A New Type of Credit Derivatives Player

July, 2002. Applied Derivatives

A company set up in March this year by several long-standing derivatives professionals to trade and invest in credit derivatives, completed some 45 deals with a notional value of $400 million in its first two weeks of operations.

Called Primus Financial Products, the independent New-York-based firm invests and trades exclusively in single-name, investment grade credit default swaps. It has a triple-A rating from both Moody's and Standard & Poor's credit ratings agencies, and it aims to complete trades worth a notional $5 billion in its first year.

Primus, which raised £270 million in financing in March, has positioned itself as a seller of credit protection, and it also has a trading operation. "We have focused on the market for single-name credit default swaps because it is the fastest growing portion of the credit derivatives market, and it is where there is the most sustained demand for hedging requirements," says Joseph Bauman, chief financial officer of Primus Financial Products, and a former chairman of the International Swaps and Derivatives Association (Isda).

The firm deals with large financial institutions including credit derivatives dealers and portfolio managers, but it plans to eventually expand its customer base to include insurance companies, other large companies and fund managers. "We should appeal to CDS dealers because we are a new name in the market with an untapped portfolio and a triple-A rating. Our buy and hold strategy means we are not just another dealer, and we are actively looking to take risk in relatively illiquid credits," Bauman adds.

Primus is very capital efficient, which means there are often attractive returns to be made in illiquid names, Bauman explains. Primus's capital efficiency comes from its low overheads — it has a staff of 20 to 25 — and the fact that it can calculate its own economic capital requirements, which protect the firm against losses, rather than having to pay regulatory capital.

Since the firm is neither a bank nor a securities trading company, and it does not trade futures, it is unregulated so it does not have to put up regulatory capital. But Primus is limited in its dealings by the ratings agencies, which review the firm's portfolio on a weekly basis to ensure it is sticking to guidelines which guarantee its triple-A rating. So the firm works with the agencies to develop its economic capital levels — the amount of cash it believes will be sufficient to cover potential losses — which are usually lower than the regulatory requirement.

As well as developing its single name CDS business, Primus plans in the third or fourth quarter of 2002 to launch Primus Re, a so-called transformer company, which translates the risk involved in insurance into credit derivatives and vice versa.

Pimus's major backers are XL Capital, which invested $75 million; Aegon and calPERS, which have invested $30 million each; and Radian Group, which contributed $20 million. Radian Reinsurance also provided a $115 million excess of loss insurance policy to Primus.