At least two community banks are raising their bidding paddles on themselves as part of the latest auction by the Treasury Department.

The Treasury on Monday commenced a modified Dutch auction on the preferred stock it holds in seven banking companies as the agency looks to slowly unwind the Troubled Asset Relief Program. Bids are due on Wednesday evening.

In regulatory filings, First Defiance Financial (FDEF) in Defiance, Ohio, and First Capital Bancorp (FCVA) in Glen Allen, Va., said they would submit bids to buy at least some of their shares.

It could prove to be a smart move for those banks, industry observers say. But the move could also put those banking companies in awkward positions because they will likely be submitting discounted bids.

"Certainly both Treasury and the banks take on some political pressure or reputational risk in redeeming at less than par," says Rob Klingler, a partner at Bryan Cave in Atlanta. "Banks are in the business of lending money out and expect to be repaid at 100 cents on the dollar. On the other hand, nothing is requiring Treasury to sell these shares right now."

A Treasury representative declined to comment and calls to First Defiance and First Capital were not returned.

The Treasury conducted a similar auction in March involving six banking companies. During that auction, regulators cleared the $2.7 billion-asset MainSource Financial Group (MSFG) and the $2.7 billion-asset Wilshire Bancorp (WIBC) to bid.

MainSource, based in Greensburg, Ind., retired $21 million of its $57 million of Tarp for roughly $20 million. Wilshire, in Los Angeles, retired $60 million of its $62 million of Tarp for roughly $57 million.

"The ability to retire some of our Tarp at a discount was the attractive feature. If we didn't get it, someone else would have," says Archie Brown, MainSource's president and chief executive. "It was also a positive pop to equity. At $1 million, it was not huge, but it was not immaterial."

Alex Ko, the chief financial officer of Wilshire, echoes Brown's comments. Wilshire booked a $3.5 million gain before taxes. "It was one of the best ways of paying back the tarp," Ko says.

The Treasury seems to have benefited from having the banks bid, too. Klingler says the average discount for MainSource and Wilshire was 6.2%, while the other four sold at an average of 12.4%.

The reasons for the varied discounts could be institution specific. MainSource and Wilshire had lower nonperforming assets and higher tangible common equity ratios than the other four.

Having a banking company bid on its preferred stock is a stroke of confidence because they had to get regulatory approval to do so. It also tells other investors that the company is looking to redeem sooner rather than later, so the investment time line is short. Both factors drive the price up, industry observers say.

"When someone bids on their own stock, they also disclose when they intend to redeem the shares, and it is typically in short order," says Brian R. Sterling, a principal and co-head of investment banking at Sandler O'Neill & Partners. Sandler is acting as auction agent and joint book-running manager with Bank of America Merrill Lynch. "If they have permission to bid that likely means they also received permission to redeem it," Sterling says.

First Defiance said in its regulatory filing that it plans to redeem any stock it doesn't buy in the auction within the next 12 months. First Capital said that it has no immediate plans to redeem its stock. Meanwhile, Wilshire said late last week that it plans to redeem the remaining $2 million of Tarp.

Christopher Marinac, an analyst at FIG Partners, says it is unlikely that First Defiance and First Capital will experience the same gains felt by MainSource and Wilshire. The first round of auctions didn't explicitly disclose a minimum bid, while this most recent round did. The Treasury is looking for at least 91 cents on the dollar for First Defiance and 82 cents on First Capital.

Marinac says he believes the banking companies will likely face pressure to bid at par or very close to it.

"I think the March auction was a trial and I think there was some sensitivity to the discounts," Marinac says. "My sense is that regulators are strongly hinting to the banks, 'if you're bidding, you're bidding at par.'"

So, if there is an opportunity to cash out at a discount, why aren't others pursuing it? It depends on the bank, industry observers say.

Bob Chapman, the chief executive of the $913 million-asset United Bancorp (UBMI) in Ann Arbor, Mich, says his bank is operating under a memorandum of understanding and lacks the cash on hand to make a bid. Wilshire and MainSource were also under MOUs when they bid.

Mark Hoppe, the chief executive of the $4.8 billion-asset Taylor Capital (TAYC) in Chicago, says his company considered bidding on its preferred stock, but decided to push the redemption until closer to when the interest payment jumps to 9% in February 2014.

"Tarp has been fantastic for us," Hoppe says. "We very well may wait to pay it at the 11th hour right before the rate goes from 5% to 9%."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.