Tuesday, May 26, 2009
Unwarranted
With banks moving heaven and earth to repay the TARP funds so that they can shed the ex post facto regulation of compensation and hiring imposed by the populists in Congress and their conductor in the White House, there is the question of the warrants that the United States Treasury received in connection with each TARP "investment." Should the Treasury, which in at least certain cases essentially ordered healthy banks to take the money, capture all the value in those warrants, or should the banks get the chance to buy them back at something below their modeled value?
Dirk van Dijk, CFA, of the investing blog Seeking Alpha argues that the government should get all the ups. Maybe. That is a normative and policy question that turns on whether you think the TARP and its related baggage was for the benefit of the owners of the banks or for some more social reason, such as to restore confidence in the system as a whole or to use mandatory cheap capital to subsidize lending that would not happen otherwise. If the latter, then perhaps it is a bit harsh for the government to keep all of its vig, especially given the subsequent conditions placed on TARP banks, which were clearly intended to exploit the government's ownership position to achieve a political and social objective rather than a financial or economic one.
That said, even if I were to agree with van Dijk on the morality of the matter I would not buy his reasoning. I'm no CFA, but this bit makes no sense to me:
Also, if the warrants were sold on the open market, they would remain outstanding, which means when they were exercised, the bank would get more capital, while buying them back depletes their capital. Given the generally undercapitalized state of the banking system, more capital is better than less capital, even if it means potential dilution to the bank shareholders.
Call me a bonehead, but if the warrants were extinguished for less than their fair market value, the issuing bank could, almost by definition, issue a like amount of new warrants for more money, thus improving its capital position now. More to the point, the dilution in question is not "potential," it is current. Whatever the merits in allowing the government to keep its profit on those warrants, that is economic value that otherwise would flow to the common stockholders. If those warrants vanished today at no cost to the banks, holding everything else constant the price of the common would go up, and banks would have to sell less of it to raise any given amount of equity capital. Am I missing something?
3 Comments:
By 
, at
Tue May 26, 09:32:00 AM:
A deal is a deal, except when it isn't.
From a strictly financial perspective, TARP money was cheap capital when it was issued -- warrants included. It's the later externalities the government imposed that have made it expensive. There's no spreadsheet or formula to measure that.
In business, you can trust people ... but never a corporation -- where you need a contract. You can never trust government, even with a contract -- political clout is what matters.
***
How about a shout out for Bronx girl -- Cardinal Spellman grad -- Sonia Sontomayor ... our next Supreme Court justice. I hear she went to some nearby college too -- the College of New Jersey, was it?
Link, over
By , at
Tue May 26, 10:43:00 AM:
We've already been through this. When the feds bailed out Chrysler the first time (late 80s - early 90s?), the warrants Chrysler gave the govt. went way up and Chrysler asked the feds to return then. The govt. said "no," and the treasury made a pile of cash.
By 
Escort81, at
Tue May 26, 12:28:00 PM:
I am not sure there is a one size fits all solution. In those cases where the institution was pressured into taking TARP funds over the mild or strenuous objections of senior management, the warrants probably ought to be extinguished. The TARP money was temporary window dressing in such cases, and it isn't clear to me why the feds would "deserve" the vig if the bank management felt it could do OK without the capital. I suppose there is an issue of duress there -- a deal is not a deal if someone has a gun to your head!
In cases of zombie banks or financial instituions that traded or lent their way into near oblivion, and were major contributors to last year's credit meltdown, the warrants should stay in place.
I think mechanically you are correct, except that I do not know the terms of the warrants and the extent to which they are tradeable and the windows during which they can be exercised. They ought to be valued as call options, but possibly in an unusual way because there is more uncertainty regarding regulatory status (separate and distinct from normal business or systemic risk). I would think that Black-Scholes would still be used to calculate modeled value, but there might be strange numbers for Rho (!) or Vega.
If I am a holder of warrants at a low conversion price and I am a believer in the long term value of the entity, obviously I want to hold on for a number of years, and exercise when I think I can make the most in risk-adjusted gain. Of course, if the tax on that gain might be doubled or tripled by then, that might cause me to act earlier, but the feds don't have to worry about that.
