Unwinding the TARP: Is Treasury Leaving Money on the Table?

The Treasury Department announced on June 10 that a select group of 10 banks are in sufficiently robust health to repay the $68 billion they received in the Capital Purchase Program (CPP) portion of the TARP. But for them, TARP's not over: the Treasury still holds warrants to buy the banks' common stock, which run for 10 years, and could turn out to be quite valuable. But in several early deals, the Treasury has let banks buy the warrants back cheaply -- how much in taxpayer gains is Treasury willing to leave on the table?

Just eight months after banks were forced to take capital from the Treasury, ten firms are being allowed to repay $68 billion, or about one-quarter of the total of the preferred stock issued (details can be seen in an excellent NYT graphic).

There are two important parts of the TARP still firmly in place, however: guarantees from the FDIC on debt the banks issued (for four of the 10 chosen firms, about $90 billion) and 10-year warrants to buy the banks' common stock, equal to 15 percent of the value of the CPP preferred stock. (Warrants are similar to stock options.)

So, for example, JPMorgan issued CPP preferred for $25 billion, and also issued warrants on $3.75 billion of common stock. The banks can repurchase the warrants when they choose, at fair market value. Determining that value is the problem.

Warrants can be very valuable. In this case, plain-vanilla ten-year warrants would be worth as much as 50 percent of the share price at the time of issue. Due to special provisions they contain, though, the financial advisory firm Duff & Phelps reckons that the TARP warrants were worth about 25 percent of the common stock price.

So far, several banks taking TARP funds have repurchased their warrants, and unless you live in Vineland, NJ, Akron, OH and a few other places, you would not have heard of them. But a finance professor at University of Louisiana at Lafayette, Linus Wilson, made a careful study of one transaction, involving Old National Bank of Evansville, IN.

In a post to Seeking Alpha, Professor Wilson wrote:

My analysis suggests that the U.S. Treasury accepted a lowball offer. ...[T]he fair market value of these warrants should have been between $1.5 million and $6.9 million. ... I am not sure that the U.S. Treasury represented taxpayers quite so well.

But the banking industry thinks it deserves to be let out of the obligations, reports Bloomberg:

The American Bankers Association has said the U.S. doesn't deserve a windfall in return for holding warrants for a few months or for investing in banks that weren't in danger of failing. The Washington-based trade group said in April the warrant buybacks create an "onerous exit fee" and a "punitive obstacle" to leaving TARP.

Banks have a right of first refusal to purchase their warrants, but if it's at all possible, Treasury should let the free market determine what the warrants are worth. The full value of those warrants is compensation to U.S. taxpayers for the risks we took when the large banks were staring into the abyss -- and the additional risk we would have taken if things had gotten worse. And we're entitled to it.