Commentary | Economic Growth

Payback time

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Now that recovering banks have begun to return their Troubled Asset Relief Program (TARP) money by repurchasing preferred shares from the U.S. Department of the Treasury, attention is turning to the 10-year warrants the Treasury acquired to ensure that taxpayers benefit as banks again become profitable.

The warrants, which are similar to stock options, give the Treasury the right to purchase a set number of common stock shares in the banks at a pre-determined price at any point during the 10-year period.

Warrants at some banks are already worth a great deal, because their stock prices have climbed above the warrant price, and expectations are that they will continue rising. On the other hand, a unique clause enables firms to cancel half of their outstanding warrants by issuing a sufficient number of common or preferred stock- a “qualifying equity offering” (QEO)- that would strengthen their capital and reduce their dependence on government support. Predictably, there are questions about how to adequately and fairly determine their current value.

Earlier this summer, Obama administration officials worked out terms with 11 small banks and a few large bank holding companies, including BB&T, State Street Corp., and U.S. Bancorp. But these deals, which comprised only a small minority of outstanding warrants, generated criticism. The Congressional Oversight Panel (COP), which was appointed to keep an eye on TARP, estimated that the first 11 warrant buy-back deals were priced 66% below their value. In addition, the special inspector general for the TARP program, Neil Barofsky, is now auditing the warrant valuation process.

Perhaps as a result of these critiques, the Treasury has become increasingly assertive in its negotiations with TARP recipients over the repurchase of their warrants.
On Wednesday, this new-found assertiveness paid off for the taxpayer, as the Treasury brokered a deal with Goldman Sachs to sell back the warrants for $1.1 billion. Combined with the dividends from Goldman preferred shares held by the Treasury until June 9, the government ultimately received an annualized return of 23% on its original $10 billion investment.

This repurchase price is consistent with COP’s estimate that the warrants should be valued between $940 million and $1.25 billion. However, it is possible that the Treasury could have gotten even more in the open market. The Congressional Oversight Panel made its calculations before Goldman announced expectation-shattering 2nd quarter profits. Financial market confidence in Goldman shot up, with analysts inching toward a “strong buy” recommendation and predicting huge growth in earnings per share through this year. Then again, the value of Goldman’s warrants could have fallen if they had met the QEO threshold- a very possible scenario.

Fortunately, the Treasury’s warrants in the other financial powerhouse-J.P. Morgan Chase- may provide a return for the taxpayer higher than their COP estimate. After a set of unproductive negotiations with the firm, the Treasury rejected an unspecified bid by J.P. Morgan Chase to buy back its warrants based on an “independent appraisal.” Instead, the Treasury decided to auction 88.4 million J.P. Morgan warrants to investors in the coming weeks, hoping to capitalize on recently boosted market expectations for J.P. Morgan’s stock and the high probability that they will not be able to cancel any warrants via a QEO. This auction could lead to a substantial profit for taxpayers: In June, the Oversight Panel estimated the warrants were worth about $1.02 billion and possibly as much as $1.56 billion, though again, market expectations have increased due to the bank’s higher than anticipated 2nd quarter profits.

The Treasury’s recent commitment to maximize returns on the TARP investments is promising, considering the significant amount of money at stake in these negotiations. Overall, the COP estimated the value of all outstanding warrants at $4.71 billion to $12.27 billion. Of that amount, 70% was attributed to the six largest TARP financial institutions: J.P. Morgan Chase, Bank of America, Morgan Stanley, Goldman Sachs, and Wells Fargo.

Using a slightly different model, Pluris Valuations Advisors estimated the overall value of warrants held by Treasury at $8.5 billion. That was $3.3 billion more than Pluris estimated three months earlier, and it was also made prior to the announcement of the expectation-raising 2nd quarter results.

Put simply, due to renewed optimism in the equities market, the warrants have significant value.

In order to further maximize taxpayer wealth, the Treasury Department should, as it is doing with its J.P. Morgan warrants, end all closed-door, bilateral negotiations. It should instead hold market-based auctions to ensure warrants fetch the highest possible price, with adequate safeguards against manipulation by financial institutions.

Legislation recently introduced in the House would wisely force the Treasury to end the backdoor negotiations. The bill also calls for warrants to be auctioned as soon as firms pay back their TARP injections. There is emerging consensus, including among Treasury officials, that quick sales are the way to go. We think, however, Treasury should have the discretion to hold on to warrants if they believe that doing so will maximize their value.

The Treasury has an unprecedented opportunity to generate substantial revenue from its initial bailout of these firms. It would be a shame if it did not pursue a truly wealth-maximizing strategy for the American taxpayer.


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