"TARP Warrants Show Banks May Reap ‘Ruthless Bargain’ (Update2)
By Mark Pittman
May 22 (Bloomberg) -- Banks negotiating to reclaim stock warrants they granted in return for Troubled Asset Relief Program money may shortchange taxpayers by almost $10 billion if Treasury Secretary Timothy Geithner’s first sale sets the pace, data compiled by Bloomberg show.
While 17 financial institutions have repaid TARP funds, two have come to terms with the U.S. on the value of the rights to buy stock that taxpayers received for the risk of recapitalizing the industry. The first was Old National Bancorp in Evansville, Indiana, which gave the Treasury Department $1.2 million last week for warrants that may have been worth $5.81 million, according to the data.
If Geithner makes the same deal for all companies in the rescue program, lenders may walk away with 80 percent of the profits taxpayers might have claimed.
“For once we’d like to get a fair value when we come into contact with the banking system,” said Representative Brad Miller, a North Carolina Democrat and chairman of the Investigations and Oversight Subcommittee of House Science and Technology Committee. “We don’t want a ruthless bargain.”
Under the Old National warrants formula, Bank of America Corp. would save $2.03 billion, followed by Wells Fargo & Co. at $1.48 billion and JPMorgan Chase & Co. at $1.46 billion. Morgan Stanley’s benefit would be $983 million, Citigroup Inc.’s would come in at $965 million and Goldman Sachs Group Inc. would have $693 million, according to the data compiled by Bloomberg.
For the 20 largest TARP recipients, the total savings would be $9.985 billion, the data show.
Senator Jack Reed, a Rhode Island Democrat and chairman of the Banking Subcommittee on Securities, Insurance and Investment, said today in a letter to Geithner that warrants were part of the TARP so that taxpayers could be compensated for the risks they took investing in lenders.
“We need to ensure that the financial industry recovers and that banks can start lending again, but taxpayers must be fairly compensated as well,” Reed said.
Geithner wants to move swiftly to sell the TARP warrants, he said on May 20. Their worth depends on assumptions about the chances the underlying stock will go higher than the rights. Depending on the input, different valuation models reach a range of conclusions.
‘Doing Our Best’
“Bank managers have stronger incentives than Treasury personnel to get a better deal for their constituents,” said Wilson, who has written about appraising warrants.
Because Old National was the first to repay TARP money and buy its rights back, the transaction “sets the price point for the whole program,” said Simon Johnson, a fellow at the Peterson Institute for International Economics in Washington.
“The point of the warrants is that taxpayers participate in the upside,” said Johnson, who testified on the securities before Miller’s subcommittee on May 19. “It defeats the whole purpose if you’re going to sell them way below market price.”
Treasury Department spokesman Andrew Williams declined to comment on Old National.
“We’re doing our best to protect the taxpayers’ interest and make sure we get fair market value,” he said.
Returning $45 Billion
The department has a “robust process” of evaluation, using two modeling systems, consulting with an asset manager and collecting bids from market participants, Williams said.
The U.S. received rights to buy 1.4 billion common shares in exchange for $287 billion in TARP capital, according to data compiled by Bloomberg.
A company that accepted aid had to grant warrants equal to 15 percent of the TARP investment at a strike price equal to the 20-day trailing average of the shares. A strike price is that at which an option can be exercised.
Now that Goldman Sachs, JPMorgan and Morgan Stanley have applied to return the $45 billion they received, they may also reclaim their warrants.
Those may be worth about $4 billion, data compiled by Bloomberg show. If the U.S. followed the Old National formula for the three New York-based banks, taxpayers would receive less than $1 billion.
JPMorgan spokesman Joseph Evangelisti declined to comment.
Mark Lake, a spokesman for Morgan Stanley, said the bank “would support any program that is focused on benefiting the U.S. taxpayer.” Goldman Sachs spokesman Michael DuVally said company officials have “always said the taxpayers should benefit from the value associated with these warrants.”
In the case of Old National, each of the 813,000 warrants had a strike price of $18.45.
On May 11, the day the U.S. announced the sale, the stock’s option-implied volatility, derived from market prices of stock options that are traded daily, was 61 percent, according to data compiled by Bloomberg. The risk-free rate of return, or the yield of government debt, was 3.47 percent that day.
Based on that volatility and that rate, the Black-Scholes options valuation tool appraised one Old National warrant at $7.18. The bank paid the U.S. $1.48 for each.
“We were able to reach a deal that was good for our shareholders and Treasury felt was good for taxpayers,” said Old National Chief Executive Officer Bob Jones.
The bank, with more than $8 billion in loans and branches in Kentucky and Illinois, hired an appraiser to evaluate the warrants, Jones said. He said the government rejected his first offer of $600,000.
The second TARP recipient to reclaim stock-purchase rights was Iberiabank Corp., a Lafayette, Louisiana-based lender with $5.6 billion in assets that took $90 million in TARP assistance.
Iberiabank paid $1.2 million to buy 138,490 warrants at $8.66 a share, according to a May 20 filing. They may have been worth $19.78 each, or a total of $2.74 million, according to data compiled by Bloomberg and modeled by Black-Scholes.
The lender was able to slash the number of warrants from 277,000 by selling common stock in December, a reduction allowed under TARP rules.
A risk management device, Black-Scholes was developed in 1973 by Fischer Black and Myron Scholes to estimate the fair market value of stock-option contracts. Williams, the Treasury spokesman, declined to say whether Black-Scholes is one of the two models the department employs.
At the University of Louisiana, Wilson used Black-Scholes and two other systems to evaluate Old National’s warrants, plugging in three volatility assumptions: 37.1 percent, 59.72 percent and 72.89 percent.
The lowest, calculated from the bank’s stock price movements over the past seven years, yielded the smallest warrant value, ranging from $2.50 to $6.72 per warrant. The highest, based on changes since Jan. 1, 2008, returned a range from $8.88 to $11.05. The middle estimate -- the options-implied volatility -- said a right was worth from $5.93 to $9.69.
Wilson said the government would serve taxpayers better by auctioning off the securities to investors. The law that established the TARP allows for an auction.
Miller, the North Carolina congressman, said the Treasury should have insisted on terms for taxpayers similar to those Warren Buffett secured for Berkshire Hathaway Inc. shareholders when he invested $5 billion in Goldman Sachs in September.
‘A Tough Penalty’
Buffett received 43.5 million warrants valued by Black- Scholes at $3.6 billion, or $82.18 each, on the date of the transaction, data compiled by Bloomberg shows. Taxpayers injected twice as much into Goldman Sachs and got 12.2 million warrants worth $882 million, or $72.33 each.
The American Bankers Association said in an April 16 letter to Geithner that a company that wants to get out of the TARP now faces an “onerous exit fee” because it has held the investment for so little time.
“There is no reason for Treasury to impose such a punitive obstacle to exiting,” said Diane Casey-Landry, the association’s chief operating officer in Washington.
After Shore Bancshares Inc. returned $25 million in TARP money, plus $208,333 in interest, it offered to buy its 173,000 warrants, according to CEO Moorhead Vermilye. He declined to disclose the bid, which he said the U.S. rejected.
The Easton, Maryland-based bank’s warrants were valued yesterday at $12.33, or $2.1 million, according to data compiled by Bloomberg and modeled by Black-Scholes. Paying that to reclaim them would amount to an annual interest rate of more than 30 percent a year.
“It’s a tough penalty for the short time we had the money -- three months,” Vermilye said.
From Kevin Rubash:
Myron Scholes and Fischer Black
"The Black and Scholes Model:
The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences.
In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts.
Assumptions of the Black and Scholes Model: