Selling the glass financial menagerie
What’s the best way to realize value from a complicated financial position? And – related question – who’s the best holder of such assets?
Someone who’ll treat them delicately
Submitted for your consideration, as discussed in this Wall Street Journal article, is a gargantuan Federal government that, for one good reason or another, now finds itself holding warrants in a series of financial institutions that it has forcibly recapitalized.
They made us an offer we couldn’t refuse
Ten big banks earlier this month paid back were cleared to pay back $68 billion in federal government aid. Those firms were: J.P. Morgan Chase & Co., Goldman Sachs Group Inc., Morgan Stanley, BB&T, U.S. Bancorp, American Express Co., Capital One Financial Corp., Bank of New York Mellon Corp., Northern Trust Corp. and State Street Corp.
Because warrants are options to purchase common stock for a preset price at any time during a stated interval, they have a positive value even if the exercise price today is above the stock’s trading value today. Further, because the warrant holder has all the optionality – choosing when to exercise – plus minimal carrying costs, the value is greater when the exercise window is long, such as ten years.
A lot could happen on that future road
Yet this very large governmental body probably ought not to be in the business of holding warrants, even from a fully transparent Bank of Glass, because aside from the sticky-finger conflicts of interest rampant in such a situation, government is a slow-moving behemoth that is seldom a good holder of complex real estate assets, nor adept at defusing unexploded financial ordnance, and still having trouble enough finding the right CEO(s) for its schizophrenic GSEs.
Under a key TARP program, the government injected capital into hundreds of banks around the country in exchange for warrants to purchase common shares.
When a publicly-traded bank repays the government, the bank can repurchase the warrants. But that process is expected to be complicated given that the warrants have an unspecified value.
One approach to valuing anything odd is to auction your headaches, but as in divorce, when the current holder(s) both know the asset well, a pre-auction negotiation is effective – and that, has been structured in to the TARP repayments that will be forthcoming shortly:
WASHINGTON — Now that large banks have started paying back government aid, the U.S. Treasury Department is shedding light on its process for negotiating warrant repurchases with banks, saying Friday that it has developed “a robust set of procedures” to protect taxpayers.
Strong enough to protect taxpayers
Treasury Friday released a packet of documents that explain the warrant repurchase process.
As an exercise in procedural negotiation, the TARP warrant repayment is an illuminating case study:
Government grows best in the sunshine, so let’s illuminate
Step 1. I hold warrants in you, so you tell me what you think it’s worth
In negotiations, who makes the first offer is a significant issue; sometimes one is best served by going first and proposing; sometimes one is better served by letting the other side go first.
Here, Treasury concluded – and I think rightly, for reasons I’ll give in a moment – that it wants to see what the financial institutions propose.
The gist is this: Within 15 days of repaying funds to the Treasury, a bank seeking to repurchase the warrants should submit a determination of fair market value to Treasury.
When one party knows much more than the other about the issue at hand, but the two parties need to reach agreement, as a general principle the side that knows less should go second, especially if
Treasury has several reasons for letting the banks lead, one of them particularly subtle.
a. Anchor the bidding. The banks want the warrants to go away; they want to buy them. Whatever the banks offer in their initial determination is immediately Treasury’s floor price. That’s significant value given that Treasury right now has no idea what the warrants are worth. Planting that first flag and knowing the discussions will only move up from there is psychologically useful.
b. You’ll educate my experts. Even as there is negotiation between principles, buyouts like this also involve examination of evidence. When Treasury asks the bank to provide a valuation, the methodology used and the data collected represent a starting point for the education of Treasury’s appraisers.
c. Now I can tweak your numbers. If your analysis is generally sound except for a few knobs, I can tweak them to my benefit, even if I don’t understand everything you’re doing.
You give me the assumptions, I’ll tweak them
Long ago, in a district court far away (Utica, New York, which from the airlines’ perspective might as well have been the far side of the moon), I was scheduled to be an expert witness in a bankruptcy matter where our client (the owner) needed to show it had value in its position. It wasn’t clear that I would be able so to opine, but fortunately for our side the other expert went first, and offered an opinion based on a set of assumptions and calculations that were much more favorable than anything I could have presented with a straight face. There then ensued a funny contra dance where I’d whisper a question to our counsel, he’d ask the witness, and the witness – who had no stake in the outcome – would answer, looking straight at me. After a few such cycles, the other side suddenly scuttled to a corner of the courtroom, agitatedly poring over the cash flow schedule they had just entered into evidence.
d. You’re under pressure to show good faith. The government has infinite patience, infinite money, and infinite time. The repurchasing bank wants out, and while there’s a procedure for a unilateral exit, no bank wants to offend its sovereign regulator.
You’re right, officer, that joke was in poor taste
In addition, the submitting bank is also certainly required to certify the valuation’s accuracy and completeness under pains and penalties of perjury. The submitting bank therefore needs to create a record that makes the bank look forthcoming and fair, even examined later in the worst possible light – especially since, even after this transaction is done, Treasury or the government will still be regulating the bank’s future.
In short, lead with something very professional or risk incurring the regulator’s wrath.
(Treasury Friday [June 27 – Ed.] would not comment on whether banks have already submitted such value determinations.)
But of course they have! The repaying banks can read the same rules Treasury can, and paying back the preferred stock is being done to rid themselves of government intrusion, so they’ll naturally want to rid themselves of the warrants (which are simply future stock shares) as well.
Step 2. I’ll tell you what I think it’s worth.
Treasury will then respond within 10 days.
Given the short time frames, we can see the value of educating the government’s appraisers, and of tweaking the bank’s numbers. Treasury has capable advisors under contract, but even so.
Step 3. We bargain … quietly.
If Treasury objects to the bank’s plan and an agreement cannot be reached –
Catch that casual passive-voice phrase? ‘Agreement cannot be reached’ means that the principals have a chance to negotiate – and if the bank’s originally submitted value is reasonably close, there will be many reasons why treasury will suggest gently, why don’t you guys raise your bid by five percent, and we’ll call it quits?
Can we reach a gentlemen’s agreement here?
Step 4. We invite two guys driving through the rear-view mirror, to value it.
Any two-person closed system requires unanimity for agreement, and as such can often reach an impasse.
When that happens, one needs a third party, preferably an independent expert
– the bank and Treasury Department will have independent appraisers step in to help determine a final price.
If you’re scoring at home, that’s the bank’s advisors, Treasury’s advisors, the bank’s third-party appraiser, and Treasury’s third-party appraiser. Lots of professionals.
Because you could hurt yourself valuing these things
Step 5. The two guys pick a Delphic oracle.
I’m presuming that the third appraiser is picked by consensus of the other two. That’s normally how it’s done.
If those appraisers can’t agree, a third appraiser is hired –
It’s always dangerous to consult the oracle … because you never know what she’ll decide.
Even a pre-Raphaelite one
Step 6. We puree the results
Not wishing to trust the oracle, somehow the parties will puree together all the information.
Yummy data, dad!
– and a composite valuation of the three appraisals is used to establish the fair market value.
This is odd, and questionable. I doubt it will be used much … but before we consider it, let’s look at the alternative approach.
Step 7: Plan B, let the market price it
Additionally, a bank can decide against repurchasing warrants.
After all, the bank might not want to cash them out right now, or it might engage in the extended negotiations with Treasury, only to be unable to reach an amicable valuation. If that happens, then Treasury gains its unilateral alternative.
In that case, Treasury said it would sell the warrants through an auction process over the next few months.
I am happy to know I shall hit something!
Auctions are at least definitive. They work well in thick markets – many buyers – or in commoditized markets – many similar products – and they’re the disposition of last resort when it’s essential to realize a cash price now.
Treasury added that it has no plans to hold onto warrants until their expiration.
From Treasury’s perspective, this is both the exit and the hammer.
An exit because the government wants to be out of the business of holding the glass menagerie.
“The president has clearly stated that his objective is to dispose of the government’s investments in individual companies as quickly as is practicable,” said the Treasury documents. It noted that it considered options that would involve the government holding warrants for a longer term or until they expire. But under those scenarios, “there was no certainty that we would realize higher values, and it was not appropriate for the government to be exercising discretionary judgment on timing market sales,” the documents said.
A hammer because Treasury can tell the bank, if you don’t like having me own you, how would you like to be owned by Larry the Liquidator?
I’m not from the government and I’m not here to help you
The department is currently establishing guidelines for the auctions.
“A fully transparent auction … provides the best method for the Treasury to realize the market value of the warrants in the near-term on behalf of taxpayers,” the documents said.
Step 8 … at which the bank itself can bid
Nothing in the rules I read prohibits the bank from bidding on its own warrants. Which makes the game almost self-referential] – negotiate, negotiate, negotiate, and then bid at the auction.
Conclusion: negotiate, negotiate, then bid?
When the ten banks paid back their TARP money, they knew that it would trigger the buyback or resale of treasury warrants. Sight unseen, I can guarantee that every such bank would like to see those warrants extinguished, and will have already planned its entire tactics,. Up through and including a potential auction of the warrants.
My guess is that at least eight of the ten banks buy back their own warrants via appraiser-aided negotiations with Treasury. Letting them go to the auction would be too hairy when compared with a known strike price that could be closed at the table there and then.
Knowing this, I expect Treasury’s advisors to be shrewd and to drive fairly tough bargains.
And not a groat more!
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