How Treasury Favors Banks over Taxpayers in Warrant Negotiations

by: Linus Wilson

The U.S. Treasury released its first public statement on its methodology for calculating the value of the taxpayers’ warrants on Friday. Its method for calculating historic volatility favors the banks at the expense of taxpayers.

This means that the U.S. Treasury is selling the taxpayers’ risky investments for pennies on the dollar to the ex-TARP banks. I estimate in the first ten transactions Tim Geithner and company are selling the taxpayers’ warrants for between 75 cents to 48 cents on the dollar, using 10-year and 2-year historic volatility as the lower and upper bounds. For the 5 transactions where the bank has traded options the implied volatility valuations are about 59 cents on the dollar so far.

The standard definition for calculating 10-year historic volatility is to find the standard deviation of the continuously compounded stock returns over the last ten years. Yet, Treasury has redefined historic volatility in a way that helps the banks. The guidelines released Friday said,

Treasury uses the average 60-day trailing volatility for the last ten years to determine a stock's historical volatility.

What is the difference? The difference is millions of dollars that the banks save and taxpayers lose because the U.S. Treasury found an obscure way to further benefit the banks at the expense of taxpayers.

According to my estimates of the value of the warrants issued by the ten large banks that repaid TARP on June 17, 2009, this seemingly small change costs taxpayers between $528 million to $686 million dollars or about 14 percent of the value of those ten bank’s warrants. Since I estimate in my paper’s tables 2 and 3, that the taxpayers’ warrants are worth $11 billion, a 14 percent discount could cost taxpayers up to $1.5 billion. JP Morgan (NYSE:JPM) alone benefits from this alternative definition by $224 to $254 million. On average, this change led to the average 10-year historic volatility of these banks fall from 50 percent to 39.5 percent.

The U.S. Treasury is supposed to be representing taxpayers in an adversarial negotiation. Yet, its opening bid is lower than the “rule of thumb” historic volatility calculation according to page 239 of the popular derivatives textbook. I’m not going to pretend that there is only one way to calculate volatility. No one knows what future volatility will be. The problem is the U.S. Treasury should be going into the negotiations with an optimistic valuation. Yet, they appear to be going to great lengths to undervalue the taxpayers’ risky investments. This is unfortunate because the process is often concluded by averaging the valuations of the bank, the U.S. Treasury, and a third party expert. The banks have strong incentives to make lowball offers. The banks who have made lowball offers, Old National (NYSE:ONB) and Sun Bancorp (NASDAQ:SNBC), have gotten the best deals so far.

According to the security purchase agreement section 4.9, only if the ex-TARP banks find the deal unprofitable, the U.S. Treasury can sell the warrants to third party investors. It is third party investors who are betting real money who are in the best position to price the TARP warrants’ volatility. Yet, the U.S. Treasury is offering the banks such great deals that we will see few sales to third party investors.

Moreover, despite the fact that press release pays lip service to setting up auctions we have not seen one third-party sale. Moreover, if present trends continue, we are unlikely to see one auction before the U.S. Treasury negotiates away over a third of the value of the of the taxpayers’ warrant portfolio in deals with the ten big banks that exited TARP on June 17, 2009.

Steve D. Jones’ “In the Money” column on Friday, June 26, 2009, on the Dow Jones Newswire (which is by subscription only) found that the U.S. Treasury received a third party bid in its negotiations with SCBT Financial (SCBT). Did taxpayers get that price? No. That price was ignored in favor of a split-the-difference negotiation between SCBT and Treasury officials. I estimate that taxpayers got between 85 and 50 cents on the dollar on that transaction.

MIT economist Simon Johnson argues the process is ripe for corruption. Treasury officials should not have the discretion to hand hundreds of millions of dollars to firms that have thousands of seven digit jobs. If they want to remove the appearance of corruption, the new Assistant Secretary of Financial Stability, Herb Allison, should take steps to ensure the TARP warrants of the ten big banks especially the investment banks, are auctioned to third party investors.

The big banks just want to be free of TARP, but unfortunately the Treasury officials appear from their press release to be all too eager to give them a sweetheart deal. If the heads of the big banks were smart, they would know a good deal on the warrants would come at too high a price in the long run. It is in the interest of shareholders of JP Morgan, Morgan Stanley (NYSE:MS), and Goldman Sachs (NYSE:GS) that these warrants are auctioned to third-party buyers.