Is Treasury Favoring Banks By Undervaluing TARP Warrants?

ap090520012627Earlier this month, the Treasury Department allowed ten of the nation’s largest banks to repay their TARP funds, bringing up the question of what to do with the warrants that the government received in exchange for TARP money. According to an analysis by University of Louisiana professor Linus Wilson, the plan that Treasury announced last Friday to sell those ten banks their warrants — which are options to buy stock sometime in the future — will shortchange taxpayers by a cool half billion:

The anticipated value of warrants for 10 of the largest banks that repaid their Troubled Asset Relief Plan funds is $3.3 billion using the Treasury’s valuation process, compared with $3.82 billion with a more conventional method, Linus Wilson, a finance professor in Lafayette, Louisiana, said in an interview. Investors are debating whether taxpayers will be fairly compensated for the risk they took by providing rescue funds for the banking industry.

Treasury’s approach to offloading the warrants is to have each individual bank suggest a price for its warrants. Treasury can accept the bank’s offer, or reject it and propose its own price. If the bank then rejects Treasury’s proposal, three arbitrators decide the final price “based on an average of the appraisers.”

But since Treasury is using a lowball determination of the warrants’ value, and the banks “have a solid incentive to bid extremely low,” it’s almost certain that the average will favor the banks, at taxpayer expense. At DealBook, Steve Davidoff made some suggestions for how Treasury can fix this:

First, make the banks’ initial repurchase offer public. They should be subject to public inspection — and shaming — if they try and take advantage of the government. Second, the government should toll the strict time limitations on the proceedings to allow time for it to respond adequately. Finally, to avoid this issue altogether the government should sell as many of the warrants it can now on the open market, before a repurchase request is submitted.

Davidoff’s first point about transparency is important. This is a transaction with taxpayers that we are talking about here, not a private business deal. The more we know about how the banks are conducting themselves in this regard, the better. Hopefully, transparent offers will also keep Treasury honest, as the public will know if Treasury accepts too low a price.

In the end, I think Simon Johnson is correct in that “the only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins.” (Felix Salmon suggested then giving the banks “the right to match the winning price, if they’re so inclined.”) This approach would both produce a fairer result and ensure that the banks don’t get one final shot in at taxpayers as they wriggle free from TARP.