Treasury Accepts Lowball Price for TARP Warrants

On Monday, May 11, 2009, with little fanfare, Old National Bank (ONB) became the first publicly traded bank to pay back the TARP’s Capital Purchase Program warrants. Warrants are call options that create new shares of stock when exercised. Privately held banks like Centra Bank, which repurchased its warrants before Old National Bank, signed an agreement to repurchase their warrants at 5 percent of the par value of the U.S. Treasury’s investment. Publicly traded banks, according to the terms of their TARP investment, can either negotiate to repurchase the warrants at “fair market value” or let the U.S. Treasury sell the warrants to third party investors. Thus, the Old National Bank transaction is the first example we have of the U.S. Treasury’s (in)ability to negotiate the fair market value of the TARP warrants.

My analysis suggests that the U.S. Treasury accepted a lowball offer. My paper “Valuing the First Negotiated Repurchase of the TARP Warrants” estimates that the fair market value of these warrants should have been between $1.5 million and $6.9 million. It is too bad that the U.S. Treasury agreed that they were worth only $1.2 million. That is, the U.S. taxpayers only got 71 percent less than the median of my lowest and highest estimates, $4.2 million, and $.3 million or 20 percent less than my lowest estimate. These results indicate that the management at Old National Bank represented their shareholders well. I am not sure that the U.S. Treasury represented taxpayers quite so well.

Taxpayers bore a lot of risk providing capital to the banks, and they deserve to get the fair market value of the warrants that they purchased. Hopefully, if Goldman Sachs (GS) and JP Morgan (JPM) try to repurchase their warrants, Tim Geithner and company will do a better job. I estimate in my paper “The Goldman Sachs Warrants” that TARP warrants at that firm alone could be worth between $250 million to $1.2 billion.

The U.S. Treasury should avoid negotiated repurchases if at all possible. The U.S. Treasury seems to be pretty good at selling bills, notes, and bonds to investors all over the world. The U.S. Treasury should try selling the taxpayers’ warrants to third party investors. That would free the banks of TARP and get taxpayers the best price.

Disclosure: I do not have any long or short positions in any banks' securities except long positions in broad-based index funds.

Comments

[ACCOUNTANT:]

The only problem with your thesis is that several of the original banks, including both Goldman and Morgan Stanley, had the government shove the TARP money down their throat. So why should the taxpayers make a bunch of excess profits off of the deal?

Let's see, we'll force the banks to take TARP money that, in several cases, they don't need or want, we will grant ourselves warrants to buy their stock at cheap prices, thus diluting stockholder value, and then, if we don't demand top dollar for the warrants, we will claim that the taxpayer is getting hosed.

Seems like an incredibly one-sided transaction to me.

May 14 12:21 PM

[ditto:]

I started to hear about this warrant issue on Bloomberg Surveillance and how there was concern that Geitner would misprice these warrants or allow banks to claw them back for $0. Back when banks were supposedy "forced" to take the money, I think Paulson did the right thing for the following reason: lack of transparency. The government was blind to the risks inside banks because the banks did not fully disclose the risk of their book. Even Goldman Sachs is included here as is my former employer Wells Fargo. These banks would not open their books to government then and they still aren't today. So, Paulson said if you don't want to open the books then you are gonna take this bailout money and give us warrants. This was the price the banks needed to pay. Now, Geitner is gonna give back these warrants or severely misprice them and the public is gonna lose out. I think Geitner needs to hire 3 independent valuation firms and value the warrants and meet in the middle. Screw the banks if they think they are gonna get away with not paying on these warrants at "fair value" All of these banks were involved in this risk taking (Wells Fargo included to some extent) and this is the price for the bailout. But, I am afraid the public will lose out here again because once again Wall Street is so much smarter and savier then Geitner et al.

May 14 12:42 PM

[GoochyPuppy:]

Geitner is not stupid. Just a crook.

May 14 12:56 PM

[Dr. Roberts:]

"Accountant" has the right idea. Pinch me, are we living in a Banana Republic?

May 14 01:16 PM

[It Figures:]

Dear ditto,

And exactly why should the banks that neither wanted nor needed govt. money be required to "open their books" to these bungling power grabbers?

In what world is it justified for the govt. to come in uninvited to dictate terms to private companies, thus robbing shareholders of value?

For those REQUESTING help, certainly the govt. has a right to know the details. But for those resisting gov.t "help", like Wells, GS, State Street, etc., they have no right whatsoever.

May 14 03:22 PM

[The Good Ne...:]

Linus,
Thanks for your papers and these articles raising the awareness. Most of US taxpayers have no idea how valuable these warrants ultimately can be... or even that negotiating is happening on their behalf... thus the lowered payback price. If we can raise the political awareness of these paybacks, the stories may change.
GNE

May 14 03:30 PM

[Jasper M:]

Given where I think these companies' stock prices are headed, this gaff by treasury may turn out to be fortuitous for the taxpayers.

I am a bit confused by the notion that Goldman 'resisted' the bailout. Certainly Wells made a show. But Goldman even went so far as to technically change their business model in order to qualify.

May 14 06:07 PM

[John Olagues:]

Linus;

As you know, the "fair value" of those warrants can be calculated quite precisely using theoretical pricing models.

Given the extreme recent historical and implied volatilities of the banks, the warrants "fair value" are very high. I am certain that the Treasury, under criminals like Geithner will not receive anything near "fair value". If the Treasury wants to sell their warrants to third parties, I am certain that the third parties will get great buys as they can immediately sell listed calls and short stock and hedge away most of the risk and pocket high theoretical advantages.

But I am confidant that the third party buyers will be friends of Geithner and Dimon and Paulson and Bernanke and other errand boys.

Please ignore the "comments" of the banking shills who seems to immediately rise when their darlings are spotlighted.

John Olagues

May 15 09:08 AM

[Linus Wilson:]

My research on this topic was reported in the NY Times at www.nytimes.com/2009/0...

You heard it here first on Seeking Alpha!

May 19 08:01 AM

[winstongator:]

How much did treasury pay for the warrants?

May 20 09:34 AM

[qrst:]

not a bad analysis.

one beef. i would guess his volatility estimates are too high, even in the low case.

the volatility seems to be pretty high — the low volatility estimate of 37% suggests that this is a volatile stock.

the high volatility estimate — 80+% is sheer nonsense. no stock in the world is going to have 80% volatility for ten years.

the methodology for choosing the middle volatility is not correct. he is using volatility from a very short dated option to price a ten year option. the observed (ie implied) volatility of a long dated option is generally much lower than the volatility of a short dated option.

in reality though there are very very few ten year options in the marketplace, and nobody would know for sure the price through a formula. instruments like these often trade at large discounts to the model. the only way to find out is to sell some of them and see what bids you get.

May 21 09:09 PM

[qrst:]

i looked up the historical vol for ONB US Equity on bloomberg. in the 2000-2006 time period the historical vol averaged 18.17 — far below the 35 used in wilson’s “lowball” estimate. and at no point in the 2000-2006 time period did the 100-day moving average historical vol go above 27.5. based on this, i think he should recompute his results.
there are other problems with the paper. why is he not using the 10Y treasury as the risk free rate, as opposed to a short dated LIBOR? also, how can he consider the low dividend assumption at all, given that this represents a situation where the bank remains distressed in which case the stock will remain low and the warrants will be worth very little?

May 22 11:18 AM

[B.M.:]

that's BS. If GS and JPM hadn't approved the TARP, they'd have gone bye-bye due to counterparty risk. they were WAY overleveraged, and the AIG payments to GS show exactly what kind of risk GS had taken. The taxpayer deserves the full auctioned value of these warrants, not to mention the gov't shouldn't have done the TARP in the first place, allowing badly run banks to fail and good ones to survive.


On May 14 12:21 PM accountant wrote:

> The only problem with your thesis is that several of the original
> banks, including both Goldman and Morgan Stanley, had the government
> shove the TARP money down their throat. So why should the taxpayers
> make a bunch of excess profits off of the deal?
>
> Let's see, we'll force the banks to take TARP money that, in several
> cases, they don't need or want, we will grant ourselves warrants
> to buy their stock at cheap prices, thus diluting stockholder value,
> and then, if we don't demand top dollar for the warrants, we will
> claim that the taxpayer is getting hosed.
>
> Seems like an incredibly one-sided transaction to me.

Jun 01 07:24 PM