Primus downgrade raises questions over CDPC model

Like other CDPCs, Primus Financial - a specialist seller of credit protection and the first established CDPC - has been hit hard since the escalation of the credit crisis in September. Events such as the collapse of Lehman Brothers, the takeover of Washington Mutual by JP Morgan, the conservatorships of Fannie Mae and Freddie Mac, and the nationalisation of three Icelandic banks have significantly affected Primus's share price.

The company was trading at $7.01 on December 31, 2007, but its share price has remained below $1 since October 17, leading the New York Stock Exchange to warn Primus twice this month, on November 7 and 21, that it would be delisted unless its share price improved within six months.

On November 5, the board responded to the falling price by authorising a $25 million share buyback - with the first trade, of $3.2 million of its common stock at $0.70 per share, announced yesterday. However, the news failed to help the stock, which closed down 14 cents at $0.58.

Primus in October saw Moody's and Standard & Poor's downgrade its counterparty ratings from Aaa to Aa1 and from AAA to AA+. Both agencies cited the deterioration in the credit quality of Primus's credit default swaps (CDS) portfolio and further exposure to corporate defaults.

In its third-quarter results on November 5, for example, Primus reported realised net losses from credit events of $84.4 million, including $73.1 million on Lehman Brothers' default, $4.8 million on Freddie Mac and Fannie Mae, and $6.6 million on Washington Mutual. The notional value of its CDS portfolio shrunk from $24.2 billion at the end of the second quarter to $22.9 billion.

Since October, the company has reported a notional exposure of $68.2 million to Kaupthing, the failed Icelandic bank, which has yet to be resolved. These difficulties have effectively made it impossible for Primus to generate new business.

"Primus Financial's counterparties, for the most part, remain frozen and are not providing any liquidity, particularly to a rated structured operating company like Primus that does not post collateral," conceded Tom Jasper, chief executive officer of Primus Guaranty, in a conference call on November 5. "When combined with Primus Financial's ratings downgrades, it will be difficult for us to write any new business for the foreseeable future."

In fact, Primus has written progressively fewer credit swaps as the crisis has intensified. In the first quarter of 2008, it wrote $1.2 billion of new CDSs, mainly in January. But in the third quarter, it only wrote $74.3 million of new swaps and is now in run-off mode.

"We are shifting from managing our credit protection around a growth model to an amortisation model," confirmed Jasper, adding that Primus is not looking to write new swaps.

Primus is not the only CDPC affected: on October 17, Fitch withdrew its ratings on five other CDPCs - Aladdin Financial Products, Athilon Capital Corp, Cournot Financial Products, Invicta Capital and Quadrant Structured Products.

The escalation of the credit crisis in September has raised questions over the CDPC business model.

CDPCs sell protection on single-name CDSs and collateralised debt obligation tranches. As they - like monolines - are not required to post collateral, CDPCs rely on AAA ratings to entice banks and other parties into doing business with them. But, according to Fitch, in a market where counterparty credit risk is a particular concern, this lack of posted collateral has "negatively impacted CDPCs' attractiveness as counterparties".

It will be difficult for such firms to generate new business unless they find a way to restore AAA ratings. "[The CDPC business model] needs to be refined," said Greg Peters, head of US credit strategy at Morgan Stanley in New York. "It was a business model predicated on the rating agencies' blessing."

"The fundamental problem is that CDPCs are essentially not regulated, and so it is only the rating agencies that fulfil that function," commented Tim Brunne, a senior credit strategist at Unicredit.

Nevertheless, Primus believes it will weather the storm. It says it has access to $736 million in cash and investments to absorb further losses. S&P also acknowledges Primus has $300 million of premiums due on contracts outstanding. That is one reason Primus and the other CDPCs might yet avoid the same fate as monoline insurers, which have been hit by huge losses and multiple downgrades in the past year. "The situation is not as dire as the monolines," said Peters.

Additionally, even if all the CDPCs were to go under, it would not result in the kind of strain on the CDS market that occurred when the true exposures of monolines became apparent.

"The CDPC vehicle is not a dominant player in the CDS market," said Brunne. "It makes up less than 1% of the total volume. It would be difficult to assess the effect a CDPC default would have on the market but the impact would not be as large as what happened with monolines."

See also: Lehman crisis hits Primus
CDPCs under pressure
The CDPC brigade

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