These Investments Warrant a Closer Look Part One: Insurance Companies
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When the subprime bubble imploded in late 2008, insurers of the bad debt were left scrambling for funds. As a lender of last resort, the federal government stepped in to rescue the companies to prevent a complete meltdown in the financial sector.
The agreed terms for most companies gave the government billions in preferred stock, with high interest rates and limited executive compensation within the companies. Needless to say, the companies wanted to remove this government stake as quickly as possible, and most did within the next few years. However, the government transactions have created another type of investment for ordinary investors to purchase: 10-year warrants.
Government sale warrants
The most common type of warrants created out of the bailouts have become known as TARP warrants. These warrants were given to the federal government as part of the bailout terms, and have since been sold to individual investors.
The Hartford Financial Services Group (NYSE: HIG) received a $3 billion bailout, but raised enough money later to buy back the government-owned preferred stock. But The Hartford had also given the government warrants to buy shares of its common stock at $9.79 per share.
What makes these warrants so attractive is the expiry date: June 26, 2019, leaving nearly seven years from today for the company to rebuild itself. With a book value of around $50 per share, these warrants could triple in value just by The Hartford rising to trade at a valuation similar to other insurance companies.
In addition, these warrants carry a very small time premium compared to the warrants of the even more bailed-out insurance company American International Group (NYSE: AIG). The Hartford warrants do not allow investors to leverage to the same extent as the AIG warrants. But an exercise price deep in the money, and a smaller time premium, reduce risks to buyers of these warrants.
Shareholder appeasement warrants
In the wake of AIG's colossal meltdown, more than 50 times as large as The Hartford's, the government acquired a 79.9% stake in the insurer. Along with the equity, the government also owned tens of billions of dollars in AIG preferred stock. In a plan to eliminate that preferred stock, the government would convert the preferred into even more common stock, increasing its stake to 92%.
AIG realized that it needed to do something to balance out the stock dilution that would result from this conversion. Their answer was an issue of warrants to existing non-government stockholders. The warrants were given a strike price of $45 per share and an expiry of Jan. 19, 2021, 10 years from the warrants' issuance.
With a strike price of $45, the AIG Warrants (NYSE: AIG-) are solidly out of the money based on the current share price. However, the book value of AIG exceeds this strike price, and a share price at book value would put the warrants well in the money.
The government also owns far less of AIG than it did a year ago, with the stake having fallen under 20% in the most recent share offering. When all of the government shares are sold, investors previously unwilling to invest in AIG may begin to build a stake, since the government uncertainty will have been fully removed. These warrants do have some strong buyers behind them -- notably Bruce Berkowitz, whose Fairholme Fund holds near a third of all outstanding AIG warrants, along with millions of shares of AIG common stock.
With the issuance of these warrants, investors now have the opportunity to leverage their exposure to companies for a long-term timeframe. Even most LEAPS are only good for a few years. With such a long time until expiration, these warrants still stand to gain if the economy remains stagnant in the near term, but grows in the long-term. While not without risks, the terms of these warrants make them compelling investments to those who would already be considering common stock in either of these companies.
TulipSpeculator1 has no positions in the stocks mentioned above. The Motley Fool owns shares of American International Group and has the following options: long JAN 2014 $25.00 calls on American International Group. Motley Fool newsletter services recommend American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.