Saturday, July 11, 2009

The State Street TARP warrant sale - a fair deal or a ripoff?

From Bloomberg:
State Street Corp. paid $60 million to repurchase warrants held by the U.S. Treasury, becoming the first major financial firm to exit the government’s $700 billion rescue program.

State Street, the world’s largest money manager for institutions, previously bought back $2 billion in preferred shares it received in October under the Troubled Asset Relief Program. The Treasury released details today about the warrant sale to the Boston-based lender.

The "Armageddon Bloggers" out there will be shouting that the US Treasury and the US taxpayer have been ripped off. Well, at Sober Look we rely on facts and observations rather than the angry verbal diarrhea one often finds in cyberspace - particularly when it comes to the financial services industry.

What are these TARP warrants really worth? The Treasury owned about 5.6 million of State Street (STT) warrants with a strike price of $53.8 expiring on 12/28/18. STT closing price on Friday was $43.66. If one looks at the traded STT options out there, it is straight forward to project the implied volatility term structure based on actively quoted warrants of other securities.

For those who are interested, the reason implied volatility term structure for stocks is generally negative sloping has to do with mean-reverting nature of equities. That means that variance does not increase linearly with time (the increase is slower) and implied volatility drops off with time to maturity.

Based on this projection the midpoint for implied volatility for the STT warrants falls in the range of 20% - 25%.

Here is the impact on warrant price due to implied volatility shifts:

This puts the mid at $13.42 per share (or about 31% of the share price) and the government's position at about $74.8 MM. The Treasury sold it for $60 MM or about 80% of the mid (or about 88% of the lower range and 74% of the upper range). It's certainly better than the 66%

It is pure profit for the taxpayer in 9 months (since the government got the warrants for free as part of the convert purchase), but is it a fair deal? It's certainly better than the 66% "valuation" in previous warrant purchases as reported by the 3 Harvard professors in this report (the 3 wise men from academia that really know how warrants like these would trade):

In a normal market 80% of course is a rip-off, but in this environment it's not crazy. Think about it, if you are taking a long-term bet on the US financial sector wouldn't you demand a discount?

JPMorgan's proposal for their warrants repurchase was rejected by the US Treasury as too low. So JPMorgan told the Treasury to go ahead and auction it off. Chances are the auction will also come in at 80-85% of the "fair value", but probably better than JPMorgan's proposal - an auction would indeed be the best process for price discovery.

The key here is for the US government to get out of the business of managing a portfolio of financials' warrants and other securities as soon as possible.

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