Auction the TARP Warrants and Everyone Wins

Healthy banks are anxious to escape from the government’s Troubled Asset Relief Program. TARP capital seemed cheap at first since the government offered more generous financial terms than were available from private investors. But now the hidden costs of government investments – compensation limits, tighter regulatory scrutiny, and a public backlash against financial bailouts – have become apparent. As a result, many banks want to pay off Uncle Sam and free themselves from the TARP.

Repayment sounds simple. Subject to regulatory approval, banks can simply write a check to Treasury that covers the amount of money they received (by selling preferred stock) plus any outstanding dividends. But there’s a complication. When Treasury purchased the preferred shares, it also received warrants to purchase common stock in the future. To fully escape the burden and stigma of TARP, the banks thus need a way to get Treasury to relinquish those warrants.

A few weeks ago, bank lobbyists argued that the solution to this problem was for Treasury to forgive the warrants. But that’s an untenable position. Taxpayers took a risk investing in these firms, and they deserve appropriate compensation – including full value for the warrants – in return.

To date, Treasury has instead required banks to repurchase the warrants, with prices determined by some combination of negotiation and outside estimates of the warrants’ value. That’s better than forgiving the warrants, but it is still a flawed approach. Treasury has sold only a handful of warrants thus far, and already we see allegations that the banks are getting sweetheart deals and that taxpayers are losing out. In today’s charged environment, those allegations will likely persist even if Treasury is doing a great job negotiating with the banks.

My advice? Treasury should give up on negotiated sales and simply auction the warrants it received through its TARP investments. Auctioning the warrants will:

• Enhance the transparency of the process (since no one can accuse Treasury of playing favorites in the auction);

• Ensure that taxpayers get a fair return on their investment (since the warrants will be sold at their real market value);

• Allow banks, if they choose, to preserve needed capital (if investors purchase the warrants, banks won’t have to use up any of their scarce capital); and

• Free banks from the nuisance of government involvement (since banks get free of TARP even if private investors end up purchasing the warrants).

The parallels to the first Chrysler bailout are instructive here. In 1980, the government provided loan guarantees to Chrysler, which was then teetering near bankruptcy. As partial compensation for providing the guarantees, the government received warrants to purchase Chrysler stock. In 1983, the company was back on its feet, and the warrants had significant value. At that point, Chrysler’s CEO, Lee Iacocca, went to Congress to argue that the government should forgive Chrysler’s warrants. Thankfully, Congress rebuffed him. The taxpayer had taken on significant risk and deserved to be compensated. The government auctioned the warrants to the highest bidder – which turned out to be Chrysler – netting taxpayers a well-deserved $311 million.

We should take the same approach today. Auctioning the warrants is a win-win-win-win proposition for taxpayers, banks, policymakers, and potential investors.

Disclosure: I have no position in any TARP recipients.

Comments

[Jasper M:]

An obvious solution - IF one supposes the goal is for "everyone to win". It seems pretty clear that is not the case.
The goal is to game the system to save the banksters, with the minimum cost to said banksters, and devil may care about the rest (taxpayers, bondholders).

This would really bug me, if I wasn't Certain that their schemes would collapse shortly.

May 26 05:55 PM

[Asitoughtobe:]

Donald,

"Auctioning the warrants is a win-win-win-win proposition for taxpayers, banks, policymakers, and potential investors."

I thought the article was right on, great read, one exception. The banks would not view your solution as a win since right now they have a better deal with their ability to buy back warrants at less than market value.
American's need to get off their duffs and get involved or the win,win,win as proposed will fall by the weigh side and the bank constituencies s will be the only winners.

Healthy Investing!

May 26 07:38 PM

[Free Market...:]

I don't see anything fair about this. Care of the freedom of information act, we already know that the banks were forced, whether they needed it or not, to take the funds. They were not told what the costs would be up front but were threatened if they turned it down. Now that the true costs have been laid out, no solvent bank wants any part of it. And by the way, the banks are paying a 5% "dividend" which rises to 9% after 5 years if not repaid. That is not a bailout, that is theft by the federal government from the stockholders.... Just like what they are doing to the bondholders at GM and Chrysler but we'll save that for another day. In Bank of America's case, it is already also on record that Hank P. told Ken Lewis he pretty much had to go through with the M/Lynch deal or he and the board could be sacked. If he had not been forced into this, B of A would probably not have needed any additional capital.... certainly not before the thresholds for what "well capitalized" meant were changed. I thought this stuff only happened in Venezuela. Leave business alone! If a company makes bad decisions that cause it to go bust, so be it. Don't bail them out and don't think the government can run a bank when they can't manage their own checking account.

May 26 10:18 PM

[Dr. Rushin:]

I liked your innovative approach proven by history of Chrysler. Can a novel solution be found instead of converting TARP preferred shares into common, as Citigroup is going to do? This will be a bailout of short sellers, who drove the stock price down. Ironically, while president Obama is blasting financial speculators, the government is going to reward them: check www.gameofbeads.com/Ci...

May 26 10:48 PM

[rich c:]

Auctioning is OK but that empowers the Money Changers. A solution I've suggested is to package the warrants into something traded (a bond, ETF, LP...) that every America can purchase for their IRA, kids college fund.... via an IPO. Let it trade and provide liquidity at a market price. $10.00 initial NAV per share, $1,000 minimum.

If the banks want to buy them, let them buy them back directly from John Q Public via the secondary market at a then market price.

I would do the same thing with FDIC loans, PPIP.... Buypass the Bill Gross' of the world and put these assets directly in the hands of those who foot the bill at par!!

May 27 01:29 AM

[Joe Bruin:]

If the government didn't step in to help all financial companies would be dollar stocks. The shorts would have taken even Goldman Sachs down to $1. Every thing got sold.

May 27 01:33 AM

[Russ Krull:]

The securities purchase agreements include a provision that eliminates half the shares in the warrants if the banks raise private capital equal or greater to the TARP investment prior to the end of 2009, so the gov't could only auction half the warrants before that.

I'd recommend selling the warrants in an open auction through TreasuryDirect with minimum lot sizes small enough to let everyone in on the bidding process. If they can't do that, put 'em on E-bay.
caps.fool.com/Blogs/Vi...

May 27 07:46 AM

[robert.b.fe...:]

Good article. Seems like a logical way to prevent or minimize shenanagans by bankers.

May 27 09:08 AM

[Hot Richard:]

TARP was always going to result in polticians buying votes and shareholders getting screwed. Make no mistake, if you have stock in a TARP-recipient you are going to make the love threesome with government and taxpayers. It is about wealth redistribution TO the government.

There is not elegant way out of TARP. Bad idea at concept and now it is full of poltical agenda.

Auctioning isn't going to win awards for "fair", but it does get the government out of the business (a little).

Now I just gotta get me a photo with the flag in the background. I mean what was I thinking with the banana leaf hat!

May 27 10:43 AM