How Treasury Favors Banks over Taxpayers in Warrant Negotiations

The U.S. Treasury released its first public statement on its methodology for calculating the value of the taxpayers’ warrants on Friday. Its method for calculating historic volatility favors the banks at the expense of taxpayers.

This means that the U.S. Treasury is selling the taxpayers’ risky investments for pennies on the dollar to the ex-TARP banks. I estimate in the first ten transactions Tim Geithner and company are selling the taxpayers’ warrants for between 75 cents to 48 cents on the dollar, using 10-year and 2-year historic volatility as the lower and upper bounds. For the 5 transactions where the bank has traded options the implied volatility valuations are about 59 cents on the dollar so far.

The standard definition for calculating 10-year historic volatility is to find the standard deviation of the continuously compounded stock returns over the last ten years. Yet, Treasury has redefined historic volatility in a way that helps the banks. The guidelines released Friday said,

Treasury uses the average 60-day trailing volatility for the last ten years to determine a stock's historical volatility.

What is the difference? The difference is millions of dollars that the banks save and taxpayers lose because the U.S. Treasury found an obscure way to further benefit the banks at the expense of taxpayers.

According to my estimates of the value of the warrants issued by the ten large banks that repaid TARP on June 17, 2009, this seemingly small change costs taxpayers between $528 million to $686 million dollars or about 14 percent of the value of those ten bank’s warrants. Since I estimate in my paper’s tables 2 and 3, that the taxpayers’ warrants are worth $11 billion, a 14 percent discount could cost taxpayers up to $1.5 billion. JP Morgan (JPM) alone benefits from this alternative definition by $224 to $254 million. On average, this change led to the average 10-year historic volatility of these banks fall from 50 percent to 39.5 percent.

The U.S. Treasury is supposed to be representing taxpayers in an adversarial negotiation. Yet, its opening bid is lower than the “rule of thumb” historic volatility calculation according to page 239 of the popular derivatives textbook. I’m not going to pretend that there is only one way to calculate volatility. No one knows what future volatility will be. The problem is the U.S. Treasury should be going into the negotiations with an optimistic valuation. Yet, they appear to be going to great lengths to undervalue the taxpayers’ risky investments. This is unfortunate because the process is often concluded by averaging the valuations of the bank, the U.S. Treasury, and a third party expert. The banks have strong incentives to make lowball offers. The banks who have made lowball offers, Old National (ONB) and Sun Bancorp (SNBC), have gotten the best deals so far.

According to the security purchase agreement section 4.9, only if the ex-TARP banks find the deal unprofitable, the U.S. Treasury can sell the warrants to third party investors. It is third party investors who are betting real money who are in the best position to price the TARP warrants’ volatility. Yet, the U.S. Treasury is offering the banks such great deals that we will see few sales to third party investors.

Moreover, despite the fact that press release pays lip service to setting up auctions we have not seen one third-party sale. Moreover, if present trends continue, we are unlikely to see one auction before the U.S. Treasury negotiates away over a third of the value of the of the taxpayers’ warrant portfolio in deals with the ten big banks that exited TARP on June 17, 2009.

Steve D. Jones’ “In the Money” column on Friday, June 26, 2009, on the Dow Jones Newswire (which is by subscription only) found that the U.S. Treasury received a third party bid in its negotiations with SCBT Financial (SCBT). Did taxpayers get that price? No. That price was ignored in favor of a split-the-difference negotiation between SCBT and Treasury officials. I estimate that taxpayers got between 85 and 50 cents on the dollar on that transaction.

MIT economist Simon Johnson argues the process is ripe for corruption. Treasury officials should not have the discretion to hand hundreds of millions of dollars to firms that have thousands of seven digit jobs. If they want to remove the appearance of corruption, the new Assistant Secretary of Financial Stability, Herb Allison, should take steps to ensure the TARP warrants of the ten big banks especially the investment banks, are auctioned to third party investors.

The big banks just want to be free of TARP, but unfortunately the Treasury officials appear from their press release to be all too eager to give them a sweetheart deal. If the heads of the big banks were smart, they would know a good deal on the warrants would come at too high a price in the long run. It is in the interest of shareholders of JP Morgan, Morgan Stanley (MS), and Goldman Sachs (GS) that these warrants are auctioned to third-party buyers.

Comments

[hoopty:]

This hasn't cost the taxpayers a cent. This is
profit to taxpayers as is dividends received.

Jul 01 07:36 AM

[hoopty:]

This does not cost taxpayers. This is profit to taxpayers as are the dividends. Banks should have never been coerced into taking the money, but it is still profit to taxpayers. You should be more concerned where the money is being spent that is paid back. Now that is going to cost taxpayers.

Jul 01 07:38 AM

[aginghippy:]

First the government forces banks to take TARP, now they want "excess profits" (to use a term politicians like) from those same banks. If the Mafia tried this, the Attorney General would be all over their case.

This is extortion.

Jul 01 08:53 AM

[biomedlives:]

If the banks wanted to avoid a government rescue of the financial system, they should have come up with their own free market solution to the crisis. They didn't, so the government had to step in.

I say that the government should forget theoretical calculations and hold an auction of the TARP warrents.

Jul 01 10:10 AM

[Moorich:]

I completely agree. The government wanted widespread participation in TARP and heavily pressured several banks to take money that wasn't needed. Now it should accept the repayment, make a good profit for the taxpayers and get out of the repaying banks' business.


On Jul 01 08:53 AM aginghippy wrote:

> First the government forces banks to take TARP, now they want "excess
> profits" (to use a term politicians like) from those same banks.
> If the Mafia tried this, the Attorney General would be all over their
> case.
>
> This is extortion.

Jul 01 12:23 PM

[ReverendSlappy:]

I think this is right for these banks. These banks that paid the TARP are arguably the ones who didn't need the money in the first place, and the TARP has been nothing but a penalty to banks like USB that did not get involved in all this crap. It costs these banks, and their respective shareholders, MAJOR amounts of money being under this TARP. I understand the psyche behind the TARP, and I'll even go so far as to say that it was probably the right move. Unfortunately, one bad apple can spoil the bunch. But, realizing in hindsight that some banks were unfairly penalized, I think the Treasury erring on the side of these strong banks is the right thing to do.

Jul 01 01:55 PM

[John Olagues:]

I believe that Linus is correct in general. But I believe he is too kind to those criminal bankers on welfare. My general observation is that their theft is far greater than he estimates.

Its really sad that the commentators (except "no money mo"...) are so ignorant of how options and warrants work and have the nerve to be critical of someone that is trying to shed some light on the subject.

I actually believe no one can be as stupid as the top six commentators and that leaves only one answer to why they spew such drivel. They are shills for criminals.

I am certain that none of the first six commentators have the ability to understand, analyze or value a warrant or a stock option.

john Olagues

Jul 02 01:06 AM

[ReverendSlappy:]

Since when does simply commenting in favor of strong banks have anything to do with options and warrants? I wasn't trying to discount what Mr. Wilson said, I was just saying how unfair it is that certain banks had to deal with this.

I actually believe you have more of an axe to grind than anybody.


On Jul 02 01:06 AM John Olagues wrote:

> I believe that Linus is correct in general. But I believe he is too
> kind to those criminal bankers on welfare. My general observation
> is that their theft is far greater than he estimates.
>
> Its really sad that the commentators (except "no money mo"...) are
> so ignorant of how options and warrants work and have the nerve to
> be critical of someone that is trying to shed some light on the subject.
>
>
> I actually believe no one can be as stupid as the top six commentators
> and that leaves only one answer to why they spew such drivel. They
> are shills for criminals.
>
> I am certain that none of the first six commentators have the ability
> to understand, analyze or value a warrant or a stock option.
>
> john Olagues

Jul 02 09:58 AM

[John Olagues:]

I would say that in all probability everyone of the banks that accepted TARP money needed and wanted the TARP funds. For example Goldman Sachs accepted $10 Billion when just weeks earlier they accepted $5 Billion from Warren Buffett where GS gave him 45 million warrants and 10% interest on the Warrants. That deal was far more onerous to GS than the TARP money.

The banks are probably borrowing from the FED at 1/2 % and paying off the TARP money which requires 5% and are trying to buy back the warrants for 50% of their value.

Perhaps executives like those at JPM who received $85 Million of SARs and Restricted stock in January 2009 which is now valued at $175 million should forfeit 50% of their gains back to JPM. JPM would be able to pay off the Treasury at its contractual value instead of begging for more subsidies from the Treasury.
John

Jul 02 12:28 PM

[hoopty:]

It is sad when "genius" former options and derivitive traders feel like only they know what is best and assume people who read their posts are ignorant and uninformed. You are a bitter person. You helped create this mess selling the very products some of these "good" banks who loan money for homes, cars, and businesses that allow you (who don't produce anything, build anything or provide a service to anyone other than how to buy and hedge fractional pieces of businesses and other gambling derivative devices to others) to make a living. The value of warrants will be determined by the Fed. The tapxayers will not lose one cent it will still all be profit. The banks who have paid back TARP were pressured into taking it. Example: John Allison chairman of BB&T sent letters to every member of congress before any was doled out against intervention. All money loaned to these banks was paid back with interest. No taxpayer loss. The loss will occur to the taxpayer when the paid back monies get spent by congress on some or other pork barrel project. While I too am not happy with outrageous stock option plans, the fact remains - Banks that were pressured into taking this money and paid it back should not be penalized. That is just right. Stupid is as stupid does.


On Jul 02 01:06 AM John Olagues wrote:

> I believe that Linus is correct in general. But I believe he is too
> kind to those criminal bankers on welfare. My general observation
> is that their theft is far greater than he estimates.
>
> Its really sad that the commentators (except "no money mo"...) are
> so ignorant of how options and warrants work and have the nerve to
> be critical of someone that is trying to shed some light on the subject.
>
>
> I actually believe no one can be as stupid as the top six commentators
> and that leaves only one answer to why they spew such drivel. They
> are shills for criminals.
>
> I am certain that none of the first six commentators have the ability
> to understand, analyze or value a warrant or a stock option.
>
> john Olagues

Jul 03 06:35 AM

[B.M.:]

You dissenters all assume taxpayer gets whole on all the banks who were given TARP. Do you forget that only a minority of banks will pay back the TARP?? So just because your AAA credits are paying, doesn't mean the "cost to taxpayers is nil", we are paying because the sub-prime banks are going to eat all our TARP and give nothing back.

Furthermore, when part 2 of this crises occurs, the gov't is going to have to bail out TARP-paybackers AGAIN.

Jul 08 09:09 PM

[B.M.:]

Forced into taking TARP? Let me remind everyone that the government tooth fairy gave out free money to GS and other banks who made bets with AIG. Those banks were aware of the counterparty risk of AIG, they chose to ignore it. Did they pay? No, the taxpayer paid. So let's not run around saying the banks took TARP against their will. Had the TARP not been there, WFC, BAC, C, AIG, FNM, FRE, and yes, GS and JPM and MS would have all gone t!ts up from a panic run on those banks.

You can't listen to people like Warren Buffett either, who say TARP and gov't bailouts were necessary. OF COURSE they were necessary according to Buffett, he's got tremendous skin in the game in the form of ownership of STI, WFC, BAC and other banks which would have gone under.

The bottom line is, this author is correct in saying the gov't is handing taxpayers money to bankers. This is a fact. Those of you in the banking industry should just shut up and be happy there isn't a lynch mob outside your door, because that is what would have happened in the old days had you ignorantly opened your mouths which are feeding on the gov't teet.

Jul 08 09:14 PM