We expect this will continue to be the case for theforeseeable future, at least until we are comfortable with the performance dataon the underlying mortgage pools.

During the past three to four months, the rating agencieshave downgraded a number of residential mortgage securities. These actions leadto three of the bonds at our credit swaps reference being downgraded by Moody'sto sub investment grade. On one $5 million CDS of ABS transaction inparticular, the reference bond was downgraded to single B from its originalrating of BBB. Unlike corporate credit swaps, a technical credit event on a CDSof ABS can be triggered, if the reference bond is downgraded to CCC. We arecarefully monitoring this particular transaction, along with the rest of theportfolio and we'll keep you informed, should we incur a credit advance. We areplanning to provide shareholders with a complete review of our credit swap ofABS portfolio at the upcoming Investor Day.

As we look forward to year end and into 2008, our challengewithin our credit protection business will be managing portfolio growth andrisk returns within an environment that is largely favorable, but that doescontain some potential barriers to grow. As I have said, on a number of occasions,it is important for shareholders to assess our growth and our performance overa longer timeframe and not just on a quarter or shorter term basis. October isa good example of why. We saw it tightening in credit spreads early in themonth, and we slowed portfolio growth as we believe this tightening would betemporary.

Our portfolio growth was $280 million, notional in October,which is quite slow in comparison in the months of July and August. Morerecently, credit spreads have widened out again and our growth has accelerated.It is hard to predict whether we will be able to produce the same level ofgrowth and returns in the fourth quarter as in the third, but we expect on ayear-over-year comparison, our growth and premium income and portfolio size inour credit protection business for 2007 will be very strong.

In summary, I am very pleased with the performance of ourcredit protection business in the quarter. It was a very good environment forus to recognize again, that there were challenges. We continue to believe thatthe current market dynamics are attractive, and then our financial strength andoperating platform position us well to take advantage of these opportunities. Ourstrong credit culture and risk framework also help to ensure that we areappropriately analyzing and pricing the risk.

Let me now turn to our asset management business, startingwith our relative value of credit strategy, Harrier. As we have discussed withshareholders on a number of occasions, our goal for Harrier has always been toincubate this strategy, create a marketable track record and then raisethird-party capital to leverage our capital investment.

While it was difficult quarter for Harrier, the harsherreality is that the significant change in the credit market conditions weretough on most credit and fund [mix] strategies. And it will make it very hardfor most managers to raise capital for these strategies in the short-term.

Given our view that a capital raise for Harrier would bedifficult for the foreseeable future and that we have other opportunitiesacross our platforms to deploy capital, we have made the very difficultdecision to discontinue Harrier's operations. We intend to reallocate most ofHarrier's capital to our credit protection business.

This capital combined with expected premium inflows adds toPrimus Financial's organic growth capacity and does not require us to raiseadditional debt capital throughout 2008. Richard will discuss the financialimpact of this change, which we will absorb in the fourth quarter.

We were not able to initiate any new managed transactionduring the quarter either in our loan or investment grade platforms. Thecollateralized loan market and synthetic CDOs structured credit market haveeffectively shutdown in the current turmoil.

However, we were able to use the widening of spreads in theloan and investment grade markets to improve the overall portfolio quality andreturns on the five transactions we are managing. All five are performing well,and we have already seen good cash returns on our equity investments andPrimus's two managed CLOs.

We are seeing signs of an awakening in both markets and areworking with dealers on various transaction structures. Realistically, we donot expect the market for structured credit vehicles to open before the firstquarter of '08 at the earliest.

Asset management continues to be a key component of Primus'sgrowth strategy. While the current market conditions for structured creditvehicles are challenging, we are committed to growing our fee-based activitiesin loan and investment grade corporate asset classes. We have strong teams inplace and their track records have been very good.

Additionally, Primus Guaranty continues to have capitalavailable from its $125 million bond offering late last year to invest in thesebusinesses, and we plan to do so.

Before I turn the presentation to Richard, I want to giveyou my perspective on our GAAP loss in the quarter and the implications it hason our business.

To begin with, I believe that economic result is how you, asshareholders, should measure our performance. It's how our board measures ourperformance and how it determines our compensation and incentives. A $128million GAAP loss will attract headlines, and I appreciate that shareholdersmaybe concerned about the implications to our business and financial stream.

To begin with, it will have no impact on Primus' AAA ratingsas our capital models or cash flow models, as Richard mentioned. It also willnot cause us to change our credit protection business model. We believestrongly that a buy-and-hold strategy that produces attractive shareholderreturns is the right strategy for us.

I do not believe it will impact our counterpartyrelationships as those institutions are well aware of our business strategy andfinancial strength. It also does not impact our liquidity position ascounterparties have no ability to unwind transactions with us based on anegative mark-to-market.

Having said all that, I understand that the volatility in ourGAAP financial results means that not all investors will be comfortable owingour shares. I want to encourage all of our shareholders to attend our InvestorDay, which is coming up on December 6th. Again, we will try to use this forumto cover in more detail opportunities and issues in our business thatshareholders should have an interest in.

In closing, I want to sum up and leave you with thesetakeaways for the quarter. We showed a strong increase in premium revenues. Wehad the highest new transaction volume in five years. We maintained a topquality portfolio with high ratings on new transaction volume. We made a verytough decision on Harrier. We showed good performance on our five PAM managedstructured vehicles. We continue to focus on risk management and mixed statevolatile and riskier market environment. We had a strong capital base,financial resources and liquidity.

Richard?

Richard Claiden

Thanks Tom. As I mentioned earlier, our economic results forthe third quarter of 2007 were $12.6 million, compared to $12.7 million in theyear ago period, and $14.9 million in the second quarter of 2007. For theyear-to-date, our economic results were $40.7 million compared with $36.8million for the first nine months of 2006.

Our economic return on equity for the third quarter of 2007was 11.7%, and the economic book value per share was $9.71 as of September 30,2007. Going down to the third quarter of 2007 results was Harrier's tradinglosses of $6.5 million, compared with trading of loss $72,000 in the thirdquarter of 2006. Most of the trading loses in the strategy were confined toJuly and August. For the year-to-date through September 30, 2007, Harrierincurred net trading losses of $6.3 million, compared with a trading loss of$209,000 in the first nine months of 2006.

During the third quarter, we saw significant volatility andilliquidity, throughout the various instruments (inaudible) traded by Harrier.While we saw solid performance from our correlation trading strategy, this wasmore than offset by losses on our credit arbitrage trading activities.

We expect to incur discontinuance costs in the range of $2million to $3 million, as a result of the decision to discontinue Harrier,which will be taken in the fourth quarter of this year. We anticipate thatthere will be ongoing savings in the form of reduced future expenses, whichwill be in the range of $2 million to $3 million annually, going forward.

Our credit protection business had an exceptional quarter.Primus Financials' third quarter premium income of $22.3 million increased byapproximately $4.2 million or 23%, compared with the year earlier quarter of$18.1 million. The increase reflects the continued growth of the credit swapportfolio, which increased by 32% from $15.5 billion at September the 30th2006, $20.4 billion at September of 30th 2007.

Included in our economic results, our amortized realizedgains from the early termination of swaps with the original life of thatterminated swap. In the third quarter of 2007, the amortization of realizedgains from the early termination of swaps was $1.4 million compared with $1.8million in the year earlier quarter.

Credit mitigation costs from the early termination of creditswaps at a realized loss were $144,000 in the quarter of 2007 compared with$1.6 million in the third quarter of 2006.

The costs incurred in both quarters are primarily related tothe mitigation of actual and potential [LBO] risks.

Net interest income, after the deduction of distributions onpreferred securities, is $3.9 million in the third quarter of 2007 comparedwith $2.9 million in the third quarter of 2006, a 34% increase.

Looking at the components of net interest income, interestrevenues were $10.9 million for the third quarter of 2007 compared with $7.1million in the same quarter of 2006. This $3.8 million increase is primarilydue to higher investment yields and an increase in the average investmentbalances, mainly arising from the investment of the proceeds from $125 millionthe senior notes issued by Primus Guaranty in December last year.

The weighted average balance on our investment portfolio wasapproximately $839 million for the third quarter of 2007 compared with $648million in the same quarter of 2006. Total financing expenses in the thirdquarter of 2007 was $7 million compared with $4.3 million in the earlierquarter. This increase was due to higher interest rates and higher debtbalances associated with Primus Guaranty debt offering, I mentioned earlier.

As many of you know all of the debt and preferred in PrimusFinancial, which totals $300 million is in the auction rate market. Rates onthe Primus Financials Securities, each 28 days to an auction process, wherebyinvestors bid for the paper. If there is insufficient demand clear the auctionthe interest rates are reset at the predetermined maximum rates and thepreexisting holder continues to holds the paper. Beginning in the August 2007,we saw a reduction in investment demand in the auction market, associated withthe general turmoil in the credit markets. We were one of over 40 companieswhose auction rate debt was affected.

The outcome of this is that our monthly reset have revertedto the maximum rates, which are as follows and the rates are presented asspreads over one month LIBOR in basis points. For our AAA debt, 150 basispoints, AA debt 225 basis points, and A preferred 357 basis points. So nowsecurities continue to be set at these maximum rates, we estimate theincremental annual financing costs to be approximately $6 million. We did notexpect to see any change in the auction rate market conditions in the fourthquarter of 2007.

And I said that it's very important to note that all of debtand preferred is permanent long-term capital with the first maturing in 2021for the AA paper, 2036 for the AAA paper, the A preferred is perpetual. Inshort, this means we are not obligated to repay principal until maturity,unless we choose to do so. In addition there is no impact to our creditprotection business capital model from the changes in the interest rates on theauction rate debt. This is because the capital level has always incorporatedthe maximum rates.

Finally, I would note that $125 million in bonds issued byPrimus Guaranty are not part of the auction market. They bear a fixed coupon of7%, although we have swapped $75 million of the issuance into floating ratedebt.

Asset management fees for the third quarter were $1.1million compared with $542,000 in the year-earlier period. This increase isprimarily due to the addition of a second CLO in July of 2007. The 2006 periodreflects only the fees from CLO 1, which were approximately $500,000.

Turning to our operating expenses, for the third quarter2007, operating expenses excluding financing costs were $9.4 million, anincrease of $300,000 over the $9.1 million in the same quarter of last year.The major components of the change were increased salary, technology and datacosts, offset by a decrease in incentive compensation.

Our data and technology expenses increased by approximately$560,000 from a year ago, resulting from the expansion of our businessactivities. Compensation expense on a total basis was $4.9 million for thethird quarter, which decreased from $5 million over the comparable period inlast year. Variable compensation costs were reduced to less than expectedresults, relative to the 2007 budget.

Turning to our capital position, Primus Guarantyconsolidated net cash capital was approximately $845 million at the end of thethird quarter. Specific to Primus Financial, cash capital in our AAA subsidiarywas $679 million at September the 30th. Primus Guaranty, a parent company, had$71 million in capital and Harrier had $65 million in capital at the end of thequarter.

This has been a very challenging quarter in many ways, giventhe turbulence in the credit markets overall. We were disappointed by Harriersperformance and have made the painful decision to discontinue it.

However, we were pleased with the resiliency of the creditprotection business, the fact that volumes and spreads have risen, and webelieve that the reallocation of capitals with credit protection business willserve the company and its shareholders as well.

We have now finished our prepared remarks, and we'll openthe call to your questions.

Question-and-AnswerSession

Operator

(Operator Instruction). And your first question comes fromthe line of Ken Zerbe of Morgan Stanley. Please proceed.

Ken Zerbe - MorganStanley

Great. Thanks. Can you just talk a little bit about, giventhat we've seen such dramatically higher credit spreads in the quarter line tothe large mark-to-market loss, it didn't seem like those higher credit spreadsare reflected and the spreads that you received on new business, it was alwayswritten in the third quarter, can you just talk about the differences there?

Tom Jasper

Hi, Ken. It's Tom. Yeah, I mean the difference is clearlywhat we for the last two quarters have been focused on increasing the portfolioquality, the overall quality in portfolio. So our focus during this pastquarter was on this the A+ and higher-rated sector of the marketplace.

Clearly, that to us is very attractive, because it offers usvery, very good risk adjusted returns. And particularly, given our outlook thanin '08, we can see a deterioration in credit fundamentals. We think that's theright thing to do for the portfolio.

That being said, I appreciate that with credit spreadsbouncing around as they did and certainly widening to the extend that they didas reflected by the index, that perhaps you would have thought that the averagespreads would have been higher. But we are very pleased with our activity andour ability to sell protection at those levels.

Ken Zerbe - MorganStanley

Okay. The other question I had, I think you mentioned thatthere were three deals on the ABS side that were downgraded to below investmentgrade, do you quantify how much in terms of the par are we talking about thesethree deals?

Tom Jasper

I think it's, let's get the exact number for you, but Ithink it's 15 million.

Ken Zerbe - MorganStanley

Okay. And has the deterioration changed your view on whetheror not you want to participate in this market? I know you are going back alittle bit, but --

Tom Jasper

Well, that's a good question, I think that the answer is,what is most important to us is to believe that all the bad news is out of themarket. Now, clearly we don't have that due today. We think there is more badnews to come.

That being said, there is an attraction in that market inthe fact that it does add diversification to the portfolio, if the ratinglevels settle down and such that you understand what's in those portfolios.

We would view it as an opportunity to go back into themarket at that point in time. So, we certainly view it as continuing to be apart of the market that we would like to do more business once the risk returnparameters in that market are better defined.

Ken Zerbe - MorganStanley

Okay. Great. And then the last question I had, just aclarification, did I hear you right saying that if your financing cost off staythe max spread, that would result in the $6 million annual increase in yourtotal financing cost?

Richard Claiden

Yes, that's correct, Ken.

Ken Zerbe - MorganStanley

And when are you going to find out or when is sort the nextauction rate that you are going to see how this spreads?

Richard Claiden

It basically occurs roughly 28 days between the mid of theday to auction at different days. But basically it's between the middle and theend of each month.

Ken Zerbe - MorganStanley

Okay. All right. Great. Thank you very much.

Richard Claiden

Thanks, Ken.

Operator

Your next question comes from the line of Darrin Peller ofLehman Brothers. Please proceed.

Darrin Peller -Lehman Brothers

Thanks. Can you just review real quickly, again, theleverage rate now, it seems like, from an economic book value perspective it isaround $430 million, including the tranche business that puts you well under 40times. Am I missing something, or and I guess maybe you can help us againunderstand what that can go to and how you can grow the portfolio from thislevel?

Richard Claiden

Yeah. I think, what you are missing, Darren, is the factthat we also got the debt and preferred in Primus Financial.

Darrin Peller -Lehman Brothers

Right.

Richard Claiden

So, the total capital of Primus Financial is something inthe order of $670 million.

Darrin Peller -Lehman Brothers

Okay. So $670 brings -- so what's the actual ratio rightnow?

Richard Claiden

The actual ratio is just still about 30 times ratio. I thinkits just 30.1 or some such, but basically a 30 times ratio...

Darrin Peller -Lehman Brothers

And that you still think you can go to about what 35 or--?

Richard Claiden

Yeah. That's a target that we are assigning for ourselves atthe moment.

Darrin Peller -Lehman Brothers

Okay. Thanks. And then, just another question on the CDS ofABS business, there is a lot ofmisunderstanding on really how that actually works. Can you help us understandreally what the total risk is about. We know there is about $80 million, Iguess we are trying to really further understand where the risk is there andhow bad it could be, if that market does considerably deteriorate, under fully understanding that you're portionis a lower tranche risk.

Richard Claiden

Yeah. Darrin, I think it’s couple of things. First off, thisis a business where we are selling protection on individual bonds. Okay, sothis is countrywide 2005 series five. I am just making that up by the way. So,we're selling protection on an individual bond, so it’s a business where you'reanalyzing who the originator was, what's in the portfolio, et cetera.

And then, obviously, where do you want to -- what slice ofthe capital structure do you want to take of that bond? And as we said, wehave, that’s a business for us, it's always been at BBB or better. And so fromthe standpoint of defining what your risk is, it is very clear that our maximumrisk exposure in that market is $80 million. We've had $15 million in bondsthat have been underlying bonds to the CDS that we saw a protection havedropped to below investment grade, which is certainly something we aremonitoring very closely. But it is a business which relative to -- we are notselling protection on CDOs, that’s not the business. This is selling protectionon individual bonds. Those individual bonds could be part of a CDO, but againthat’s not our business model. Is that clear?

Darrin Peller -Lehman Brothers

That makes sense, yes. And then, I guess just lastly, canyou explain exactly the credit swaps undertaking the [out side] risk is thatassociated with the CDS of ABS risk that was taken on this quarter with thedown grades or?

Richard Claiden

That’s was more to do with the tranches rate actually wherewe actually bought some protection against some of the tranche exposure that wehave, this is a very limited amount as you can see.

Darrin Peller -Lehman Brothers

Yes. And how does that flow through, there is -- the actualpremium that you are paying now is what exactly?

Richard Claiden

About $80,000 a month.

Darrin Peller -Lehman Brothers

That goes through as a counter revenue item or?

Richard Claiden

Yes.

Darrin Peller -Lehman Brothers

Okay. Alright, thanks guys.

Richard Claiden

Thanks.

Operator

Your next question comes from the line of Geoffrey Dunn ofKBW. Please proceed.

Geoffrey Dunn - KBW

Thanks. Good morning. With what's happened in the CDOmarket, I was curious as to whether or not your thoughts of the long-termattractiveness of ramping up an asset management business still holds?

Richard Claiden

Absolutely, Geoff, I think the loan market is a market thatis very attractive to us and so that’s one. We have a very good team, we arecertainly looking, as I said, at various structures currently and there is alot going on in that marketplace, which again, we are hopeful that in '08, wewill see an opportunity to do more of the CLO type transaction that we've donetwo currently. It’s an attractive business to us in terms of the fees that itgenerates, and an attractive business to us in terms of the returns on oursmall amount of capital we have invested in that business.

On the synthetic CDO market, again that’s investment gradecorporate risk. So there is no ABS in it, it's all corporate risk, and I thinkthat again we feel that the investment grade corporate market is a veryattractive market and I think part and parcel of what will have to happen forthat market and the CLO market to open up, it's just a sort of a better feelingwithin the credit markets, which is clearly not the case currently. I meanthere is a lot of volatility, there is a lot of anxiety, I mean there is a lotof headlines we read everyday. But we think that that market will also open up.So, the long and the short of it, we view both markets as asset classes that weare committed to for the long-term and we want to do more CDO, CLOs in them.

Geoffrey Dunn - KBW

Very helpful, thank you.

Operator

(Operator Instructions) And your next question comes fromthe line of Mark Laneof William Blair.

Mark Lane - William Blair

Hi, good morning. Say for instance on a pro forma basis, youwere saying that at the end of the third quarter, if you were riding at 35 to 1that could support, whatever $23.5 billion portfolio, excluding the additionalcontribution from Harrier of $65 million?

After 35 to 1 that you are still well above the ratingagency capital requirements, I mean how much of a cushion is there? Is it $10million or is it $50 million? I mean under the assumption that you would alwayswant to maintain some cushion, but what is the cushion?

Tom Jasper

Ken, I think that we have not disclosed the cushion, but letme give you a benchmark. We are thinking about it. We have talked in the pastabout the fact that if you look at our rating agency capital models for the AAAratings, that we have done a lot of analysis as to what is the last incrementaldollar of risk that we put on in terms of leverageable risk before it wouldtrip, we moved to AAA.

And we have said that that number is somewhere in themid-40s. And the reason we say somewhere in the mid-40s is it clearly dependsupon the portfolio quality. So, if your portfolio quality goes up, clearly,your ability to leverage goes up too. So we'll say mid-40s.

Right now, as Richard said, we are operating around 30 to 1.And we have said that the level that we are comfortable with its moving ortargeting is 35 to 1. So, I think that that spread differential between the twoshould give you pretty good indication as to what kind of capital cushion thereis over time that we have been managing.

Mark Lane - William Blair

Okay. And then just to clarify, Tom, what you said was thatyou could support portfolio growth with current capital till the end of thefirst quarter '08, and then Richard said through '08. So does the latter implyor include the benefit from the additional $65 million?

Richard Claiden

Absolutely.

Tom Jasper

Yes.

Richard Claiden

And again, what we're trying to address here is, we'retrying to say, look, we have said for a long time that there are two risks atthe growth strategy in Primus Financial. Number one is the availability ofcapital. The other is counterparty capacity. And we've also said in the callthat or I said that, you know, when we talk to our bankers currently, there isno clear approach or path to raising additional capital on PFP certainly in thenear-term. By near-term, I am talking about over the next three to four months.

So, from our perspective, one of issues that we've looked atis given the overall volatility in the credit markets is it is to be able totake one of the risks of the growth strategy off the table, i.e., capitalavailability to grow the portfolio is the right thing to do. And so the plan isto reallocate the capital that's freed up from Harrier into our creditprotection business.

Mark Lane - William Blair

And how much -- you said you had $71 million to parentcompany, is that correct?

Tom Jasper

That's correct.

Mark Lane - William Blair

How much liquidity do you generally feel like you needthere?

Tom Jasper

Under the terms of it, we agree with the rating agencies. Wekeep just under $20 million there. Basically, it's two years worth of debtfinancing costs.

Mark Lane - William Blair

So that's a little bit of cushion as well.

Tom Jasper

Yes. So it's about $17.5 million in practice that we keepthere. So effectively, we've got just over $50 million we could redeploy fromthe parent company.

Mark Lane - William Blair

And just to follow up on the question about, I meanconceptually, I understand that if you are going to write higher credit qualitybusiness and everything else is equal, the premium rates are going to be lower.But, even adjusting for the move to credit quality, I mean you are saying theaverage credit rating on new business written was A+/A2. What was it lastquarter? I mean was it similar or was it even lower than that?

Richard Cladien

It was more or less, it was similar. But again, last quarterwas really focusing on the tranches. This is the second quarter. And thisquarter was really focusing on the single names. I think if you look at theindices, the average quality within the indices, as I recall, is more or lessBBB, BBB+. So it's substantially below that sort of A+ and above level that wehave been writing.

Mark Lane - William Blair

But did you write a lot of business in July before spreadsreally blew out?

Richard Cladien

We commented our single name activity, Mark, was over $700million in July.

Mark Lane - William Blair

Okay. Over $700 million, so pretty equally spread.

Richard Cladien

Yes.

Mark Lane - William Blair

Okay. All right. Thank you.

Operator

Your next question comes from the line of Gregory DiMarzioof Century Capital. Please proceed.

Gregory DiMarzio -Century Capital

Hi, guys. I just wanted to know as far as engaging theinvestment banks to raise capital, probably I would guess there is a preferencefor debt, but I wanted to see if you have started conversations to I thinkstrategic investors.

I know that that’s tough to swallow with the stock belowbook value, but clearly that’s the most powerful lever to the stories to raisesome capital and really ignite growth?

Tom Jasper

Greg, I want to make sure that I understand the question. Imean a couple of things. We certainly have always felt that the ability toraise debt within Primus Financial and to be able to leverage off the equityobviously boosts the returns in Primus Financial. So that was very much a goodthing for shareholders. I think relative to looking to raise capital at the PGOlevel, either equity or some form of equity again, we are obviously veryconcerned about where the stock is trading, and as Richard has already said, wehave a significant amount of capital up at the PGO level, so we have not seen theneed really to look at that sector. I'm not sure that’s answering your questionthough.

Gregory DiMarzio -Century Capital

Yeah, I'm sorry it’s to clarify. I was just trying to seehow far could you give more details in terms of where discussions are in termsof raising capital?

Tom Jasper

On the debt side? Richard.

Richard Claiden

I can discuss that. Clearly our intention before the creditturmoil erupted in the third quarter was to raise that capital at PFP in thethird quarter. In this term of $100 million to $125 million, that was our plan.Clearly what's happened in the third quarter and continues has made thatdifficult though, very difficult. So, we basically -- we've had discussion withthe bankers, they've indicated that windows do open up, they shutdown again.Windows do open up, so we are basically readying ourselves for an issuance. Butwhen that will occur, I am not sure, I don't think it will occur in the fourthquarter in May, but really, perhaps more likely in the first quarter of nextyear. But the market is very difficult to predict at the moment, given what'shappening.

Gregory DiMarzio -Century Capital

Got you. Thank you very much.

Operator

Your next question comes from the line of Greg Eisen of ICMAsset Management. Please proceed.

Greg Eisen - ICMAsset Management

Thanks. Good morning. Regarding and going back to thequestion of raising debt capital, you said $125 million was what you werelooking for in the third quarter?

Tom Jasper

$100 million to $125 million, yeah.

Greg Eisen - ICMAsset Management

Okay. And then I can multiply that by 35, but I guess what Iwas going to drive, how leveraged would you want the whole capital structure tobe at most in terms of debt capital versus the equity capital before you wouldfeel like you had to come back to the equity market?

Richard Claiden

Traditionally, we were in the sort of one for one ratiobetween the debt and the equity and clearly we have grown the equity at PrimusFinancial's through the retention of earnings. So, broadly speaking, we earnedabout $60 million a year in PFP and growing. So, that enabled us to raiseroughly that amount each year and it doesn't work on an annual cycle based ayear and half worth of earnings enables us to do raise $100 million in debt.

So, net net we aim for that one to one ratio. Ourconstraints really is, constrains to one is the availability at the market andI have intimated that's difficult at the moment and second is the capitallevel, we could actually raise the ratio debt to capital, equity capital, alittle beyond the one to one ratio if we chose. But that's been our benchmark.

Greg Eisen - ICMAsset Management

Okay. I understand. And then going back to the ABS products,$15 million was downgraded by the rating agency. Let's take a extreme examplewhich probably isn't that worth of the mortgage behind these ABS's are 100% badand you have a total loss on this. Would your incurred loss be a number greaterthan the $15 million?

Tom Jasper

No, the maximum loss we could take on the portfolio,maximum-to-maximum is $80 million. That's just everything, every mortgage inthat entire portfolio, because we have an $80 million portfolio and everymortgage was bad.

Richard Claiden

And no recovery.

Tom Jasper

And there was no recovery we had incurred $8 million loss.So that's the extent of the overall loss. Clearly, we don't expect that, butand as we have said we have had the $15 million in bonds that $15 millionnotional bonds had have been moved to non-investment grade

Greg Eisen - ICMAsset Management

I see. And obviously it's reasonable expectation that a losswould be a partial loss then. (inaudible)?

Richard Claiden

If a credit event occurs, could there be a full loss of thenotional amount of the credit swap? Yes, there could be. But one would notexpect that. One would expect a recovery value underlying it.

Greg Eisen - ICMAsset Management

Okay. And again, your economic shareholders equity is 437,and essentially 80 million is the number that, I guess the market is panickedover in a general sense. Taking that away, then economic group value issomething somewhere around 790 or something like that?

Tom Jasper

Yeah.

Greg Eisen - ICMAsset Management

Okay. That was just my questions. Thanks.

Richard Claiden

Thank you.

Tom Jasper

Thank you.

Operator

And there are no further questions at this time. I wouldlike to turn the call over to Richard Claiden for closing remarks.

Richard Claiden

Thank you for attending our call and for your questions. Weare looking forward to seeing you at our Investor Day in New York on December the 6th. Thank you,again, bye.

Tom Jasper

Thanks, everybody.

Operator

Thank you for your participation in today's conference. Thisconcludes the presentation. You may now disconnect. Good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!