Goldman Sachs, Morgan Stanley: Half Price on TARP Warrants?

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 |  Includes: BAC, GS, MS, STT, XLF
by: Linus Wilson

Morgan Stanley (NYSE:MS) reports earnings today, Wednesday, July 22, 2009. Its rival Goldman Sachs (NYSE:GS) busted through earnings estimates a week earlier, raking in $2.7 billion in quarter two. Both banks have a decision to make about the TARP warrants.

They, of course, could opt for an auction of the TARP warrants as both Jim Cramer and I advise. A public auction, as opposed to a closed door negotiation, is a win-win for taxpayers and the investment banks. Taxpayers get higher prices for the warrants, and the investment banks inoculate themselves from criticism by the media and Congress. My research shows that the auction of taxpayers’ Chrysler warrants in 1983 generated prices much closer to the theoretical Black-Scholes value than the U.S. Treasury is currently obtaining through negotiations.

Yet, MS and GS also have to decide if they want to get half price on the warrants. The way they can do that is to issue more equity. Section 4.4 of their securities purchase agreement for the Capital Purchase Program of the TARP allows them to cut the number of warrants in half by issuing $10 billion of equity before the end of 2009. To get half off on the warrants, Goldman Sachs must issue $4.25 billion more in stock, and Morgan Stanley has to issue $3.66 billion more in stock.

By my estimates, both banks could gain on net around $200 million dollars for their shareholders by issuing equity right away or much more if they can afford to postpone the decision until year end.

My model takes into account the costs of issuing equity and weighs it against benefit of cancelling half the warrants. The dilution in the share price from issuing more equity is relatively minor, because new investors pay just below the market price for new shares. (It is only the under-pricing of the new stock and the fees paid to underwriters that hurt existing shareholders.)

Since both MS and GS are major underwriters of equity, the underwriting fees are probably much smaller than for other firms. We will see if they take advantage of this valuable opportunity to cancel half the warrants in the coming days and months.

Disclosure: This is not investment advice. The author makes no warranties about the valuations, data, or methods. The author only has long positions in broad-based index funds.