No Way Out: Treasury And The Price Of TARP Warrants

Buried in the late wire news on Friday – and therefore barely registering in the newspapers over the weekend – Treasury announced the rules for pricing its option to buy shares in banks that participated in TARP.

The Treasury Department said the banks will make the first offer for the warrants. Treasury will then decide to sell at that price or make a counteroffer. If the government and a bank cannot agree on a fair price for the warrants, the two sides will have the right to use private appraisers.

This is a mistake. 

The only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins.

In Treasury’s scheme, there is significant risk of implicit gift exchange with banks - good jobs/political support/other favors down the road – or even explicit corruption.  For sure, there will be accusations that someone at Treasury was too close to this or that bidder.  Why would Treasury’s leadership want to be involved in price setting in this fashion?

Treasury apparently sees corruption as an issue about personalities (i.e., WE aren’t ever corrupt) rather than about institutional structure. For example, if you create an arrangement that easily permits corruption, such as through nontransparent decision making or negotiation around warrant pricing, you set up incentives to be corrupt.  Either existing people change their behavior, or new people will seek appointment in order to participate in corruption.

This is also a point, by the way, that Treasury has been making for years through its representatives at the International Monetary Fund – including during the Clinton Administration, when the same people were running U.S. economic policy as now.  It’s a good point and never easy for countries-with-potential-corruption to hear.  It applies as much to the United States as to anywhere else.

Treasury will argue the disposal of warrants is a one-off event, but this is not a plausible line: it is part of a much longer series of nontransparent decisions over finance.  The attitude that “we can be nontransparent because we will never be corrupt” creates reputational risk for both Treasury and participating banks.  If extraordinary support for the financial sector lasts several years, we will likely have at least one time-consuming and damaging investigation into all the details of these settlements.

In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable.  But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House – hopefully, senior congressional leaders will quickly make this point behind the scenes. 

There is obviously unappealing midterm election risk in this pricing scheme and making a correction now – before major banks have participated – would be relatively straightforward.

(Primer on option pricing, applied to warrants; background on how we got here)

By Simon Johnson

43 responses to “No Way Out: Treasury And The Price Of TARP Warrants

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  2. Late Friday? Back in the day, under the Bush administration, we used to call that sort of announcement a 5:00 Horror.

    Plus ça “change,” plus c’est la même chose …

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  4. Thank you, Simon Johnson (and James Kwak), for your hard work into the night. Your indefatigable efforts are much appreciated. This stuff should be screaming across all the pages and screens in America until our leaders are shamed into decency. Rather than being bothered by repetition, let’s each keep beating the drum.

  5. Lavrenti Beria

    “Why would Treasury’s leadership want to be involved in price setting in this fashion?”

    Three guesses and the first two don’t count. The larceny just goes on and on and ….

    There simply will be no parliamentary way of ever bringing these and similar practices to an end. The entire “system” is just so beset with rot that the bacteria that run and administer it will never be held to account using the very methods they’ve learned so successfully to corrupt and exploit. And you’ve wondered why I’ve so consistently called for the incarceration and trial of the entire political class together with the barnacle lobbyists that accompany them in every aspect of their so-called “public service”, whether it relates to financial, foreign, or arms procurement policies? Here’s just one reason why.

  6. The PBS Frontline show that aired recently (and included Simon Johnson) painted a picture of a relationship between Treasury and the banks in which Treasury wore the pants. What happened? Is it that the banks are holding a live hand-grenade over the economy and threatening to drop it if their demands are not met? Or do they have some more personal dirt on Geithner/Summers?

  7. Thanks for calling them out on this Simon. These activities need to be put in the spotlight. I guess mainstream media is busy covering our modern heroes like Michael Jackson.

    The folks at CNBC will hit the snooze alarm once again, and let small investors fend for themselves.

    While the anchors at CNBC are giggling and blushing with bank CEOs like some high school girl talking to the team quarterback, Simon Johnson has to do the REAL financial journalism.

  8. One has to wonder why they elected this method instead of some form of auction (and there are half a dozen formats that would work just fine). Surely someone of Larry Summers’ intellectual firepower understands that auctions are better…

    Interestingly, they did reserve the right to auction to third party bidders for cases where the bank doesn’t want to repurchase its own warrants. And there is a proviso for a third appraiser if the first two don’t agree (what does that mean? what sort of difference would constitute disagreement?)

    So it’s plausible that the bank’s appraiser is too aggressive, the govt. appraiser (miraculously) holds the line at a high price, they get a third appraiser which also (miraculously) holds the line at a high price, and we end up in a public auction. Of course, if it takes that long the warrant prices will probably stabilize in value (at a more transparent price) and the banks will remain under Federal legal restrictions longer, so the banks will probably try to accelerate this process.

    I suppose it’s possible that Larry “Master-Of-The-Universe” Summers doesn’t trust auctions. It would, admittedly, be ridiculously embarrasing if the auction was underbid (perhaps due to anticipated legal challenges or something) and the govt. had to tell taxpayers that they sold the paper back cheap. But as SJ notes, a minimum bid (preferably sealed, so the banks don’t know what it is) would cover that.

  9. Also released this weekend (and buried underneath the King of Pop’s demise), was the Bank of International Settlements report. The full text on chapter 1 is a good synopsis of where we are… http://www.bis.org/publ/arpdf/ar2009e.htm

    BIS is a critical institution – it’s located in Basel Switzerland for a reason (aka, the Basel Accords). We don’t here as much about it as the IMF, but day-to-day it’s pretty important.

    The BIS perspective is broadly consistent with the policy perspective of Baseline: shrink the financial sector, extend regulation to peripheral securities, avoid systemic risk, etc…

    There is one massive contradiction, however, in their declaration. On the one hand, the BIS takes the position that we should avoid protectionism at all costs. On the other hand, the BIS argues that developed countries need to decrease their debt-financed dependence on imports… And developing countries should, uh, become less dependent on exports? (And this is going to happen under a free trade system? Yah, right…)

    So should, or should not, governments take an active hand in managing current account flows (which ultimately are tied to the real economy via trade)?

    On the one hand, BIS (accurately) argues that we need deep structural change. On the other hand, BIS seems to be arguing for a return to a (slightly modified) free-trade orthodoxy. Which is it?

  10. Cathy Adamson

    Is there a section of history that documents what happens when an entire government is corrupted? What happens to private property and people? What should we try to prepare for?

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  12. The foxes are in charge of the hen house now. The opportunities for payoffs are just to big for this administration to say no.

    These guys just can’t keep themselves from helping out their friends in a big way. Take a look at the most recent health care proposal for the public option- the unions will get to have their own special private plan. Another goodie for a favored special interest with the appropriate vote rigging attached. So let’s see, elected officials and their staff will get the platinum plated Congressional plan, the union members will get the gold plated plan and the rest of us will get the bottom of the barrel stinky crap plan that will deny us coverage when we really need it.

  13. It is the same argument for suspension of “habeas corpus”, the allowance of torture, the support of the “State Secrecy Act”, and the support of “indefinite detention” – we’re the good guys so we’d never abuse any of this.

    First of all, there are too many agents involved here, so you can never assume WE are the good guys. Second, by setting precedent, a future administration who is NOT the good guys has it at their access. Third, we are really NOT the good guys and have shown that over and over (that is, even with the best of intent, abuses occur). Finally, as you state, people who would wish to abuse gravitate to its uses.

  14. This comment has nothing to do with Simon’s post. My apologies.

    I would just like to draw readers’ attention to a new very interesting article by Ryan Lizza in The New Yorker. (I wish there was a thread on this website where we could point to good articles elsewhere)

    It’s a portrait of Sheila Bair, the current head of the FDIC. It deals with many issues that are discussed at Baseline Scenario.

    Here are 2 excerpts:

    1) “Bair was a friend of Joshua Bolten, a fellow Senate staffer, who became George W. Bush’s deputy chief of staff, and in 2001 Bush put Bair in charge of financial institutions at the Treasury Department. It was there that she began to take an interest in predatory lending, and discovered a curious trend emerging in the housing markets. Some fringe lenders were enticing home buyers to sign mortgage agreements that they couldn’t afford. These so-called subprime lenders weren’t brick-and-mortar banks that relied on their depositors’ savings to make loans. Rather, they were financed by Wall Street speculators. Instead of simple thirty-year fixed rates, Bair noticed, the loans had hidden fees and exotic features, like low introductory rates that exploded after a few years.”

    2)”The Bair acolytes, however, point to firms like Bank of America and Citigroup, which they argue are insolvent and need to be temporarily nationalized. Citigroup remains the focus of the debate between Geithner and Bair. Geithner has reportedly defended Citigroup’s managers and cautioned that the company should be given more time to execute its current turnaround plan. The New York Post recently summarized the dispute with a picture of Bair and Geithner dressed as characters from “Batman.” Geithner “is doing a pretty good Joker impression outfoxing FDIC ‘Batgirl’ cop Sheila Bair, who’s pushing for the busting up of ailing Citigroup,” the caption read.”

    The article:
    http://www.newyorker.com/reporting/2009/07/06/090706fa_fact_lizza

  15. Simon,
    You write about these fellows as if they have any clue what they are doing, making me question my otherwise positive impression of your situational understanding here.. You give them far, far too much credit. They are being outplayed at every turn by relatively sharp bankers; Geither most of all just strikes me as an intellectual dullard playing poker with professionals and a few trillion of our money. Hoping they remember him when it comes to time to retire from his inglorious public life and collect his well-earned millions from GS etc.
    Eric

  16. Treasury apparently sees corruption as an issue about personalities (i.e., WE aren’t ever corrupt) rather than about institutional structure.

    Government always claims it’s like this: the “bad apples” did it. It’s not fundamental to the structure.

    That’s also the way the media reports it.

  17. StatsGuy, it seems to me that Summers is one of the most corrupt economic advisers in history. Obama would be well advised to fire him, before he steals more.

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  19. is there any mention in the warrant terms about whether the treasury has the right to auction them off?

  20. Don’t get to paranoid Cathy, I don’t think it’s THAT bad. But as far as corruption and lack of property rights, modern day China is a very good example.

    Some people worry about China because they own so many of our Treasury bonds, and the economy has grown so fast. But the truth of the matter is before 1979 there was for China to go but up.

    There’s really only three reasons to be scared of China: 1) Sheer size(population), 2) Market power(economies of scale) and 3) Absolute ruthlessness to achieve goals(including killing their own citizens)
    They are NOT a free market economy. They are NOT a quasi- version of a free market economy as some journalists report. If America goes down it will be because of our own foolishness, not debt to China.
    That’s a long-winded answer. I could go into more detail about China than anyone on this site would want to hear (I’d be labeled a racist even though I’m nothing of the kind). Suffice it to say Cathy it adds up to a kind of morbid-passive-unhappiness of the citizenry.

  21. In the above post, I meant to type: before 1979 there was no place for China to go but up. I’m glad Mr. Kwak doesn’t give us essay scores on these posts.

  22. Master-Of-The-Universe Summers (let’s call him MOTU-MOTU) is either blinded by his ego or corrupt, or both.

    Either that, or like MOTO-MOTO from a recent children’s cartoon, he has very particular economic tastes when it comes to banks…

    “I like ‘em big
    I like ‘em chunky
    I like ‘em big
    I like ‘em plumpy
    I like ‘em round
    With something, something
    They Like my sound
    They think I’m funky”

    (Thank you will.i.am)

  23. I like auctions too. My research on the TARP warrants is at http://www.linuswilson.com/bankbailouts.html.

  24. An auction for the TARP Warrants is indeed the way to go. Are there caveats to multiple rounds of bidding vs. just the one proposed above?

    It would appear the administration is bending over backwards to give the banks what they want. When you surround yourself with bankers, you’re going to end up knee deep in ‘BANKNIP. Why a private appraiser? Is there some rule that things appraised only sell for prices set by the appraisers? How is appraising a better option than getting all interested parties in a room and letting the highest bidder be the ultimate ‘decider’? Is the auction not the truest embodiment of “Whatever the market will bare…”?

    This “we can be nontransparent because we will never be corrupt” is an easy sell in this country and we might as well face it. We probably have the shortest collective memories of any country and sadly appear to only act en masse more out of anger certainly than responsibility. That isn’t to say that we think ourselves incorruptible. It would appear instead that we assume there’s going to be some level of corruption and as long as it stays below some unspoken level we’re good with that. Go above and we are outraged.

    Transparency in my mind always indicates at the very least, an honest desire to do the right thing. Conversely, a simple early warning system for potential corruption, goes off with the sound of doors being closed just as conversations that carry the most weight heat up.

  25. I have always advocated auctions over negotiations. The problem is that the purchase agreement sets up this negotiation process, but I agree that the process is ripe for corruption. The Treasury can only auction warrants where negotiations have broken off. Yet, Treasury has been slow to set up auctions. My valuations of the first 10 repurchases indicate the U.S. Treasury has given the banks great deals at taxpayers’ expense. Tables 2 and 3 of http://ssrn.com/abstract=1413442 provide valuations of 68 banks’ warrants including the 10 that repaid the preferred on June 17, 2009.

  26. DesolationRow

    “The attitude that “we can be nontransparent because we will never be corrupt” creates reputational risk for both Treasury and participating banks.”

    Is Cheney running Treasury now?? Kind of reminiscent of the secret no-bid contracts to KBR.

  27. Me, a few months ago:

    I find myself wondering what the difference between Lawrence Summers and Sarah Palin is. And I think it’s mainly that Summers is a well-connected white boy. But the stunning egotism is the same. Probably part of why Summers denigrates women is that they see through him: somewhere, inside, there’s a greedy little boy. There’s a whole article on testosterone poisoning in the financial system to be written, I think. Geithner, Summers: these people ought not be in charge of anything that matters.

  28. “In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable. But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House – hopefully, senior congressional leaders will quickly make this point behind the scenes.

    There is obviously unappealing midterm election risk in this pricing scheme and making a correction now – before major banks have participated – would be relatively straightforward.”

    This really is appalling. Has SJ not read the terms of the Standard Form Securities Purchase Agreement promulgated by the Paulson Treasury and which all the warrant issuers and Treasury agreed to in October 08-January 09 (pre-Obama) time frame? There were no new rules announced Friday, just additional information on how Treasury will come up with its bid. The procedure itself is contractually detailed, and could not be changed by the White House, Congress, or for that matter the banks.

  29. Simon, by now you must understand that these guys in Treasury are so enamoured with what they see as a plan which give them the right to have white hats permanently installed on their heads. This is just more of the same, namby-pamby pro financial conglomerate policy that will permanently cripple our economy. Until the results of this policy result in failure, they will keep puckering up at the derieres of those who run the toxic asset infested lenders. Sorry, same stuff, different day!! As they say.

  30. Let’s go to the videotape:

    Friday’s announcement:
    http://www.ustreas.gov/news/index2.html

    Treasury’s CPP (including warrant) FAQ:
    http://www.financialstability.gov/docs/CPP/CPP-FAQs.pdf

    The subject standard Securities Purchase Agreement. Section 4.9 governs redemption of warrants by a bank that has redeemed its preferred shares:
    http://www.financialstability.gov/docs/CPP/spa.pdf

    Treasury’s authority re warrants (EESA § 113, 12 USC 5223):
    http://www.gpo.gov/fdsys/pkg/PLAW-110publ343/html/PLAW-110publ343.htm

    Notwithstanding § 113(d), while both administrations have taken pains to assert that to help the banks was to help main street, the immediate intent of the TARP aspect of EESA was to help banks, like it or not. It should not surprise us then that when it comes to, say, removing troubled assets from bank balance sheets, the gov’t is willing to extend credit and subsidies to investors who are willing to take a bare minimum of risk, so as to get the banks the best possible price. Similarly, when it comes to the redemption of the warrants, the gov’t wants to do so on terms favorable to the banks. I agree that an open market process is more transparent and less conflict-prone than the negotiated repurchase contemplated by the SPA, but perhaps this was not foreseen in the moment of “crisis.” Possibly it was discounted in the urge to consummate a sweetheart deal. Finally, had I been forced to take TARP funds against my will, I would not care to see warrants for my stock be auctioned to the highest bidder.

  31. Sometimes there’s totalitarianism, sometimes the government falls, sometimes there’s a military coup, sometimes there’s war, sometimes a revolution. Nothing good for the little guy in the short term, anyway.

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  33. Don’t worry Simon, I’m sure CNBC was all over the story of the pricing of TARP warrants today. I guess Maria Bartiromo was probably interviewing Larry Summers and others in the Treasury Department today. If/When they told her everything “was doing ok” she might say something like “it’s AMAZING!!!!!” like when she interviewed John Thain…………
    http://www.thedailyshow.com/video/index.jhtml?videoId=220252&title=CNBC-Financial-Advice

  34. By now, these banks have had plenty of time to sort through their toxic assets to determine what they hold. If the toxic assets cannot be sold because they are worthless, the banks should write down and realize their losses.

    In the meantime, they should be selling some of their assets, downsizing, laying off employees, taking salary cuts, etc. to gain capitol in order to offset their losses.

    The assets they hold in offshore tax havens, which is in the billions, should also be used to offset those losses. And guess who’s turned up in a new government report about tax havens? Eleven giant recipients of your bailout tax dollars:

    * American Express
    * AIG
    * Bank of America
    * Citigroup
    * General Motors
    * GMAC
    * Goldman Sachs
    * JP Morgan Chase
    * Merrill Lynch
    * Morgan Stanley
    * Wells Fargo

    Together they’ve collected more than $227 billion. See the source:
    http://www.cbsnews.com/stories/2009/02/23/eveningnews/main4822689.shtml

    Although proponents say most businesses in tax havens are perfectly legal and legitimate, it’s estimated that tax havens cost U.S. taxpayers $100 billion a year in lost revenue.

    One favorite among the bailout companies is the Cayman Islands. There’s no income tax, no corporate tax and no capital gains tax.

    Goldman Sachs has 15 subsidiaries there. Bank of America: 59. Citigroup: 90.

    But Morgan Stanley beats them all with at least 158 subsidiaries in the Cayman Islands – seven times the number of hotels.

    So until all of the above is done and more no more subsidizing these banksters.

    Why isn’t there a yellow crime scene tape around Washington D.C. and Wall Street? This is the largest transfer of public wealth to the wealthiest individuals in U.S. history.

    When will the bank CEO’s and Board of Directors be fired and investigated? When is the Financial Crisis Inquiry Commission (Pecora Commission) going to get started?

    I want criminal investigations into all those that have brought down the global economy, starting with AIG’s Joseph Cassano and the rating agencies. Why is it taking the FBI so long to announce some important arrests? This is the largest Ponzi scheme – this beat Madoff and now he’s in prison with a 150 year sentence.

  35. Side Note:

    I hope all of us have learned a valuable lesson.

    Vote each and every one of our incumbent House and Senate members out of office this next election to send Washington D.C. a ‘Yes We Can’ message. Let’s get the lobbyists out of Washington, D.C. with newly elected officials. Perhaps with the changes the ‘Yes We Can’ message will finally sink in and they will do what is right for the country and its people.

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  39. Simon–while many of your points are true, it is important to recognize that Treasury’s warrant repurchase process does place a large emphasis on objectivity and transparency. Treasury has stated clearly that in evaluating the fair market value of warrants, it will use a combination of observable market prices (including price quotes from 5-10 other banks), well-known option-pricing models, and even independent appraisals from third-party asset managers to ensure fairness. Most important, Treasury will publish information on each purchased warrant, including the bank’s initial and subsequent repurchase offers, as well as the independent assumptions used in Treasury’s option-pricing models regarding volatility, dividends, etc.

    Although your criticism contains some truth, your claim that the warrant repurchase process reflects Treasury’s attitude that “we can be nontransparent” is not consistent with the emphasis that Treasury’s repurchase policy has placed on transparency and independent valuation.

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  41. Believe it or not, the negotiated warrant repurchases have been working well, based on our analysis.

    Except for the first repurchase (Old National Bancorp.), prices paid have been close to the “fair value” that we calculated based on years worth of warrant transaction data.

    A copy of our study is available here:
    http://www.plurisvaluation.com/site/liquistat.html#2.

    You can also download the Pluris white paper on valuing warrants here: http://www.plurisvaluation.com/site/pressroom/whitepapers.html.

    Espen Robak, President”

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