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TARP Warrants...Deal or No Deal?

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September 01, 2010 – Comments (8) | RELATED TICKERS: BAC

I came across two very interesting articles on special situations yesterday that I wanted to share with everyone.

The first involves the TARP warrants that were issued to the government when it provided aid to a number of banks at the height of the credit crisis.

Francis Chou - An Interesting Way To Invest In Banks (Warrants That Were Issued To The U.S. Treasury)

A blogger called CanadianValue published an article on GuruFocus about hedge fund manager Francis Chou's write-up of TARP warrants.

For anyone who isn't familiar with warrants, they're essentially like long-term options or LEAPs.  They provide holders with the option to purchase a share of a company's stock at a certain price on a certain date.  One can figure out what level the stock has to be trading at for them to break even by adding the price that the warrant is going for to its strike price.

Let's look at theBank of America Class A warrants as an example.  They are currently trading at $7.12 perwarrant and their strike price is $13.30/share.  That means that in order for warrant-holders to break even on their investment, Bank of America's common stock, BAC, must be trading at or above $20.42 on January 16, 2019.

BAC closed yesterday at $12.46/share.  In order for the warrants to be worth anything, this stock must rise by $7.96 over the next eight years and change.  That's a total gain of nearly 64%, or approximately 8% per year.  That's looking at things a little simplisticly because it doesn't include compounding...i.e. of BA rose 8% this year it wouldn't have to rise by quite as much in future years because the next 8% would be coming off of a higher level.

The great part about the TARP warrants is that unlike most normal warrants. the government negotiated a clause in them that any dividends over a certain level that are paid to shareholders must be subtracted from the strike price.  For the BAC warrants, that level is $0.01.  That means that if Bank of America recovers to the point that it pays shareholders a decend dividend in the future, anything over a penny per share, the dividends would lower the level that the stock needs to climb to for the warrants to break even.  This can make a huge difference in the profitability of this investment.

The question is, are these TARP warrants a good deal?  I certainly am intrigued by them.  I have seen them described in several different places, by some very smart people as a solid bet.  I am still somewhat skeptical about the current economic "recovery" and the health of many banks.  As such I haven't been able to bring myself to pull the trigger on this trade yet.  Still seven to eight years is a long time, even for someone who is a fairly long-term investor like myself. 

If the economy really slows down and the market takes it on the chin, perhaps the prices of some of these warrants will fall to truly attractive levels.  That would make the trade much more enticing from my perspective.  I might have been inclined to pick up some of these warrants in CAPS if they were available, but I don't believe they are.  Perhaps I'll request that they be added.

I'd love to hear others' thoughts on the TARP warrants.

Deej

8 Comments – Post Your Own

#1) On September 01, 2010 at 8:34 AM, rd80 (98.23) wrote:

I covered the warrant auctions on my alter ego blog, TARPedBanks, but haven't updated that player in some time now.  I missed the dividend adjustment clause.  Based on the numbers in the article, the one BAC series is the only one where it's likely to be meaningful anytime soon.  And I have no clue when BAC will be in a position to reinstate the dividend.

Treasury still holds warrants for Citigroup and the smaller banks that haven't repaid the money yet.  Those will be sold in a public auction at some point, which could be another way to play if you're interested. 

I do know that trying to run a Black-Scholes (sp?) model to value these warrants generates results that look pretty suspicious.  I've read that B-S isn't very good for long term stuff, or it could be that I don't know what I'm doing.

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#2) On September 01, 2010 at 3:17 PM, tekennedy (72.44) wrote:

The reason Black Scholes doesn't apply is one of it's major inputs is expected volitality.  In the short term it makes sense as if there is a lot of volatility there is a greater chance of the options being used.  Over the longer term the increase in earnings power of the company is far more relevant.

The absolute break even would equate to around 6.4%, instead of 8% due to reinvestment.  To take into account compounding you need to do the nth root of the increase(1.64 or 164%) where n is the number of years.  With the number of years being 8 its simpler as you can do the square root 3 times, yielding the 8th root.

The way I've tended to evaluate options is as a leveraged long position in the stock and long a put, as this is mathematically equivalent to a long call.  The break even relative to the stock would be even higher however at 12.1%; this is found by using the difference between the stock price and the warrant price of $5.34 and comparing it to the $13.30 in 8 years(making the NPV zero requires a 12.1% rate).  The break even point of stock vs warrant would occur around $31.  The warrant however would outperform the stock below $5.34 due to the artificial put.

In essence you should buy the stock if your estimation of fair value is between the current price and $31 and the warrant at any point higher, including all dividends pair during the period(which is an interesting kicker). 

BTW thanks for putting up these special situations, they are interesting.

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#3) On September 01, 2010 at 6:53 PM, TMFDeej (99.30) wrote:

You're welcome, Ted.  I'm absolutely fascinated by them.

Great analysis, BTW.

Deej 

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#4) On September 01, 2010 at 8:12 PM, portefeuille (99.60) wrote:

A blogger called CanadianValue

The author is this guy. More of his articles are here.

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#5) On September 01, 2010 at 8:14 PM, portefeuille (99.60) wrote:

also see this post.

Opportunity in TARP Warrants

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#6) On September 01, 2010 at 8:20 PM, portefeuille (99.60) wrote:

With the number of years being 8 its simpler as you can do the square root 3 times, yielding the 8th root.

It is not really more difficult for any other number (if you have any decent calculator or an internet connection) ...

http://www.google.com/#q=1.64^(1/8)

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#7) On September 01, 2010 at 10:13 PM, rd80 (98.23) wrote:

I ran a little model comparing the return on buying BAC common vs. buying the A class warrants.

The dividend adjustment is a swag.  But, I assumed BAC reinstates a dividend three or four years from now that averages 15-cents/share per quarter, i.e. runs the last five years of the warrant life.

With today's close for the stock and the warrants, the above dividend assumption and ignoring the time-value of the dividend payments, BAC would need to climb to about $27 a share before expiration in order for the return on the warrants to exceed the return on the common.

Unless I messed something up (very possible), BAC would need to climb at an annualized rate of more than about 10% from here and reinstate a decent dividend for the warrant buy to make more sense than the common.

If you like BAC, buy the common.  If you really, really, really like BAC, buy the warrants.

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#8) On September 02, 2010 at 11:01 AM, Option1307 (29.89) wrote:

Great discussion, +1!

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