Treasury's Pricing of TARP Warrants: No Way Out

By Simon Johnson

Buried in the late wire news on Friday – and therefore barely registering in the newspapers over the weekend – Treasury announced the rules for pricing its option to buy shares in banks that participated in TARP.

The Treasury Department said the banks will make the first offer for the warrants. Treasury will then decide to sell at that price or make a counteroffer. If the government and a bank cannot agree on a fair price for the warrants, the two sides will have the right to use private appraisers.

This is a mistake.

The only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins.

In Treasury’s scheme, there is significant risk of implicit gift exchange with banks - good jobs/political support/other favors down the road – or even explicit corruption. For sure, there will be accusations that someone at Treasury was too close to this or that bidder. Why would Treasury’s leadership want to be involved in price setting in this fashion?

Treasury apparently sees corruption as an issue about personalities (i.e., WE aren’t ever corrupt) rather than about institutional structure. For example, if you create an arrangement that easily permits corruption, such as through nontransparent decision making or negotiation around warrant pricing, you set up incentives to be corrupt. Either existing people change their behavior, or new people will seek appointment in order to participate in corruption.

This is also a point, by the way, that Treasury has been making for years through its representatives at the International Monetary Fund – including during the Clinton Administration, when the same people were running U.S. economic policy as now. It’s a good point and never easy for countries-with-potential-corruption to hear. It applies as much to the United States as to anywhere else.

Treasury will argue the disposal of warrants is a one-off event, but this is not a plausible line: It is part of a much longer series of nontransparent decisions over finance. The attitude that “we can be nontransparent because we will never be corrupt” creates reputational risk for both Treasury and participating banks. If extraordinary support for the financial sector lasts several years, we will likely have at least one time-consuming and damaging investigation into all the details of these settlements.

In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable. But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House – hopefully, senior congressional leaders will quickly make this point behind the scenes.

There is obviously unappealing midterm election risk in this pricing scheme and making a correction now – before major banks have participated – would be relatively straightforward.

(Primer on option pricing, applied to warrants; background on how we got here)

Comments

[Zachary Sch...:]

Your points on the potential for corruption (or just the perception of corruption) are valid, but the biggest issue appears to be this administration's aversion to free markets. A dutch auction of some sort where market participants as well as the individual banks participate in bidding for these warrants would not only bring the US taxpayers the greatest return for the risk taken over the last 6 months, but would also lead to better liquidity, confidence, and price discovery in the banking industry.

Good catch - interesting article. Hopefully we can get some revision to this measure before its too late.

Zach
zachstocks.com

Jun 29 03:30 PM

[optionsgirl:]

This is a very good article exposing another bad move by the Treasury, putting the banks before the American taxpayer AGAIN.

Jun 29 03:38 PM

[Linus Wilson:]

I like auctions too. My research on the TARP warrants is at www.linuswilson.com/ba....

Jun 29 04:02 PM

[dcb:]

Hey, maybe Obama is even more corrupt than Bush. Maybe he is just a better used car salesman. I hate to say this but starting with the AIG bonus issue, and at each and every step of the way Obama is giving the banks any and everything they could ask for.

In the last election the american people voted for change from a grass roots level. The election has been high jacked by the exstablishment and Mr. Obama himself. I see him as becomming the greates disappointment ever elected by the Anmerican people and one of histories greatest failures. When given the mandate of change by the American people he chose to sell them out to special interest groups. At leat in Iran the People knpw enough to riot when an eletion ahs been stolen from them. Mr Obama stole the election from us, the very people who actually voted for hem.

Jun 29 04:11 PM

[dcb:]

Although, He may have been replaced be a robot. The only thing I can say for certain is that he isn't the person the American people elected to lead them.

Jun 29 04:12 PM

[Linus Wilson:]

The problem is that the purchase agreement sets up this negotiation process, but I agree about the potential for corruption. The Treasury can only auction warrants where negotiations have broken off. My valuations of the first 10 repurchases indicate the U.S. Treasury has given the banks great deals at taxpayers' expense. Tables 2 and 3 of ssrn.com/abstract=1413442 provide valuations of 68 banks' warrants including the 10 that repaid the preferred on June 17, 2009.

Jun 29 04:25 PM

[Old Rick:]

Beware of the eloquent liar!!


On Jun 29 04:11 PM dcb wrote:

> Hey, maybe Obama is even more corrupt than Bush. Maybe he is just
> a better used car salesman. I hate to say this but starting with
> the AIG bonus issue, and at each and every step of the way Obama
> is giving the banks any and everything they could ask for.
>
> In the last election the american people voted for change from a
> grass roots level. The election has been high jacked by the exstablishment
> and Mr. Obama himself. I see him as becomming the greates disappointment
> ever elected by the Anmerican people and one of histories greatest
> failures. When given the mandate of change by the American people
> he chose to sell them out to special interest groups. At leat in
> Iran the People knpw enough to riot when an eletion ahs been stolen
> from them. Mr Obama stole the election from us, the very people who
> actually voted for hem.

Jun 29 09:38 PM

[Moon Kil Woong:]

The reasoning is rather simple for politicians. It justifies another big wad of lobbying money.

For the Treasury, I would tend to agree that they appear generally against the free market system. This is not an Obama only issue. The whole TARP construct under Bush Jr. flaunted the free market system as well as accountability to the US taxpayer. Both the Treasury and Federal Reserve have used this crisis to exempt themselves of regulation and grab power. How long more will we let this proceeed? Shameful...

Jun 29 10:00 PM

[sethmcs:]

I have seen this method of appraising warrants in venture capital deals where the company is a private company. Obviously, the TARP banks in question are public traded institutions. There is enough data available to determine a fair value of the warrants but remember TARP was rammed down the throat of many banks. To ask for too "fair a price" for a six month intervention is unfair. Let's see how this plays out.

Jun 30 12:21 AM

[thegreatyakk:]

Its a little late to realize you made a mistake! Why don't you do your homework next time, before you rush out and vote!!


On Jun 29 04:11 PM dcb wrote:

> Hey, maybe Obama is even more corrupt than Bush. Maybe he is just
> a better used car salesman. I hate to say this but starting with
> the AIG bonus issue, and at each and every step of the way Obama
> is giving the banks any and everything they could ask for.
>
> In the last election the american people voted for change from a
> grass roots level. The election has been high jacked by the exstablishment
> and Mr. Obama himself. I see him as becomming the greates disappointment
> ever elected by the Anmerican people and one of histories greatest
> failures. When given the mandate of change by the American people
> he chose to sell them out to special interest groups. At leat in
> Iran the People knpw enough to riot when an eletion ahs been stolen
> from them. Mr Obama stole the election from us, the very people who
> actually voted for hem.

Jun 30 12:41 AM

[Mr. Ed, Jr.:]

I was sure "transparency" meant something else, so I looked it up. I'll be darned....

trans·par·en·cy

1. Corrupt, incestuous schemes, usually involving government and various members of elite banking or business. Generally portrayed by government as being reasonable under the circumstances, and as embracing free-market principles, while simutaneously looting the treasury and transferring wealth of citizenry to "others".

Jun 30 04:11 AM

[John Lounsbury:]

Simon - - -

You are a great discussion leader here. There is one factor about transparency that has not been discussed, although Linus Wilson has touched on the subject when he said:

"The Treasury can only auction warrants where negotiations have broken off. My valuations of the first 10 repurchases indicate the U.S. Treasury has given the banks great deals at taxpayers' expense. Tables 2 and 3 of ssrn.com/abstract=1413442 provide valuations of 68 banks' warrants including the 10 that repaid the preferred on June 17, 2009."

If an auction were held (with minimum bids required), what would the result be if no bids were offered exceeding the upset price? Presumably the upset price would be equal to the lowest ask by the government in the failed negotiations. Isn't it likely that others would place bids no higher than what the banks themsleves offered?

If the government threw a party and no one came, what would the result be? I believe the result would be a spectacular collapse of confidence which now shows some green shoots of revival and a big hit to the stock market.

Jun 30 12:28 PM

[Old Trader:]

Nope..he's EXACTLY the person the US electorate elected to lead them. Only its unfortunate that too many were seduced by his intellect, and his delivery (esp. in contrast to his predecessor) to listen to his "message".


On Jun 29 04:12 PM dcb wrote:

> Although, He may have been replaced be a robot. The only thing I
> can say for certain is that he isn't the person the American people
> elected to lead them.

Jul 01 02:37 AM