Friday, 28 January 2011
You may or may not be pleased with the way the government handled the bailout of the banks and automotive sector, but perhaps I can offer you at least a little insight into how the Treasury (aka the citizens of the U.S.) is getting paid and how you can perhaps get a piece of the TARP payback. Of course there are caveats and risks, but I am sure you will find this interesting.
TARP in a Nutshell
As you may know, the Troubled Asset Relief Program, or TARP, was set up to insure or purchase up to $700 billion worth of “troubled assets.” These assets could be residential or commercial mortgages and/or any securities, obligations or other instruments that are based on or related to those mortgages, and was later extended to include the automotive sector.
Meaning that if banks owned mortgage securities that were faltering, the U.S. Treasury would step in, purchase them and assume the risk. It’s similar to owning a stock at $100 that paid a 5% dividend that was supposed to be stable. All of a sudden, the stock dropped to $75, stopped paying a dividend and was illiquid, which means that if you tried to sell it, there was no one there to buy. To compound the issue, you had minimal knowledge of the health of that stock. Would you be scared? Well, this scenario was occurring on a massive scale.
What TARP essentially did was step in and purchase those securities, slowing the price decline and giving the banks cash flow and security, which was supposed to motivate them to lend again amidst a major crisis (that big increase in lending still hasn’t happened).
For that investment from the U.S. Treasury, the banks and companies that borrowed funds had to make some concessions, including limiting executive compensation, offering equity stakes in their company, and paying interest on preferred stock and warrants (more on those in a second) that were issued as a “bonus.” The Treasury, in all fairness, structured the program as best they could to get paid back and not add to the national debt.
By February 2009, $296 billion was spent and many banks were still on the “endangered” list, and many still are not lending even a fraction of what they were before the crisis.
Warrants
Many of the banks that borrowed money from TARP were required to give warrants to the Treasury as another way of paying back their debt. A warrant is EXACTLY like a call option: one warrant gives the owner the right to buy one share of stock at a specific price for a certain period of time. The Treasury would sell these warrants back to the bank, if of course the bank had enough money to buy them back. For the banks that can’t afford to buy back the warrants, they are being sold to investors — YOU CAN BUY THESE WARRANTS!
(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)
Warrants for Sale
This week the U.S. Treasury auctioned off 255,033,142 Citigroup warrants, which were exercisable at $10.61 and are good until Jan. 4, 2019. You might be thinking, why the heck would I want to buy a warrant that gives me the right to own Citi stock at $10.61 when it’s trading at $4.80?
This is where the options markets come in. Call options offer leverage and can limit your risk; they are generally less expensive than buying the stock outright.
Right now, there are $10 call options (they give you the right to buy Citi at $10) that expire in January 2013 that would cost you about $0.14.
Let’s say we quadruple that cost for an option (warrant) that expires in 2019; you might pay $0.60 or even $0.75 for it. Even though that seems crazy, if you thought that Citi could be at $15 by 2019, would you rather risk $0.60 or $4.79?
If Citigroup stock went to $15.50 by 2019 (or before), the $0.60 warrant investment would return about 833% and the $4.79 stock investment would return about 300%… don’t forget that the $0.60 investment would have less monetary risk.
Some banks have chosen to buy back their warrants from the Treasury directly. Keep in mind that the more the Treasury gets from selling these warrants, the better it is for the taxpayer — it’s OUR money!
Early on the Treasury severely mispriced several million dollars’ worth of warrants, and while investors got a great deal, our U.S. debt suffered. The auction process has helped the Treasury obtain the best pricing possible, after getting low-balled in the beginning.
How Do You Buy a Warrant?
Warrants can be bought and sold similar to stocks once they begin trading on an exchange. For example, you can track the Bank of America warrants under the ticker symbol BAC.WS.A. Those warrants were originally sold for $8.35 back in early March; they traded as high as $9.35 and now are at about $7.30. Bank of America’s stock was at $16.75 then and is now trading at $13.44. You can see how warrants will mimic the underlying stock to an extent.
The Citigroup warrants were offered though an auction process in which investors can bid for a price and quantity of warrants that they want to buy. The starting bid for the $10.61 (remember this is like the strike price for an option) January 2019 warrant was $0.60.
Based on my calculations I figured the warrant should be worth about $0.79, but it sold for $1.01, which tells me a couple things about the marketplace:
- Higher volatility is expected.
- Higher interest rates are expected.
- Investors may be slightly bullish on Citigroup.
You have the right to invest in warrants, either before they begin trading publicly (as part of an IPO or registered offering) or after.
There are certainly risks and limitations, but if you are a savvy investor, you have a right to read the prospectus and see if it makes sense to you. Remember that warrants are essentially call options, so many of the same rules apply.
As of today, the U.S. Treasury has sold many of the larger national bank warrants, netting nearly $7 billion in proceeds from those warrants, but there are many small and mid-size banks that have yet to be auctioned off.
If you are interested in learning more about or investing in warrants, you should contact your broker to assist you. If you’re not ready to jump into trading warrants alone, many of our editors here at Taipan Publishing Group offer you unique alternative investment ideas that can offer exceptional returns across all asset classes, even the not-so-well-known ones like these TARP warrants.
Editor’s Note: When I sifted through this huge government report, I couldn’t believe my eyes. Now I’m saying “what recession?”…While others were losing their retirement accounts and jobs, I discovered this secret billionaire blueprint. You could earn $2.3 million in your retirement account. Works in an up market or down. Here’s why a government report could mean millions for you…
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Other Related Topics: Banks , Jared Levy , Options Trading , Smart Investing Daily , US Treasury , Warrants
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