First TARP Warrant Auction Set for Tomorrow

Includes: COF, JPM, KBE, TCF, XLF
by: Linus Wilson

The U.S. Treasury has finally taken a small step toward trusting markets. It normally cuts deals with banks before investors can make an offer on the taxpayers’ warrants. Taxpayers obtained warrants as part of their banking sector bailout in the Troubled Asset Relief Program (TARP).

Yet, before Thanksgiving it announced that it would be auctioning off the warrants of JP Morgan Chase (NYSE:JPM), Capital One Financial (NYSE:COF), and TCF Financial (TCB). According to Dow Jones Newswires, this Thursday, December 3, 2009, it will auction off taxpayers' nearly 12.7 million warrants to buy Capital One Financial (COF) stock.

These warrants that expire on November 14, 2018, give the holder the right to buy a share of Capital One’s stock at a price of $42.13 per share at any time before the expiration date. According to the preliminary prospectus, these warrants will trade on the secondary market under the ticker COF-W.

The second price, sealed bid, Dutch auction mechanism outlined in the prospectus is very conducive to small investors participating. The minimum lot size is 100 shares like most option contracts. The highest price that sells all the warrants (subject to a reserve price of $7.50) is the uniform price that all bidders pay. If an investor bids over the reserve price, he or she will receive all the warrants she bid on. Only bidders that bid the reserve price will get a fraction of their desired quantity. It is generally optimal for bidders to bid their maximum willingness to pay in a second price, Dutch auction.

Consider the following example where about 12.7 million warrants are being auctioned. Bidder A bids for 2 million warrants at $25 per warrant; Bidder B bids for 10 million warrants at $24 per warrant; and Bidder C bids for 1 million warrants at $21 per warrant. If all other bids are lower than bidder C, then the price set by auction is $21 per warrant. Bidder A gets 2 million warrants, and Bidder B gets 10 million warrants. Bidder C gets about 0.7 million warrants or about 70 percent of her desired quantity while the higher bidders get all the warrants they wanted.

In 1983, the U.S. Treasury auctioned warrants obtained from bailing out Chrysler Motors for $311 million or about $675 million in 2009 dollars, according to my short paper. Chrysler was the winning bidder. Nevertheless, the bidding process was substantially different. A bid had to be for all the warrants on offer not small lots of 100.

Further, it was a first price, sealed bid auction. I estimated that the Chrysler auction came much closer to my middle estimate of the theoretic value of the warrants than negotiations had achieved for the first twelve TARP warrant repurchases.

Whether or not investors endorse or reject my estimates of $19 to $30 per warrant, I am glad we are putting our faith in markets not bureaucrats even for just one day.

Disclosure: This is not investment advice. Warrants take active management and may not be suitable investments for some investors. I do not plan to bid in the upcoming warrant auctions. I own broad-based index funds. I do not have long or short positions in individual securities issued by Capital One. I have no positions in COF, JPM or TCB.

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