Auction the Warrants: Follow-Up

Summary: Readers had some excellent comments on last week’s post about auctioning the TARP warrants.  Here are some updated thoughts. 

Last week I argued that the Treasury should auction off the warrants it received when it made TARP investments in banks.  Specifically, when banks are ready to repay the TARP investment, Treasury should auction the associated warrants to the highest bidder, which might turn out to be a private investor or the bank itself. Among other things, I argued that this approach would enhance the transparency of the process, ensure that taxpayers get a fair return on their investment, and allow banks to preserve needed capital.  A potential win all-around.

In response, readers sent me several very helpful comments that deserve highlighting.

First, several readers asked whether auctions would really be a win for the banks, as I suggested.  Good question.  That depends on what the alternative is.  If the banks would otherwise be able to convince Treasury to forgive the warrants (as some bank lobbyists have suggested) or would be able to repurchase the warrants at sweetheart prices (as some critics have alleged), then the auction would indeed make them worse off — appropriately in my mind.  On the other hand, if the banks really do want to preserve capital, then an auction that sells the warrants to private investors would leave them better off, relative to a situation in which they had to buy the warrants themselves.

Second, several readers raised doubts about claims (by outside critics, not me) that Treasury is selling the warrants at sweetheart prices.  These readers argue that prices have been reasonable to date, and that Treasury is, in fact, a good negotiator. And this may well be true — Treasury is certainly staffed with capable folks.  Unfortunately, there’s no way to tell from the outside.  Absent a transparent sales process — e.g., an auction — there will always be room for critics to make their own calculations that purport to show that Treasury is being too generous with the banks. 

Finally, and most important, was a message I received from a friend who was involved in the design and implementation of the TARP investments.  This person writes (slightly edited by me):  

TARP is the most highly scrutinized and overseen government program in history. One thing I learned was that people may not like the policies and rules, but the criticism is particularly intense when the rules change. Then the process seem arbitrary.  The 600 investment agreements in CPP all spell out an identical negotiated warrant repurchase process. And that process has already been used to buy back warrants from something like a dozen small firms.  To change the process now might seem like doing a favor for the big banks.  And it will seem arbitrary.  So, although I agree with the spirit of auctions, I would stick to what’s in the contracts.

This is a key point.  “A deal is a deal” should be a guiding principle in dealings between the government and the private sector.  Unfortunately, that hasn’t always been the case in TARP.

I originally became interested in auctioning the warrants, for example, when I learned that banks were trying to wiggle out of their part of the deal by getting Treasury to forgive the warrants. Their only plausible argument was that repurchasing the warrants would use up scarce capital.  But solving that problem doesn’t require that Treasury forgive the warrants.  Instead, it is sufficient for Treasury to sell the warrants — e.g., through an auction — to private investors.  The banks still get free of TARP without reneging on their part of the deal.

For that reason, I hope that there’s a broad consensus that selling the warrants via an auction is far superior to forgiving them.

That leaves the question of whether Treasury should auction warrants that the banks would otherwise be willing to repurchase through negotiation.  I still place great weight on the transparency benefits of the auction approach and, in retrospect, wish that it had been adopted from the start.  But I must admit that “a deal is a deal” is a strong argument in favor of the current, negotiated approach, particularly if Treasury can find a way to demonstrate that it is getting fair prices.

Readers, what say you? 

P.S. See my earlier post linking to a discussion of other potential uses of auctions in public policy.