Variant Perceptions

Category: Chou

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

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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Be greedy when others are fearful, Francis Chou edition

From his latest letter, Francis Chou seems keen on financials, retail and pharma equities, and for financials he discloses his thesis for stock warrants of large banks.

Medium banks were easier to understand and bound, so that is where I focused first, but TARP warrants was how I expected to buy large banks when things became more clear. And things are becoming clearer by the day.

Large banks are an opportunity that I have been procrastinating for quite a while, in particular Bank of America that looks very cheap at 0.5 BV and 3x PTPP earnings. Large banks are sound with strong balance sheets but it is difficult to pull the trigger when probably there are more surprises coming. Francis Chou conveniently lists some of these potential negative events.

This is not an original idea, everyone that has read You Can Be a Stock Market Genius will remember Joel Greenblatt’s discussion on the use of LEAPs (long dated call options) for situations with binomial outcomes like the Wells Fargo turnaround in the 1990s. Greenblatt liked very much Bruce Berkowitz’s WFC thesis but had similar concerns to Chou’s today on the transparency of the balance sheets. Greenblatt decided to buy LEAPs, because in case of a collapse both common stock and LEAPs were worth zero, but you can commit less capital with LEAP derivatives for a similar upside to the common stock so the payoff proposition was much better.

Chou’s decided instead to buy warrants and it might be an even safer bet. The expirations are much longer and they include some very interesting anti-dilution clauses negotiated by the federal government that the general investor can now enjoy. We should still remember though that the attractiveness of these instruments also depends on the price and upside expected for each specific bank.

This is the excerpt from Francis Chou’s letter:

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REVISITING THE BANKS:

In the 2006 annual report, we noted our alarm at the cavalier approach of financial institutions with regard to their lending standards, particularly to subprime borrowers. We also expressed concern with the widespread use of derivatives by financial institutions (…) Well, starting in 2007, financial institutions went through a cataclysm. Directly or indirectly, almost all of them had to be bailed out by the U.S. government. Looking back at the crisis, this is what we have observed:

  1. The U.S. government will not let major financial institutions fail.
  2. The financial institutions that survive will be the ultimate beneficiaries of any recovery in the economy.
  3. Interest rates will be kept at artificially low levels for the foreseeable future. The spreads between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. After being severely burned, they have tightened their lending criteria and have been extremely cautious with their lending practices. In general, the quality of loans now being made are quite high and for the first time in many years, banks are being paid handsomely according to the risks they are taking.
  4. Financial institutions in general are hoarding capital. This will provide them with ample cushion to absorb losses if a double dip recession were to occur.
  5. The books of financial institutions were carefully examined by all kinds of government agencies, including regulators, before the government allowed them to repay the U.S. Treasury under the Troubled Asset Relief Program (TARP).
  6. Most of the big banks are selling below 10 times their potential earning power in the future.

An Interesting Way to Invest in Banks

Please note: the investment described below is the view of the writer and should not be seen as a recommendation.

One of the more interesting ways to invest in the better capitalized banks is through the stock warrants that were issued to the U.S. Treasury by the banks when they received funds under TARP. The stock warrants give the holder the right to buy the bank’s stock at a specific price. When the banks repaid TARP funds to the U.S. Treasury, the U.S. Treasury either sold the stock warrants back to the banks or they auctioned them to the public.

So, what is so unique about these stock warrants?

  1. They are long dated, with most expiring in 2018 or 2019. This time frame of eight- plus years allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant.
  2. The strike price is adjusted downward for any quarterly dividend that exceeds a set price. Normally, you don’t see that in a stock warrant. This is a truly stringent condition. In this case we should give the government credit for extracting a pound of flesh. An example: for Bank of America, class ‘A’ warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent a share.
  3. Many of the banks have excess capital on their balance sheet. When the economy settles down, we expect the banks to use this excess capital either for buybacks or a one-time special dividend that may reduce the strike price on the stock warrants if this provision applies.
  4. The concerns over financial reform and its ultimate impact on the earning power of the banks may be somewhat exaggerated. We believe the banks will most likely be able to pass the majority of the costs to customers. For an economy to flourish we need sound financial institutions that can generate reasonable profits.
  5. Investing in financial institutions requires a leap of faith. Mind you, this leap of faith is no greater than those we make on any company’s future prospects, its position in the industry and how well it will do in a future economy. Looking forward, as each year goes by, the quality of earnings of the banks should be higher, the books should be cleaner, the risks will be lower and management will be far more risk averse. Too bad we had to go through so much turmoil to get there.

Below, August 13, 2010 prices of some banks stock warrants.

Even so, everything is not hunky dory for the banks. Banks face many issues and challenges. I have listed a few here:

  1. We still do not fully understand or trust the numbers
  2. Financial regulatory reform may reduce earning power
  3. New Basel rules may require more capital and reduce profits
  4. There may be a double dip recession
  5. The unemployment rate may go higher and create more defaults
  6. Commercial real estate prices may fall dramatically
  7. Banks are still not marking loans in their books properly
  8. Residential real estate prices may fall further
  9. States and municipalities are in bad shape

Our investing horizon is long-term – eight years or more for these bank warrants. Over that period, we believe the odds are it will work out to be decent investment – more so for the better capitalized banks. We view it as the glass being more than half full rather than being more than half empty.

No position