Thursday, July 9, 2009

Tarp exit could be more difficult than planned

Posted in the Financial Times by Aline van Duyn:

A week ago, a small bank in Sioux Falls, South Dakota, struck a deal with the Treasury to buy back warrants that were part of the US government’s rescue of the banking system. HF Financial Corp handed over $650,000.

So far, about 10 other banks have repurchased similar warrants, handed over to the Treasury in exchange for billions of dollars of bail-out funds.

Goldman Sachs, JPMorgan Chase, Morgan Stanley and other banks that have repaid money received as part of the troubled asset relief programme (Tarp) also want to fully sever their ties with the government by getting rid of outstanding warrants.

Leaving the Tarp fully means restrictions on compensation and other conditions can be put aside too.

The price at which warrants are sold is important. Too low a value could lead to accusations that the Treasury has favoured banks at the expense of US taxpayers.

Deciding on how much banks should pay is easier said than done, however.

As the financial crisis has shown, determining the value of financial instruments that are unusual and not traded – or illiquid – can be extremely difficult.

Value of Tarp bank warrantsMany different potential values can be placed on the banks’ warrants. The volatile market conditions of the last year have made valuing warrants and options more difficult across the board, says Edward Tom, analyst at Credit Suisse.

Warrants are essentially long-dated call options and are usually valued using options models such as the Black-Scholes model.

The model, which has six inputs, can generate a huge range of values. The six inputs – stock price, strike price, risk-free interest rate, dividend yield, time to maturity and implied volatility – have to be based on assumptions. In the case of the bank warrants in question, which have a 10-year maturity, these assumptions can vary hugely.

Mr Tom says liquidity remains limited, especially for long-dated warrants, which makes valuation even harder.

A recent analysis by Credit Suisse shows that the combined value of the warrants issued by Goldman Sachs, JPMorgan and Morgan Stanley ranged from about $3bn to nearly $5bn, just by using different estimates of implied volatility.

“There are a myriad of different and equally justifiable techniques one may use in order to derive implied volatility,” the Credit Suisse report says.

Pricing of warrants is usually below the theoretical model value. Factors that tend to reduce the price are illiquidity and a long maturity.

An analysis of the 11 banks that have bought back warrants by Pluris Valuation Advisors shows that the value at which they are sold by the Treasury seems to be getting closer to “market value”.

The first warrant repurchase by Old National Bancorp in May was done at more than 50 per cent below market value, suggesting taxpayers lost out. HF Financial was 1.8 per cent higher than market value, Pluris found.

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