For once we’d like to get a fair value when we come into contact with the banking system

TO BE NOTED: From Bloomberg:

"TARP Warrants Show Banks May Reap ‘Ruthless Bargain’ (Update2)

Share | Email | Print | A A A

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.

‘Stronger Incentives’

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.

Lenders shouldn’t be trusted to make suppositions that would be to the advantage of taxpayers, said Linus Wilson, an assistant professor of finance at the University of Louisiana at Lafayette.

‘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.

Black-Scholes

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.

Risk Management

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.

Serving Taxpayers

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.

To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net.

Last Updated: May 22, 2009 15:43 EDT "

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:

1) The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price.

2) European exercise terms are used

European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.

3) Markets are efficient

This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous Itô process. To understand what a continuous Itô process is, you must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An Itô process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper.

4) No commissions are charged

Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model.

5) Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model.

6) Returns are lognormally distributed

This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options. "

"Once upon a time, people saved a portion of their earnings for the proverbial rainy day"

Via Paul Kedrosky, I came upon this interesting article by Niall Ferguson in Vanity Fair:

"This crisis, however, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system, extending from the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unfathomable in scale.

Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that “great contraction” of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment. If the more openhanded monetary and fiscal authorities of today are ultimately successful in preventing a comparable slump of output, future historians may end up calling this “the Great Repression.” This is the Depression they are hoping to bottle up—a Depression in denial."

So, here we go again. It's the system that has broken down. An article purportedly about human agency begins by blaming the system. Then, although the Fed was important in managing this crisis, there is no consideration of the fact that the implicit and explicit government guarantees played any role in this crisis. They're purely benign institutions.

"By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. Once it became clear that this formula worked, the Age of Leverage could begin. For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.

Nearly all of us did it. And the bankers were there to help."

So, we go from:

A: I want to invest in something that appreciates more than the rate of inflation ( However you're measuring that ) ( Makes sense )

to:

B: Borrow to the hilt and leverage your investments idiotically ( Idiotic )

What did I miss?

"The future is in large measure uncertain, so our assessments of future asset prices are bound to vary. If we were all calculating machines, we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and mood swings. When asset prices surge upward in sync, it is as if investors are gripped by a kind of collective euphoria."

So, from:

1) The future is largely uncertain ( True )

2) Humans aren't calculating machines ( True )

3) Humans are moody ( True )

4) When investments all go up, our mood becomes euphoric ( Not buying it )

5) When euphoric, we invest idiotically ( I supplied this one ) ( Not sure )

"The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks."

The Spigot Theory appears. Turn on the tap too high, the tub floods. Again, this might be a necessary condition, but it's not sufficient. For one thing, what's easy? Do you mean lending foolishly? So, if Bank A lends foolishly, Bank B will follow, and then... By the way, what's a false bubble? This is a purely mechanistic explanation, disguised as being about behavior because a lot of people are choosing to do the same thing at the same time. Surely that absolves individual agents, and creates a mania, a bubble, which is the system's fault, not individual human agents.

"What was not immediately obvious was that Greenspan’s easy-money policy was already generating another bubble...

I thought that you just agreed with the Spigot Theory. If not, the alternative is that easy money didn't create the crisis. At best, it was a tool that was misused, by people.

"Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset."

So, the alternatives are:
1) Put money in mattress ( No interest )
2) Put money in bank safe ( Interest? )
3) Idiotic borrowing to gain massive interest ( Self-Explanatory )

"So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue."

If people borrow to finance houses, a bubble will ensue. That's just nonsense. What else could brainwashing imply? It must be idiotic, and needs brainwashing to be overcome.

"There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago."

It worked for me, and all I did was read Jane Bryant Quinn.

"Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered “investment grade.”

And yet this guarantee is not part of the problem.

"These changes swept away the last vestiges of the business model depicted in It’s a Wonderful Life. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later."

Finally something I agree with. The lenders should know enough about the borrowers in order to make the loan reasonable.

"As a business model, subprime lending worked beautifully—as long, that is, as interest rates stayed low, people kept their jobs, and real-estate prices continued to rise. Such conditions could not be relied upon to last.."

See, to me this obvious, and I'm not a banker.

"The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard “to arrive” futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born.

Because they are derived from the value of underlying assets, all futures contracts are forms of derivatives. Closely related, though distinct from futures, are the contracts known as options. In essence, the buyer of a “call” option has the right, but not the obligation, to buy an agreed-upon quantity of a particular commodity or financial asset from the seller (“writer”) of the option at a certain time (the expiration date) for a certain price (known as the “strike price”). Clearly, the buyer of a call option expects the price of the underlying instrument to rise in the future. When the price passes the agreed-upon strike price, the option is “in the money”—and so is the smart guy who bought it. A “put” option is just the opposite: the buyer has the right but not the obligation to sell an agreed-upon quantity of something to the seller of the option at an agreed-upon price.

A third kind of derivative is the interest-rate “swap,” which is effectively a bet between two parties on the future path of interest rates. A pure interest-rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit-default swap (C.D.S.), meanwhile, offers protection against a company’s defaulting on its bonds."

I included this just because I like explanations.

"But how exactly do you price a derivative? What precisely is an option worth?"

You'd better figure that out if you plan to make money on them.

"The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational..,"

Postulate away, as long as your not silly enough to think that's this planet.

"But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash"

Please don't tell that this means they were making statistical predictions of future events and only looking back five years. I must be missing something here.

"But there was a catch. The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The Asian savings glut was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge-fund population explosion. It was the underlying reason why private-equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts. And it was the underlying reason why the U.S. mortgage market was so awash with cash by 2006 that you could get a 100 percent mortgage with no income, no job, and no assets."

Here we go again with the mechanistic explanations. The Giant Sloshing Pool Of Money that need be invested idiotically against all human will or knowledge. I'm sorry, again, at best a necessary condition. At best.

"But back here on Planet Earth it suddenly seems like an extraordinary popular delusion."

The delusion here on planet earth is reducing this crisis to:
1) Low interest rates
2) Giant pool of money
3) Complicated investments
4) The behavior of crowds

Individual human agents don't appear here. How could they? They have to be dealt with individually, and that's too hard and messy. Or is it?

The causes of the crisis are:
1) Poor lending
2) Poor borrowing
3) Fraud
4) Negligence
5) Fiduciary misconduct
6) Implicit and explicit government guarantees
7) Poor compensation schemes
8) Lack of supervision
9) Wishful thinking
10) Overlooking risk

A motley list of human frailties that we see or hear about on most days. That's what got us into this mess. The only difference was the number of people involved. To the extent that these events are explained mechanistically, expect it all to happen again. Only risk borne at the individual level can solve this problem, and that means ridding individuals of the chance of a bailout.

Does that mean not having a decent and just social safety net? Of course not. It simply means that private businesses cannot transfer their losses to the taxpayers, by having too much concentrated power and wealth to ensure that.

The simple application of anti-trust laws, enforcing fraud, and minimal but effective regulation can solve this. That's the sad truth.