24 Aug 2009, Mark Pengelly, Risk magazine
The warrants are held by the government under the Troubled Assets Relief Program (Tarp), and are linked to 88.4 million units of the dealer's common shares. Banc of America Securities-Merrill Lynch analysts priced the JP Morgan warrants at $1.049 billion in a research note on August 11.
On August 10, a 10-Q filing by the bank said it had revoked a repurchase notice given to the Treasury regarding the warrants. Consequently, the bank said, it believed the Treasury was organising a public auction of the warrants.
In recent weeks, at least one major dealer has confirmed to Risk it is assisting the Treasury with the auction process. The Treasury had told JP Morgan that it would be allowed to participate in such an auction, the 10-Q filing said.
According to a spokesman for the Treasury in Washington, DC, no decisions about the auction’s structure or timing have yet been taken. “We are still in the process of designing the auction mechanism and have not yet set a date,” he said. This stands in contrast to a Treasury statement on June 26 that announced it was establishing guidelines for the auctions, which would be held “over the next few months”.
The delay might reflect difficult questions about the form the auction will take.
In designing an auction mechanism, the Treasury could benefit from looking at an auction of stock warrants linked to Detroit-based automaker Chrysler in 1983, said Linus Wilson, an assistant professor of finance at the University of Louisiana at Lafayette, who has written several papers on issues surrounding the Tarp warrants, including an analysis of the results of the 1983 auction.
In 1980, the embattled car company was given $1.2 billion in federal aid in the form of guarantees on commercial loans. In return, the government received 14.4 million shares in Chrysler, with a strike price of $13. The warrants had a similar 10-year maturity to those issued by JP Morgan under the Tarp.
Three years later, Chrysler offered to buy back the warrants from the Treasury for $250 million – a price representing only the warrants’ intrinsic value – but was refused. The Treasury subsequently ran a first-price, sealed-bid auction. The auction was won by Chrysler, beating banks including First Boston, Goldman Sachs and Morgan Stanley.
The result of the auction was that Chrysler paid $311 million, or $21.60 per warrant. According to Wilson’s research, the figure represents around 91% of fair market value – a better price than that received so far on many of the Tarp warrants. “The auction produced 91% of estimated fair market value, so it seems like auctions would be better all round,” he said.
But to allow market participants to bid on a level playing field, the Treasury should consider disadvantaging JP Morgan in a similar way to Chrysler, he added. This would be a response to the fact the company held greater information about the stock whose warrants it was bidding on. “JP Morgan has an advantage in the auction, so it may make sense for the government to disadvantage it,” he said.
As with Chrysler, this might involve a sealed-bid auction, he said. It could also involve forcing the bank to pay a heavy premium or limiting the value of warrants it is able to buy. Most radically, it could even entail excluding JP Morgan from the auction altogether – in which case, the Treasury’s advice to the bank would prove a costly mistake.
Nonetheless, some dealers remain dubious about whether the warrants will garner enough interest from other market participants, given their large size and the difficulties of hedging the complex risks associated with them.
So far, Tarp warrant repurchases by publicly traded banks have brought in $2.81 billion for the Treasury, according to Wilson. This compares with his valuation estimates ranging from $2.95–$4.26 billion. In other words, the Treasury has received approximately 66–95% of fair value, depending on the volatility assumptions used to price the warrants.
In July, a Congressional Oversight Panel report claimed the Treasury recouped 66% of fair value for warrant sales on 11 smaller banks conducted earlier this year.
JP Morgan is the only bank to have publicly opted not to repurchase its warrants on a negotiated basis – paving the way for an auction. Capital One and Northern Trust are the only other large banks to have repaid their Tarp preferred investments and not to have bought back their warrants. Capital One did not return calls for comment, while Northern Trust said it was working with the Treasury to buy back its warrants. However, under the disposition process outlined by the Treasury, it is possible more of the large Tarp recipients could repay their preferred investments and decide not to repurchase the warrants, forcing the Treasury to repeat the exercise.
See also: Treasury gets bank assistance with warrant auction
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