How Much Do We Bank On?
By STEVEN M. SEARS
Uncle Sam's speculation on some banks is starting to pay off.


WASHINGTON HAS A license to print money and a reputation for knowing very little about making profits, especially on sophisticated financial instruments such as stock warrants.

Yet the government is desperately in need of derivatives expertise, as the financial crisis has made it the owner of 10-year warrants on some 270 U.S. banks. Any bank that borrowed money under the Troubled Asset Relief Program (TARP) had to give Uncle Sam 10-year warrants equal to 15% of the loan. The warrants' strike prices were based on the 20-day trailing average price of the banks' shares. The warrants, which let the holder buy stocks at a certain price over a certain period, could ultimately be very valuable as banks recover from the credit crisis. In fact, many bank stocks already have jumped.

Among the big institutions receiving TARP money were Bank of America (BAC), Citigroup (C), JPMorgan (JPM), Morgan Stanley (MS), Wells Fargo (WFC) and Goldman Sachs (GS). We asked Credit Suisse derivatives strategists Edward K. Tom and Sveinn Palsson for help valuing those warrants, which of course aren't publicly traded and so have no obvious price. Doing this wasn't easy. To come up with their numbers, these analysts built a computer model that takes into account stock prices, the implied volatility of 10-year credit-default swaps (basically insurance policies against a company's default on its obligations) and other factors. Implied volatility is the anticipated fluctuation of a stock associated with a derivative like a warrant or option. The warrant-pricing model is complex; Credit Suisse used five different methods to calculate the volatility component of the Black-Scholes options-pricing model.

One of the methods includes implied volatility from 10-year credit-default swaps. Based on this methodology, Citigroup's warrants were worth about $166 million on May 20, down from $1.67 billion when issued Oct. 28; Bank of America's warrants were worth about $221 million, versus $921 million; and Wells Fargo's, about $1.06 billion, down from $1.48 billion.

On the other hand, this method showed that Uncle Sam has made money on the warrants issued to Goldman, Morgan Stanley and JPMorgan. Goldman's warrants were calculated to be worth $982 million on May 20, up from $680 million; JPMorgan's, $1.4 billion, up from $1.2 billion; Morgan Stanley's, $1.25 billion, versus $410 million. The combined value of those three rose from about $2.3 billion on Oct. 28 to about $3.7 billion, producing a gain of $1.4 billion.

But the actual gain could be larger or smaller, because different methods produce different values for the banks' warrants. The lowest number the Credit Suisse analysts came up with is $3.01 billion; the highest, $4.84 billion.

If the financial sector recovers, as it will someday, it is nice to know that warrants issued by TARP recipients on Wall Street and elsewhere will eventually generate billions of dollars for the taxpayers who handed over billions to save the likes of Citi, AIG and BofA. Just how to cash in will be a matter of debate, however.

Not surprisingly, some banks would love to see the warrants canceled, but that is extremely unlikely. At the least, most banks are reluctant to discuss the warrants. Spokespeople at Citi, Wells Fargo, Bank of America and JPMorgan were mum on the issue Friday.

Ed Canaday, a Goldman Sachs spokesman, was more forthcoming. He said Goldman is eager to buy back the warrants and repay its TARP loan. "We think taxpayers should get a decent return on the warrants and we look forward to providing that," Canaday said, without being more specific. At Morgan Stanley, spokesman Mark Lake struck a patriotic pre-Memorial Day note: "We are happy to support any program that is focused on benefiting the U.S. taxpayer."

Treasury Secretary Timothy Geithner has indicated he is reluctant to hold onto the warrants to maximize their value, but would rather cash them in now. Others say Uncle Sam should take a longer view in the hope of reaping a mega-gain. Says Brad Hintz, a Sanford Bernstein analyst: "I would love to have these warrants in my own portfolio on the same terms that the U.S. government received, and having bought warrants at a low price in a distressed environment, I would recommend to hold them through an economic recovery, not sell them."

If the government tries selling the warrants to investors, as some in Congress have suggested, valuation will be a key issue and, as the Credit Suisse study makes clear, coming up with a definitive price won't be easy.