The TARP funding made available to US banks, or in some cases forced upon them, has several different components: the CPP preferred stock, total $239 billion; FDIC backing on some new bond issues; and warrants to purchase the banks' common stock, gains on which were intended as the vig for the US taxpayer who stood behind the whole thing. (Our earlier post gives greater detail on TARP and warrants.)
The Congressional Oversight Panel, which provides adult supervision for the TARP, released a progress report on Friday July 11, showing some impressive early results. Thirty-two banks have repaid about $70 billion of preferred stock, or 29 percent of the total issued.
Eleven banks have gone to the next level and repurchased the TARP warrants they issued. This is where the question becomes more interesting: the $19 million these banks paid to take the warrants out of circulation, plus the dividends on the preferred stock, represents a rate of return of 12 percent on the Treasury's investment (time weighted). Not bad in this environment.
But the COP goes on to say that the banks paid for the warrants only 66 percent of what valuation models said they were worth. The A-students will of course read the entire report, but for everyone else, the COP commented:
In interpreting these results, it is important to bear in mind the scale of the warrant repurchases as compared to the total warrant portfolio. The sold warrants represent less than one quarter of one percent of the Panel's best estimate of the value of Treasury's warrant portfolio on July 6, 2009. Thus, these sold warrants represent a very small slice of the outstanding warrants, and Treasury's relative performance in selling them may not accurately predict its success in selling the balance of the warrants it holds.The big banks, JPMorgan Chase, Bank of America, Goldman Sachs, et al., have not yet bought them back, but the report alludes to negotiations going on with ten of them. The value of the warrants is very subjective, because it's estimated with a complex formula that relies heavily on the unknowable variable of implied volatility (the Black-Scholes option model). The COP values the warrants at a range bounded by $4.7 billion and $12.2 billion, with a "best estimate" of $8 billion. At the midpoint, the estimates for B of A, JPMorgan, Morgan Stanley, Goldman Sachs and Wells Fargo are about $1 billion each.
The Wall Street Journal suggests that the negotiations are not getting very far.
The Treasury has rejected the vast majority of valuation proposals from banks, saying the firms are undervaluing what the warrants are worth, these people said. That has prompted complaints from some top executives.JPMorgan is taking another approach, says the WSJ, by letting the market decide how much the Treasury should be paid:
Some banks argue they shouldn't have to pay much, saying the government's investment was essentially a short-term loan they accepted under duress to help stabilize the financial sector.
Others argue that the government shouldn't be draining bank capital at such a fragile time. At least one bank has argued it shouldn't have to pay the government anything at all.
The bank has waived its right to buy the warrants and will allow the Treasury to auction them in the public market, which bank executives say will result in an actual market price.Of course, the heads of the banks represent their shareholders first, and have an obligation to be arrogant and to try for the best deal. But we need the Treasury to stick to its guns, and turn a profit on the TARP, even if it's large only in percentage terms - the symbolic value will be important.
And the banks should be happy to pay that profit: they're back on their feet now, but no one really knows how close to a meltdown the financial system was last year, and which of the apparently strong institutions would have folded if more banks had gone under. All we really know is who would have been on the hook: the US taxpayer.
Update July 14
An astute reader comments: "What is the return adjusted for risk?" Indeed, the risks taken to earn that return were enormous. Adjusted for risk the returns were miniscule, but ones that had to be taken. What was the ROI on the invasion of Normandy?