Treasury Ups the Ante With BofA Warrant Auction

by: Linus Wilson

Investors have seen great returns investing in the Troubled Asset Relief Program (TARP) warrant auctions in December. Warrants are call options that increase the number of shares outstanding upon exercise. The simple average returns to buying the warrants, which were issued by Capital One Financial (NYSE:COF), JP Morgan Chase (NYSE:JPM) and TCF Financial (NYSE:TCB), at auction in December 2009 and selling them at the end of February 2010 was 22.8 percent by my calculations. (That is a roughly two to three month return. Annualized returns would be higher!) That is better than the simple average return to those banks' stocks over that period of 2.8 percent.

Perhaps the U.S. Treasury thinks it has been leaving some money on the table. The U.S. Treasury has set a high bar for anyone wanting to buy the group A, in-the-money warrants, in the Wednesday, March 3, 2010, auction of Bank of America (NYSE:BAC) warrants. This is the first ever auction that my middle estimate exceeds the auction reservation price. My middle, best, estimate is $6.88 per warrant for the BofA warrants that expire on January 16, 2019, with an exercise price of $13.30. My high estimate is $9.06 per warrant in group A. In the last two auctions, my final middle estimate on the day of the auction has been 91 percent and 83 percent of the auction price. Thus, it is possible that the auction will be oversubscribed at $7 per warrant or higher. If the auction is not over subscribed, the U.S. Treasury may choose to sell as little as half the warrants at $7.00. If less than half the bidders want the warrants at $7.00 or greater, then the auction is cancelled. Perhaps the U.S. Treasury thinks it can get higher prices with higher reservation prices. The banks appeared to get lower negotiated prices on the bailout warrants making low opening offers, according to my research.

Bidding in group B seems less problematic to me because the reservation price is $1.50, which is below my low estimate. Yet, these are riskier call options with a strike price of $30.79 and an expiration date of October 28, 2018. My best estimate is $3.04 with a range of $1.69 to $5.09 each.

The Dutch auction format means that investors pay the highest uniform price that sells all the warrants in each group if the auctions are oversubscribed. (If the group's auctions don't get enough bids to sell all the warrants, either winning bidders will pay the price floor, or the U.S. Treasury will cancel the auction. See the preliminary prospectus for group A and group B, respectively.) There are two schools of thought on bidding in Dutch auctions. The first school of thought says that you should bid your valuation in Dutch auctions. The other school of thought believes you should shave down your bids to avoid the "winner's curse" whereby you have won because your valuation is much more optimistic than anyone else's.

The minimum bid is for 100 warrants. You probably need to go through one of the brokers listed at the bottom of the U.S. Treasury's press release to participate. Bids can be submitted between 8 A.M. and 6:30 P.M. on Wednesday, March 3, 2010.

My paper, "The Biggest Warrant Auction in U.S. History", explains my methodology. I hope the U.S. Treasury sells out all its warrants at or above its reservation price. That would mean that taxpayers would rake in more than the previous record holder for the biggest warrant auction in U.S. history (the JP Morgan Chase auction in December 2009). Moreover, if all the 272 million warrants are sold at the reservation prices, taxpayers stand to take in more than the $1.1 billion raised from the negotiated repurchase of the Goldman Sachs (NYSE:GS) warrants in July 2009. With all these billions coming back to taxpayers, I glad we did not give away the warrants to the banks like the American Bankers Association (ABA) wanted us to do in April of 2009.

Disclaimer: This is not investment advice. The author makes no warranties about the content or valuations. Warrants are not suitable for all investors. Investors in warrants stand a good chance of losing all their investment.

Disclosure: I have no positions except long positions in broad-based index funds.

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