Tarp warrant sales could drive down vol on financials

As well as buying preferred shares in banks with Tarp funds, the Treasury also received warrants for common stock with a market value of at least 15% of the original investment. The exercise price of the warrants was set at each bank's average share price during the 20 days before they were approved to participate in the programme – giving the government participation in any upside to their share prices over a 10-year period.

While some warrants have already been bought back by smaller institutions, the repayment of $68 billion in Tarp funds by 10 large banks earlier this month has led the Treasury to detail a formal plan to deal with the outstanding warrants. Under Tarp, banks may buy back the warrants once their original preferred stock investments have been repaid – something many of the 10 banks are eager to do.

"Earlier in the crisis, getting into the Tarp was a seal of approval, and if you didn't get Tarp money people thought you might be on the brink. Now, we've come 180 degrees, and it's perhaps looked upon as something negative," said Pri de Silva, a New York-based analyst at research firm CreditSights.

The Treasury's plan includes a process for dealing with disputes over the fair value of the instruments. This could prove a point of contention between banks and the government, analysts believe, partly due to their long maturity and the importance of modelling assumptions.

According to Tarp rules, the institutions have 15 days from the date of their share buybacks to submit a determination of fair value for the warrants. Over the following 10 days, the Treasury will submit its own determination.

According to a statement on June 26, the Treasury will use a range of factors in doing so – including market prices for similar instruments, binomial and Black-Scholes modelling and the use of external consultants. If the two sides cannot agree, each will hire an external appraiser to conduct their own valuations and attempt to agree on a final price. If the two appraisers cannot agree, a third appraiser will be hired, and a composite valuation of the three estimates will be used to establish fair value.

Should institutions decide not to buy back the warrants, the Treasury has said it will sell them into the market via an auction over the next few months. "The President has clearly stated that his objective is to dispose of the government's investments in individual companies as quickly as is practicable," emphasised the Treasury statement.

The process for any such auction has not been made public and Treasury officials could not be reached for comment on the issue.

While it was not clear if and how many Tarp warrants could be sold back into the market, "the potential impact on the existing options market could be significant", said Banc of America-Merrill Lynch research analysts in a report on June 26.

For the 10 banks that have bought back Tarp preferred shares, the report estimates the value of the Treasury's outstanding warrants to be $4.8 billion.

Banks may cancel half of the warrants issued by completing a Tier I equity offering for a cash amount equal to the Treasury's original investment before the end of 2009.

Nonetheless, if half of these were sold into the market, it would double the vega outstanding in the listed options market, the report said. Vega is the sensitivity of the price of an option to changes in volatility.

In longer-dated options, the amount of vega supplied by the warrants would far exceed that available in the listed market, according to the report. On average, the vega of the warrants would be 3.6 times the vega outstanding in the listed options market for options with 2010 maturities. For options maturing in 2011, they would provide 9.4 times the vega, it added.

This would mean any disposal of the warrants could result in notable downward pressure on the volatility of S&P 500 financials. And given the importance of financial stocks in determining S&P 500 volatility, this could have an impact on the index as a whole, the report suggested.

The 10 banks that repaid Tarp funds earlier this month include American Express, Bank of New York Mellon, BB&T, Capital One, Goldman Sachs, JP Morgan, US Bancorp and State Street – none of which was found to need additional capital during US government stress tests released in May.

They also included Morgan Stanley, which was forced to raise an additional $1.8 billion, as well as Northern Trust, which did not participate in the tests.

See also: 'Improvement in market conditions' sees Fed cut bank aid 
Banks repay $68bn in Tarp funds to US Treasury 
Treasury silent on Tarp as banks submit $75bn SCAP capital plans 
"$78 billion Tarp windfall" for banks

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