The new TARP: Summary and numbers rundown for WFC
Treasury Sec. Paulson’s initial plan to buy troubled assets from banks has morphed in to an equity injection. The initial $250 billion TARP funding will be used to purchase preferred equity in banks with half of it going to nine of the largest banks in the country.
For this post, I’m going to try to set aside my opinion of the gov’t plan and take a closer look at what it means for investors in the companies that will participate in the program.
First, how is the program going to work? I like to get source documents when possible since the media can be less than reliable. Treasury has issued an announcement and a public term sheet outlining the plan details. Summarizing:
- Treasury may purchase senior preferred stock in qualifying banks (basically US based institutions). Maximum purchase amount is lesser of $25 billion or 3% of risk weighted assets.
- Banks must apply by 14 Nov and deals are expected to be completed by the end of 2008.
- The preferred pays a 5% dividend for the first 5 years and then jumps to 9%.
- The issuing bank can buy the preferred back after three years. They can buy it back earlier provided they raise at least 25% of the amount sold to Treasury in an offering of common or preferred.
- Preferred dividends must be paid before the bank can pay dividends on the common.
- The bank has to get permission from Treasury to raise the dividend or repurchase shares for three years, unless they’ve bought the preferred back from Treasury.
- Executive compensation restrictions.
- Warrants get issued with the preferred in an amount equal to 15% of the preferred sale. Strike price and valuation for determining the 15% are based on a 20-day trailing average from the date of agreement. The bank can buy the warrants back at fair market value if they’ve bought the preferred back. The number of warrants can be reduced by raising capital.
- The preferred stock doesn’t give the government any voting rights or board representation. If the bank falls behind on the dividend payments, the gov’t is entitled to board seats.
That’s about as de-gibberished as I can make it.
From news reports I’ve read, there will be nine banks participating initially with the program being opened to smaller institutions soon. The participating banks and reported amounts are: $25 billion each - JP Morgan (JPM), Citigroup (C), Wells Fargo (WFC), and Bank of American (BAC) combined with Merrill Lynch (MER). $10 billion each – Goldman Sachs (GS) and Morgan Stanley (MS). $2-3 billion each – State Street (STT) and Bank of New York Mellon (BK). The Treasury statement indicates all participation is voluntary, but early news reports indicated some of the banks were pressured into agreeing. These nine banks get about half the initial $250 billion, leaving another $125 billion for the smaller banks.
In addition to the preferred stock purchases, the gov’t will be guaranteeing bank debt and expanding deposit insurance coverage through the FDIC.
To help make sense out of this, I walked it through with WFC. That’s a good choice because they had announced they were going to raise capital in conjunction with the Wachovia acquisition and because I’m a shareholder.
The $25 billion of preferred is pretty simple; WFC gets $25 billion of new Tier 1 capital at a cost of 5% or $1.25 billion per year. Tier 1 means they can leverage it up by about 10 to 1 if they want. The 5% preferred dividend is lot better deal than the 10% GE and GS had to pay Berkshire Hathaway (BRK) and I don’t think WFC should have much trouble earning better than 5% on this new capital. Current return on equity is running a little over 15%. 9% is a much tougher threshold if they can’t buy it back before the rate jumps in five years.
WFC also needs to issue warrants. 15% of the $25 billion is $3.75 billion. Counting back from today the 20-day trailing average comes to $33.98 per share. That would be a little over 110 million new shares or about 3.3% dilution. But, exercising the warrants would bring in the additional $3.75 billion of fresh capital.
Overall, this looks pretty good for WFC. I haven’t seen any news releases, but expect they’ll try to go ahead with the capital raise planned as part of the Wachovia deal to get the option to buy the preferred back. However, the gov’t money will probably set a ceiling for the terms of any new offering and they may not be in any hurry to buy the Treasury preferred back. It will be interesting to see if that offering goes forward, how it’s structured, how much they raise, and whether or not they buy back the gov’t preferred. The current dividend yield on WFC common is just under 5%, so the only real advantage to bringing in private money is to take some of the warrants out. If they raised $25 billion, half the warrants come back.
The biggest downside to shareholders I see is possible limits on dividend increases or share buybacks. We’re at the mercy of gov’t regulators there and have to hope WFC management can make a good case if business conditions warrant a dividend hike or buyback program. Or just do a capital raise for a little over $6 billion and buy the preferred back from Treasury.
Treasury could have pushed for higher rates and better terms on the warrants, but that would have made subsequent capital raises more challenging and might have done more harm than good in getting capital into the credit markets. It also would have discouraged the stronger banks from playing. As it is, the gov’t is borrowing 5-year money at 2.5 – 3% and earning 5% plus upside potential on the warrants. Not great, but probably a better deal for the taxpayer than paying a premium for mortgage paper and hoping it goes up in value.