Warrant Sales Could Cost Government $10 Billion

Mark Pittman at Bloomberg estimates the total potential cost to taxpayers of selling warrants back to banks at low prices: $10 billion.  These are the warrants that banks had to issue to Treasury in exchange for preferred stock investments under TARP. Pittman uses the Old National example as a benchmark: Old National paid $1.2 million to buy back warrants that he estimates at $5.8 million. (Linus Wilson, the first person I know of to do the calculations, estimated a range of values from $1.5 million to $6.9 million.) Extrapolating that “discount” to all the other warrants that Treasury currently holds, Pittman finds:

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.

If you are concerned about banks’ capital levels, that’s one way to help them out. The alternative, suggested by Wilson and others, would be for Treasury to auction off the warrants; if the bids were too low, it could create a trust, transfer them from Treasury to the trust, and release the banks of any TARP obligations triggered by those warrants.

It also contrasts sharply with the treatment of private (not publicly-traded) banks such as Centra, as documented by David Kestenbaum of Planet Money.

I’ll have more on option pricing later.

By James Kwak

18 responses to “Warrant Sales Could Cost Government $10 Billion

  1. any discussion of fair warrant pricing needs to include the pricing assumptions used.

    wilson to his credit did include his assumptions. his assumptions are very easy to disagree with. i left a comment at the original post a couple days ago discussing this.

  2. Jim, to sell the warrants at a discount to some estimate of value doesn’t “cost” the taxpayers a dime. If the government tore up the warrants it would not cost the taxpayers anything. Am I wrong? I agree that depending one what the banks pay to purcahse the warrants the government with profit more or less. But it’s still a profit, even if as the the orginal piece states we may be “shortchanged.”

  3. Yes, you are wrong.

    All of the government’s money ultimately comes from the taxpayer. Right now, the government owns the warrants, and the warrants have value. If the government gives away something that has value, the difference will ultimately be made up by tax revenue.

    These warrants are part of the (massively below-market) price the government charged the banks for these capital injections to keep them from going bankrupt. To throw them away now is to burn taxpayer wealth, period.

    Or maybe someone should tell Warren Buffett to tear up his GS and GE warrants because “it would not cost him anything”. Hilarious!

    These warrants were part of the deal. It was always a bad deal for taxpayers, and now the banks are using our captured political system to make it a worse deal.

    The best course for taxpayers would be simply to hold the warrants for (say) five years and then to auction them off. That will never happen because we do not own our government anymore.

  4. Nemo: “The best course for taxpayers would be simply to hold the warrants for (say) five years and then to auction them off. That will never happen because we do not own our government anymore.”

    Yes. I was shocked by the warrant sale at this point in time. I thought that the idea was that, assuming that the bailouts and other government action enabled a recovery, the sale of the warrants ***after the recovery*** would help the taxpayers recoup. Wrong again!

  5. that’s what makes the most sense. in fact the govt should hold them to maturity (option pricing theory says that it almost never makes sense to prematurely exercise a warrant).

    as far as i can tell the only reason the treasury is selling them is to release the TARP restrictions, which they could do by fiat.

  6. Just to be clear, I did not suggest “exercising” the warrants. As you say, that would be stupid. I suggested auctioning them off.

    Holding them to maturity would also be fine.

    Weren’t these warrants pitched as a way for the “taxpayer to participate on the upside, if any”? Oh well, never mind, move on.

  7. Wayne Martin

    Isn’t this the same scenario that Elizabeth Warren documented a few months ago in her TARP oversight work?

  8. winstongator

    How much do options to buy ONB @ $18 cost today? The quote I saw was $0.75-$1.35. Treasury paid $1.50. Why was this such a bad deal?

    Treasury made an equivalent 7.4% annual yield on their ONB investment – is that bad in this environment? Will we see that from all the tarp funds? Is this nearly as important as the preferred -> common swap?

  9. Yes, that Treasury was receiving warrants was sold as part of the “upside” for the taxpayer.

    Now we see that not only was this, like every other TARP-related assurance, a fraud, but it’s even being used as another illegal laundering mechanism.

  10. you mean ‘treasury got 1.50′

    if it was a bad deal, that was because these are long dated options and so should be worth much more than short dated options.

  11. Well I hope you had a good laugh, honestly I do. But it still looks to me like Treasury made money on this particular deal. They got all their TARP money back plus a $1.2 million kicker. I do not disagree that they could have held out for more, or that someone else might pay more for those warrants than the bank did. But is the Treasury out of pocket on this? If so that’s scandalous.

    Maybe somebody here could answer a question that’s been bugging me for a while. Is the FDIC’s TLGP a money maker? Participants are paying a fee for the guarantee. So far as I know there have been no defaults on these effectively subsidized obligations. Is that costing the taxpayers money? I think Bernanke said it was going to make money.

  12. it’s likely to make money except in the case of a huge catastrophe. however, that’s no certain proposition. it is putting taxpayer money at risk directly and gets the government in a business where it shouldn’t be.

  13. I and another commenter go through some of the math on this other thread here: http://baselinescenario.com/2009/05/19/tarp-warrant-pricing-old-national/

    After looking at this a few times I think the Treasury got a decent deal. Of course it depends very strongly on your assumptions, and so reasonable folks can disagree.

    No idea though why the treasury forced the sale.

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  17. When you claim the warrant sales would ‘cost’ the government, are you saying the government would recoup less than it’s investment in the deal based on the purchase price or miss out on profiting by selling them back at their purchase price when the could be sold at a higher price?

    In my mind there is a big difference. I have no problem with the government breaking even on the deal even if it means the banks made money by getting access to absurdly cheap capital. I don’t like the banks any more than the next guy but also understand that we need a strong, or at least solvent, banking system and as long as the taxpayer isn’t actually losing money in the transaction, having the banks become fully independent sooner rather than later is a good thing.

  18. Agreed. My first post was semantic pedantry. I’ll leave it to the economists to explain whether a foregone profit can be considered a cost (maybe a type of opportunity cost or something) but I think when read colloquially the term cost means “expense” or something you pay out of pocket. Clearly that is not the case with the warrants. So I took exception with the use of the term cost, which by the way is not used in the Bloomberg article. And I would also quibble with that article’s title “TARP Warrants Show Banks May Reap ‘Ruthless Bargain.’” Whoever coined the title I think misundertood (or simply turned it around to be sensational) what Rep. Miller said:

    “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.”

    Miller is saying he wants to cut a fair deal, not a ruthless bargain, on behalf of taxpayers.

    You all probably know that one of the purposes of TARP is “to ensure that [TARP] facilities are used in a manner that maximizes overall returns to the taxpayers of the United States.” EESA § 2(2)(C). So Treasury is not supposed to give away the store for sure. Of course the first purpose is “to restore liquidity and stability to the financial system of the United States.” EESA § 2(1). “Maximize” is a strong mandate yet Treasury can always accept less returns on the theory that it makes the participant banks more stable.