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Large U.S. banks like Bank of America (NYSE:BAC), Citigroup (NYSE:C), JP Morgan (NYSE:JPM), PNC Financial (NYSE:PNC) and Wells Fargo (NYSE:WFC) have rallied significantly from March 2009 lows. Many investors may be interested in buying into the banks, but are reluctant to do so at current levels. There may, however, be a way to gain exposure to these banks with reasonably-priced leverage and hidden value.

Hidden Value

  • The TARP warrants' exercise prices have anti-dilutive features to protect against cash dividends. Each warrant's dividend adjustment threshold is different. This offers potentially huge value to warrant holders over the lives of these long-dated derivatives.

Reasons to Be Cautious

  • Underlying stock price matters. Buying warrants because implied volatility is less than peers or because the dividend anti-dilution feature is undervalued can lead to significant gains, but you ultimately have to be bullish on the stocks before you can be bullish on the warrants. Stock price movements will likely dominate the value of the warrants.
  • The warrants will not be compensated for any loss of time value because of a catalyst that reduces the life of the warrant. For example, if Bank of America is acquired in one year, even if the buyout price is a premium to the existing stock price, the warrants could lose value because the optionality on the full life of the warrant disappears. When dealing with 8-10-year warrants, the time value is a significant portion of the security's value. When dealing with the nation's largest banks, this risk is minimized because the Wells Fargos and Bank of Americas of the industry are unlikely acquisition targets.

Here are some warrant summaries with excerpts related to each issue's dividend threshold for exercise price adjustment.

BAC
BAC-WTA
Expiration: January 16, 2019
Strike: $13.30

Quarterly dividend threshold for strike readjustment: $0.01 Additionally, the exercise price of, and the number of shares of our common stock underlying, the warrants will not be adjusted for any regular quarterly cash dividends that are in the aggregate less than or equal to $0.01 per share of common stock, which is the amount of the last dividend per share declared prior to the date on which the warrants were originally issued to Treasury on January 16, 2009.

BAC-WTB
Expiration: Oct 28, 2018
Strike: $30.79

Additionally, the exercise price of, and the number of shares of our common stock underlying, the warrants will not be adjusted for any regular quarterly cash dividends that are in the aggregate less than or equal to $0.32 per share of common stock, which is the amount of the last dividend per share declared prior to the date on which the warrants were originally issued to Treasury on October 28, 2008.

C
C-WTA
Expiration: Jan 4, 2019
Strike: $10.61
Quarterly dividend threshold for strike readjustment: $0.01

Additionally, the exercise price of, and the number of shares underlying, the warrants will not be adjusted for any regular quarterly cash dividends that are in the aggregate less than or equal to $0.01 per share of Common Stock, which is the amount of the last dividend per share declared prior to the date on which the warrants were originally issued to Treasury.

C-WTB
Expiration: Oct 28, 2018
Strike: $17.85
Quarterly dividend threshold for strike readjustment: $0.16 per share.

Additionally, the exercise price of, and the number of shares underlying, the warrants will not be adjusted for any regular quarterly cash dividends that are in the aggregate less than or equal to $0.16 per share of Common Stock, which is the amount of the last dividend per share declared prior to the date on which the warrants were originally issued to Treasury on October 28, 2008.

JPM
JPM-WT
Expiration: Oct 28, 2018
Strike: $42.42
Quarterly dividend threshold for strike readjustment: $0.38 per share.

Additionally, the exercise price of, and the number of shares underlying, the warrants will not be adjusted for any regular quarterly cash dividends that are in the aggregate less than or equal to $0.38 per share of common stock, which is the amount of the last dividend per share declared prior to the date on which the warrants were originally issued to Treasury in October 2008.

PNC
PNC-WT
Expiration: Dec. 31, 2018
Strike: $67.33
Quarterly dividend threshold for strike readjustment: $0.66 per share.

If we increase our regular quarterly dividends in the future, your warrants will not be adjusted for, and you will not receive any benefit of, any aggregate regular quarterly dividend less than or equal to $0.66 per share.

WFC
WFC-WT
Expiration: Oct. 28, 2018
Strike: $34.01
Quarterly dividend threshold for strike readjustment: $0.34 per share.

Additionally, the exercise price of and the number of shares underlying the warrants will not be adjusted for any regular quarterly cash dividends that are in the aggregate less than or equal to $0.34 per share of common stock, which is the amount of the last dividend per share declared prior to the date on which the warrants were originally issued to Treasury on October 28, 2008.

Many of these warrants were extremely mispriced when they first came to the market. Not only were the features of the warrants overlooked, there were also technical headwinds including issuance size and ownership restrictions among long-only stock funds. These warrants are now more properly priced, but they still offer hidden value for investors bullish of banks' abilities to pay and grow dividends in the near future.

In the near future, the warrants will likely trade as leveraged versions of the underlying stocks, but they will likely breakout once banks are allowed to reinstitute normal dividend payout ratios. In the mean time, the warrants offer unprecedented low cost, long dated options on the nation's largest banks.

Most of the warrants offer hidden value for bullish bank investors, but the Class B Citigroup and Class B Bank of America warrants are the least attractive because of the high exercise prices and high quarterly dividend threshold for strike readjustment. In practice, it will be very difficult for either bank to appreciate enough for warrant holders to finish in the money, considering the fact that both banks are close to their regulatory limits on deposits.

Source: TARP Warrants: Hidden Value Among the Mega-Banks