Though many banks are eager to repay their federal lifelines, it might make more sense to let Uncle Sam keep the warrants issued as part of its bailout program.
That is certainly counterintuitive advice, given many executives' instincts. Surely, they should get the billions of dollars worth of warrants out of the Treasury Department's hands to erase the nationalization stigma and prevent loss of control to outsiders or dilution of common stock if the warrants are exercised, no?
No, say a growing number of industry watchers. Their reasoning: The warrants carry a hefty price tag, and the risks posed by third-party ownership or stock declines are slight.
Even if the Treasury sells the warrants on the open market, Fred Dickson, the director of private-client research at D.A. Davidson & Co., said the effect would be minimal. "Typically, independent, passive investors with small minority positions don't attempt to influence operating management in any way, shape or form."
David Hendler, an analyst at CreditSights, tried to calculate just how much buying back the warrants would cost and, in a report Sunday, concluded that for some banking companies the answer is "plenty." Bank of America Corp.'s warrants could cost $2.1 billion to $2.8 billion, and Citigroup Inc.'s tab could be $1.3 billion to $1.5 billion, according to Hendler's research.
Anthony J. Polini, an analyst at Raymond James & Associates, said banks that repay funds received under the Troubled Asset Relief Program should "ignore" the warrants if they prove too expensive and simply let the government hold or sell them to other investors.
Though banks want to get out from under the federal government's thumb, Polini said, repaying Tarp will not save them from heavy-handed regulation or insulate them from new laws governing credit cards and compensation. "Whether you are out of the warrants or not is a moot point," he said. "The government is going to put just as much pressure on you moving forward."
To date, 579 banks have received Tarp funds, and two banks have repaid the Treasury. Old National Bancorp spent $100 million to buy back its preferred stock and $1.2 million for its warrants; Iberiabank Corp. spent $90 million to buy back its preferred and $1.2 million for its warrants. But Signature Bank decided in March against negotiating for its warrants when it repaid the $120 million it had received from the Treasury.
Joseph J. DePaolo, chief executive of the New York bank, said in a conference call with analysts in April that it was not worth buying warrants, given their relatively steep exercise price of $30.21 per share.
"We've notified the Treasury ultimately that we're not going to repurchase the warrants," DePaolo said. "For us, we are in a position of growth. We don't see how it makes any sense to utilize capital to purchase warrants that were issued at practically two times book value."
Vincent Reinhart, a former official at the Federal Reserve and now a resident scholar at the American Enterprise Institute, said this kind of strategy makes sense for a couple reasons.
Banks have better things to spend capital on, he said, and they can generate higher returns by making new loans or investments rather than "investing in themselves."
Feigning disinterest in the warrants is also a smart negotiating tactic with the Treasury, he said. "If they go into the discussion saying, 'We desperately want them back,' they hand over some of their negotiating power."
Though banks might be inclined to collect the warrants to forestall the possibility of further share dilution, this issue could be resolved in time.
The holders of the warrants probably will not exercise them for years, given how far off the exercise price most of them are, according to Eric Hovde, the president, chief executive officer and portfolio manager of Hovde Capital Advisors LLC.
"If that's the case, I don't know why you'd want to buy them back," Hovde said. "They're not going to exercise [them] because [they are] not in the money. Most of these banks are trading below the strike value of the warrants."
Even if the warrants are exercised, the dilution in many cases will be reasonable.
For instance, Hendler said in his report that exercising Tarp warrants would cause dilution of 1% at Fifth Third Bancorp, Bank of New York Mellon Corp. and State Street Corp.
Wells Fargo & Co., JPMorgan Chase & Co. and Goldman Sachs would see dilution of 2%.
William Fitzpatrick, an analyst at Optique Capital Management, said dilution of 2% or less is negligible.
For other companies, though, the dilution would be higher. Citigroup Inc.'s dilution would be 8%, and Morgan Stanley's 5%.
"The further you go up [in dilution], the more damaging, obviously," Fitzpatrick said. "If it's only a couple percentage points, I think the market would react favorably."
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Corrected May 22, 2009 at 6:49PM: An earlier version of this story misspelled the name of Signature Bank's CEO, Joseph J. DePaolo.