The government is running out of options. A key part of the 2008 bank bailout program is losing value.
During the height of the financial crisis in the fall of 2008, Congress passed the Emergency Economic Stabilization Act, which included the Troubled Asset Relieve Program, or TARP. Option-like contracts were a big part of this program. Unfortunately, the value of these contracts is falling rapidly.
Most of the more than $20 billion in bank bailout money has been repaid. The total outstanding bank investments under the TARP program are just over $64 billion as of the Treasury’s June 30, 2010 report. What the U.S. Treasury, an ultimately taxpayers, will make on the program is very much up in the air.
At the start of the program in October 2008, the Treasury made direct purchases of preferred stock in bank holding companies. The first to receive funds was Bank of America. The last was purchase was on Dec. 29, 2009 for $4 million in preferred stock from Illinois State Bank.
Almost all of the 700 purchases over the 14 months of the program included warrants that gave the Treasury the option to buy common stock in the banks.
A stock option is a contract between any two parties giving the buyer the right, but not the obligation, to buy or sell the stock at some preset price, called the exercise price, before some future date, called the expiration date. Warrants act just like stock options, but the seller of the contract in this case is the issuer of the stock itself, not some outside party.
Warrants and options have two sources of value. The first is called intrinsic value. If the value of the stock is above the preset price for the warrant, the contract has intrinsic value. When this is true the warrant or option can be exercised, purchasing the shares below their current market price and selling them on the open market for an immediate profit.
The second source of value is time. If the warrant contract is not set to expire for a long time, there still may be hope if the current market value of the stock is below the preset exercise price. There is a chance the price of the stock will rise over time.
The many warrants currently held by the Treasury are well below their respective stock prices. The quick payback for much of the funds and the initial returns may look good, but the ultimate return depends on stock prices that may still be low when the warrants expire.
According to a report this week in The Wall Street Journal, banks have on average earned taxpayers just over 10 percent. Much this gain is due, however, to a few big banks that repaid their funds quickly and repurchased warrants before recent stock market drops.
Goldman Sachs Group Inc. and Morgan Stanley, for example, quickly repaid the $10 billion they owed under the program, generating annualized returns of nearly 20 percent and 16 percent, respectively.
The government got decent returns but much less on their investments in two large banks operating in Idaho. Wells Fargo & Co. returned 6.2 percent on its $25 billion in TARP funds, and U.S. Bancorp returned just about 8 percent.
The longer-run return for the entire program is questionable because most warrants are now worth very little. The KBW index of bank stocks is off over 8 percent since May and down more than 17.5 percent since TARP began in late October 2008.
The currently low value of bank stocks is encouraging banks to get fully out of the program. U.S Bancorp repaid the initial investment in June of last year and repurchased all the warrants one month later. Four Idaho-based banks — Intermountain Community Bancorp, Idaho Bancorp, Syringa Bancorp, and D.L. Evans Bancorp — received $61.8 million in TARP funds in late 2008 and early 2009. These banks have made $2.9 million in dividend payments since receiving the funds, a return of just over 3 percent for the 18 months.
Only one of the four banks has outstanding warrants. Sandpoint-based Intermountain Community Bancorp issued warrants to Treasury for up to 653,226 shares of the bank’s common stock with an exercise price of $6.20 per share.
The Treasury may have to wait a long time for a return on this investment. At the time the warrants were issued, Intermountain’s stock was selling at over $5 per share. It trades below $2 today.
News that the Treasury is getting taxpayer money back is great. But real value in the investments, the options, is running out.
Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.