Banks Making Lowball Offers Are Rewarded in Bailout Warrant Negotiations

by: Linus Wilson

If you are a smart car buyer, you won’t decide what you will pay for a car based on the sticker price at the dealership. If you do, you are guaranteed to get a terrible deal. Nevertheless, it seems that was what the U.S. Treasury has done in its negotiations with banks. The ironic thing is that the U.S. Treasury has access equivalent of dealer’s invoice.

Therefore, they don’t have to rely on the bank’s low offers to know how much the taxpayers’ warrants are worth. The U.S. Treasury has access to third party estimates, market quotes, and its own valuation model to price the Troubled Asset Relief Program (TARP) warrants.

Warrants are call options that give the buyer the right but not the obligation to buy shares at a preset exercise price before a specified date. All banks except the smallest banks receiving taxpayer monies issued warrants to the U.S. Treasury. Most of the TARP warrants expire in 2018 or 2019.

Once a bank repays its preferred stock, it has to submit a bid for the taxpayers’ warrants in fifteen days otherwise the warrants will likely be auctioned. (The U.S. Treasury held three auctions in December, and they announced their intent to hold four more in March last week.)

I analyzed twenty-eight deals where the U.S. Treasury and the bank reached a negotiated agreement after the bank submitted two or more bids. All value estimates are scaled by third party consultants' or the Congressional Oversight Panel's estimates of "fair market value." If a bank makes a lowball offer on the bailout warrants, my paper “Anchoring Bias in the TARP Warrant Negotiations” found that a bank gets a much lower price. If the bank makes an opening offer 10 percent lower it gets a 5.7 to 9.6 percent break on the price according to my research.

This well known behavioral “anchoring bias” means that taxpayers will miss out on hundreds of millions if not billions of dollars negotiating with over 200 banks over the next several years for these warrants.

Anchoring bias is when seemingly irrelevant numbers affect your assessment of the value of an item or the probability of an event. Psychologists Amos Tversky and Daniel Kahneman, the latter professor won the Nobel Prize in Economics, pointed this human foible in the 1970s.

More recently, Dan Ariely describes an experiment in his book Predictably Irrational. He had MBA students write down the last two digits of their social security numbers on a piece of paper. The future MBAs then were asked to bid on items ranging from keyboards to bottles of wine. The B-school students with the last two digits of their social security number between 80 and 99 bid the highest, and the students with the last two digits of 01 and 20 bid the lowest.

Just over 240 banks still have warrants that they have not repurchased from the U.S. Treasury, which would be eligible for negotiations. If the U.S. Treasury focuses on irrelevant first bids instead of what it can get at auction or what it can earn if it holds onto the warrants, then taxpayers could leave hundreds of millions or billions of dollars on the table. So far, it seems Tim Geithner and Company have been focusing on the banks’ lowball offers. I hope that changes.

Disclosure: I only own broad-based index funds. I do not own individual securities in the companies mentioned.

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