Who says the price is unfair? Part 1, there’s what we think …
Now that the first TARP-repaying-bank warrant repurchases have been completed, how did the repurchasing banks do, and how did we American taxpayers do?
Are we taxpayers winning?
A month ago, Treasury first cleared ten banks to repay their TARP funding, creating rules to sell its glass financial menagerie:
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.
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.
At the time, I speculated:
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!
Did we? It depends who you ask, and let’s start with some shrill Monday-morning warrant buyers over at the Huffington Post, whose title leaves no doubt where they stand: Ignoring Watchdog Report, Treasury Gives Three Major Banks Sweetheart Deals:
Less than two weeks after a congressional watchdog called attention to backroom deals in which the Treasury Department repurchased stock warrants from bailed-out banks at well below market value, three more such transactions have now been reported. The big loser: The U.S. taxpayer.
It was easier in the old days of smoke-filled rooms
Before we can call the taxpayers ‘losers,’ it’s as well to remember that any bank that has repaid its TARP has cost taxpayers nothing, and in fact we made money on the interim TARP dividends.
[Also, don't forget that many banks, Goldman Sachs among them, took the TARP under extreme duress, and were not happy about having to do so. – Ed.]
The warrants are additional consideration, so here’s the equation:
What we put in What we got out
+ Capital advanced + Capital repaid
+ Risk of losing capital + Dividends (at five percent annually)
+ Value of the warrants
Although the risk of losing capital is significant, for the repaying banks, we haven’t lost any money. Even the five percent dividends look decent in this interest rate environment, with sovereign rates close to zero. So the warrants are ‘playing with house money,’ and what causes the Huffington posters to fulminate is that we sold them back to the issuing banks at a price the post, in its wisdom, believes to be below what we could have gotten had we auctioned them:
The Congressional Oversight Panel reported earlier last month that in 11 transactions with small banks, taxpayers walked away with about 66% of what they could have gotten.
That’s why Monday-morning quarterbacks are never wrong: they can never be disproved. Who knows what the auction would have fetched?
Who knows what I would have done, if I’d done something different from what I did do?
Before we go completely ga-ga on this subject, we need to understand precisely what the warrants are, as outlined in a more balanced Washington Post view on the subject:
Many major banks that received federal aid are seeking to exit the Troubled Assets Relief Program. To completely sever ties with the program, the companies must also buy back these ownership stakes, known as stock warrants, which were given to the government in exchange for aid.
[Snip]
Stock warrants give their owner the right to buy a company’s stock after a set period of time at a predetermined price. The Goldman warrants allow the holder to buy 12.2 million shares at $122.90 apiece 10 years from now.
[Snip]
But the long-term nature of the warrants makes them difficult to value because no one knows what the stock price will be after a decade.
A lot can change in ten years
Between now and a decade from now lies inflation and uncertainty. Future dollars will be worth less than present dollars – quite possibly, much less – and the alternate uses of capital in that interval could be quite high-yielding.
At a hearing on the warrant repurchase program in the House on Wednesday, Herbert Allison Jr., a senior Treasury official, insisted that the sweet deals the banks got were needed to aid the liquidity of the smaller institutions.
I absolutely doubt that’s what Mr. Allison said, but leave that be.
But now, in three out of the four newly-reported transactions, all with much bigger institutions, the deals have only gotten worse. The transactions returned between 54% and 65% of what the taxpayers could have gotten on the open market, according to one estimate.
How many birds in the bush is a bird in the hand worth?
Do you think the answer’s two? Bueller? Anyone?
BB&T agreed to buy back its warrants for $67 million, as reported in a July 17 press release. On July 8, the Treasury sold warrants back to State Street Corporation for $60 million. On July 15, Treasury gave up warrants to U.S. Bancorp for $139 million. The latter two transactions are listed by the Treasury in its transactions report for the period ending July 17.
“We are very pleased to have completed the repurchase of the warrant, effectively concluding U.S. Bancorp’s participation in the Capital Purchase Program,” said Richard K. Davis, chairman, president and chief executive officer of U.S. Bancorp, when announcing the deal.
As well they should be. The warrants that USB bought from the taxpayer for $139 million had a fair market value of $260 million, says an academic who has closely tracked the bailout and the warrant repurchase program. Linus Wilson is an assistant professor of finance at the
A man who did his own math: Linus Wilson
At issue isn’t the method of valuation, but rather the assumptions used to make the calculations.
According to Wilson’s calculations, the
Judging from his home page, Professor Wilson is certainly qualified to do the calculations, and some interesting byplay about whether the pricing was right suggests he’s genuinely interested in the truth, not (unlike the Huffington Post) in scoring cheap rhetorical points.
A Treasury official said in a statement to the Huffington Post that the process it uses to determine the price of the warrants is fair: “The warrants for common stock held by Treasury do not trade on any market and therefore do not have observable market prices. Their values can only be estimated.”
Valuing financial assets that are not going to be traded always involves an element of uncertainty.
Maybe I’m worth it, maybe I’m not
Conversely, the act of selling them changes reality permanently, so that if you go to the auction and are disappointed, you have no way of going back and taking the negotiated offer.
“Treasury follows a comprehensive approach to estimating these values, which involves using a variety of inputs including a set of well-known financial models. These models will include, but will not be limited to, binomial and Black-Scholes option-pricing models, and are widely used in financial markets to value options and warrants.”
This is what Professor Wilson did:
The specific flaw in the Treasury methodology, business professor
While I have every confidence that Professor Wilson knows what he’s talking about, the quote attributed to him here doesn’t buttress the sentence that preceded it. Obviously current price means something, but as we know, stock prices fluctuate, so without reading Professor Wilson’s analysis in depth, I can’t evaluate how much difference current stock price makes in a Black-Scholes forward projection.
Meanwhile, Treasury brought into its estimations several other data sources unavailable to the good professor:
“Treasury also relies on indications from market participants as to what they would be willing to pay for the warrants.”
That’s sound. In real life, my for-profit company provides independent valuations of complex real estate financial interests. We build detailed financial models (discounted cash flow, which is to real estate interests what Black-Scholes is to options), populate them with the most defensible and evenhanded assumptions, and derive a value. Then, when we have that value, whenever possible we go find people who might be buyers of whatever unique asset we are valuing, describe it (anonymously, of course) and ask, “how much would you pay for this asset?”
How much would you pay for all this?
But wait!
There’s more!
We do this because a sequence of reasonable assumptions can sometimes derive an unreasonable conclusion, whereas a market-maker in the money store will bring a holistic assessment of what the object is worth – and after all, that’s the real definition of value, what price will be paid by an independent party dealing at arm’s-length.
We’re dealing at arm’s-length
“We obtain quotes from three separate market participants who regularly invest in or trade similar securities.”
Not just one quote, but three. Excellent confirmation if you can obtain it.
If we three agree, you gonna disagree?
“We also retain outside managers to provide full, independent valuations.”
These experts, one presumes, will have been drawn from the banking and valuation sectors.
“Together, these various methods constitute a robust process for estimating value and protecting the taxpayers’ interests.”
In point of fact, they do – when one needs to estimate, one gets a better answer by using multiple categorically distinctive approaches and then comparing the results. So the Huffington Post, by not only relying on a single estimate (and if I were the author, I’d be cringing at the hyperventilated overclaims being made using my report as sole evidence) but also ignoring the ancillary procedural evidence, all of it relevant, whips itself into a lather.
Ignoring evidence? I’m not ignoring evidence!
“Banks get a very good deal,” said
Perhaps; perhaps not. I have direct personal experience suggesting that a tortuous internal negotiation can be a good result for the government, much better than allowing the market to work.
The best road isn’t always a straight line
[Continued tomorrow in Part 2.]
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