Auction the TARP Warrants

Treasury should give up on negotiated sales and simply auction the bank warrants it received through its TARP investments. Auctioning the warrants will enhance the transparency of the process, ensure that taxpayers get a fair return on their investment, free banks from the nuisance of government involvement, and allow banks, if they choose, to preserve needed capital.

Summary: Treasury should give up on negotiated sales and simply auction the bank warrants it received through its TARP investments.  Auctioning the warrants will enhance the transparency of the process, ensure that taxpayers get a fair return on their investment, free banks from the nuisance of government involvement, and allow banks, if they choose, to preserve needed capital.

Healthy banks are anxious to escape from the government’s Troubled Asset Relief Program.  TARP capital seemed cheap at first since the government offered more generous financial terms than were available from private investors.  But now the hidden costs of government investments – compensation limits, tighter regulatory scrutiny, and a public backlash against financial bailouts – have become apparent.  As a result, many banks want to pay off Uncle Sam and free themselves from the TARP.

Repayment sounds simple.  Subject to regulatory approval, banks can simply write a check to Treasury that covers the amount of money they received (by selling preferred stock) plus any outstanding dividends.  But there’s a complication.  When Treasury purchased the preferred shares, it also received warrants to purchase common stock in the future.  To fully escape the burden and stigma of TARP, the banks thus need a way to get Treasury to relinquish those warrants.

A few weeks ago, bank lobbyists argued that the solution to this problem was for Treasury to forgive the warrants.  But that’s an untenable position.  Taxpayers took a risk investing in these firms, and they deserve appropriate compensation – including full value for the warrants – in return.

To date, Treasury has instead required banks to repurchase the warrants, with prices determined by some combination of negotiation and outside estimates of the warrants’ value.  That’s better than forgiving the warrants, but it is still a flawed approach.  Treasury has sold only a handful of warrants thus far, and already we see allegations that the banks are getting sweetheart deals and that taxpayers are losing out.  In today’s charged environment, those allegations will likely persist even if Treasury is doing a great job negotiating with the banks.

My advice?  Treasury should give up on negotiated sales and simply auction the warrants it received through its TARP investments.  Auctioning the warrants will:

  • Enhance the transparency of the process (since no one can accuse Treasury of playing favorites in the auction);
  • Ensure that taxpayers get a fair return on their investment (since the warrants will be sold at their real market value);
  • Allow banks, if they choose, to preserve needed capital (if investors purchase the warrants, banks won’t have to use up any of their scarce capital); and
  • Free banks from the nuisance of government involvement (since banks get free of TARP even if private investors end up purchasing the warrants).

The parallels to the first Chrysler bailout are instructive here.  In 1980, the government provided loan guarantees to Chrysler, which was then teetering near bankruptcy.  As partial compensation for providing the guarantees, the government received warrants to purchase Chrysler stock.  In 1983, the company was back on its feet, and the warrants had significant value.  At that point, Chrysler’s CEO, Lee Iacocca, went to Congress to argue that the government should forgive Chrysler’s warrants.  Thankfully, Congress rebuffed him.   The taxpayer had taken on significant risk and deserved to be compensated.   The government auctioned the warrants to the highest bidder – which turned out to be Chrysler – netting taxpayers a well-deserved $311 million.

We should take the same approach today. Auctioning the warrants is a win-win-win-win proposition for taxpayers, banks, policymakers, and potential investors.

10 thoughts on “Auction the TARP Warrants”

  1. i don’t think the treasury should auction them off at this point. the treasury should push private equity toward buying common bank stock in order to help recapitalize the banks. maybe in a few years though.

    right now in fact it might be tough to find people willing to pay real money for illiquid, unhedgeable instruments like these.

    fwiw, i think the treasury got a plausibly fair price for the ONB warrants. i can paste a link to my math if you would like.

  2. Donald: Glad to hear from you in blog form. Your suggestion to auction the TARP warrants is so obvious that I have to blame the Treasury for not going straight to that answer without being prompted. No institution has had the experience with, or the mechanisms for, conducting auctions as the Treasury. They have been immensely successful. Negotiation is another story – no depth of experience at the Treasury and a bias favoring banks almost assures that taxpayers will lose.

  3. Thanks for your comments folks.

    David and David: Glad to hear that you are on board for auctions.

    q: You raise an important question of just how willing market participants will be to purchase these instruments. The banks had a great run over the past few weeks in issuing new common stock, so there is some willingness to invest in these firms. But yes, the warrants would likely be less liquid.

    I’ve seen some healthy debate about the pricing on the ONB warrants, but my concern for Treasury is as much perception as reality. Even if Treasury does a stellar job negotiating warrant sales, I worry that the lack of transparency and real counter-offers will leave lots of room for doubt.

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