TARP warrants: let every eye negotiate for itself and trust no agent

by PlanMaestro

A secret about the TARP warrants is starting to spread.

Most have heard of the adjustment to the strike price after dividends but there is more to the anti-dilution clauses than just the adjustment to the strike price. A few months ago I decided to cryptically suggest this insight in a visited message board, where many were buying TARP warrants, to see who else had caught it.

Actually, not many. One of the few, the author of today’s post.

Over the last few months we have discussed the anti-dilution clauses. He recently decided that it was time to confirm the major insights: discussed them with a few lawyers, that did not help much, and ran the math with one of the small banks that has TARP warrants. He finally put some of the insights, but not all, in a document. It starts with a great Mark Twain quote so how could I not like it. I am thankful that he accepted to share it in this blog.

Both Bruce Berkowitz and Francis Chou mention the secret in their most recent letters. It is mentioned so cryptically as if they did not want it to be known. In the same cryptic style, the author of this post asked to remain anonymous.

There is a lot more to the anti-dilution clauses than what is being discussed in the blogs, the press, and even this post. If you are interested, I suggest you separate several hours and READ the prospectuses fine print.  Also the numbers are from a few weeks back and not all warrants mentioned in the table are from TARP or even have the same fine print. There are no shortcuts in this investment, you have to read a lot.

For more information, I first mentioned the TARP warrants almost two years ago in the following post:

https://variantperceptions.wordpress.com/2010/08/29/francis-chou-on-large-bank-warrants/

Disclosure, we both are long a few of the mentioned TARP warrants

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WE LOVE TO READ WHAT MOST OTHERS DO NOT BOTHER TO READ

I am frequently asked, “So what is XXXX’s edge?” I think it is possible that in some cases we eliminate 80% of the competition when we start by reading the annual report. It never ceases to amaze me, how frequently we find that an investor in a particular company did not bother to read the annual report, including professional investors.

Now get ready for some tedious reading! If you do not feel like chewing leather than you are well advised when I say you should skip the following two pages.

Recently, I realized again how few investors bother to read the primary documentation, when researching the TARP warrants of US banks. I expect analysts and investors in these warrants to be do more research than the average sophisticated investor in equities due to the offbeat nature of warrants. However, it quickly became clear to me that analysts, investors and the press clearly did not bother to read the prospectuses of the warrants. Samuel Clemens (a.k.a. Mark Twain) used to say that “A person who won’t read has no advantage over one who can’t read” and that certainly rings true here.

For the benefit of those that have not heard about TARP warrants;

  • TARP- Troubled Asset Relief Program
  • Warrant- The right to purchase an equity security for a certain period at a certain price.

TARP is one of the programs that the US government created to bail out the banks. For example it allowed the US Treasury to purchase newly issued preferred equity from various banks e.g. Bank of America. The US Treasury received warrants, called TARP warrants in this case, with these shares. In time the US Treasury either sold the warrants back to the respective companies or it sold it off into the market where lesser mortals like us can now buy them.

The warrants have some important features.

  1. They are long term; 10 year warrants expiring around 2018-2021
  2. They have various anti-dilution adjustments
  3. The exercise price when compared to current tangible book value is low.

Continuing with the BAC A warrants as an example,

You can learn this by simply reading the relevant prospectus.

Technically, in the case of BAC and others, it is not the prospectus that holds the important information, it is the supplement to the prospectus. When you read the anti-dilution adjustments you note that the exercise price is adjusted downwards in some cases (e.g. when a cash dividend is declared) AND the number of warrant shares (shares/warrant) is adjusted upwards.

You can learn this by simply reading the relevant prospectus.

Last year you could purchase the BAC warrants for as little as $2.00-$3.00 with an exercise price of $13.30. Today, BAC’s book value is $21 and tangible book value is $12. We are NOT advocating that paying $2.00- $3.00 for the right to buy BAC until 2018 for around current book value is a good deal, but it is worth investigating. Particularly if there is potential for the exercise price to be reduced AND the number of warrant shares to be increased every time a dividend is declared.

You can learn this by simply reading the relevant prospectus and looking up the price.

There seems to be a general misconception in the market that the anti-dilution adjustments only apply to AIG TARP warrants, mainly because Bruce Berkowitz spoon fed the market with a statement in the press about AIG. However, these adjustments are not exclusive to AIG TARP warrants; in fact the exact opposite is true.

You can learn this by simply reading the relevant prospectuses.

In the case of BAC it also pays to read the “prospectus” for the warrent, Warren Buffett negotiated for Berkshire Hathaway in Aug 2011. Warrent, Warren. Get it? Eh, ok, I will move on.

The warrent comes with a strike price of $7.14 and 700m warrent shares (6% of BAC outstanding shares) and has the same anti-dilution adjustments as the TARP warrants. It is quite plausible for the warrent shares to increase from 700m to 1Bn AND the exercise price of $7.14 to be reduced to $5.00 over the 9 years to 2021. What can we say? The Master strikes, yet again!

You can learn this by simply reading the relevant prospectus.

Those of you that stuck with me through the section on warrants either enjoyed it or must feel like the man that tried to commit suicide by drowning himself in a puddle of water, one inch deep. The good news is, it is almost over.

When you research the various warrants you should realize that all these warrants are not created equal and we have found the most significant differences are evident when

  1. you compare the relevant company’s current tangible book value with the warrant’s exercise price and
  2. the normalized dividend per share.

In the case of b) I mentioned that the warrant shares adjust upwards AND the exercise price downwards when a dividend is paid. Technically the relevant amount is the difference between the dividend per share paid and a threshold dividend per share. This threshold was set by the last dividend per share payment at the time the warrant was issued. Most of these warrants were issued in the depth of the financial crisis, which means that in most cases the “last” dividend that was paid was at a time of peak profitability and before very substantial share dilution. Therefore, it is prudent to adjust for this and when we do so we come up with the following comparison.

We reiterate, neither are we making a case for or against buying the warrants nor are we saying this is anything more than a simplistic analysis. As always you have to do our own homework! 

We are simply saying that the relationship between the exercise price and the current book value and the relationship between the historical dividend per share and the threshold for the dividend to give you the “kicker” are very different from company to company. Therefore the investor that has that knowledge most certainly has a huge competitive advantage and in the case of the TARP warrants we believe it is a minority that understands the differences. All it takes is for the investor to read the relevant prospectuses.

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