A New Proposal: Bank Annual Optional Warrant Acquisition Operation

| About: SPDR S&P (SPY)

I have a modest proposal. I believe it will rein in the banks, and compel them to behave properly. Here it is.

  • If any bank fails to comply in the future with federal capital or lending guidelines, then the US Treasury receives an option to acquire warrants in the common stock of that bank or its parent company.
  • This option will be granted to the US Treasury for each reporting period (either year or quarter, to be determined) that the bank is NOT in compliance.
  • The tenor, or term, of the warrants will be ten years. The warrants’ strike price will be the average stock price for any 20 consecutive trading days selected by the Treasury.
  • The twenty-day period must fall within a two-year window that begins one year before the Treasury announces that the bank is not in compliance; and ends one year after the Treasury’s non-compliance announcement.
  • The number of warrants will be set as a percentage of the average number of outstanding common shares of the non-compliant bank or parent company, for the 20 consecutive trading days used to establish the “strike.”
  • The actual percentage will be a small but not insignificant positive percentage that is fixed for all companies, by statute. The specific percentage will be determined by a bill originating in the US House.
  • The Treasury will have the ability to hold the warrants until their expiration. It does not have to exercise the warrants that it holds on behalf of US taxpayers.
  • The Treasury may also elect to sell the warrants that it holds - in whole or in part, at any time - to private parties in a public competitive auction.
  • The Federal Reserve and a private company will jointly administer the auction. The private company would presumably be BlackRock, unless BlackRock warrants are being offered, in which case Goldman Sachs would be the private auction co-administrator.
  • The Secretary of the Treasury will report to the US House and Senate, twice a year, on the status of its warrant holdings. This report will include a full accounting of the warrants held, acquired, auctioned, or lapsed. The Secretary will report on the gains – or profit – if any, that the Treasury earns on the warrants.

If portions of the above sound familiar, that would be because the terms resemble those of warrants granted to the US Treasury under the 2008 TARP Capital Purchase Program [“CPP”], as I described in The Real Options Monster.

Since I penned that Monster piece, events have moved swiftly.

Even the US Congress realizes that they would have left a lot of money on the table – more than $4 billion – if they had botched the disposition of taxpayer CPP warrants for more than 300 banks. As reported by Bloomberg on 20 May 2009:

[Treasury Secretary Timothy] Geithner … reiterated that the government can sell the [TARP CPP] warrants back to the bank or to a third party.

New legislation, passed by Congress late yesterday, removes previously imposed deadlines for extinguishing the warrants once a bank repays the government’s main equity stake, allowing the government more flexibility.

The Treasury says banks can choose whether to negotiate over the warrants or not. If the bank refuses or can’t agree on a price, then the government will sell the warrants to a third party, as outlined in the original contracts [emphasis added].

Source: R. Christie, Bloomberg, Geithner Says Treasury May Move ‘Quickly’ to Sell TARP Warrants, 20 May 2009.

If Congress enacts the Bank Annual Optional Warrant Acquisition Operation (BAOWAO, pronounced “bow-wow”) program described above, it should restrain the Lords of finance and compel them to prudently manage their regulated financial quasi-utilities.

If not, the Lords (who had no problem rewarding themselves with well-timed stock options in the high times of what is now seen as low finance) will face the warranted wrath of their taxpayer vassals.

Finally, since the program is conditional upon future financial sector missteps, it preserves the spirit, if not the substance, of our hallowed free-enterprise system.