State Street TARP Warrant Deal: The Costliest So Far

by: Linus Wilson

Like a company hiding restated earnings, the State Street (NYSE:STT) warrant deal was announced by the U.S. Treasury at the end of the work day on a Friday afternoon. The deal was actually consummated on Wednesday, July 8, 2009, but neither State Street nor the U.S. Treasury announced the deal before the business press had already packed up their notebooks for the week. It is well known that the best way to minimize press coverage of something is to announce it on a Friday afternoon.

It wasn’t a good deal. The twelfth TARP warrant deal was a typically bad one, but it cost taxpayers more than the first eleven warrant deals combined, according to my estimates. I estimate that the warrants were worth between $84 and $100 million. Thus taxpayers got between 72 to 60 cents on the dollar when their representatives accepted a price of $60 million. Thus, taxpayers left between $24 million and $40 million on the table. In my analysis of the first eleven warrant deals, the U.S. Treasury has left between $7 to $23 million dollars on the table.

The irony is that the State Street Deal is the best we can hope for unless the Treasury changes its playbook. It was consummated so quickly that it looks like State Street jumped on a good deal when it had it. The U.S. Treasury’s press release on the warrants (which was also issued on a Friday afternoon) explains the US Treasury’s weird volatility calculations. The US Treasury’s methodology has been criticized by the Congressional Oversight Panel’s (COP) report on the warrants (p. 57), most recently, and myself, earlier, for being unusual and favoring the banks. Moreover, the COP report says that the U.S. Treasury used the 10-year average dividend yield in some instances.

Using the Treasury’s methodology to value the taxpayers’ warrants, I got a value of $61 million for the STT warrants. By the U.S. Treasury’s estimation they made a cool $1 million above fair market value on the deal. The U.S. Treasury gets an “A+” when grading itself! Personally, I think Geithner, Allison, & Company get a “C” at best on the State Street deal.

The US Treasury would make its job easier if it adopted more optimistic assumptions to value the taxpayers’ warrants. Only an optimistic negotiating stance will convince most banks to forgo negotiations. The best result for taxpayers would be that most banks would do what JP Morgan (NYSE:JPM) did and say “auction the warrants.” Economic theory indicates that auctions are better than negotiations because they attract many different bidders. Many will have higher valuations than the issuing bank.

Moreover, competition among bidders leads to truthful revelation of the bidder’s valuations. Sealed-bid, second-price auctions, which allow small investors to participate seem best to me, but I am interested in hearing what economic auction experts have to say on this. I estimate the J.P. Morgan warrants could be worth between $1.4 billion to $2 billion. A lot of money can be made if an auction is done right, and a lot can be forgone if it is done wrong.

Thus, it is worth the money for the U.S. Treasury to design effective auctions. Plus, I hear that economic (auctions) consultants (footnote 49 on page 186) come cheap relative to investment bankers.

Disclosure: I only have long positions on broad based mutual funds. This is not investment advice. I make no warranties about the data, methods, or valuations above.