Taxpayers' TARP Warrants Are Worth Billions: Don't Give Them Away

Includes: BAC, C, GS, JPM, MS, WFC
by: Linus Wilson

The Wall Street Journal reported on April 22, 2009, that the banks are lobbying Congress to have the U.S. Treasury give away the warrants that taxpayers paid for as part of the Capital Purchase Program.

The two largest banks which have wanted to quickly retire the TARP investments, JP Morgan (NYSE:JPM) and Goldman Sachs (NYSE:GS), stand to gain $2.7 billion if the Treasury gives away the warrants. My estimates indicate that despite the fact that these warrants are or have recently been out of the money they are very valuable because they have about 9.5 years before they are exercised. (Options are out of the money if they would be worthless today if exercised.) Over nine years or so, Goldman Sachs’ and JP Morgan’s stock prices could rise substantially to the benefit of U.S. Taxpayers or whoever owns the warrants. It would be a massive loss to taxpayers if the U.S. Treasury retired these warrants for free.

The U.S. Treasury holds 88.4 million of JP Morgan’s TARP warrants. These warrants on JPM are worth $20.20 each or about $1.79 billion according to my estimates. According to my estimates, taxpayers’ 12.2 million warrants on Goldman Sachs are currently worth $74.87 each or about $914 million dollars. I used option pricing models to calculate these figures based on intraday prices on April 22, 2009. I adjusted for dividends and the dilution associated with warrant exercise

Instead of JP Morgan and Goldman Sachs buying (or worse being given) the warrants from the Treasury, it is a better idea for the U.S. Treasury to sell those warrants to 3rd party investors. Section 4.9 of the Securities Purchase Agreement for the Capital Purchase Program requires the U.S. Treasury to sell the warrants to 3rd party investors if the issuing bank is not willing to buy them for “fair market value.” Fair market value for the GS and JPM warrants is a lot closer to $2.7 billion than $0.

My research on bank bailouts (such as “Debt Overhang and Bank Bailouts”) indicates that it would be a bad idea for bank regulators to encourage the mega banks to buy the warrants themselves. Buying back warrants or shares reduces banks’ cash cushion and makes them less likely to withstand tough market environments. We don’t want GS and JPM returning to the taxpayer money in the future.

Disclaimer: No one should construe this article as investment advice. The estimates are believed to be reasonably accurate at the time of writing, but they are not guaranteed. Option values can vary substantially from models, and there are many assumptions in option pricing models that may not be borne out. I do not have any long or short positions in any banks' securities except long positions in broad-based index funds.