The CDPC brigade

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Five years after its launch, Primus Financial's chief executive, Tom Jasper, finds his company's chosen line of business still remarkably uncrowded. Although the credit derivatives market has grown beyond recognition - from $2 trillion in notional value outstanding in 2002 to $34 trillion in 2006, according to the International Swaps and Derivatives Association - only a few companies have followed Primus' lead in selling protection on a highly leveraged basis on single-name credit default swaps and collateralised debt obligation tranches.

This is set to change - and Jasper welcomes the establishment of credit derivatives product companies (CDPCs). "We are aware of three groups preparing to enter the market," he says. "There are rumours of three to six more by the end of the year. That validates our business model. If one chooses to go public, it will make our job easier because the market will have a definitive comparison. Right now it doesn't." Primus Financial floated on the New York Stock Exchange in September 2004. So far it is the only CDPC to do so.

However, Jasper is not worried about rising levels of competition. First, the CDPC business is not easy, he says. "There are a lot of moving parts between debt issued, equity issued and the swap portfolio, particularly around the leverage you intend to apply in your business model. It will be a learning experience," Jasper asserts.

Second, the market is big enough - and growing rapidly enough - to accommodate all of them. Asked what Primus will do when the market starts to slow, Jasper replies: "You're making an assumption that I'm not sure you should make. I was there in the early days of the interest rate swaps market, and we made similar predictions that the market would have to slow down because it was growing (extremely rapidly), like the credit swap market is now. It never did."

Jasper started his career at Salomon Brothers in New York, where he helped establish the bank's swaps business in 1982 - and he sees a similarity in the evolution of the interest rate swaps and credit derivatives markets. "In the Treasury market now, the interest rate swaps curve prices the obligations. The derivatives are pricing the cash rather than the cash pricing the derivatives." The same switch happened two years ago in the corporate debt market, he says.

This year has seen a sharp widening in credit spreads, with the iTraxx Europe five-year credit index reaching 68 basis points on July 30, up from 22.9bp on January 2, while the CDX five-year investment-grade index hit 82bp on August 16, up from 37bp on March 20. This volatility has caused losses for a number of market participants, including Primus. But Jasper says this will benefit the company in the long term: "It means spreads have probably widened and gives us an opportunity to sell protection at wider spreads - which is very good for us." The company reported $1.3 million in realised losses in the second quarter, representing early termination of certain swaps - a precaution against suffering a credit event. It took $993,000 in realised losses in the first quarter for the same reason - both figures were increases on 2006, which saw losses of $776,000 in the first quarter and $219,000 in the second.

"We don't anticipate (credit event losses) anytime. The losses we are taking now are the result of the leveraging up of corporate America through leveraged buyouts. It's not a credit event, but has caused us to take credit mitigation expenses as we unwind parts of that position to either zero or a smaller number than we would have if the company was still BBB or A rated," Jasper explains.

Nonetheless, Jasper fears a collapse of liquidity could come suddenly, either triggered by a corporate event or simply a shift in perception. Indeed, the European Central Bank pumped billions of euros in the money market starting August 9 amid concerns about a drying up of liquidity in the credit markets. "Most of the people trading these instruments on the Street are very smart but they are young people, and, by definition, they probably haven't traded through a cycle like that before. That is a problem."

Alexander Campbell

Biography: Tom Jasper

1998: Chief executive, Primus Financial Products

1996: Chairman, Salomon SwapCo

1994: Chief operating officer Asia-Pacific, Salomon

1984: First co-chairman of Isda

1982: Head of interest rate swaps, Salomon Brothers.

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