Joint work by Wendy Yan Wu and myself, “Common (Stock) Sense about Risk-Shifting and Bank Bailouts,” and solo work, “Debt Overhang and Bank Bailouts,” found that $1 of subsidy on a preferred stock recapitalization is equivalent in terms of incentives to $1 of new common stock issued. A greater common stock cushion means that the bank is more likely to make good lending decisions, and is less likely to make bad decisions that lead to bailouts in the future.
I looked at the yields of JP Morgan’s non-TARP preferred stock on June 1, 2009. It yielded about 7.5 percent. The TARP preferred stock pays a 5 percent dividend for the next four and a half years. This means that JPM is giving up a subsidy with a present value of about $2.4 billion by paying back TARP before the TARP preferred stock dividend rises to 10 percent. Buying back warrants is roughly equivalent to repurchasing shares. It reduces the common equity cushion. By my estimates, the JP Morgan warrants were worth about $1.6 billion by the close of trading on Monday, June 1. Suppose that JP Morgan pays $1.6 billion to repurchase the TARP warrants. On net, that means that its common equity cushion has increased by $5.0 - $2.4 - $1.6 = $1.0 billion.
Taxpayers win on two counts. First, the $2.4 billion subsidy is returned by repaying the preferred early. Second, JP Morgan has more, but not much more, common equity and is less likely to make bad decisions that lead to future bailouts.
I don’t agree with Jamie Dimon that JP Morgan should get a half price sale on the TARP warrants. The purchase agreement that he signed says half the warrants will be forgiven if he raised $25 billion of stock. (I already took into account the chance, 14 percent according to my model, that JP Morgan would want to raise the full $25 billion, reducing my valuation of those warrants by about 7 percent.) If he wants half price on the TARP warrants, he should raise $25 billion not just $5 billion of common stock. I’m sure Mr. Dimon won’t agree to give back half his stock options. Nor should taxpayers give away half their warrants. There is no economic justification for such subsidies when JP Morgan can easily tap equity markets. If Mr. Dimon wants to get the government out of his business, he should stop asking for subsidies.
Disclosure: I do not have any long or short positions in any banks' securities except long positions in broad-based index funds.