12 Aug 2009, Mark Pengelly, Risk magazine
The largest of the outstanding warrants, valued at more than $1 billion, is linked to 88.4 million units of JP Morgan's common stock.
Any auction of these could be the biggest in history, according to University of Louisiana assistant professor of finance Linus Wilson. Banc of America Securities-Merrill Lynch analysts priced the JP Morgan warrants at $1.049 billion in a research note on August 11.
If this came to market by the end of the year, the vega supplied could triple the total outstanding in the listed options market, the bank's analysts wrote. It would also "significantly exceed" that of long-dated listed options, they added. The vega supplied by the warrants would be 4.9 times the vega outstanding in 2010 listed options, and 7.9 times the vega outstanding in 2011 listed options, according to the bank.
Despite news of a possible auction, some in the market remain sceptical of whether there are any natural buyers for the instruments. "The only winner from this scenario is JP Morgan - it doesn't help the government at all," remarked one London-based volatility trader. The difficulties of hedging the trade made it unlikely anyone would buy the warrants apart from JP Morgan, he said. This would involve taking on the risk of a recovery in financial dividends and the possibility of further restrictions on short-selling financial stocks. "You really only have one buyer for this and that's JP Morgan," he said.
Neither JP Morgan nor the Treasury would return requests for comment.
Banks receiving Treasury investments under the Tarp have been required to issue warrants so taxpayers can share in any upside from the scheme. For each firm, the size of the warrants issued was determined by the size of the Treasury's preferred investment - with outstanding Tarp warrants equal to common stock worth at least 15% of the preferred shares. The strike price of the warrants was set at each bank's 20-day trailing average at the time they were issued.
The Treasury outlined a disposition process for the warrants in a statement on June 26. This gives banks an opportunity to buy back their warrants by submitting valuations within 15 days of repaying their Tarp preferred investments. Within 10 days, these valuations would be reviewed by the Treasury using a combination of market prices for comparable securities, financial modelling and advice from external consultants, the statement said.
If the two sides could not agree, each would hire an external appraiser to conduct their own valuations and attempt to agree on a final price. If the two appraisers could not agree, a third appraiser would be hired, and a composite valuation of the three estimates would be used to establish fair value.
Use of the auction process would be invoked only if issuers decided not to repurchase the warrants, the Treasury said. Guidelines for the auctions would be made available "over the next few months", it said, although no further details have yet been released.
In June, 10 of the large banks that participated in the Treasury's stress tests paid back preferred investments of $68 billion. All these institutions have since bought back the Tarp warrants, apart from Capital One, JP Morgan and Northern Trust. A spokesperson for Capital One could not be reached for comment. Northern Trust said it had submitted a determination of fair value to the Treasury and was complying with its guidelines to repurchase the warrants.
The Treasury has been under strong political pressure to gain as much from the warrant sales as possible. In July, a Congressional Oversight Panel (COP) report claimed it had recouped as little as 66 cents on the dollar for warrant sales it had conducted earlier in the year. Harvard University law professor Elizabeth Warren, the COP's chairwoman, said the report raised "serious questions about whether Treasury should consider other measures". Such measures could include holding the warrants long-term, or selling them in an auction, she said.
See also: Tarp inspector general calls for more clarity on banks' use of funds
Tarp supervisor finds Treasury's oversight is still inadequate
Tarp warrant sales could drive down vol on financials
Banks repay $68bn in Tarp funds to US Treasury