"Don't make me angry. You wouldn't like me when I'm angry."
— The Incredible Hulk
Oh, no, no, no, no, no.
Nuh-unh. No way. Forget it.
John Carney over at Clusterstock called my attention this morning to a little nugget in The Wall Street Journal which I missed yesterday. In retrospect, I understand why I skipped over the offending piece, because it started in the most unsurprising and anodyne way possible:
Financial Firms Lobby to Cut Cost of TARP Exit
By DAMIAN PALETTA and DEBORAH SOLOMON
WASHINGTON -- The banking industry is aggressively lobbying the Treasury Department to make it less costly for financial institutions to get out of the Troubled Asset Relief Program.
Big whoop, right? That's what I thought, and that's why I didn't even bother to scan the rest of the article. Who needs to read about yet another pork-fed banker from East Bumfuck, Arkansas complaining how those evil, socialist TARP funds prevent him from serving deep-fried Twinkies to his retail customers? Not me.
Fortunately, however, Carney actually read the thing, as good journalists are wont to do. Then he offered up a slightly more accurate headline for what is going on:
Banks Lobby To Screw Taxpayers Out Of Billions
Well, that caught my attention. Being a taxpayer and all.
It turns out those clever little scamps from K Street are pressuring the government to "expunge," or void, the warrants the Treasury Department received in TARP funds recipients' stock when it loaned them the money. The Journal explains:
Many banks want to return their TARP money and, as part of that effort, want to expunge the warrants. To do that, banks must either buy them back from the government or allow the Treasury to sell them to private investors.
...
Bankers say it is unfair to charge what amounts to a "prepayment penalty," which makes it additionally onerous to escape TARP. Bank representatives say the cost of buying back the warrants could be equivalent to paying 60% annual interest on short-term loans. That, they argue, would exacerbate banks' existing problems.
Aww. Poor, poor pitiful bankers. Don't you just bleed for them?
But Carney detects a darker subtext to the article:
The banking sector lobbyists have been arguing that they should be allowed to purchase the warrants back at deeply discounted values, or [perhaps] even have them cancelled outright on the grounds that they are currently worthless.
Based on some key passages from the WSJ article, and what I know of human depravity, I suspect he is right. But the rub here is that these warrants are in no way worthless, even though the prices at which the Treasury could exercise them and exchange them for common stock are currently above the market prices for the underlying banks' stock.
In fact, they are extremely valuable. (Carney's source pegs the combined value of the Goldman and JPMorgan warrants alone at around $3 billion.) It is pretty easy to understand why.
Simply put, a warrant is nothing more complicated than a long-dated, privately contracted form of call option on an underlying stock. The key word here is "option." The warrant holder has the option, not the obligation, to exchange the warrant for shares of the underlying stock at any time during the life of the security. Therefore, the fact that the underlying stock is trading below the exchange or exercise price at any one time (i.e., is "out of the money") means approximately bupkis. The warrant still has value, because the holder still has an opportunity to exchange it for stock at a profit at any time during the remaining life of the warrant.
Unless you believe there is absolutely no chance that any of the bank stocks subject to the TARP warrants will ever climb higher than their exercise prices over the next nine or so years, you have absolutely no basis to claim that the warrants are worthless. In fact, I might venture out onto a limb and speculate that even such a rank, moldy piece shit as Citigroup stock might crawl out of the cellar sometime in the next decade. (Well, don't quote me on that.) Ten years is a very long time, in market terms.
The handy-dandy graph above shows the relationship between the value of a call option, or warrant, at any one time, and the option's "intrinsic value," or "moneyness," which represents the value of the underlying stock minus the exercise (or "strike") price of the option. You can see that an option always has value, even if it is out of the money. This is because there is always the possibility that the underlying stock could move in the option holder's favor, thereby coming into the money and generating a profit. You will also notice that, even at the far right edge of the graph, where the option is deep in the money, the option is still worth more than its intrinsic value alone. As long as any time whatsoever remains to expiration, a call option gives its holder an opportunity to make more money if the stock moves up even further and also confers the valuable right to walk away without exercising if the stock suddenly drops far enough to make exercise uneconomic. Obtain such rights over a highly volatile stock like Citigroup or Bank of America for ten years, and you have a really valuable piece of paper.
You would think the self-styled paper of record for financial matters in the United States would understand this. (It is Options 101.) You would be wrong. Instead, the Journal reporters spoon feed their readers this bit of tendentious nonsense:
Today, most of the warrants are essentially worthless, because their exercise price is higher than where most banks' stocks are trading. But the government believes the warrants still have value, since they give the Treasury the right to buy common stock at a set price for 10 years.
You got that, Rick Santelli? The warrants really are worthless, but the government "believes" they still have value. And we all know if the current government "believes" something, it must be cover for a creeping socialist plot. If any recent Journal sentence is more likely to end up on a hand-lettered poster carried by a financially illiterate troglodyte at the next anti-government "Tea Party," I would like to know what it is.
So I can throw up now and get it over with.
Anyway, I am with Carney in hoping there is someone at Treasury who is smarter than these reporters, and who has the taxpayers' interests enough at heart to beat the crap out of any banker who comes whining for relief with such disingenuous bullshit. Someone also needs to take Barney Frank aside so he can head this attack off at the pass in Congress, too. I shudder to think what mincemeat a clever banking lobbyist can make of the bog standard Congressman or -woman who can't balance his or her checkbook.
Frankly, getting warrants in the underlying stock of the TARP recipients was one of the few elements of the whole misbegotten process I thought the Treasury got right. If we taxpayers are going to pull the collective chestnuts of a bunch of incompetent boobs out of the fire by lending vast amounts of funds at below-market interest rates, I—unreconstructed capitalist that I am—sure as hell want to make sure we share in said boobs' potential recovery. No (balance sheet) remediation without (profit) participation, you might say.
But in the final analysis, I worry that Tim Geithner and his three junior colleagues at Treasury persist in bringing rusty penknives to a gun fight. Career bureaucrats and third-year Analysts fired from Merrill Lynch just can't compete with investment bankers who compute option vegas in their heads and persuade Eastern European prostitutes to pay them for sex.
You need some help, man. Hire some real bankers to negotiate for you.
The offer still stands. Call me.
© 2009 The Epicurean Dealmaker. All rights reserved.
