Earlier 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.

Reuters has some new data today on a foreclosure prevention initiative that Philadelphia has implemented. Under the city’s mandatory mediation program, before a homeowner can be foreclosed upon, the lender and borrower must meet with judges, housing advocates and attorneys “in the hope that a resolution can be found under which owners will resume payments they can afford and lenders will no longer need to dispose of distressed property.”

The lender is in no way forced to find a workable solution with the borrower, but the simple act of putting all the parties together in a room has produced some encouraging results:

A program to avert residential mortgage foreclosures has saved almost 60 percent of its participants from losing their homes in a sheriff’s sale, officials said on Tuesday. Philadelphia’s Mortgage Foreclosure Diversion Pilot Program…resulted in 2,776 properties permanently or temporarily saved from sale between its inception in June 2008 and May 31 this year out of 4,690 that were referred to the program.

A statewide program in Connecticut has produced similar numbers, with 57 percent of borrowers able to stay in their homes. But despite the effectiveness of mediation meetings, as of the end of last year, about 80 percent of homeowners at risk of losing their homes had not engaged in any efforts to make a deal with their lender.

Sen. Arlen Specter (D-PA) is reportedly putting together legislation to replicate the Philadelphia program at the national level. Conveniently, CAP’s Andrew Jakabovics and Alon Cohen have some suggestions for the sort of steps that the federal government can take to promote such an effort:

– Congress should fund state and local mandatory mediation programs just as it provides neighborhood stabilization funds to alleviate the housing crisis.

– The Department of Housing and Urban Development should issue guidance that explicitly permits community development block grants to be used to fund mandatory mediation programs.

– The government should require mediation for all federally insured home mortgages.

Bloomberg reported yesterday that delinquencies on prime mortgages more than doubled in the first quarter of 2009, compared to a year earlier, “as U.S. efforts to help homeowners failed to keep pace with job losses.” The foreclosure problem is simply not going to abate any time soon, so any reasonable steps that can keep borrowers in their homes — including mandatory mediation — can, and should, be taken.