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What about all those warrants?

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May 26, 2009 – Comments (5)

I had what I thought was a great blog topic and idea for how Treasury could dispose of the bank warrants acquired through the TARP Capital Purchase Program (CPP).  Then, as often happens, facts got in the way and the direction changed a bit.

First, as most readers are aware, when the US Treasury (UST) made all those TARP investments in bank preferred stock, we got warrants for common stock as part of the deal.  The exercise price was the average of the 20-day trailing market price, total value was 15% of the TARP investment and the warrants are good for 10 years from date of issue.  Banks can repurchase the warrants after they’ve repurchased the preferred.  The warrant repurchase price is determined by two evaluators, one representing the bank and one representing UST.  If they can’t agree, the two evaluators pick a third evaluator and they average the results.

With a few banks now having repurchased TARP preferred and the warrants, there have been a number of pieces discussing whether UST got a fair price for the warrants.  Matt Koppenheffer published Banks Are Getting a Great Deal at Our Expense! for TMF earlier today.  The issue is also addressed in TARP Warrants Show Banks May Reap ‘Ruthless Bargain’ by Mark Pittman at Bloomberg.  On Seeking Alpha, Linus Wilson published Treasury Accepts Lowball Price for TARP Warrants, which does a good job of showing how wide the valuation range for these long-term options can be.  Dr. Wilson’s work also shows that even compared to his lowest valuation for the warrants, UST got a lowball price for Old National’s warrants.

One kicker that isn’t well covered in these and other articles I’ve seen is that the number of options gets cut in half if the banks complete equity offerings equaling the amount of the TARP investment by the end of 2009.  So, if GS completes $10 billion worth of equity offerings, the warrant for 12.2 million shares turns into a warrant for 6.1 million shares.  Recall last fall UST wanted to encourage banks to raise private capital and this was one incentive.  Based on that incentive, UST cannot execute or transfer more than half the warrants before the end of 2009.

The fact that got in the way was in a Treasury Frequently Asked Questions document.  The response to ‘What will happen to the warrants…?’ concludes with ‘The warrants cannot be sold to an investor until the bank has had an opportunity to repurchase them.’  I did not find anything in the term sheet or Securities Purchase Agreement supporting that restriction – doesn’t mean it isn’t there, just that I didn’t find it.

Dr. Wilson’s article and some others I’ve read recommend UST sell the warrants to third party investors and, assuming the warrants can be sold without first offering them to the banks, I’d like to propose a framework for doing just that.

The rationale behind it is simple:
 - Government officials have consistently told us they don’t want to own these institutions
 - We’ve been consistently told taxpayers are supposed to participate in the upside
 - President Obama is on record stating the US long-term debt load is unsustainable

Treasury is sitting on assets they don’t really want to own (or so they say), our government could use the money to reduce borrowing and recent capital raises by banks have shown markets have some appetite for bank securities.  Simple answer – sell off the warrants.  Auctioning the warrants won’t magically balance the budget, but a few billion will make a tiny dent in the need for bond auctions.

A key to the auction framework is that individuals be able to participate.  How many times have you seen an IPO or secondary and wished you could be part of it?  The Government is supposed to work for the people.  This shouldn’t be a Wall St. only party and with current internet auction technology, it doesn’t need to be.  Besides, wider participation brings better prices.

Treasury already has TreasuryDirect for individuals to purchase bonds; it shouldn’t be a big deal to add warrant auctions to the menu and come up with a mechanism to transfer the warrants to brokerage accounts.  The UST warrants would need to be split into manageable pieces.  Bidders could bid on as many warrants as they want in blocks of 100 with some minimum number of shares and/or dollar value – minimum 100 share units or $100 bids.  It doesn’t have to be that low, but shouldn’t be out of reach for a typical individual investor.  Open the bidding for a reasonable amount of time, maybe two weeks to a month.  Allow hedge funds, banks, brokerages, individuals, US and foreign investors, as many as bidders as possible, to participate.   At auction close, the highest bid for each bank gets filled, then second highest, flowing down until all available warrants are sold.

Given the number of banks that took TARP, an auction might need to be done in tranches (I think that’s the first time I’ve used that word).  Best time frame to start is early 2010.  The window for banks to cut the warrants in half by completing equity raises will be closed and UST will know how many warrants they have available to sell.

The potential spoiler for an otherwise great plan is the apparent restriction from the FAQ requiring Treasury to give the banks first shot at buying back the warrants.  That’s not necessarily a show stopper, but a bank’s warrants could only be auctioned if they declined to repurchase them.  If the FAQ is wrong, just sell them; no need to waste time or resources with valuations – an open auction will provide the best possible valuation.

If the government can’t figure out how to do it with TreasuryDirect, they can always put ‘em on E-bay.

OK Fools, what have I missed? 

Before I go tilting at windmills and start writing letters, help me make the plan better.

Fool on!

Russ

5 Comments – Post Your Own

#1) On May 29, 2009 at 3:21 PM, TMFKopp (98.25) wrote:

Good stuff Russ! I love the idea.

As for the banks being given the opportunity to repurchase the warrants, that's fine... as long as they're willing to pay a fair price!!!

Your catch on the capital raise clause is a good one, but if we can expect more buybacks like Old National then the fact that the UST even has these warrants is pretty much a joke.

Matt

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#2) On May 29, 2009 at 7:29 PM, rd80 (98.26) wrote:

Matt,

Thanks for the comment. 

Not sure if I was clear on the implications of the capital raise clause.  That puts Treasury in a very weak negotiating position for the second half of the warrants.  When you consider that Treasury really only has rights to half the warrants, the Old National deal doesn't look quite as bad.

To illustrate, consider the following for GS.   The Government holds a warrant for 12.2 million shares with a strike price of $122.90.  GS closed today a little under $145.  I haven't run a valuation on the warrants, but for the sake of this example assume the value iaw the TARP purchase agreement method is determined to be $30 for each warranted share.

At first glance, it looks like the gov't has warrants worth $366 million.  Not so fast, GS has already raised $5 billion in an equity offering.  If they were to raise another $5 billion, half those warrants go away.

As a hypothetical, put yourself in the place of the Treasury negotiator.  GS comes to the table and tells you they'll buy back 6.1 million of the warrant for $183 million, the agreed valuation for a 6.1 million share warrant.  Then GS gives you an option - sell back the other half of the warrants for $10 million or GS will do a share issue for $5 billion to void them and announce a concurrent $5 billion share buyback so they don't dilute their common.

Your choice is now take $193 million for all the warrants or take $183 million and make GS go jump through the hoops of issuing and buying back shares.  As much fun as it might be to make GS jump through hoops, that adds no value to the taxpayer.  The gov't choice is clear - take the $193 million.

I don't know if something similar happened with Old National, but it's plausable.

Fool on!

Russ

P.S.  In case any GS (or other bank) executive is reading this and hadn't already thought of the negotiating strategy, you can use the idea.  Just reduce the amount you offer Treasury to $9 million and send me the other million.  I'll even take stock in lieu of cash.  You're welcome. :)

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#3) On June 03, 2009 at 2:32 AM, TMFKopp (98.25) wrote:

Of course that's true, but I would like to think that the capital raise clause isn't just about making companies jump through hoops -- it's a measure of soundness and ability to access non-Treasury capital.

Even the fact that the Treasury put that clause in there in the first place is annoying because it just further sets up a heads I win, tails you lose situaiton for the banks. If the banks can go out and raise new capital then they're in good shape and the warrants are probably worth something. Of course at that point they get whacked in half.

The companies that don't have access to the capital markets to raise new money... well, they're probably in bad shape and the warrants aren't worth a whole heck of a lot.

So the question I would raise is why put the warrants in there at all? They don't offer downside protection and much of their upside apparently gets wiped out.

Matt

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#4) On June 03, 2009 at 9:54 AM, rd80 (98.26) wrote:

You're right, the capital raise clause wasn't about making companies jump through hoops.  When the program was initiated, Treasury wanted the banks to raise private capital and the warrant clause was an incentive for them to do that.  The current market simply puts a bank that's able to buy back the preferred without a big capital raise in a strong negotiating position.  They'd not only be stupid, they'd be violating fiduciary responsibility if they didn't use that leverage to minimize the price they pay to cancel those warrants.

The objective for TARP was to stabilize credit markets, not maximize profit for the taxpayer.  Even so, other than Citi, GM and maybe BAC, Treasury is turning a profit on the program.  They're borrowing money at 2-4% to finance preferred shares that yield 5%, then jump to 9% and they have a handful of warrants with a 10-year life.  In the case of GS, I suspect the value of those warrants is much greater than what I used in the hypothetical. 

As far as much of the upside being wiped out, even half of 12.2 million 10-year GS options with a strike of 122 and change is a lot of money. Based on stock price since Nov, the Morgan Stanley warrant should be worth quite a bit more than Goldman's.

 

 

 

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#5) On June 03, 2009 at 4:25 PM, TMFKopp (98.25) wrote:

The objective for TARP was to stabilize credit markets, not maximize profit for the taxpayer.

True, but if you're going to be putting a heck of a lot of taxpayer money at risk, there should be a reasonable return if it does all work out.

The bottom line is that I'm happy if credit markets are recovered and stable (not ready to hang that banner quite yet...), but the principal of the matter still rubs me the wrong way. You give these institutions low-cost capital at a time when capital is at a premium and then cut us off from a healthy chunk of the upside.

It's not like these are charitable organizations, the compensation ratios at places like GS and MS typically hover around 50%, so we know exactly who's getting the majority of the spoils. 

Matt

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