Goldman Sachs, J.P. Morgan: Who Got the Better Deal on TARP Warrants?

Includes: GS, JPM
by: Nicholas Waltner

When the initial debate over the valuation of TARP warrants erupted following a review by the Congressional Oversight Panel (“COP”) in July of this year, which asserted that the US Treasury was receiving significantly less for the warrants than they should have been via direct repurchases of them by TARP participants, I wrote that the prices received for the warrants were indeed fair ones.

Later that month when Goldman Sachs & Company’s (NYSE:GS) paid $1.1 billion to Treasury to retire its warrants, I argued that Goldman had perhaps “paid up” to fully exit TARP, as the implied volatility of the transaction stood at 43.9%, which was roughly in line with the LEAPS market. At that time I argued that a disinterested, third-party would have paid as much as $70 million less for those warrants, which was equivalent to a five volatility point discount relative to the listed LEAPS (“Long-Term Equity Anticipation Securities”) market to cover the expected hedging and liquidity costs of the nine-year warrants.

This theory was borne out on Friday in the public auction of the JP Morgan & Company (NYSE:JPM) TARP warrants. As it turned out, the JPM warrants were sold at a scant $10.75, which equates to an implied volatility of only 23.7% (assuming a 2.0% dividend) representing a ten volatility point discount relative to the LEAPS market using the January 2012, 40 strike call options, which closed at a 33% volatility on Friday and arguably a twenty point discount to where they were trading just a month ago at 43%. Thus, when the warrants started trading on the NYSE after the auction, they quickly traded up roughly by two volatility points to close at $11.35 with JPM’s common stock slightly lower from the time of the auction. Thus, a delta-hedged derivative trader could have pocketed an attractive 5-6% profit on a hedged position by participating in the auction.

Many, including academics and the COP, had been arguing that the warrants’ “fair price” was in the range of $12-18 and even one academic’s estimates from June of this year would have argued for a fair price of $25, using a 53% volatility. However, as I have argued, all of these estimates ignored the real world effects of dividend and volatility uncertainty over nine years for JPM and other TARP recipients, not to mention the sheer size of the warrants, which in the case of JPM’s 88.2 million warrants equates to a dilutive impact of 2.24%. At the end of the day, if TARP recipients were not concerned about the potential dilution of their share prices, then the warrants were likely to be sold at a steep discount to the various estimates of “fair value”, which was exactly what happened on Friday.

If Goldman Sachs had waited until now to have its warrants auctioned off to the public, a ten volatility point discount relative to the LEAPS market would have implied a 25.5% volatility for the warrants, thereby having delivered proceeds of nearly $200 million less to the Treasury. From Goldman’s perspective one could argue that this was a relatively small price to pay to fully exit TARP and “lock-in” a promising 2009 compensation pool, which now has grown to over $20 billion. Thus, I would argue that both institutions, Goldman and JP Morgan, “won” in their different approaches to their full exit from TARP via the Treasury’s disposition of their warrants.

For the remaining banks in TARP, the relatively “cheap” auction prices for the COF and JPM warrants would likely indicate that the banks will have greater leverage in negotiating a direct repurchase of their warrants from Treasury in order to avoid potential dilution. However, in cases where there is political or other expediency to fully exit TARP, the market may see more cases like Goldman’s, but for the most part I am of the opinion that the Treasury auctions will continue to come at significant discounts to the LEAPS market and possibly even steeper ones for less liquid TARP participants, as the long-dated nature of the TARP warrants leave very few natural buyers of them and risk capital continues to be scarce in the marketplace.

Disclosure: No positions

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