Shock and Awe: Government Raises Citi Warrants' Strike Price to $20

Includes: AIG, BAC, C, FMCC, FNMA, JPM
by: Michael Steinberg

Bloomberg reports “Summers Says TARP to Be ‘Very Different’ Under Obama.” The director of the White House’s National Economic Council stressed transparency, accountability; and the push for banks to leverage TARP funds into consumer mortgages and car loans. Larry Summers said that the Obama Administration was not out to benefit financial institutions, but “of course we need to stabilize financial institutions -- without a stable financial system the economy can’t work.” Summers refused to provide any detail on President Obama’s plan or even philosophy for strengthening financial institutions until after New York Federal Reserve President Timothy Geithner is sworn in as Treasury Secretary. I guess with Geithner the Senate will be voting on a "pig in a poke".

While the Administration is getting its lipstick ready, I would like to suggest dramatic policy change that would jumpstart private investment in our banking and insurance systems. The Treasury, FDIC and Federal Reserve should raise the strike prices on the warrants they received for TARP and other programs to the estimated value of these companies in normal times. If a conservative estimate of a shrunken Citigroup (NYSE:C) in normal times would be $20 per common share, investors would know the government would not dilute until the shares reach that level. Above that level it would be an opportunity for Citigroup to raise capital from whoever bought the warrants from the government. This would end the fears of nationalization and cause a short squeeze as the shorts attempt to cover. Moral hazard on the shorts – what a concept!

Raising the government’s strike price would do more to prevent short raids and build investor confidence than restoring the uptick rule and temporary bans on short selling. I think that it would be even more powerful than the mortgage loss backstops that were provided to Bank of America (NYSE:BAC), Citigroup and to a lesser extent JP Morgan (NYSE:JPM).

The Treasury, Fed and FDIC did consider open market common stock purchases to raise Citicorp’s stock price and improve confidence during the last rescue. But they determined that the amount required to move the market would be equivalent to nationalizing the company. Raising their warrant strike would be far less disruptive and far cheaper.

I know there is tremendous political pressure to squeeze harder for taxpayer upside in these deals. Warren Buffett got a better deal than the government on his Goldman Sachs (NYSE:GS) investment could often be heard in Congress. But the government’s shortsightedness has actually aided the shorts in squeezing their prey to death or near death, causing the government to actually increase its risk participation. How many small banks have failed or suffered severe capital losses because the Treasury killed the value of the Fannie Mae (FNM) and Freddie Mac (FRE) preferreds? Think of the lost leverage. President Obama does not appear to be garnering the political will to restore the financial system in the most efficient, but politically unpopular means.

The controversial and often maligned former American International Group (NYSE:AIG) CEO Hank Greenberg has often said the government’s role in rescues should be to save jobs and return companies to strong taxpaying entities, not maximize the government’s profit. I won’t pass judgment as to whether Greenberg was responsible for AIG’s venture into more risk than it could manage or conversely is the messiah that has the answers to AIG’s rescue. But, the irony is that the government is on a path of squeezing so hard that they are winding up minimizing their profits.

Along with warrant repricing, the government should consider reducing the number of warrants outstanding to reward good behavior. For a government that actively manages all sorts of behavior through the Internal Revenue Code, this would not be a step very far out on the limb.

Let’s not forget that we cannot have a private enterprise banking system without equity capital. And we cannot have equity capital without common stock shareholders. Scaring away common stock shareholders just can’t be the solution, encouraging them must be. Even the Chinese Communists understand that, so our communist Larry Summers should too.

Disclosures: Author is long AIG, BAC, C, FNM and FRE.